Many small businesses use the VAT flat rate scheme (FRS) to simplify VAT reporting and some gain a cash advantage from using the scheme.
When using the FRS you simply multiply your gross sales (including VAT charged at normal rates) by the FRS percentage for your trade sector. You ignore VAT incurred on purchases, except for capital items costing £2,000 or more. The FRS percentage is set to take account of the VAT likely to be incurred on business expenses.
A business which incurs few expenses, and operates in a sector with a relatively low FRS percentage, will pay out less VAT to HMRC under the FRS, than outside the scheme. This is the cash advantage.
The Government is set to remove this cash advantage from 1 April 2017 by requiring low-cost traders to use a FRS percentage of 16.5% of gross sales. This is equivalent to 19.8% of net turnover, leaving almost no credit for VAT incurred on purchases.
You will be classed as a low-cost trader if your annual expenditure on goods (not services) is less than 2% of your gross turnover, or if more than 2%, less than £1,000 per year. This will discriminate against businesses who incur VAT on services such as rent, software licenses, IT support, digital journals, subcontractors, and telecoms.
Knowledge-based businesses such as consultants, journalists, estate agents and lawyers, may find it uneconomic to use the FRS. If you work in a knowledge-based trade, we should discuss whether you should withdraw from the FRS from April 2017 or even deregister from VAT.