Deciding Whether to Use the VAT Flat Rate Scheme (FRS)

Please note that this article is aimed at UK-based IT contractors.
At first glance, for IT contractors who have very few expenses per month (purchases on which VAT can be claimed), joining the VAT Flat rate Scheme (FRS) seems like a no-brainer, and for many it probably is.
It is, however, worth weighing up all the figures before deciding to join the scheme. Basically, how the scheme works is demonstrated in the following example.
Net Invoice Amount = £10000
VAT Charged = £2000 (20% of £10,000)
Gross Amount = £12000
VAT Payable = £1740 (14.5% of £12000)
Difference between VAT charged and VAT payable = £260
In this example, the contractor would have made £260 in profit, which isn't bad, for doing nothing.
Bank interest
However, if the contractor has a lot of money in his/her company bank account, and earns interest from that money, then the interest has to be added to the gross amount. Let's say, for example, that the contractor earns £100 per month in interest. The figures will now be:
Net Invoice Amount = £10,000
VAT Charged = £2000 (20% of £10,000)
Gross Amount = £12000 + £100 = £12100
VAT Payable = £1754.5 (14.5% of £12100)
Difference between VAT charged and VAT payable = £245.5
The contractor would now have to pay £245.5, which is still pretty good. Don't forgot though that this means two lots of tax are effectively being charged on the bank interest. Because bank interest is paid gross by the bank, it is subject to corporation tax at 21%, and it is also subject to the 14.5% VAT because of the VAT FRS.
Zero rated and exempt supplies
If the contractor also has other revenue generated by VAT exempt or zero rated supplies, these will also need to be included in the VAT calculation. So, for example, if £3000 per month is generated by supplies to other European countries, the figures would become:
Net Invoice Amount for UK Supplies= £10,000
VAT Charged = £2000 (20% of £10,000)
Gross Amount = £12000 + £100 + £3000 = £15100
VAT Payable = £2189.5 (14.5% of £15100)
Difference between VAT charged and VAT payable = -£189.5
Now the figures have been completely turned on their head. If you add to this the fact that most contractors have at least one or two purchases per month on which VAT can be claimed, you can see that the contractor in our example would be better off not being in the VAT FRS.
Although for most contractors, joining the VAT FRS is probably a worth while thing to do, it is important for contractors to take advice from their accountants before joining the scheme - just to make sure it is the right decision for them.