Choose a VAT scheme

Once you're VAT registered, you can choose how you account for VAT. The standard method requires you to calculate VAT on every invoice you issue and reclaim VAT on every purchase. This works, but it can be time-consuming and create cash flow challenges if customers pay late.

HMRC offers three alternative schemes designed for smaller businesses. Each simplifies VAT in different ways, and the right choice depends on your business type, cash flow patterns, and administrative capacity.

Quick comparison of VAT schemes

Here's how the four main approaches compare:

The standard scheme is the default. You must actively apply to use any of the alternative schemes below.

Flat Rate Scheme

The Flat Rate Scheme simplifies VAT by letting you pay a fixed percentage of your gross turnover to HMRC, rather than calculating VAT on individual transactions. You still charge customers the standard 20% VAT, but you pay HMRC a lower flat rate based on your business type.

How the flat rate works

You charge customers VAT at the normal rate (usually 20%), but you pay HMRC a fixed percentage of your VAT-inclusive turnover. The percentage depends on your business type - for example, accountants pay 14.5% while food retailers pay 4%.

The difference between what you charge customers and what you pay HMRC is yours to keep. This can work in your favour if your actual VAT liability would be higher than the flat rate.

You cannot reclaim VAT on purchases (except for capital assets costing more than £2,000 including VAT).

Limited cost businesses

If you spend less than 2% of your turnover on goods (or less than £1,000 per year), HMRC classifies you as a 'limited cost business'. This means you must use the higher flat rate of 16.5%, which often makes the scheme uneconomical. This rule targets businesses with low material costs, such as consultants and service providers.

When the Flat Rate Scheme works well

• You buy few goods and services with VAT, so you lose little by not reclaiming input VAT
• Your flat rate is lower than your effective VAT rate, so you keep the difference.
• You want simpler administration, with no need to track VAT on every purchase.
• You want to predict your VAT bill easily from turnover.

When to avoid the Flat Rate Scheme

• You make significant purchases with VAT, which you would lose out on by not reclaiming.
• You are a limited cost business, because the 16.5% rate rarely makes sense.
• Your costs fluctuate significantly.
• You are growing fast and will soon need to leave when turnover exceeds £230,000.

Cash Accounting Scheme

Under normal VAT rules, you account for VAT when you issue an invoice, regardless of when the customer pays. Cash Accounting changes this: you only pay VAT to HMRC when your customers pay you, and you only reclaim VAT on purchases when you pay your suppliers.

How Cash Accounting helps cash flow

The main benefit is timing. With standard accounting, you might pay VAT to HMRC before your customer has paid you - effectively lending HMRC money. Cash Accounting aligns your VAT payments with your actual cash receipts.

This is particularly valuable if you:

• Give customers extended payment terms
• Have customers who pay late
• Experience seasonal cash flow variations

Automatic bad debt relief

If a customer never pays, you never paid VAT on that sale. Under standard accounting, you'd need to claim bad debt relief separately.

When Cash Accounting works well

• You provide B2B services and invoice in advance of payment.
• Your customers may take 30-60 days to pay.
• Your cash flow fluctuates through the year.
• Some customers may not pay at all.

When to avoid Cash Accounting

• You usually reclaim more VAT than you pay, because you will get refunds later under Cash Accounting.
• Your customers pay at the point of sale (retail, hospitality), so there is no timing benefit.
• You often deal in invoices with payment terms over 6 months or in leased or hire purchase goods, which the scheme cannot cover.

Annual Accounting Scheme

Instead of submitting four quarterly VAT returns, the Annual Accounting Scheme lets you submit just one return per year. You make advance payments throughout the year based on your estimated VAT bill, then settle any balance when you file your annual return.

Payment options

You can choose between two payment schedules:

• 9 monthly payments of 10% of your estimated annual VAT, with a balancing payment at year end
• 3 quarterly payments of 25% of your estimated annual VAT, with a balancing payment at year end

The final return and balancing payment are due 2 months after your accounting year ends.

When Annual Accounting works well

• Your turnover and purchases are steady, so advance payments work smoothly.
• You have limited admin time and want one return a year instead of four.
• Fixed monthly or quarterly payments would help your cash flow planning.
• You want to combine it with Cash Accounting for maximum simplification.

When to avoid Annual Accounting

• You typically reclaim more VAT than you pay (for example, on zero-rated exports), because you would get one refund a year instead of four.
• Your turnover is volatile: advance payments are based on estimates, so you may overpay or face a large balancing payment.
• Your cash flow is tight, as monthly advance payments may be harder to manage than quarterly payments after the event.

Choosing the right scheme for your business

The best scheme depends on your specific circumstances. Consider these factors:

Combining schemes

You can use Cash Accounting and Annual Accounting together. This gives you the cash flow benefits of paying VAT when you receive payment, combined with the simplicity of one annual return.

However, you cannot combine:

• Flat Rate Scheme with Cash Accounting
• Any scheme with VAT group registration

You can use the Flat Rate Scheme with Annual Accounting.

Switching schemes

If you leave a scheme (by choice or because you're no longer eligible), you must wait 12 months before rejoining it. This prevents businesses from switching in and out to gain short-term advantages.

When leaving Cash Accounting, you must report and pay HMRC any outstanding VAT on unpaid invoices. You have 6 months to do this if you leave voluntarily, or must pay immediately if your turnover exceeded the limit.