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A contractors guide to VAT

Value Added Tax (VAT) is a standard consumption tax levied on almost all goods and services in the UK. If you’re a contractor, working through your own Limited Company, registering for VAT could significantly improve your tax efficiency.

An introduction to VAT

VAT is something we’re all at the very least aware of. It’s a standard consumption tax added to the cost of most goods and services, for both business to business and business to consumer markets. In the UK, VAT is most commonly set at a standard rate of 20% of the cost of purchases. However, there are exceptions which are eligible for a reduced rate (5%) or are zero-rated (0%).

Registering for VAT

Matt Poyser from inniAccountsBy Matt Poyser, who now writes for Listentotaxman.com on matters relating to contracting and limited company taxes.

Matt is a previous contractor with a wealth of experience and the Director of Client Experience at inniAccounts (an accountancy service tailored for contractors, consultants and freelancers).

Have a question? inniAccounts are happy to help Listentotaxman visitors with any queries,
simply contact them here.

If your limited company has a gross income of £85,000 or more per year (the VAT threshold for the 2018/19 tax year) you must register for VAT and make the appropriate charges to your clients or run the risk of being fined. It’s important to note that the VAT threshold changes, be sure to check the threshold each year on the HMRC website to see if your company’s situation has changed.

If you expect your taxable turnover to be below the threshold, you can still register voluntarily. For many contractors this is an option well worth considering.

Assuming you’re registered to the standard rate VAT scheme; VAT is charged on top of your net invoice amount – for example if you charge a client for 10 days work at £200 per day your invoice will total £2,400 including VAT (at 20%). As well as charging clients VAT you can also claim back the VAT from purchases your company makes – you only pay the difference between the VAT you charge to your clients and the VAT you pay via purchases.

If you choose to become VAT registered, it’s important that you keep thorough records of all sales and purchases, even those that were created in error or later cancelled. You will also need to provide VAT invoices to your business clients. There are certain pieces of information that are required on a VAT invoice listed by HMRC here.

Advantages of registering

Being VAT registered is often advantageous as it allows you to recover VAT on your business expenditure. Day to day, you will incur expenses including VAT (such as purchasing a new business laptop), being registered will allow you to lower your tax bills and improve your tax efficiency. Being VAT registered is a great way to convey a professional image for your company and show greater financial stability to potential clients. When looking for contracts, many businesses will specify that they will only engage with limited companies who are registered.  Just as you are able to claim back the VAT you have incurred, your clients will also have the opportunity to claim back the VAT on your invoices - so they won’t be put off by the extra VAT charges.

Disadvantages of registering

If the majority of your clients are consumers, or very small businesses rather than VAT registered businesses (e.g. the general public, charities, some public sector organisations), there may be price sensitivity issues. Being VAT registered means you need to charge your customers VAT, probably at 20%. Your competitors, if not VAT registered, would be at a significant advantage by being able to charge customers less. If this is the case, adding VAT may price you out of the market. If you’re unsure if registering for VAT is the right decision for your limited company, it’s best to discuss this with your accountant.

Choosing a VAT scheme

There are several VAT schemes contractors can register to, including; the standard rate VAT scheme, VAT flat rate scheme, annual accounting VAT scheme and cash accounting scheme, though the latter two are less widely used by small businesses.

It’s important to occasionally review the VAT method used by your company; this will both help you to stay on top of any VAT rate changes and keep your tax bill as low as possible. For example, consider if you would be better moving away from flat rate VAT to the standard or cash accounting scheme or vice versa.

Flat Rate VAT Scheme

The VAT Flat Rate Scheme (FRS) was introduced by HMRC as a way to simplify the process of paying and reclaiming VAT for small businesses who may not have a large turnover. The FRS sets a fixed rate of VAT for businesses to pay to HMRC and businesses do not reclaim VAT on their purchases (except certain capital). This means that businesses do not need to work out the difference in VAT received from customers and VAT spent on business expenses, they simply pay a fixed amount.

While the FRS has typically been the scheme of choice for small businesses to pay and reclaim VAT, changes introduced in April 2017 to limit potential abuse of the scheme and ensure all businesses paid the appropriate taxes, has made FRS less beneficial for contractors. The introduction of a new flat rate category, the Limited Cost Trader (LCT), sets a rate of 16.5% for businesses whose VAT eligible expenditure on goods is:

  • Less than 2% of their VAT inclusive turnover, or
  • Less than £1,000 in total per year

The key change here is the definition of goods. When working out the amount spent on goods, it cannot include purchases of any capital expenditure (i.e. asset purchases), food or drink, or vehicles and fuel. This definition also excludes the purchase of services such as hosting fees, subscriptions to online journals, phones, email, insurances, accountancy fees, associate fees.

For many contractors falling into the LCT category, they could potentially end up worse off financially if they opt to use the FRS.

Standard Rate VAT Scheme

The standard VAT scheme is how the majority of VAT in the UK is paid, particularly in big businesses. Under the standard rate scheme, businesses deduct the VAT they have paid on goods and services from the VAT they have charged customers, and the difference is then paid to HMRC. The process for this involves manually reclaiming the VAT for each eligible item that is bought or sold and paying VAT at a rate of 20% to HMRC. With the help of online accounting software, the standard VAT method is easy and straightforward to manage.

Reclaiming VAT on expenses

While reclaiming VAT on your expenses may sound like extra hassle, as long as you’re keeping accurate and complete records it’s very straightforward. Reclaiming VAT on expenses is done by submitting a VAT return to HMRC, usually every 3 months (quarterly), this will include elements of your VAT records such as total sales and purchases, the amount of VAT owed and the amount of VAT you can reclaim.

Some supplies you are likely to use that incur VAT include; accountancy fees, fuel, large hotel and restaurant chains, multistory car parking and most purchases from large UK suppliers. You can also reclaim VAT on your business mileage. VAT is only claimable on mileage for a car or motorbike that uses petrol, diesel or gas. You can not claim back VAT on fully electric vehicles. VAT also can’t be claimed back on business entertaining expenses.

VAT rate can commonly be found on your purchase receipts, the main rates are:

  • Standard (20%): The VAT rate charged on most expenses
  • Exempt: Bank charges, postage, insurance, and mortgage interest
  • Zero: Train tickets, flights, books, newspapers, food
    (except hot prepared food to eat in or takeaway which is standard rated)
  • Reduced (5%): Domestic fuel & power, energy saving materials

Don’t forget that with any VAT claim, you should have a corresponding receipt with enough VAT to cover the claim; this includes any fuel receipts. You can’t reclaim VAT using an invalid invoice, a proforma invoice, statement or delivery note.

Please note: if you use the VAT Flat Rate Scheme, VAT is not reclaimed on individual expenses; it’s calculated using the flat rate percentage for your business type and recording individual expenses won’t influence your VAT calculations and return directly.

VAT returns

If your company is VAT registered, then you need to submit a VAT return to HMRC every quarter, even if you have no VAT to pay or reclaim. The VAT return will include the total amount that you have charged in VAT for the period and the amount of VAT that you have incurred on company purchases. Once the return is submitted to HMRC they will review your information. If your charged VAT exceeds your incurred VAT you’ll need to pay the difference, if not you will be entitled to a refund. You may also be able to claim back VAT on costs that you incurred before you registered for VAT provided that you have the correct records and meet all the requirements. Many accountants will process VAT returns for you as part of their service, be sure to check out what’s included in your accountancy package when you sign up.

Next steps

Registering and ensuring you stay on top of your VAT admin could make your limited company significantly more tax efficient. Calculating your charged and reclaimed VAT may seem like a bother and just more admin to take up your time. But, charging VAT at the correct rate, calculating the correct reclaim amounts and submitting your return can all be easily handled by a specialist contractor accountant, leaving you with a clear picture of what your incoming VAT bill will always be.

Matt Poyser from inniAccountsBy Matt Poyser, who now writes for Listentotaxman.com on matters relating to contracting and limited company taxes.

Matt is a previous contractor with a wealth of experience and the Director of Client Experience at inniAccounts (an accountancy service tailored for contractors, consultants and freelancers).

Have a question? inniAccounts are happy to help Listentotaxman visitors with any queries, simply contact them here.

This article was published in our Guides section on 08/01/2019.

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