VAT flat rate scheme for an online seller: the 16.5% limited cost trader test, worked on four invented shops

An accountant says you should join the VAT flat rate scheme because it is simpler. You sell mainly your own designs, printed to order, and you buy very little in the way of goods. Will it save money?

It might cost you money. The "how much you pay" page on GOV.UK describes a test that moves some businesses onto a higher rate.

What the pages say

From the two GOV.UK pages:

• You pay a fixed rate of VAT to HMRC and keep the difference between what you charge customers and what you pay HMRC.
• You generally cannot reclaim VAT on purchases, with an exception for certain capital assets over £2,000.
• You work out the tax by multiplying your flat rate by your "VAT inclusive turnover", which is your income plus the VAT charged on it.
• You are a "limited cost business" if your goods cost less than 2% of turnover, or £1,000 a year if your costs are more than 2%.
• A limited cost business pays 16.5%.
• You get a 1% discount in your first year as a VAT-registered business.
• The scheme page says you may be able to join if your VAT turnover is £150,000 or less, excluding VAT.

Our reading of the test is that you are limited if you fall below either line: under 2% of turnover, or under £1,000 a year. The wording is short, so check it against the page before relying on it.

Four invented shops

Each charges 20% VAT. Shops 1 to 3 sell £40,000 before VAT, so VAT-inclusive turnover is £48,000 and output VAT is £8,000. Shop 4 sells £100,000, so VAT-inclusive turnover is £120,000 and output VAT is £20,000. "Goods spend" is the VAT-inclusive amount spent on goods for resale, so one sixth of it is VAT you could reclaim under normal VAT.

Check the arithmetic. 2% of 48,000 is 960; 2% of 120,000 is 2,400. 16.5% of 48,000 is 7,920 (48,000 x 0.165); 16.5% of 120,000 is 19,800. A sixth of 840 is 140, of 6,000 is 1,000, of 984 is 164 and of 2,160 is 360. 8,000 less 140 is 7,860, less 164 is 7,836; 20,000 less 360 is 19,640.

Shop 2 is outside the limited cost test, so it pays the normal flat rate for its trade. That rate is not on the pages we read, so we have not worked it out.

Shop 3 shows the edge: £984 is more than 2% (£960) but less than £1,000, so it is still limited. A shop that buys almost nothing pays the high rate, and pays a little more than it would under normal VAT.

The first-year discount

In its first year as a VAT-registered business, shop 1 takes 1% off: 15.5% of £48,000 is £7,440. Normal VAT is £7,860, so the first year saves £420 (7,860 less 7,440). From the second year the saving turns into the £60 cost in the table. A scheme can look good in year one for that reason alone.

What to do this week

1. Add up what you spent on goods for resale in the last twelve months and compare it with 2% of your VAT-inclusive turnover and with £1,000.
2. Work out your output VAT less the VAT on your purchases, as in the table, and compare it with 16.5% of your VAT-inclusive turnover.
3. Ask your accountant which rate they have assumed for your trade and whether you pass the limited cost test.
4. Look at the £2,000 capital asset exception if you plan to buy a printer or similar.

For the threshold that makes you register, see the VAT threshold guide for online sellers, and for the charge on delivery, see VAT on postage and delivery charges.

Overlyft can set up AI staff who join your team, total each period's VAT-inclusive sales and goods spend from your shop and payout reports, run this comparison and flag when you cross the 2% line, ready for a person to check and approve.

This is general information, not tax advice. The GOV.UK pages and your accountant give the answer for your own business.