When your business is registered for VAT, it must charge output VAT on all its taxable sales, and can reclaim some of its input VAT too. But how is that VAT then paid over to HMRC? Emily Coltman ACA, Chief Accountant to FreeAgent – who provides an online accounting system for small businesses and freelancers – explains how to work out VAT.
On a regular basis (usually quarterly, but sometimes annually and very occasionally monthly), a VAT-registered business must work out how much VAT it owes HMRC for the period in question (usually 3 months), fill in these calculations on a form called a “VAT return”, and pay anything that is owed. But the calculations can be done in several different ways.
Also called the “standard method”, here’s how to work out invoice accounting for VAT. You add up all the output VAT for the invoices you’ve issued to customers dated during the VAT quarter – regardless of whether your customer has actually paid you for that invoice – to get your figure for total output VAT for that quarter’s VAT return.
Then, to work out your input VAT, you add up all the input VAT on invoices that your suppliers have given you which are dated during that quarter, whether or not you’ve already paid the supplier.
The difference between the output VAT and the input VAT is what you pay to HMRC for that quarter. Invoice accounting is advantageous if your customers all pay you on the nail, as is the case for retail businesses, because you may be able to reclaim input VAT before you pay your suppliers.
But if you have customers who are often late in paying, then invoice accounting could be bad news for your cashflow because you could have to pay HMRC before your customers pay you. And if your customer doesn’t pay you at all, then you have to wait at least 6 months from the date of the invoice before you can ask HMRC to pay you back that VAT by means of “bad debt relief”.
HMRC offer an alternative calculation method called “cash accounting”. Under this scheme, you need only include output VAT on your return when customers have paid you for their invoices. However, you also only get to reclaim input VAT once you’ve paid your suppliers.
Not everyone can use the cash accounting scheme.
You don’t have to apply to HMRC to use it, but you can’t use it if your VAT taxable sales are more than £1.35 million a year, or if you’ve been convicted of a VAT offence or charged a penalty for VAT evasion in the last 12 months.
You also can’t use cash accounting if your VAT returns and records aren’t up to date. Once you’ve started using cash accounting you can go on using it until your annual VAT taxable sales reach £1.6 million – then you’ll have to start using invoice accounting.
HMRC designed the VAT flat rate scheme as a way to save record-keeping for the smallest businesses. Under the flat rate scheme, you work out what’s payable to HMRC in VAT in a very different way.
You add up all your sales, including the output VAT you’ve charged, and including exempt sales (though not sales that are outside the scope of VAT). Then you multiply that figure by a percentage, which is called your flat rate percentage.
The resulting figure is what you pay to HMRC.
There’s no input VAT to reclaim, except in some circumstances which we’ll look at in a moment.
The flat rate percentages are set by HMRC and depend on what your business’s trade is – for example, if you’re running a farm, your flat rate percentage would be 6.5%.
The percentages are set as they are because different trades usually incur very different amounts of input VAT.
Farms have a lot of costs, so their percentage is low to take into account the input VAT they could claim if they weren’t on the flat rate scheme.
The flat rate percentage for a management consultant, on the other hand, is 14%, because this individual is selling his or her own services and won’t have many costs on which they would normally reclaim input VAT.
You can only reclaim input VAT on the flat rate scheme under a small number of circumstances, of which the most common is if you spend more than £2,000 (including VAT) in one go on a large piece of equipment for your business (a “capital asset”).
You have to apply to HMRC to join the flat rate scheme and be accepted before you can actually start using it.
Only businesses with annual VAT taxable turnover (using the normal way of working this out, i.e. including standard-rated, reduced-rated or zero-rated sales only) up to £150,000 a year can join the flat rate scheme, but once you’ve joined you can remain in the scheme until your total business income goes over £230,000 a year.
The VAT flat rate scheme isn’t designed to save small businesses money, though in some cases it can. It’s important to work with your accountant and choose the best scheme for your particular business needs.
Using an online accounting system – such as FreeAgent – can also help, because it will fill in your VAT return correctly whether you are invoice accounting or cash accounting.
It also seamlessly handles the flat rate scheme and automatically posts the required accounting entries for that. Make sure you choose the right scheme for your business.
* Emily Coltman ACA is Chief Accountant to FreeAgent, who provides an online accounting system designed to meet the needs of small businesses and freelancers. Try it for free at www.freeagent.com.