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VAT Flat Rate Scheme – choosing the correct percentage

Contractors and freelancers who offer specialist and niche services don’t always fit into one of HMRC’s VAT Flat Rate Scheme Trade Sectors. As a result their business may be misclassified, and be paying too much, or too little VAT.

“It is up to each individual contractor to choose the Trade Sector that their business fits best,” explains James Abbott, founder and head of tax at contractor accountant Abbott Moore. “You might ask HMRC about the best category, but ultimately it is up to the business owner.”

Abbott highlights that there are currently 55 different classifications with flat rate percentages varying between 4% and 14.5%: “Choosing the right category is straightforward for some contractors. But those offering niche services may struggle to find a good fit.”

Beware of ‘auto-classification’ when registering for VAT

Abbott warn contractors that they need to think about their FRS Trade Sector when first registering for VAT: “When a contractor applies for VAT registration online, they have to give an indication of what their business does and select a trade category.

“Then, when the contractor ticks the box to apply for the FRS, HMRC’s online portal will automatically try to suggest a Trade Sector category based on the trade category provided during the initial registration.”

HMRC's suggestion may be right or wrong, but it is important that contractors check the suggestion and that they are happy with that classification

James Abbott, Abbott Moore

In the case of an IT developer contractor or civil engineering contractor, this may well be correct. However, life is not as simple and straightforward for many contractors and freelancers, who have to think carefully about where there business sits within HMRC’s classification.

“HMRC’s suggestion may be right or wrong, but it is important that contractors check the suggestion and that they are happy with that classification,” adds Abbott.

Not every contractor is automatically a ‘management consultant’

Another trap contractors regularly fall into is assuming that they fall under the ‘management consultancy’ heading. Abbott says that this is a default position for HMRC to adopt when a contractor does not fit anywhere else

He explains: “HMRC states in its VAT Notice 733 that: ‘If you act as a consultant and you do not fit into another specific sector, you should choose Management Consultancy. This sector is not restricted to businesses that fit the traditional idea of management consultant.’

“VAT notices are not law, and therefore not binding. They are only HMRC’s opinion. Plus not every contractor is a consultant, and their business may legitimately fall into the ‘business services that are not listed elsewhere’, which has an FRS rate of 12%, whereas management consultants pay 14.5%.”

How to select the correct Trade Sector

Abbott’s advice to contractors unsure of their classification is straightforward: “Think of how you might describe what you do to a neighbour at a barbeque. Contractors should then look at the Trade Sector classifications, and if there is not an obvious one, break down what services their business delivers to the very simplest level.

“If the service still does not fit into one of the classifications, then contractors could choose the ‘business services that are not listed elsewhere’. If a contractor was being cautious, they would choose the management consultancy category.”

However, Abbott points out that it is possible to be over-cautious, as the Calibre Tas Limited v HM Revenue & Customs VAT tribunal case in 2008 showed: “HMRC claimed that, despite the taxpayer choosing the ‘business services that are not listed elsewhere’, Calibre Tas should be categorised as a management consultant.

“What the company actually does is to provide forensic employment consultancy and expert witness services. HMRC said this is consultancy, so must fall into the management consultancy classification. The taxpayer argued and won the case that they were not a management consultant. So, sometimes it pays for a contractor to stick to their guns.”

What happens if you get it wrong?

Abbott continues: “If a contractor chooses the wrong category, then if that choice was reasonable at the time of registration, then taxman can’t come back and says it disagrees and demand any additional VAT that might be due. But the contractor must use the correct percentage going forward.

“This also works both ways. If a contractor picks a Trade Sector and percentage that was reasonable at the time, then they can’t change their minds a few years later to save some cash. The classification and percentage can only change if the nature of the business changes.”

In Abbott’s experience, HMRC does misunderstand what some contractors actually do and target contractors unfairly: “Oil and gas contractors are often targeted by HMRC because the specialised nature of many roles means many choose the ‘business services that are not listed elsewhere’.

“HMRC seems to think that oil and gas contractors should fall into the ‘architects, civil and structural engineer or surveyor’ category. There is a 2.5% difference in the FRS rates, and actually what many oil and gas contractors do bears little resemblance to the activities of architects, engineers and surveyors.”

Only one FRS Trade Sector and rate can be applied

Abbott notes that it is not uncommon for contractors have more than one income stream: “If you have an IT consultant who also does computer repairs on the side, which represent two Trade Sectors with rates of 14.5% and 10.5% respectively, then the company must use the sector with the dominant income stream. You can only operate one FRS percentage at a time.”

This flags up another issue, which is that FRS rates apply to all of a contractor’s income including zero rated, reduced rate, standard rate and exempt products and services. Out of scope goods and services are not included in FRS.

“A contractor putting the rental income from an investment property through their FRS registered limited company must apply the rate to the rental income even through their tenant is not paying VAT. The same applies if, for example, a contractor self-publishes a hardcopy book through their limited company.”

Abbott concludes by suggesting contractors play it safe and seek professional advice: “If you look at the whole VAT and tax planning package, you would not want a contractor to have problems with something relatively small, like their FRS percentage. Better not to have the argument at all, than win the argument of classification.”

Published: 29 September 2014

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