The Flat Rate Scheme (FRS) was introduced to make VAT reporting simpler for small businesses by eliminating the need to track and claim VAT on purchases. Instead, businesses apply a fixed rate of VAT (known as the flat rate percentage) on their total VAT-inclusive turnover.
We’ve already explored ‘What is the VAT Flat Rate Scheme (FRS) for Small Businesses: 8 Step Guide‘, it’s advantages, disadvantages and more.
But how do you operate the Flat Rate Scheme?
Let’s look in detail, how you manage and account for FRS through your business.
Don’t have time? Here’s the wrap-up of this article in less time it takes to eat a taco 🌮
▪ The Flat Rate Scheme (FRS) simplifies VAT accounting for small businesses.
▪ VAT liability is calculated using a fixed percentage on your business turnover.
▪ You can’t reclaim VAT on most business purchases, except capital assets over £2,000.
▪ Businesses must pick the most appropriate flat rate sector, and the correct percentage must be applied based on turnover.
▪ Limited cost traders face a higher 16.5% VAT rate.
▪ Operating under FRS means that special rules apply to the completion of VAT returns, specifically for boxes 1, 4, 6, and 7 (see step 10)
▪ n.b. Stay Sharp, Stay Savvy and Keep Winning.
Skip right to…
- Operating the Flat Rate Scheme (FRS) – The Basics
- 1- Let’s Start With An Example
- 2- Choosing an Appropriate Flat Rate Percentage
- 3- Multiple Business Activities & Potential Mistakes in Choosing the Right Sector
- 4- Determining Flat Rate Turnover
- 5- The Basic Turnover Method
- 6- The Cash-Based Turnover Method
- 7- Confusion Over the Cash-Based Turnover Method in Specific Situations
- 8- The Retailer’s Turnover Method
- 10- Keeping Records and Issuing Invoices
- 10- Completing a VAT Return Under the FRS
- 11- Practical Points for Operating the FRS
- Conclusion: Simplified VAT, but Not for Everyone
Operating the Flat Rate Scheme (FRS) – The Basics
1- Let’s Start With An Example
An accountancy business using the FRS would choose the ‘accountancy or book-keeping’ sector, with a flat rate percentage of 14.5%. If this accountant’s VAT-inclusive turnover is £120,000, their VAT due to HMRC would be £17,400. That’s calculated as £120,000 x 14.5%.
The benefit? You don’t need to keep detailed input tax records for most business purchases. However, the scheme does come with some complexities, like selecting the correct business sector and accounting for capital goods.
These nuances are particularly relevant when you have more than one business activity or if you meet the conditions for a ‘limited cost trader’ (read more about what is a limited cost trader).
2- Choosing an Appropriate Flat Rate Percentage
To operate the FRS, businesses need to choose the correct flat rate percentage based on their type of activity. HMRC provides a list of sectors, each with its own percentage, published on the gov.uk website.
The selection can sometimes be tricky, as some businesses may fit into more than one category. If so, HMRC accepts any choice that is ‘reasonable‘, provided a record of the decision is kept.
OMB Connect Pro Tip: Always keep documentation explaining your choice of category, and update it if your business activities change significantly.
3- Multiple Business Activities & Potential Mistakes in Choosing the Right Sector
If your business has multiple revenue streams, you must apply the flat rate percentage of the activity with the highest turnover. It’s essential to avoid splitting activities and applying multiple flat rates. The turnover with the highest percentage must dominate your calculations.
Choosing the wrong sector can have serious consequences. A lower rate than required could mean penalties and interest if HMRC catches the mistake. Conversely, a higher rate than necessary means you’re overpaying VAT.
If HMRC changes the rate for your business’s sector, you’ll need to apply the new rate immediately. This might mean calculating VAT using two different rates within a single VAT period: one for before and one for after the change.
4- Determining Flat Rate Turnover
Your flat rate turnover is crucial, as it determines your VAT liability. For example, if your turnover is £100,000 and you’re a limited cost trader using the 16.5% rate, your VAT due will be £16,500.
HMRC provides three calculation methods:
| Method | Description |
|---|---|
| Basic Turnover Method | Based on payment for supplies during the VAT period |
| Cash-Based Turnover Method | Based on payments received during the VAT period |
| Retailer’s Turnover Method | Based on ‘daily gross takings’ for retailers |
5- The Basic Turnover Method
When using the Flat Rate Scheme, turnover is calculated by adding up the VAT-inclusive value of all supplies that have their ‘tax point‘ within the VAT accounting period. The tax point refers to the time at which VAT is applied to a transaction, which is usually the invoice or payment date.
This method is particularly recommended for businesses that primarily supply goods or services to other VAT-registered customers. If your business can operate on an invoice-issued basis, this method would be the most appropriate.
The Time of Supply rules (commonly referred to as ‘tax points’) are critical for determining when VAT is due, and these rules are covered in more detail under HMRC’s general guidance on tax points.
6- The Cash-Based Turnover Method
For businesses opting for the cash-based turnover method, turnover is calculated based on the VAT-inclusive value of supplies for which payment has been received during the VAT accounting period.
This method is often chosen by businesses that prefer cash-based accounting due to its ability to manage cash flow more effectively.
Summary of how different types of payments are considered under the cash-based turnover method:
| Type of Payment | Payment Date |
|---|---|
| Cash (coins or notes) | The date the money is received |
| Cheques | The date the cheque is received or the date on the cheque (whichever is later) |
| Giro, standing order, or direct debit | The date the bank account is credited |
| Credit or debit card | The date a sales voucher for the card payment is made (not the date of actual receipt from the card provider) |
7- Confusion Over the Cash-Based Turnover Method in Specific Situations
There can be some confusion when operating the cash-based turnover method in certain circumstances.
For example, when a payment is received net of deductions (such as commission), the full amount before any deductions must be included in the flat rate turnover. Similarly, if a trader receives payments in kind—such as a barter or part exchange—the value of these transactions must also be included in the flat rate turnover. The payment is considered received when the goods or services are received in place of money.
This method can be particularly beneficial for businesses that experience a significant gap between invoicing and receiving payment.
For example, a business issuing invoices on 90-day terms could gain a cashflow advantage by adopting the cash-based turnover method, as the obligation to account for VAT would be deferred until payment is actually received, rather than at the point of invoicing.
8- The Retailer’s Turnover Method
For businesses that mainly sell goods directly to consumers, the retailer’s turnover method is often the most appropriate. Under this method, payments from customers are recorded as they are received, and daily takings are totalled.
The starting point for calculating these daily takings is the till roll or another sales record, which is then added to any other business income (such as rent) to determine the flat rate turnover.
summary of what should be included and excluded in daily takings under this method:
| Include in Daily Takings | Deduct from Daily Takings |
|---|---|
| Cash | Void transactions (e.g., an incorrect transaction) |
| Cheques | Illegible credit card transactions |
| Debit or credit card vouchers | Unsigned or dishonoured cheques from cash customers |
| Electronic cash (Switch, Delta, etc.) | Counterfeit notes |
| Full value of credit sales | Business owners float discrepancies (petty cash) |
| Value of payments in kind for retail sales | Till breakdowns (e.g., mechanical errors) |
| Face value of gift vouchers redeemed | Training till usage (where tills are reset) |
10- Keeping Records and Issuing Invoices
Businesses that use the flat rate scheme must still maintain detailed records.
Specifically, you need:
▪ A VAT account: This should include a record of the business turnover and the VAT calculated using the flat rate percentage.
▪ A record of flat rate calculations: This ensures accurate reporting in the VAT account. Any capital expenditure goods costing more than £2,000 should be included in the VAT account in addition to flat rate VAT.
Issuing Invoices Under the FRS
Even under the flat rate scheme, businesses must issue VAT invoices to their VAT-registered customers. Importantly, the VAT shown on the invoice should be the normal VAT rate for the supply, not the flat rate percentage used in calculating the business’s VAT liability.
10- Completing a VAT Return Under the FRS
| VAT Box Number | Description | FRS Special Rules |
|---|---|---|
| 1 | VAT due on sales | Include VAT calculated using the flat rate percentage and any VAT outside FRS (e.g., capital sales) |
| 4 | Total input VAT | Typically left empty, but use for claiming VAT on capital expenditure goods over £2,000 |
| 6 | Total value of sales | Include flat rate turnover plus any sales accounted for outside the FRS (e.g., capital goods) |
| 7 | Total value of purchases | Usually left blank unless claiming capital expenditure or including reverse charge transactions |
11- Practical Points for Operating the FRS
Choose your flat rate sector carefully. If there are multiple reasonable categories, consider selecting the one with the lowest percentage.
▪ Remember the 1% reduction in the flat rate for the first 12 months of VAT registration. Avoid applying this reduction beyond the first year.
▪ Keep track of changes in your business that could affect your flat rate category, especially if you begin or cease specific activities during the year.
▪ Be aware of the limited cost trader rules, as this designation can override your normal flat rate percentage.
▪ Ensure that all income, including exempt supplies like rent, is included in your flat rate turnover calculations.
▪ Choose the turnover calculation method best suited to your business needs—whether that’s the basic turnover method, cash-based method, or retailer’s turnover method.
▪ Special rules apply for bad debt relief when using the cash-based turnover method.
By understanding these detailed aspects of operating under the Flat Rate Scheme, businesses can maintain compliance while taking advantage of the scheme’s simplified VAT process.
Conclusion: Simplified VAT, but Not for Everyone
The Flat Rate Scheme offers simplicity but is not without its complexities.
Selecting the right sector, calculating turnover, and navigating the limited cost trader rules are crucial for avoiding costly mistakes. Always keep accurate records, consult with your accountant, and review your eligibility regularly to stay compliant and make the most of your VAT scheme.
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