How much VAT do contractors pay?

A looming VAT bill and the sense of dread that comes with it is steeped into the subconscious of our small company culture here in the UK.

But does that need to be the case? In short, for a contractor, no it does not, writes Christian Hickmott, managing director of Integro Accounting.

‘How much VAT do contractors pay?’ is a fair query, but first…

Before I answer the often-asked ‘How much VAT do contractors pay?,’ let’s put this tax which was first introduced in the UK in 1973 into a contractor setting, here in 2024-25.

A VAT-registered business, such as a contractor limited company, collects VAT on top of their sales invoicing and passes that Value Added Tax on to HM Revenue & Customs.

VAT is simply added to each sales invoice and such VAT is then collected later down the line by HMRC through the VAT return.

As most contracts are business-to-business the contractor’s client can usually reclaim that VAT themselves -- through their own VAT return. It is therefore rare for a contractor to have to consider VAT as part of their pricing policy.

What are the advantages of VAT registration?

The advantages of VAT registration are two-fold to a contractor:

1. Financial

A VAT-registered business reclaims the VAT paid on eligible business expenses through their VAT return; significantly reducing the cost of purchases.

An almost universal expenditure for contractors will be an accountancy fee so, taking our Integro Prime package as an example, a business that is not VAT registered would pay the gross amount of £132 per month while a VAT-registered business would be able to reclaim £22 of that payment -- with the overall cost then being reduced to the net amount of £110 per month. Over the course of the year, these small amounts do add up!

It is often possible to reclaim business expenses prior to the company’s registration; going back up to four years for goods; but just up to six months for services.

2. Credibility

A VAT registration can lend credibility to a business in the eyes of prospective clients, banks and even lenders.

Whether this is fair is a debate for another time!

But this credibility boost remains a draw to registering with HMRC for VAT nonetheless. Perhaps for that reason VAT-registration is often a prerequisite to a contractor’s engagement with a client IN 2024-25.

Benefits of being VAT-registered

Now that we have established that VAT does not cost contractors anything, it’s best we tackle “How much VAT do contractors pay?” on its head and, keeping in mind the advantages mentioned above, pinpoint a few benefits from being VAT registered.

Generally speaking, these advantages of being VAT registered will depend on the type of VAT scheme that your business signs up for, so let’s take a closer look at those options:

1. HMRC standard VAT scheme

The standard VAT scheme is the one most contractor business owners will instinctively bring to mind when thinking of VAT. At its most basic, VAT is added to your sales invoice and that VAT is then paid over to HMRC, less any VAT incurred on business expenses.

So on the standard VAT scheme, your client pays VAT in addition to your billed time on your sales invoice, but your business only has to pay to HMRC the VAT collected from the sales invoice -- less any VAT from eligible expenses.

The financial gain under the standard VAT scheme to the contractor equates to the total of the VAT on the business expenses.

The standard VAT scheme requires VAT on sales invoices and purchase invoices to be taken into account on the invoice date.

This can give rise to a cashflow issue if sales invoices are not paid until after the VAT has fallen due. However, this would be an unusual scenario for a contractor as the invoice amount will normally percolate through from the end-client in plenty of time.

2. HMRC Cash accounting scheme

The cash accounting scheme has been designed to overcome the cashflow obstacles mentioned above with the standard VAT scheme.

The monetary answer will be the same over the passage of time but the VAT on sales is only accounted for once the invoice has been paid, and likewise for purchases.

3. HMRC Flat Rate VAT Scheme (‘FRS’)

The flat rate scheme significantly simplifies the accounting burden of VAT for small businesses and is based on paying a fixed percentage to HMRC.

For example, on an invoice of £10,000 you would still add 20% to that to arrive at the gross invoice amount of £12,000. A management consultant would have a ‘flat rate percentage’ of 14%, for example, and would then pay 14% of £12,000 to HMRC. This would mean paying £1,680 to HMRC instead of the full £2,000, allowing the business to keep the £320 difference. However, the VAT on business expenses cannot then be reclaimed.

The flat rate percentage varies from contractor to contractor: a management consultant as mentioned above uses a flat rate of 14% while those in ‘entertainment or journalism’ would be 12.5%. You can see the categories for different types of business here on .gov.

Be aware, during the first year as a VAT-registered business, there is a 1% reduction to the usual flat rate percentage.

So our management consultant -- in the example above -- would get to apply a flat rate of 13%.

However, the FRS comes with some significant hoops that need to be jumped through before you can be considered eligible for the full benefit of it. In April 2017, the concept of a “limited cost business” was introduced by HMRC. This description means if your business costs of supplying services / goods are less than 2% of your turnover; or less than £1,000 if your costs are more than 2% of your turnover, your business is deemed for flat rate purposes as a “limited cost business.”

If your business is a limited cost business (as would be the case for most contractors and consultants), then you have to apply a higher flat rate of 16.5%. HMRC has a calculator which can help you determine whether you would be considered a limited cost business or not.

Which VAT scheme is best for contractors?

As with most things tax and accounting the answer to this question is ‘it depends.’

The potential gain from using a flat rate percentage needs to be weighed up against the VAT the business incurs on expenses. A good accountant will be able to quickly assess this for you and give you tailored advice as to which VAT scheme and approach is best for your business.

So, how much VAT do contractors pay? You’ll like the answer…

So how much VAT do contractors pay? The good news is that provided the rules are applied correctly and all submissions and payments are made on time, VAT does not cost contractors a penny!

With a bit of careful consideration and planning there may even be a small gain to be made from becoming VAT registered; and perhaps most importantly, registration can also lend credibility to your business in the eyes of many relevant stakeholders.

Tuesday 30th Apr 2024
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Written by Christian Hickmott

Founder and CEO of Integro Accounting, Christian Hickmott has over 20 years of accountancy and working practice knowledge. He understands the wants and needs of contractors, having lead some of the largest accountancy firms in the business before founding Integro Accounting in 2013. A multi-award-winning brand based on integrity, trust and loyalty.

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