Introduction -UK VAT guide for contractors and small business 

This Hmrc VAT guide (United Kingdom) is a handy reference point as it covers VAT for contractors and small businesses in the UK. It will explain how VAT works and is an in-depth IT contractor VAT guide. In addition, we will cover in this dummies guide to VAT many aspects that you may need to consider when your Business is VAT registered. When you run your own company and are VAT registered, it is helpful to know how does VAT work for small businesses. As the owner of a UK contractor limited company, once you are registered, VAT is one of your main contractor taxes. Therefore, we will investigate how does VAT work for a limited company.

VAT can be pretty complex for laypeople, and the technical bits can even confuse a bright person. Therefore, let’s consider do businesses pay VAT, how does VAT work and how does it affect your business. Let’s also consider do contractors pay VAT and do contractors charge VAT. In this easy-to-follow UK VAT guide we will cover the basics of small business and limited company contractor VAT and how this all works under the UK VAT system.

For ease of reference, we also have written about limited company taxes. In addition, we also have a guide which covers the filing dates for official documents and tax payments.

Initial thoughts

VAT for contractors -how does VAT work for a business and what is VAT (UK)?

How does business VAT work in practice? In this VAT for dummies guide, it is key to note, VAT is a tax in the United Kingdom. VAT stands for Value Added Tax. This is a tax on UK business sales and it is known as the trading tax, and most countries have such a tax. VAT is chargeable by VAT-registered businesses on most goods and services which they provide to their customers.

The UK VAT rate

At present, the standard VAT rate in the UK is 20%. When we consider how does VAT work in UK and do companies pay VAT, if you are a VAT-registered business, when you create a sales invoice, you will likely need to add VAT to your services or sales at 20%. 

VAT for contractors -the VAT registration processes 

Compulsory registration

A business must register for VAT if:

• It expects its VAT taxable turnover to be more than £85,000 in the next 30-day period.

• The business had a VAT-taxable turnover of more than £85,000 over the last 12 months.

When we consider contractor VAT, if a business exceeds the VAT threshold of £85,000, it must register for VAT within 30 days. Basically, the £85,000 annual threshold is the business’ taxable turnover and this is the income which is subject to VAT. However, certain services and goods and services to foreign B2B customers are not subject to UK VAT.

Some business owners may ask do you pay VAT on the first £85,000. However, once you are VAT registered you will charge VAT on all of your vatable services. In turn you will then pay this over to HMRC after you deduct any VAT on costs (see later).

The VAT registration threshold usually increases slightly in most years. Therefore, if you are near the turnover threshold, you need to keep your eye on this. Notably, it would help if you keep your eye on this on an ongoing (annual) basis.

Voluntary registration

As part of this VAT guide in the UK, it is essential to take note that a business can choose to register voluntarily if its taxable business turnover is below £85,000. Many UK contractors decide to register for VAT when they first set up. They will do this even if they are or will be beneath the VAT threshold. When a business is VAT registered, it can reclaim the VAT on its business expenses.

HMRC VAT guide -the VAT registration time frame and the VAT application process 

Today, you can apply for VAT registration online, unlike the old paper forms in the past. When we consider UK VAT registration, the online process now has a much quicker turnaround time when we compare this to applying through the post.

As part of the online process, you will set up a Business Taxes account with HM Revenue & Customs (HMRC). When you do this, you can apply to register for VAT simultaneously. However, the postal route is still available but this will take much longer.

Once you submit your UK contractor VAT registration application form online, it will generally take two working days to receive your VAT registration number. When your VAT number comes through in a message from HMRC, you must wait another two working days. After this, you will have full access to the VAT service on your HMRC Business Taxes account. As part of this, you can download your VAT certificate. However, in more recent times it seems HMRC are now posting out VAT registration numbers for new registrations. Their online message says it could take up to 30 days to receive this. In practice this does seem to come through within 10 to 14 days. 

VAT for contractors -what to do once you register for VAT 

Initial considerations   

Your clients may request to see your VAT certificate as a VAT-registered business before you start work for them. Once you have the certificate, you can send this on to them for their records.

As we mention earlier, when you register for VAT, if you are supplying VAT-chargeable services or goods, the standard rate of VAT will apply to your business. Therefore, you will charge your customer or client and issue VAT invoices. When you do this, you will add VAT to your services at 20%. 

UK VAT guide -further considerations

As part of this HMRC VAT guide in the UK, it is important to note that if your customers are VAT registered, they can reclaim the VAT you charge them. If you send invoices to your customers who are not VAT registered, such as individuals, your VAT charge will be an extra cost to them, on top of the charge for your services. Therefore, this is something to bear in mind if you will invoice customers who are not VAT-registered. It will make you more costly, and you may be uncompetitive compared to your rival businesses. As a result, you may then need to reduce your charges accordingly to stay competitive.

It is also worth noting that there are other benefits of being VAT registered. As a limited company contractor, the business world can will see your company as more `official,’. Notably, it will give more credibility to you than not being VAT registered. When quoting for work, some companies mandate that suppliers must be a company and be VAT registered.

Before you register for VAT, it is worth a chat with your accountant. Basically, they can advise you on what is best in your circumstances. 

VAT explained for small businesses -our guide to VAT 

Charging VAT as a small business

In this guide to VAT, we now look at when you first need to start charging VAT as a small business. The date you first register for VAT with HMRC is your `registration date.’ Your choice of registration date is the day you want to start charging VAT on your goods or services. When we consider this, you could choose the day you start contracting. Alternatively, you could choose the date of your expected first invoice as your VAT registration date.

If you have applied to register for VAT, are waiting for your VAT number, and need to charge your customer or client, you may ask can I charge VAT without being registered? The answer is no as you cannot charge VAT as you do not yet have your VAT number. As mentioned above, it usually takes two days for your VAT number to come through but can take longer now. Therefore, in most cases, you will need to wait until you receive this before you raise your invoice and charge VAT on your work.

What to do if you are waiting for your VAT number?

On some occasions, your VAT number does not come through in two days, and there is a delay on HMRC’s side. If this happens and you need to raise an invoice, you can go ahead and do this. The invoice will show your charges or sales but you cannot add VAT yet. Instead, and you need to add a `footnote’ to the invoice. This footnote should read, `we will issue a VAT-only invoice in respect of these charges at a later date once we receive our VAT registration details.’ Then, in due course, once you receive your VAT number, you can raise a VAT-only invoice. On this you can cross-refer to the original invoice(s) where you did not charge VAT.

Once you are VAT registered, you must include your VAT number on all your invoices to your customers and clients. 

Basics of VAT -the VAT return period 

In this VAT guide in the UK, we now look at what periods small business VAT returns cover. Unless you plan to report on the Annual VAT Scheme, VAT returns will cover three-month periods. Therefore, dependent on when HMRC sets your first VAT return, your small business VAT returns could end on:

• 31 January, 30 April, 31 July, and 31 October.

• 28 February, 31 May, 31 August, and 30 November.

• 31 March, 30 June, 30 September, and 31 December.

There is also the option to file monthly VAT returns, and you may opt for this if you will be due refunds from HMRC regularly. This could occur if most of your customers are abroad (sales abroad do not usually attract VAT), yet you have lots of UK costs that include VAT, and hence you are due regular refunds. As we mention above, you could also file VAT annually however not many UK contractors or businesses opt for this.

When you file your future VAT returns, the due date with HMRC within one month and seven days of the end of the VAT return period. HMRC also needs to receive the VAT payments within the same time frame. Therefore, as a UK contractor, if your ltd company VAT return ended on 31 January, you would need to ensure that HMRC will receive the VAT return and the payment in respect of this (if a payment is due) by 7 March.

When we consider VAT for small business, you can also choose to pay your VAT bills by direct debit. If you do, HMRC will give you an extra three days before they take this. In the above example, they would take the direct debit on or around 10 March. 

VAT for contractors -Making Tax Digital (MTD) 

As part of this UK VAT guide, it is now essential to highlight the recent introduction of Making Tax Digital (MDT). This is the method of digital reporting of your VAT return figures to HMRC. Today, all VAT-registered businesses must submit their VAT returns via MTD online accounting-compliant software.

Popular accounting software choices for businesses include FreeAgent, Xero, and others. Indeed, FreeAgent is the most popular choice for UK contractors and an accounting system such as this is good to record your company’s transactions. When you have good records for your business it will make things easier for your accountant in terms of preparing year-end annual accounts. This in turn will reflect on what your accountancy costs are for your company.

Basics of VAT for contractors -the actual VAT return 

Output VAT and Input VAT

The term we use for VAT on your sales and services is the `output’ tax.

Likewise, the term we use for the VAT on your business expenses and costs is the `input’ tax.

Complete the VAT return 

When we investigate how does VAT work (UK), the VAT return contains nine boxes that you need to complete on each VAT return. What’s more, the `normal’ contractor will only need to complete the following boxes:

1 The VAT on sales –output tax.

4 The VAT on business purchases and expenses –input tax.

6 Net sales -outputs.

7 Net purchases and expenses -inputs.

Box 5 is, in effect the sum of box 1 less box 4.

Therefore, box 5 is the amount that you need to either:

• Pay to HMRC or

• HMRC needs to refund your business. If a VAT refund is due, HMRC will repay this.

When you have a liability, the VAT you’ve paid will be credited against your liability with HMRC. Likewise, if a refund is due, once HMRC refund this it will go against the amount that they owe you. 

VAT on your costs and expenditure

Guide to VAT -reclaim VAT 

One of the main plus points when you register for VAT is that you can reclaim the VAT on any business purchases that include VAT. Therefore, in the future, the actual cost of these to your business will be the amount before VAT. When you claim back VAT, you will need to obtain and retain any invoices or receipts that relate to the expense (and VAT) that your business is claiming.

If you usually pay VAT to HMRC, there may be times or instances when the VAT on purchases and expenses exceed the VAT on your sales in a given VAT quarter. In this case, HMRC will refund the difference to the business.

VAT for contractors -the types of costs which do not include VAT 

When we investigate how VAT works, do bank charges have VAT? Furthermore, do rail fares have VAT? Notably, certain services and goods are exempt supplies and fall outside the UK VAT system. Such goods and services which are not subject to VAT include:

• Insurance -this is taxable through the insurance industry.

• Flights -these are taxable through the aviation industry.

• Rail fares.

• Postages.

• Bank charges.

• Certain educational training and teaching costs.

• Books, booklets, brochures, pamphlets, and leaflets.

• Newspapers, journals, and periodicals.

• Most food from shops and supermarkets (not restaurants).

• Many other items which HMRC regard as `essentials’.

Some goods and services also have a reduced VAT rate, including home energy and children’s car seats. During the recent pandemic, there was also a reduced rate of VAT given to the hospitality sector. This ended on 31 March 2022.

VAT on digital products and services

When your business supplies digital products or services to a client in an EU country, the VAT to charge is based on the customer’s country’s VAT rate.  Your business will also need to register for the VAT Moss scheme and submit Moss returns in the future.

Guide to VAT -the reverse charge procedure

This seems like a complex solution to a straightforward issue with regard to how VAT works for foreign transactions. However, it applies when you buy services from outside the UK. The reverse charge on services that you purchase only applies when a) the supplier is in a different country from you, b) you are in business, c) you belong in the UK and d) you receive either:

• One of the services covered by the general rule for place of supply of services.

• Certain other services.

When you deal with the reverse charge, you will calculate the amount of VAT (output tax) on the total value of the services supplied to you. On your company’s VAT return, you will enter:

• The amount of VAT you calculate in box 1.

• If you are entitled to reclaim some or all of the VAT on your purchase of these supplies, you will also put the same figure in box 4 (this, in effect, cancels out the figure in box 1).

• The supply’s full value in box 6 and box 7.

This UK VAT guide from HMRC covers in more detail VAT on imports, acquisitions, and services from abroad.

Guide to VAT -types of VAT schemes 

There are several different VAT schemes available when you register for VAT. This VAT guide in the UK now investigates what HMRC offers to suit different businesses.  

Standard VAT Scheme 

Under this scheme, the VAT paid to HMRC is based on:

The total amount of VAT you charge on invoices that you raise during the VAT period.

minus

Any VAT you incur on purchases and expenses by your business during the period.

Cash Accounting scheme 

This scheme is the same as the above, except you only pay VAT to HMRC once you receive the funds from your customers and clients. Similarly, you can only reclaim VAT on purchases and expenses once you pay the supplier. This scheme is useful for cash flow purposes. Most owners of a contractor limited company who register for VAT, operate under the cash accounting scheme. The alternative to this is an `invoice scheme’ where you pay over and reclaim VAT once they are issued. Notably, this scheme applies to larger businesses. 

VAT for contractors -the Flat Rate VAT scheme 

This VAT Flat Rate scheme is a sub-scheme that many limited company contractors would have often used in the past.

However, contractors rarely use this nowadays as it is no longer as beneficial as it used to be. HMRC initially brought this scheme out to make accounting easier. Under this scheme, you would still invoice clients at the standard rate, but you would pay HMRC a fixed percentage rate of your gross quarterly turnover, depending on the industry in which you operate. For IT contractors, the rate is 14.5%, and in the first year of operation, the contractor can also benefit from a 1% reduction to the fixed rate.

However, in April 2017, the new ‘limited cost trader’ rules came in. They removed most of the benefits of using the VAT Flat Rate VAT scheme for most small businesses, particularly those with low quarterly costs. If you do not qualify under the new rules, the change, in effect, is that you instead pay over 16.5% of the gross amount invoiced.

This change was sneaky, as 16.5% of the gross is the same as 19.8% of the net. The standard VAT rate is 20%. Therefore, now you will only save 0.2% of the VAT you charge under this scheme. On a £10,000 + VAT invoice, the saving will only be £20.  Thus, operating under the Standard VAT Scheme and Cash Accounting scheme are part of our handy tax tips for contractors and small business owners.

Penalties 

Why you may miss a VAT return deadline

There are penalties for no VAT registration or late VAT registration. There can also be fines for the late payment of VAT bills that can be pretty hefty. Therefore, it is key that you make sure you and your accountant keep on top of your company’s tax and VAT accounting.

For various reasons, a contractor may miss a VAT filing deadline. If this occurs, the business will receive a letter from HMRC. It will state that HMRC will place the company on a `warning’ for the next twelve months.

Introduction to VAT penalties

The VAT penalty system for late VAT returns and payments was overhauled at the start of 2023. Therefore, from 1 January 2023, you’ll receive penalty points if you submit a VAT return late. This includes any nil payment returns. HMRC will also charge interest on late VAT payments too from 1 January 2023.

VAT return penalties

Under the new rules, for each return you submit late to HMRC, you’ll receive a penalty point. When you reach the penalty point threshold, you’ll incur a £200 penalty. You’ll also incur a further £200 penalty for each subsequent late return while you’re at the penalty point threshold. If you have reached the threshold for late submission penalty points, you’ll need to take action to get these removed to avoid further £200 penalties. If you have not reached the threshold them penalty points will expire after a period of time. However, if you have reached the threshold HMRC has two conditions that you need to complete in order for HMRC to remove these. You can find out more here on how to remove penalty points.

VAT payment interest

Any VAT periods which start on or after 1 January 2023, will also be subject to interest if you make late payment. Therefore, if you pay VAT-related amounts late, HMRC will ask you to pay late payment interest on the amount outstanding. This will apply from the first day your payment is overdue up to the day you pay it in full.

Avoid the penalties

It is clearly in your best interest to avoid these penalties. What’s more, if you are consistently late, it will result in increased scrutiny from HMRC, and they may take a closer look into your affairs. Therefore, you should ensure that you or your accountant are processing your VAT returns on time. You could also set up a direct debit so you will never miss a payment (but this relies on the return being filed first).

Other considerations

VAT for contractors -correction of VAT errors 

If you discover an error after you submit a VAT return the options are:

• If the error is under £10,000 you can correct this via your next VAT return.

• If the error is over £10,000 you will need to report this to HMRC via form VAT652. 

VAT for contractors -other thoughts 

As we mention earlier in this VAT guide in the UK, customers and clients that are VAT registered can reclaim the VAT that you charge to them. This is not necessarily an advantage for you however, being VAT-registered can help create a more professional image for your business. As a result, the customer may be more inclined to use your business again soon, with knowledge that your business is VAT registered and they can reclaim their input VAT too.

Your accountant will typically take care of your UK contractor VAT registration for you. This is one of the first tasks they will carry out when you set up a new company.

VAT for contractors -further thoughts 

This VAT for small businesses and contractors guide should give you a good insight into how VAT works. Your accountant, however, will be able to advise you which scheme is most suited for you.

Today it is better for contractors to operate under the Standard VAT Scheme, rather than the VAT Flat Rate scheme. That is unless they qualify as a limited-cost trader under the Flat Rate Scheme, which in most cases is unlikely. We would also recommend the Cash Accounting choice.

VAT de-registration 

When your business finishes trading and it needs to de-register for VAT, it can do so through the VAT service in your HMRC Business Tax account. There is an option to de-register within the main options on the screen after you login and access your VAT service. Once you select this option you can follow the procedure online. Basically, you will need to pick a date for your de-registration and there are also several questions to answer before you can submit the application.

Alternatively, you can complete VAT form 7 and send this through the post to HMRC.

As part of de-registering, you may also need to complete a final VAT return form up to the date that your business de-registers. Once the you submit application, HMRC will write to you to confirm the business is de-registering. In addition, they will let you know if there is any final VAT return form to complete. You can file the final return via your online software and, once you have done this, there should be nothing more to do on VAT.

Furthermore, if you incur any VAT that you have not claimed via your VAT returns, you can claim this back via form VAT427.

Final thoughts 

As you can see from this HMRC VAT guide and when we look at how VAT works, it is a very complex area. In fact, there are many VAT rules to bear in mind which cover all sorts of areas in respect of the UK VAT system. Notably, VAT is one of your main contractor taxes and you can easily get lost if you are not sure. Therefore, we hope this UK VAT guide for contractors and small businesses has given good insight, but if you have any questions, you should check these out with your accountant.

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