A contractor's guide to VAT

As a contractor operating through your own limited company, understanding the intricate world of Value Added Tax (VAT) is pretty important, writes Lara Hodkinson, head of accounting at Danbro Accounting.

What is VAT?

VAT is a UK sales tax that’s added to most goods and services, and it can significantly impact your ‘bottom line.’

In this guide, exclusively for Free-Work UK, I want to delve into the complexities of VAT and explore how it can help or hinder IT contractors and freelancers like you.

VAT threshold: to register or not register as a freelancer?

First things first, if your limited company's gross income surpasses £85,000 per year, you are required to register for VAT with HMRC. Failure to do so may result in penalties being issued to your company, so it's essential to stay compliant.

If your income falls below the £85,000 threshold, you still have the option to register voluntarily for VAT, and it's a choice that could prove advantageous depending on your circumstances.

Voluntary VAT registration: what are the benefits to freelance contractors?

While registering for VAT might seem like an additional administrative burden, it can be beneficial to your bottom line.

One of the most notable advantages is the ability to reclaim ‘input tax.’

Input tax refers to the VAT you've paid on goods and services purchased for your limited company. By registering for VAT, you can offset this input tax against the VAT you charge your clients, reducing your overall VAT liability.

Reclaiming input tax -- example:

Let’s say you buy a laptop for your business at £399, with VAT charged at the standard rate of 20%. That's £66.50 in input tax that you can reclaim, effectively reducing the cost of the laptop to £332.50.

Positively, this concept applies to all business expenses, ranging from office supplies to tech equipment, so it can add up to a substantial saving.

But it is worth consulting with your accountant before registering for VAT, to check that you are eligible to register, and that VAT registration will be beneficial to your business.

VAT returns: your VAT obligations

Contractors registered for VAT must submit quarterly VAT returns to HMRC.

These tax returns detail the VAT you've charged your clients and the VAT you've paid on business expenses. The net difference between these two figures determines your VAT liability.

Let's take the example of invoicing a client for five days of work at £300 a day. If you've also claimed £66.50 in input tax from the (above) laptop purchase, your net VAT payable is £233.50. This means you get to keep £66.50 of the VAT you’ve charged your client, making your expenses more tax-efficient.

Flat Rate VAT

For some limited company contractors, HMRC’s Flat Rate VAT Scheme can be an attractive option, too.

This scheme simplifies VAT calculations and may benefit those with certain levels and types of expenditure, but the saving can often depend on your type of business / sector.

So, before making the switch to the FRS (‘Flat Rate Scheme’), consult with a specialist contractor accountant to determine if it's the right choice for your business.

VAT registration: the disadvantages

If you work directly with clients in sectors such as financial services, parts of the public sector, or charities, you may encounter a unique challenge.

Clients in these sectors are often unable to reclaim VAT, which means passing on 20% VAT to them could be detrimental to your working relationship.

In such cases, you might want to consider creating a separate limited company that is not VAT-registered, specifically for clients who can't reclaim VAT. This way, you’ll avoid imposing the additional cost on your clients while staying compliant with VAT regulations.

VAT inspections

Being VAT-registered can occasionally lead to a VAT inspection by HMRC. While such scrutiny from the tax department may seem daunting, a VAT probe is actually manageable if you've maintained proper records and followed tax regulations.

However, it's essential to be cautious. If the VAT inspector discovers incorrect or unjustified claims, you could face penalties and be required to repay any VAT you’ve claimed. To navigate a VAT inspection successfully, it's prudent to seek professional advice from a qualified accountant who specialises in contractor accounting.

Finally, don’t underestimate VAT’s importance to your contracting journey

VAT is a crucial aspect of your contracting or freelancing journey that can significantly impact your finances. Whether you're obliged to register for VAT due to exceeding the income threshold or choose to do so voluntarily, understanding the nuances of VAT can lead to substantial savings.

Keep in mind the potential advantages of reclaiming input tax; the importance of accurate VAT returns, and the considerations of working with clients in non-VAT-reclaimable sectors.

When it comes to VAT and contractor accounting, selecting the right accountant is paramount. Beyond regulatory compliance, a proficient accountant should offer personalised tax planning, limited company tax advice, and industry-specific expertise. With the right knowledge and support, you can optimise your VAT strategy and secure your financial success as a contractor.