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New VAT rate rules for contractors – changes due to the 20% rate from 4 January 2011

Contractors who raise invoices on behalf of their VAT registered contractor limited companies for payment by agencies and clients will be required to account for the standard VAT rate rise from 17.5% to 20%, which comes into force on 4 January 2011.

In addition to adjusting invoices, contractors will also be required to take the new rate into account when completing VAT returns and claiming the VAT back from purchases made by their limited company and on contractor expenses claimed. Special rules apply for contractors using the VAT Flat Rate Scheme, and for services supplied over the transition date, pre-payments and continuous supplies.

Umbrella company contractors will not be required to adjust invoices as their umbrella company should make this change automatically, but contractors should check with their umbrella company’s customer services team to find out what changes will be required when claiming expenses and making purchases.

Basic changes to invoices and timing the change

All invoices issued by VAT-registered contractor limited companies, and umbrella solutions providers, on or after 4 January 2011 must charge VAT at the new 20% rate. If, for example, a contractor started work on a new contract on 4 January and submitted an invoice after working for a month at £350 per day on 1st February, the VAT would be calculated as follows:

  • 20 days at £350 = 20x350 = £7,000
  • VAT is calculated by [7,000/100] x 20 = 70x20 = £1,400
  • The invoice would total £8,400, including VAT at 20%

However, HMRC has special rules for sales that span the rate change on 4 January:

Contracts started before 4 January 2011 and completed afterwards: Contractors should calculate VAT on days/hours worked up to and including 3 January at 17.5%, and days/hours worked from 4 January at 20%. So if a contractor’s contract month is mid-December to mid-January, days worked before 4 January 2011 will be charged at 17.5%, and days worked on or after 4 January 2011 will be charged at 20%.

Continuous supplies of services: For contractors working on a flat rate, rather than day rate, on a project that spans 4 January 2011, VAT should be accounted for on the date when the VAT invoice is issued, or when payment is received, whichever is earliest. Contractors can choose to charge VAT at 17.5% on the work completed to 3 January 2011, and 20% on the work completed subsequently, but must be prepared to substantiate the calculation if challenged by HMRC.

Prepayments/payments on account/deposits: Where a contractor issues a VAT invoice to an agency or client before 4 January for work completed after the deadline, then the 17.5% rate should be applied. So if a client asks a contractor to invoice in December for January’s work, the contractor should charge 17.5% on the invoice raised and sent to the client in December.

For most contractors, the last working day of the year is Friday 31st December 2010, and the next working day is Tuesday 4th December, so it should be possible for many contractors to submit their weekly/monthly invoices without needing to use the special rules.

HMRC has special rules for sales that span the rate change on 4 January

And if a contractor completed work in December, but was for example on holiday and unable to invoice the agency or client until January, the contractor can choose to invoice VAT at 17.5%

What VAT can be reclaimed and how to complete the VAT return

Purchases made and expenses incurred before 4 January 2011 will include VAT at 17.5% and this ‘input tax’ can be claimed on the VAT return using the rate charged on the receipt or VAT invoice.

It is also possible that invoices for purchases made before 4th January 2010 will arrive after that date with VAT charged at the 17.5% rate. According to HMRC’s guidance, the VAT claimed for these purchases should be at the 17.5% rate.

The frequency and due dates of VAT returns will not be affected by the rate rise. If a contractor’s VAT return spans the rate change with sales and purchases made at both rates, the contractor should:

  • Add together all the sales invoices charged at 17.5%
  • Add together the sales invoices charged at 20%
  • Add both sets of sales together and put the total into box 1 (output tax) on the VAT return.

VAT claimed on business purchases and expenses should be calculated in the same way and added to the VAT return in input tax box 7 (and 8 if relevant).

Special VAT schemes – the Flat Rate

Contractors who use the Flat Rate Scheme to account for VAT must use the new flat rate percentages calculated by HMRC to take into account the new 20% rate. The new rates can be found in Annex D of HMRC’s guide to the VAT rate change.

The new rates most likely to be used by contractor limited companies include:

  • Accountancy or bookkeeping: 14.5%
  • Advertising: 11%
  • Architects, civil and structural engineers and surveyors: 14.5%
  • Business services not listed elsewhere: 12%
  • Computer and IT consultancy or data processing: 14.5%
  • Computer repair services: 10.5%
  • Entertainment or journalism: 12.5%
  • Management consultancy: 14%.

These rates must be used from 4 January 2011. The Flat Rate Scheme thresholds have not changed, and contractor limited companies with ex-VAT income of up to £150,000 can apply to join the scheme.

How to correct mistakes made when implementing the VAT rate rise

If a contractor makes an error when completing the VAT return that spans the period of the rate change, in most cases the contractor can simply adjust the VAT return for the next period to correct the mistake.

In some cases, the contractor may be required to issue a credit note to the agency or client. This in effect cancels the original invoice, with the credit note including the VAT at the correct rate.

Published: 24 November 2010

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