VAT planning for contractors: quick-wins and where to beware

It’s a call to the chancellor which is sounded once if not twice a year and because it concerns VAT, limited company contractors might ordinarily get behind it because typically for them, VAT planning matters, writes Anthony Mellor, founder of Mellor & Co.

The £85,000 VAT threshold? It's not moved in forever

And the call comes before whichever is nearer at the time - Spring Budget or Autumn Statement. Its thrust is simple -- that the VAT registration threshold (£85,000 since what feels like forever -- April 1st 2017) should be increased to something much higher. It’s a quite understandable call, especially if you’re of the self-employed community but not of the contractor variant.

In fact, it’s well known that many one-person businesses (try to) avoid having to register for VAT simply because their customers are not VAT-registered. So for the striving solopreneur, registering with HMRC for VAT will cost 20% of their sales; where prices are probably already cut to the bone. And if a tiny trader increase their prices by that 20% as a result, then all their customers will potentially move to the trader’s competitor who isn’t VAT-registered. It's all about survival.

Contractor VAT plans aren't often higher registration threshold-related

In my experience, limited company contractors operating as IT contractors don’t typically have this ‘problem,’ because their clients are always VAT-registered and they simply add 20% VAT to their sales invoices. It’s simple, partly because nobody loses out but this is also why PSCs don’t feel obliged to echo those bi-annual calls to the chancellor for the VAT registration threshold to be hiked to above £85k.

One such call was sounded just last month, by the FSB, ahead of Spring Budget 2024.

What contractors I speak to are concerned about is that the VAT-man - aka Her Majesty's Revenue and Customs – is today the result of both the Inland Revenue and Customs & Excise jamming together as one entity. From what I still see, neither still really knows much about the other despite merging way back in 2005. My advice? Be distinctly aware of which you are dealing with.

The VAT Flat Rate Scheme (FRS)

Once upon time, VAT planning for contractors represented a bit of a sweet spot in the shape of the VAT Flat Rate Scheme.

But for limited company IT contractors, the FRS was pretty much written off as appealing by the introduction of the “low cost trader” criteria in early 2017, thanks to Autumn Statement 2016 courtesy of then-chancellor Philip Hammond.

Under this change, if you don't buy relevant goods that amount to more than two per cent or at least £1,000 in the VAT reporting period, then your percentage on the FRS is an immovable, unappealing, 16.5% of your VAT-inclusive sales.

Simplicity, exiting FRS, and the VAT Annual Accounting scheme

If your goal of VAT planning as a contractor is simplicity, then you’re probably not annoyed. In fact, the “low cost trader” criteria retains the advantage of simplicity – which you could argue that the HMRC scheme is all about in the first place.

But also under the change, contractors lose any reflection of the input tax recovery they might have expected. My recommendation? If you have input tax to recover, then exit the FRS entirely and opt for standard VAT treatment.

If you don't, or even if you do op for standard VAT, next consider the VAT Annual Accounting (AA) scheme.

Under the AA, you’ll file a VAT return only once a year -- with three on-account estimated payments each quarter (or month if you prefer). Again, if simplicity is your goal, then your VAT planning as a contractor might now be sorted.

Good luck trying to telephone HMRC about VAT planning

But if you’ve got VAT queries which you want to ask the taxman, beware. The process of asking HMRC anything non-urgent (that includes ‘tax-efficiency’ if you’re brave enough) has become difficult, ever since the department’s telephone helplines have become the pits. In my experience, even when the lines are technically open, it’s still hard to get an answer let alone a substantive, helpful, response. Oh, and writing a letter to HMRC gets no reply either (-- so far, many months later).

Central to VAT planning as a contractor is to be very aware of what HMRC calls ‘Disaggregation.’ It’s clear from a Contractors’ Question only this month that IT contractors like having more than one string to their bow and, ironically, the questioner had VAT on their mind. So it’s clear ‘Disaggregation’ is relevant.

HMRC & Disaggregation: explained

Why? Well, disaggregation is the framework HMRC has put in place to prohibit enterprise owners from artificially separating out two (or) more businesses, to avoid VAT payments or VAT registration, when those businesses are, in reality, a single entity.

To those of you who read this article’s introduction, you’re hopefully now (rightly) thinking that IT contractors seem to have more cause than they might realise to back those bi-annual calls to the chancellor to introduce a higher VAT threshold. If we did have a VAT threshold of, say, £100,000, then a fair few contractors might not need engage in any artificial separating out of their commercial activities.

Contractors and their so-called ‘second’ businesses

Indeed, too often, I’ve seen contractors try to create a second business which for all intents and purposes, really is just a part of their first business. But still they try to run their second business as either non-VAT registered, or under a different VAT scheme.

Pointing a disapproving finger and citing ‘Disaggregation,’ the VAT-man will likely call and inform you that these two commercial operations (typically one LTD and one sole trader), which you’ve separated out, are actually, in reality, the same business.

The ensuing HMRC demand? It can be huge, as it will be for all the VAT that went unpaid i.e. which you saved.

Not a single tick-box exercise if a VAT inspector calls

Be further aware, there isn’t just one box you’ll need your visiting VAT inspector to tick to leave you alone. In fact, HMRC’s guidance manual for its officials advises that, in determining whether your separation is artificial, the inspector should give due regard to the “financial, economic, and organisational” links which the two (or more) outfits appears to have with each other. There’s penalties and prosecution awaiting if you cannot disprove such links.

So disaggregation is not a simple matter; it’s a dangerous one. Almost needless to say, if you want your night-time app business to not be VAT-registered but your day-job as contractor limited company supplying IT project management services to be VAT-registered, the two businesses must be independent of each other in every way.

To get any deeper into VAT planning as a contractor – while still keeping on the right side of HMRC of course – speak to your accountant.

Tuesday 27th Feb 2024
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Written by Anthony Mellor

With over 46 years of professional experience, Anthony Mellor is an expert in accountancy and business consultancy, with a special focus on Excel. His practice Mellor & Co serves contractors, freelancers, small companies, sole traders, and partnerships, primarily in the UK. Anthony qualified as a chartered accountant in 1984 and today specialises in business risks, compliance and financial planning for firms wanting to thrive.

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