VAT Flat Rate Scheme: The Limited Cost Trader Test

The VAT Flat Rate Scheme is designed to make life simpler. For some businesses, though, a rule called the limited cost trader test pushes the flat rate up and wipes out the benefit. If your business spends very little on goods, it is worth understanding the test before you join the scheme or when you review it. This guide explains how it works in plain language and what to check.

Key takeaways

• The limited cost trader test looks at how much you spend on relevant goods compared with your turnover.
• If you fail it, you pay a higher flat rate, which can make the scheme worse than standard VAT accounting.
• The test is applied to each VAT accounting period, so your status can change.
• Only certain goods count, and many common costs are excluded.
• Check the current test and rates on GOV.UK, because they are specific and can change.

What is a limited cost trader?

A limited cost trader is a business on the Flat Rate Scheme that spends very little on goods that carry VAT, relative to its sales. The idea behind the rule is that businesses with almost no VAT-able costs should not benefit from a flat rate that assumes some purchase VAT. HMRC therefore sets a single higher flat rate for these businesses. The test and the rate are set out on GOV.UK's Flat Rate Scheme page, and you should use the current version there.

How the test works

For each VAT accounting period, you add up what you spent on relevant goods, including VAT, and compare it with your turnover for the period, also including VAT. HMRC sets out two tests, one based on a percentage of turnover and one based on a pound amount for the period. If your spending falls below the limits, you are a limited cost trader for that period and use the higher rate. Because the figures are precise and could change, read the current wording before you apply the test.

Which costs count?

Not every cost counts towards the test. The goods that count must be for use in the business and be the sort that you would resell or use up, such as stationery, materials and equipment you buy for the business. Certain things are specifically excluded, including most services, rent, phone and utility bills, food and drink for you or your staff, and vehicle costs such as fuel for most businesses. This is a common area for mistakes, which is why the official list is worth checking line by line.

Standard rate versus limited cost rate

Worked example (illustrative)

"Nadia", an illustrative example, is a freelance consultant on the Flat Rate Scheme. Her main costs are travel, a phone plan and software, which are mostly services or excluded items. In one quarter her spend on relevant goods is a tiny fraction of her turnover, so she fails the test and uses the higher rate. Her VAT bill is larger than she planned for. When she runs the numbers for standard VAT accounting, the VAT she can reclaim on those costs would have reduced her bill, so she asks her accountant whether to leave the scheme. The comparison is exactly what our guide to flat rate versus standard VAT describes. The figures here are not real rates, only an illustration of the method.

What to do if you are a limited cost trader

First, keep a clear record of your spending on relevant goods for every period so you can show how you reached the answer. Second, use the right rate in each period and do not assume it will stay the same. Third, compare the cost of staying in the scheme with leaving it. HMRC has rules on when you can leave and when you can rejoin, so check those before acting. Our VAT registration threshold guide and bookkeeping for a VAT registered business help you keep the right records. You can also read HMRC's overview of the Flat Rate Scheme.

How to keep evidence for the test

Because the test depends on your spending in each period, you need a clear audit trail. Keep purchase invoices and receipts, and mark which ones relate to goods that count under the HMRC rules. A simple spreadsheet or a tag in your bookkeeping software can do this. At the end of each VAT period, total the relevant spend, compare it with your turnover and note which rate you used. If HMRC ever queries a return, that one page shows how you reached the answer.

Should you stay on the scheme?

The Flat Rate Scheme is optional. If you find yourself regularly on the higher rate, it is worth asking whether standard VAT accounting would leave you better off, since you could then reclaim the VAT on your purchases. Remember that standard accounting involves more record keeping. The decision is a trade between effort and money, and the answer can change as your business grows or your costs change. Review it at least once a year, and speak to your accountant before you leave or rejoin, because the rules on timing are specific.

One practical point: a change in how you work can change your result. Buying equipment for the business, for example, may lift your spending on relevant goods above the test limits for one quarter and not the next. Plan large purchases with this in mind, but never buy goods only to pass the test, because the spend must be genuinely for the business.

Common mistakes

• Assuming the test is a one off. It applies every VAT period.
• Counting costs that are excluded. Services, food and fuel are common traps.
• Using the wrong rate. Failing the test means the higher rate for that period.
• Not comparing with standard VAT. The scheme may no longer be the cheapest option.
• Poor records. You need evidence for your spending figure.

If you are unsure whether the Flat Rate Scheme still suits you, our VAT returns service can run the test and compare both options for your business. Get in touch for a straightforward answer.