Which VAT Scheme Should I Use for My Business?

VAT can be confusing, particularly when you first register.

One reason is that there isn’t just one way of accounting for VAT.

There are several VAT schemes available, but for many small businesses the three you’re most likely to come across are:

• Standard VAT accounting, often referred to as the accrual basis

• The Cash Accounting Scheme

• The Flat Rate Scheme

They work differently, particularly in terms of when you pay VAT to HMRC and how much VAT you can reclaim.

So which one should you use?

Standard VAT Accounting – The Accrual Basis

This is the normal method of accounting for VAT.

Broadly, you account for VAT on your sales when you issue your sales invoices, rather than simply waiting until your customer pays you.

Similarly, you can normally reclaim the VAT on qualifying business purchases based on your purchase invoices, assuming you have the appropriate VAT evidence.

For example, suppose during a VAT quarter you have:

VAT on sales: £10,000

VAT reclaimable on purchases: £4,000

You would normally pay the difference of £6,000 to HMRC.

If the VAT you’re entitled to reclaim exceeds the VAT you’ve charged, you may instead receive a VAT repayment.

The important issue from a cash-flow perspective is that you can potentially have to pay VAT to HMRC before your customer has actually paid you.

And that’s where the Cash Accounting Scheme can become attractive.

What Is the VAT Cash Accounting Scheme?

Under the Cash Accounting Scheme, the principle is slightly different.

You generally pay the VAT on your sales when your customers actually pay you.

But the other side of the equation changes as well.

You normally reclaim VAT on purchases when you actually pay your suppliers.

Imagine you issue an invoice for:

£10,000 + £2,000 VAT = £12,000

Under cash accounting, you don’t normally account for that £2,000 of VAT simply because you’ve issued the invoice.

You account for it when the customer pays you.

That can make a significant difference to cash flow if your customers take 30, 60 or even 90 days to pay.

Of course, the reverse also applies.

You can’t normally reclaim the VAT on your purchases until you’ve actually paid your supplier.

Who Can Use VAT Cash Accounting?

Cash accounting isn’t available to every business.

You can generally join the scheme if your estimated VAT-taxable turnover for the next 12 months is £1.35 million or less.

You would normally have to leave if your VAT-taxable turnover exceeds £1.6 million, although there are detailed rules around eligibility.

For many small businesses, however, the turnover limits aren’t going to be the deciding factor.

The more interesting question is whether cash accounting improves the cash flow of the business.

If your customers pay you quickly but you take longer to pay your suppliers, standard VAT accounting might actually be more attractive.

If your customers take a long time to pay you, cash accounting could be much more useful.

What Is the VAT Flat Rate Scheme?

The Flat Rate Scheme works differently again.

You still charge your customers VAT in the normal way – usually 20%.

However, instead of calculating the VAT payable to HMRC by deducting the VAT on every qualifying purchase from the VAT you’ve charged your customers, you apply a flat-rate percentage to your VAT-inclusive turnover.

The percentage you use depends on the type of business you operate.

For example, suppose you invoice a customer:

£10,000 + £2,000 VAT = £12,000

Under the Flat Rate Scheme, you apply your particular flat-rate percentage to the £12,000 gross amount to calculate the VAT you pay to HMRC.

You keep the difference between the VAT you’ve charged your customer and the amount you pay HMRC.

However, you generally cannot reclaim VAT separately on your purchases, although there are exceptions for certain capital assets.

Who Can Use the Flat Rate Scheme?

The Flat Rate Scheme is aimed at smaller businesses.

You can generally join if you expect your VAT-taxable turnover, excluding VAT, to be £150,000 or less in the next 12 months.

There are then separate rules determining when you have to leave the scheme.

Again, it’s important not to choose the Flat Rate Scheme simply because it sounds easier.

You need to look at the numbers.

What About Consultants and Businesses With Very Few Costs?

Historically, the Flat Rate Scheme could be particularly attractive to consultants, personal service businesses and other businesses with relatively few costs.

However, there is an important complication.

The limited cost trader rules can require businesses with very low expenditure on qualifying goods to use a flat rate of 16.5%.

Because that percentage is applied to VAT-inclusive turnover, much of the potential financial benefit of using the Flat Rate Scheme can disappear.

So I wouldn’t automatically assume that the Flat Rate Scheme is best simply because you’re a consultant with very few expenses.

You need to do the calculation.

Which VAT Scheme Is Best?

There isn’t one answer for every business.

Standard VAT accounting may be perfectly suitable if your customers pay promptly and you have significant VAT-bearing expenses.

Cash accounting can be attractive if your customers take a long time to pay because you aren’t generally funding the VAT before you’ve received the money yourself.

The Flat Rate Scheme can simplify VAT accounting for some smaller businesses, but you need to consider your particular flat-rate percentage and whether the limited cost trader rules apply.

There are also other VAT schemes available for particular businesses and industries.

The important point is that being VAT registered doesn’t necessarily mean that every business should account for VAT in exactly the same way.

Don’t Choose a VAT Scheme Just Because It’s Simpler

When deciding which VAT scheme to use, I’d look at several things.

How quickly do your customers pay you?

How quickly do you pay your suppliers?

How much VAT do you normally reclaim on your expenses?

What type of business do you operate?

What Flat Rate Scheme percentage would apply?

And, perhaps most importantly, what effect will the different schemes have on your cash flow?

Modern accounting software has made VAT administration considerably easier than it once was.

So I’d be more interested in choosing the scheme that suits the economics and cash flow of your business rather than simply choosing the one that appears to involve the least bookkeeping.

The Bottom Line

The three VAT methods many small businesses are most likely to encounter are standard VAT accounting, cash accounting and the Flat Rate Scheme.

They can produce very different results, particularly when it comes to cash flow and the timing of VAT payments.

If you’re VAT registered or approaching VAT registration, don’t simply assume the standard scheme is your only option.

Look at how your business actually operates and run the numbers before deciding which VAT scheme is most appropriate.

Sometimes a relatively simple change in the way you account for VAT can make a noticeable difference to your business’s cash flow.

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Paul Marks & Co Chartered Accountants
Wimbledon, London

If you’d like to discuss VAT registration or which VAT scheme may be appropriate for your business, please get in touch for a no-obligation conversation.