Value Added Tax (VAT) can be a complex area for many businesses. Choosing the right VAT scheme can significantly affect your cash flow and compliance requirements. This article will guide you through the various VAT schemes available, helping you determine which one might be the best fit for your business.
Accruals Basis (Standard VAT Accounting)
The Accruals Basis, also known as Standard VAT Accounting, is the traditional method of accounting for VAT. This scheme requires businesses to account for VAT at the point of invoice issuance or receipt, rather than when the payment is made. It is a mandatory scheme for businesses that do not qualify for or choose not to opt into other VAT schemes.
How the Accruals Basis works
Under the Accruals Basis, VAT is recognised at the time an invoice is issued for a sale or purchase, regardless of when a payment is made or received. This means you record the VAT on sales in the period when the invoice is issued, and you can reclaim VAT on purchases in the period when you receive the invoice, not when you pay the supplier.
Key features
- Invoicing and VAT liability. When you issue a sales invoice, you account for the VAT at the point of issuing, regardless of when the customer pays. Similarly, when you receive a purchase invoice, you account for the VAT at the point of receiving the invoice, even if you pay the supplier later.
- VAT returns. Businesses must submit VAT returns typically on a quarterly basis, although monthly returns are also possible. VAT returns must detail all the VAT you have charged on sales and all the VAT you have paid on purchases during the period.
- Compliance and record-keeping. Businesses need to keep records of all invoices issued and received, as well as other documents relevant to VAT transactions.
Advantages of the Accruals Basis
- Aligns with standard accounting practices. For companies already using accrual accounting for financial reporting, using the Accruals Basis for VAT is straightforward as it aligns with their existing accounting methods.
- VAT recovery timing. Businesses can reclaim VAT on purchases as soon as they receive the invoice, which can help manage cash flow, particularly for large purchases.
Disadvantages of the Accruals Basis
- Adverse cash flow impact. Since VAT is accounted for when invoices are issued rather than paid, businesses might face cash flow challenges if there are delays in receiving payments from customers.
- Bad debt risk. If a customer fails to pay an invoice, the business is still liable for the VAT on that sale, which can lead to financial losses unless they qualify for VAT Bad Debt Relief.
Is the Accruals Basis right for your business?
The Accruals Basis is generally suitable for businesses that:
- Have consistent and predictable cash flow, allowing them to manage the timing difference between invoicing and payment.
- Are already using accrual accounting methods for their financial reporting.
However, businesses with irregular cash flow or high levels of unpaid invoices might find this scheme less advantageous. In these circumstances, exploring alternative VAT schemes like the Cash Accounting Scheme might be beneficial.
Cash Accounting Scheme
The Cash Accounting Scheme is an alternative method of accounting for VAT, designed to help improve cash flow for small businesses. Under this scheme, you account for VAT on your sales and purchases based on when you receive and make payments, rather than when invoices are issued or received. This can be particularly beneficial for businesses with clients who delay payments or where cash flow management is crucial.
How the Cash Accounting Scheme works
Under this VAT scheme, VAT is only accounted for when payments are received from customers or paid to suppliers. This contrasts with the standard Accruals Basis, where VAT is accounted for based on the invoice date. This method ensures that you do not have to pay VAT to HMRC until you have received payment from your customers, which can significantly aid cash flow management.
Key features
- VAT on sales. You only account for VAT on sales when your customers pay you. If a customer delays payment, you do not have to pay VAT until the payment is received.
- VAT on purchases. Similarly, you can only reclaim VAT on your purchases when you have actually paid your suppliers. This ensures that your VAT liability aligns with your cash flow.
- Eligibility. To join the Cash Accounting Scheme, your estimated VAT taxable turnover must be £1.35 million or less in the next 12 months. If your turnover exceeds £1.6 million, you must leave the scheme and revert to the standard Accruals Basis.
Advantages of the Cash Accounting Scheme
- Improved cash flow. You only pay VAT once you have received payment from your customers, which can significantly help with cash flow management, particularly for businesses with delayed payment cycles.
- Bad debt relief. There is no need to account for VAT on bad debts, as VAT is only paid once the payment is received. This reduces the financial risk associated with unpaid invoices.
Disadvantages of the Cash Accounting Scheme
- Delayed VAT reclaims. You can only reclaim VAT on purchases once you have paid your suppliers. If you have significant upfront costs, this delay can impact your cash flow negatively.
- Suitability. The scheme may not be suitable for businesses with high volumes of cash sales or those that receive payments upfront, as the cash flow benefit is less pronounced.
- Turnover Limit. Businesses with a turnover exceeding £1.35 million cannot join the scheme, and those whose turnover grows beyond £1.6 million must leave it, necessitating a change in VAT accounting processes.
Is the Cash Accounting Scheme right for your business?
The Cash Accounting Scheme is particularly beneficial for:
- Small businesses with a turnover under £1.35 million.
- Businesses that experience delayed payments from customers and need to manage cash flow carefully.
- Businesses that want to avoid the complexity and financial risk associated with accounting for VAT on bad debts.
However, businesses that regularly pay suppliers before receiving payment from customers, or those with significant upfront costs, might find the delay in reclaiming VAT to be a disadvantage. Additionally, businesses nearing the turnover threshold for the scheme should consider the potential impact of having to switch to the standard VAT accounting method if their turnover increases.
The Flat Rate Scheme
The Flat Rate Scheme (FRS) is designed to simplify VAT accounting for small businesses. It offers an easier way to manage VAT by reducing the amount of record-keeping and calculations required. Here, we’ll dive deeper into how the Flat Rate Scheme works, its benefits, potential drawbacks, and who it’s best suited for.
How the Flat Rate Scheme works
Under the Flat Rate Scheme, businesses pay a fixed rate of VAT to HMRC based on their total VAT-inclusive turnover. This rate is determined by the type of business you run and is lower than the standard VAT rate to account for the VAT that businesses usually reclaim on their purchases.
Key features
- Fixed rate calculation. The fixed percentage rate is determined by HMRC and varies by industry. For example, a pub has a flat rate of 6.5%, while a business consultant has a rate of 12%. You apply the rate on your VAT-inclusive turnover. This means you calculate the VAT due by multiplying your total sales including VAT by your flat rate percentage.
- VAT invoicing. You still charge your customers the standard VAT rates (20%, 5%, or 0% depending on the goods/services). Rather than accounting for VAT on each purchase, you pay HMRC a percentage of your gross turnover.
- Limited reclaim on purchases. Generally, you cannot reclaim VAT on most purchases. However, you can reclaim VAT on capital assets worth £2,000 or more, including VAT, if they are a single purchase of capital goods.
- Eligibility and joining. To be eligible, your VAT turnover (excluding VAT) must be £150,000 or less in the next 12 months. Once you join, you must leave the scheme if your turnover (including VAT) exceeds £230,000.
Advantages of the Flat Rate Scheme
- Simplified record-keeping. The primary advantage is reduced administrative burden. You don’t need to record VAT on every transaction or keep detailed records of the VAT you pay on purchases.
- Predictable VAT payments. Knowing your flat rate percentage allows for more predictable cash flow management, as you pay a consistent rate on your turnover.
- Reduced risk of errors. Simpler calculations mean there’s less risk of making mistakes in your VAT returns, which can save time and avoid potential penalties.
- Cash flow advantages. Some businesses may end up paying less VAT overall compared to standard VAT accounting, especially if they have few VAT-able purchases.
Disadvantages of the Flat Rate Scheme
- Limited VAT reclaim. The inability to reclaim VAT on most purchases can be a disadvantage if your business has significant VAT-bearing expenses.
- Not always cost-effective. If your business has high input costs, the flat rate scheme might result in paying more VAT than under the standard scheme, where you can reclaim input VAT.
- Sector-specific rates. The fixed rate varies by business type, and if your business’s expenses don’t align well with the flat rate, it might not be beneficial.
- Annual review requirement. You need to monitor your turnover to ensure you remain within the scheme’s eligibility criteria. Exceeding the turnover limit requires you to leave the scheme, which can be disruptive.
Is the Flat Rate Scheme right for your business?
The Flat Rate Scheme is beneficial for:
- Businesses with lower VAT-able expenses such as consultants, IT professionals, and freelancers can benefit due to fewer reclaimable purchases.
- If your business doesn’t have significant input costs, the flat rate can simplify VAT calculations and potentially save money.
- Those looking for simplified accounting processes and predictable VAT payments will find the scheme advantageous.
However, businesses with substantial VAT-bearing expenses might find the inability to reclaim VAT a significant disadvantage. Additionally, businesses nearing the turnover threshold for the scheme should consider the potential impact of having to switch to a different scheme listed above if their turnover increases.
The Annual Accounting Scheme
The Annual Accounting Scheme (AAS) is designed to ease the administrative burden for businesses by allowing them to file one VAT return per year instead of the usual quarterly returns. This scheme can simplify cash flow management and reduce the frequency of VAT paperwork. Here, we’ll explore how the Annual Accounting Scheme works, its benefits, potential drawbacks and who it’s best suited for.
How the Annual Accounting Scheme works
Under this VAT scheme, businesses make advance VAT payments based on their estimated VAT liability for the year. These payments can be made either monthly or quarterly. At the end of the year, a final balancing payment is made when the annual VAT return is submitted.
Key features
- Interim payments. Businesses make nine monthly payments or three quarterly payments throughout the year. These payments are based on an estimate of the previous year’s VAT liability or, for new businesses, an estimate of the first year’s VAT liability.
- Annual VAT return. Only one VAT return is submitted at the end of the year. This return will include the actual VAT liability for the year, and a final balancing payment (or refund) is calculated based on the difference between the interim payments and the actual VAT due.
- Eligibility and joining: Your estimated VAT taxable turnover must be £1.35 million or less. You can join the scheme if you expect your turnover to be within this limit. If your turnover exceeds £1.6 million, you must leave the scheme.
Advantages of the Annual Accounting Scheme
- Reduced frequency of returns: Filing only one VAT return per year significantly reduces the administrative burden associated with quarterly VAT returns.
- Improved cash flow management. Spreading VAT payments throughout the year with predictable interim payments can help businesses manage their cash flow more effectively.
- Simplified administration. The scheme reduces the frequency of detailed VAT calculations and paperwork, freeing up time and resources for other business activities.
- Flexibility for small businesses. The AAS offers flexibility and can be particularly advantageous for businesses with seasonal fluctuations in income, as they can adjust their cash flow to match their revenue patterns.
Disadvantages of the Annual Accounting Scheme
- Large balancing payment. If interim payments have been underestimated, a significant balancing payment may be required at the end of the year, which could be a financial strain if not anticipated.
- Less frequent monitoring. Less frequent VAT returns mean less frequent monitoring of VAT liabilities. This could lead to unexpected financial surprises if the interim payments do not accurately reflect the actual VAT liability.
Is the Annual Accounting Scheme right for your business?
The Annual Accounting Scheme is ideal for:
- Businesses with a steady cash flow and a turnover below £1.35 million can benefit from reduced administrative tasks and improved cash flow management.
- Those with fluctuating income levels throughout the year can find the flexibility of the AAS beneficial for aligning VAT payments with their revenue cycles.
- Companies with stable and predictable sales patterns can accurately estimate their annual VAT liability, making the AAS a good fit.
However, new businesses may find it challenging to estimate their VAT liability without historical data and could face large balancing payments, putting their cash flow at risk. Businesses with highly variable expenses may find it difficult to accurately estimate their VAT liability, leading to cash flow issues. Furthermore, rapidly growing businesses might exceed the turnover threshold quickly, necessitating a switch back to the standard VAT accounting scheme, which can be disruptive.
Other VAT Schemes
Retail Schemes
VAT retail schemes can simplify the VAT process for the retail industry; however, there are a few of them to choose from. The right scheme for your business depends on how you operate, and what your retail net turnover (excluding VAT) is. For instance, you can only use the Point-of-Sale Scheme if you identify and record VAT at the point that you make a sale, whereas the Apportionment Scheme is available if you buy goods for resale.
In certain circumstances, you can combine a retail scheme with the Cash Accounting Scheme or the Annual Accounting Scheme. Although, there are separate rules for caterers, pharmacists and florists. The good news is, Taxsure is here to help guide you through these complexities. Click here to get in touch with our expert VAT accountants.
Second-hand Margin Scheme
The VAT Second-hand Margin Scheme can be used by business owners who sell second-hand goods, works of art, antiques and other collectors’ items. The scheme taxes the difference between what a business has paid for an item and how much it sold it for (instead of taxing the full selling price).
There are some exceptions to this scheme. These include investment in gold, precious metals and stone, and any purchases for which you were charged VAT. There are also special considerations regarding auctions, second-hand vehicles, horses and ponies, and pawnbrokers.
Tour Operators Margin Scheme (TOMS)
TOMS was designed to simplify the VAT accounting process for tour operators. It works by allowing businesses to account for VAT on the margin between the cost of buying accommodation services and the price they sell them for. This contrasts with the standard VAT accounting method, where VAT is calculated on the full selling price of the service. However, the scheme can also benefit businesses within the Serviced Accommodation industry. We have a dedicated article on this topic which you can read by clicking here.
In conclusion
The best VAT scheme for your business depends on various factors, including the nature of your business, turnover, cash flow, and administrative capacity. Here are some general guidelines to help you decide:
- Accruals Basis: Best for businesses with stable cash flow and sufficient administrative resources.
- Cash Accounting Scheme: Ideal for small businesses with cash flow concerns and turnover under £1.35 million.
- Flat Rate Scheme: Suitable for small businesses seeking simplified VAT calculations and with turnover under £150,000.
- Annual Accounting Scheme: Good for businesses that prefer to manage VAT with annual planning and consistent cash flow.
At Taxsure, we can provide tailored advice based on your specific circumstances to help you choose the right VAT scheme for your business.
Click here to contact our specialist VAT accountants. A member of our team will be in touch with you discuss your options.