VAT for UK contractors has been a moving target since the introduction of the limited cost trader rate in April 2017. The Flat Rate Scheme was historically the obvious choice for IT contractors and consultants, a simple flat percentage paid to HMRC instead of the input/output VAT calculation. The introduction of the 16.5% limited cost trader rate (for businesses with goods spend below 2% of turnover) effectively eliminated the FRS advantage for most service-based contractors. The decision now depends on specific cost-base structure and turnover, and the ability to recover input VAT under standard accounting often produces a better outcome than FRS at 16.5%.
This guide covers the contractor-specific VAT decisions. Each section links to a detailed companion piece.
The 16.5% limited cost trader trap
Most service-based contractors (IT, consulting, marketing, design) have very low goods spend relative to turnover and therefore fall into the 16.5% Flat Rate trap. At 16.5%, the FRS effectively eliminates the 1% margin that previously made the scheme advantageous. Many contractors who joined FRS pre-2017 are still on it without realising they are paying more than they would under standard VAT accounting.
FRS vs standard VAT for IT contractors
Worked example for a typical IT contractor with £100,000 of turnover and £5,000 of recoverable input VAT (mostly software, equipment, professional services):
| Approach | VAT collected | VAT paid to HMRC | Net to business |
|---|---|---|---|
| Standard VAT accounting | £20,000 (charged to client) | £15,000 (output less £5,000 input recovery) | £0 net (passes through) |
| FRS at 16.5% (limited cost trader) | £20,000 (charged to client) | £19,800 (16.5% of gross £120,000) | £200 net cost |
| FRS at 14.5% (IT consultancy rate, pre-2017 baseline) | £20,000 (charged to client) | £17,400 (14.5% of gross £120,000) | £2,600 net benefit |
For a service-based contractor with low input VAT, the 14.5% FRS rate would have produced ~£2,600 of additional margin. The 16.5% limited cost trader rate eliminates this. Standard VAT accounting becomes the right answer for most service contractors. A specialist review confirms which side of the limited cost trader test the contractor falls on.
The limited cost trader test
The 16.5% rate applies when the contractor is a "limited cost trader". The test:
- 1Calculate goods spend (excluding capital expenditure, food/drink, vehicles/fuel) over the relevant period.
- 2If goods spend is less than 2% of VAT-inclusive turnover, the 16.5% rate applies.
- 3If goods spend is at least 2% of turnover but less than £1,000 per year, the 16.5% rate still applies.
- 4Otherwise, the standard sectoral rate applies (typically 14.5% for IT consultancy).
For most IT contractors and consultants, "goods spend" is dominated by stationery, basic office supplies, and minor equipment, typically well under £2,000 per year on £100,000 of turnover. This puts most contractors firmly in the limited cost trader category.
B2B cross-border services for international clients
For UK contractors providing B2B services to overseas business customers, the place of supply is generally where the customer is based:
- Services to a US business customer: outside UK VAT scope; the US client accounts for any local sales tax.
- Services to an EU business customer: outside UK VAT scope; the customer accounts for the VAT under their local reverse-charge rules.
- Services to a non-EU non-US business customer: same outside-scope position.
- B2C services (where the customer is a consumer, not a business) follow different place-of-supply rules.
For a contractor with substantial international clients, the standard VAT registration with full input recovery often outperforms FRS, since most input VAT is fully recoverable while the output is outside scope.
MTD for VAT compliance
All VAT-registered businesses (since April 2022) must be MTD-compliant: digital records, digital links between systems, submissions through the HMRC API. FreeAgent, Xero, and Sage all handle MTD natively. Spreadsheets with bridging software (e.g., Vital Tax, Datadear) are also acceptable. Manual entry into the HMRC portal is no longer permitted.
Pre-registration VAT recovery
A contractor who registers for VAT can recover input VAT on costs incurred before registration:
- Goods purchased up to 4 years before registration that are still in use (laptops, equipment): full VAT recovery on the first VAT return.
- Services received up to 6 months before registration: full VAT recovery.
- Apportionment for any goods used for non-business purposes pre-registration.
VAT on recharged expenses
When a contractor recharges expenses (travel, hotels, subsistence) to the end client, the VAT treatment depends on the structure:
- Disbursements (the contractor pays a third-party expense on behalf of the client and recharges the exact same amount): no VAT charged on the recharge; the client ultimately bears the original supplier's VAT.
- Recharges (the contractor pays an expense as a normal business cost and includes a margin in the recharge): standard VAT applies on the full recharge amount; the contractor recovers the input VAT on the original cost.
- The classification matters for both VAT treatment and contract drafting; specialist review when contracts include substantial expense recovery.
VAT scheme review needed?
A contractor accountant will model FRS vs standard VAT for your specific cost base and turnover, and switch you to the better scheme. Free initial assessment.