Understanding VAT Schemes: Which One Is Right for Your Business?
When your business registers for VAT, you do not just get a VAT number, you also have to decide how you will account for the VAT you charge and pay. HMRC offers several different VAT accounting schemes, each designed to suit different types of businesses and cash flow situations.
Choosing the right scheme can improve your cash flow, simplify your bookkeeping, or even save you money. Choosing the wrong one can lead to unnecessary administrative headaches. This article explains the four main VAT schemes, Standard, Cash, Flat Rate, and Margin, and highlights a crucial trap for construction businesses using the Domestic Reverse Charge.
1. The Standard (Accrual) Scheme
This is the default scheme. If you register for VAT and do not actively apply for a different scheme, HMRC will automatically place you on the Standard Scheme.
Under this scheme, you account for VAT based on the invoice date, regardless of whether your customer has actually paid you yet.
How it works:
If you issue a VAT invoice on 30th March, you must include the VAT from that invoice on your March quarter VAT return and pay it to HMRC, even if the customer does not pay you until May. Conversely, you can reclaim VAT on your supplier invoices as soon as you receive them, even if you have not paid the supplier yet.
Who it is for:
This scheme is mandatory for businesses with a VAT taxable turnover exceeding £1.35 million. It is also beneficial for businesses that receive payment immediately at the point of sale (like retail shops) or businesses that buy a lot of goods on credit.
2. The Cash Accounting Scheme
The Cash Accounting Scheme is designed to help small businesses manage their cash flow. Instead of accounting for VAT based on the invoice date, you account for it based on the payment date.
How it works:
You only pay VAT to HMRC once your customer has paid you. If a customer makes a part-payment, you only pay HMRC the VAT proportion of that part-payment. The flip side is that you cannot reclaim VAT on your purchases until you have actually paid your suppliers.
Example:
Invoice is £1,200 (£1,000 net + £200 VAT at 20%). Customer pays £600.
The VAT element of that £600 receipt is: £600 × (200 ÷ 1,200) = £100 to HMRC
When the customer later pays the remaining £600, you’d account for the other £100 at that point.
Who it is for:
Businesses with an estimated VAT taxable turnover of £1.35 million or less. It is highly recommended for businesses that offer credit terms to customers, as it provides automatic bad debt relief, if a customer never pays you, you never have to pay the VAT over to HMRC.
An Important Note for Construction Businesses: Domestic Reverse Charge (DRC)
If your business operates in the construction industry and you carry out work subject to the VAT Domestic Reverse Charge (DRC), there is an important rule you need to be aware of.
You cannot use the Cash Accounting Scheme for any supplies or services that are subject to the DRC. Those transactions must be accounted for on the invoice date, using the Standard (Accrual) method.
However, and this is the key distinction — you can stay on the Cash Accounting Scheme for all your other, non-DRC transactions. For example, if you also supply services to private individuals or end users who are not subject to the reverse charge, you can continue to account for those on a cash basis.
In practice, this means a construction business on the Cash Accounting Scheme may need to account for two types of transaction differently within the same VAT return: DRC supplies on the invoice date, and all other supplies on the payment date.
Example of Invoicing:
1) If you are a subcontractor who is both VAT registered and CIS Registered and your contractor is also CIS registered and VAT registered – you should apply the CIS Labour Account code (which automatically applies the CIS deductions) and Domestic Reverse Charge at 20%
2) If you are a subcontractor that is both registered for CIS and VAT but your contractor is CIS registered but isn’t VAT registered, you would apply the CIS labour account code but the VAT rate would be the standard 20%
3) If your customer is not CIS registered, your sales code will be the standard sales code with VAT applied at the standard rate (20%) (in most cases)
A note for Xero users:
If you use Cash VAT in Xero, it is important to be aware that Xero will automatically include reverse charge invoices on the invoice date rather than the payment date on your VAT return. This is correct behaviour, but it is worth understanding so that your VAT return figures are not a surprise. If you are unsure how your Xero settings are configured, please get in touch and we can review this with you.
3. The Flat Rate Scheme
The Flat Rate Scheme is designed to simplify VAT record-keeping for very small businesses.
How it works:
Instead of calculating the exact VAT you have collected on sales and subtracting the exact VAT you have paid on purchases, you simply pay HMRC a fixed percentage of your total gross (VAT-inclusive) turnover. You still charge your customers 20% VAT, but you pay HMRC the lower flat rate percentage. You cannot reclaim VAT on your everyday business purchases (with a few exceptions for capital assets over £2,000).
Who it is for:
Businesses with a VAT taxable turnover of £150,000 or less (excluding VAT).
The rates:
The percentage you pay depends on your business sector. For example, a photographer pays 11%, a management consultant pays 14%, and a general builder pays 9.5%.
Note: If you spend very little on goods (less than 2% of your turnover or less than £1,000 a year), HMRC classes you as a “limited cost business” and you must use a punitive flat rate of 16.5%, which often makes the scheme financially unviable.
4. The VAT Margin Scheme
The VAT Margin Scheme is a specialist scheme for businesses that buy and sell second-hand goods, works of art, antiques, or collectors’ items.
How it works:
Normally, you charge VAT on the full selling price of an item. Under the Margin Scheme, you only calculate VAT on the **margin, **the difference between what you paid for the item and what you sold it for. You pay VAT at 16.67% (one-sixth) on this profit margin.
Who it is for:
Used car dealers, antique dealers, and second-hand retailers. You cannot use the Margin Scheme for new goods, or for goods where you were charged VAT when you bought them.
A Note on Making Tax Digital
Whichever VAT scheme you use, you must comply with Making Tax Digital (MTD) for VAT. This means you must keep digital records and submit your VAT returns to HMRC using MTD-compatible software. Modern accounting software can handle all of these schemes, including the complex DRC rules, provided it is configured correctly.
Additionally, the general rule of thumb is, without a valid UK VAT receipt/Invoice we have to zero-rare transactions when doing your bank reconciliation, as HMRC are cracking down and carrying out VAT inspections. So it is imperative that we receive VAT invoices/receipts for all business transactions in order to be able to claim back the VAT. Also you need to ensure that the invoice has a valid UK/GB VAT number on their invoices applied, especially with companies that may be providing services internationally to numerous foreign countries such as software providers like Dropbox, Microsoft, Adobe etc. Without a valid UK/GB VAT number, we are unable to claim the VAT back for you.
You can always check if a UK VAT number is genuine via the gov.uk website – https://www.gov.uk/check-uk-vat-number
We Can Help
Choosing the wrong VAT scheme can damage your cash flow or leave you paying more tax than necessary. If you are approaching the VAT threshold, or if you are already registered but think a different scheme might suit you better, we can help.
At Penney’s Accountancy, we review our clients’ VAT positions regularly. If you are a construction client affected by the DRC rules, or if you simply want to discuss your VAT options. Please get in touch.
Penney’s Finance School
For more practical guidance on managing VAT, cash flow, and the essentials of business finance, visit Penney’s Finance School. We offer a range of courses designed to empower small business owners with the financial knowledge they need to succeed.
Important Information: The information contained in this article is for general guidance only. It does not constitute financial or tax advice and should not be relied upon as such. Tax rules can change and the impact of any tax planning will depend on your individual circumstances. You should always seek professional advice tailored to your specific situation before taking any action.