What is the VAT Flat Rate Scheme "limited cost trader" test?

Full answer

The limited cost trader rule was introduced specifically to stop the VAT Flat Rate Scheme being used by businesses (particularly certain contractors and consultants) purely to generate a VAT profit with minimal genuine goods costs, and it significantly changes the maths for many service-based small businesses. **How the Flat Rate Scheme normally works** Under the standard VAT Flat Rate Scheme, instead of reclaiming input VAT on individual purchases and calculating output VAT owed in the normal way, a business simply applies a single flat percentage (set according to their specific trade sector, ranging roughly from 4% up to around 14.5% depending on the sector) to their VAT-INCLUSIVE turnover, paying that flat percentage to HMRC and keeping the difference between what they charge customers (20% VAT) and what they pay over under the flat rate. **What counts as "relevant goods" for the test** The limited cost trader test looks specifically at spending on GOODS (not services), and further excludes certain categories even if they are physically goods -- capital expenditure (such as equipment or vehicles), food and drink for consumption by the business owner or staff, and vehicles/fuel (unless the business is in transport and the vehicles are used specifically for that purpose) do not count towards the goods spending test, even though a business might genuinely spend money on these things. **The 2% / £1,000 test** A business is classed as a limited cost trader in a given VAT period if its spending on qualifying relevant goods in that period is both less than 2% of its VAT-inclusive turnover, AND either that same amount is more than £1,000 a year (pro-rated for shorter periods) -- if goods spending is below 2% of turnover but also above £1,000 a year, the business would not usually be a limited cost trader; conversely, if goods spending is below £1,000 a year, the business is treated as a limited cost trader even if that figure happens to be above 2% of a very low turnover. Getting the precise mechanics of this combined test right requires checking the specific numbers each period, since trading patterns can push a business in or out of limited cost trader status from one VAT period to the next. **Why this often catches service businesses** Businesses that are primarily selling their own time and expertise (consultants, IT contractors, many other professional services) often have very low genuine goods spending (perhaps just some stationery or minor supplies), meaning they frequently fall into the limited cost trader category and are forced to use the higher 16.5% flat rate, rather than benefiting from a lower sector-specific rate that might otherwise apply to their type of business. **Worked example** An IT contractor operating through their own limited company has quarterly VAT-inclusive turnover of £15,000, but spends only £150 on relevant goods that quarter (a laptop bag and some minor stationery, since most of their actual costs are on services like subcontractor fees, software subscriptions, and travel, none of which count as "goods" for this test). Because £150 is both less than 2% of £15,000 (£300) and also below the £1,000 annual-equivalent threshold, the contractor is a limited cost trader for that quarter and must apply the higher 16.5% flat rate to their VAT-inclusive turnover, rather than a lower rate that might apply to IT consultants who are not limited cost traders -- this often makes the Flat Rate Scheme financially unattractive compared with standard VAT accounting (reclaiming actual input VAT) for businesses regularly caught by this test. **Practical tip** Businesses on or considering the Flat Rate Scheme should calculate whether they are likely to be classed as a limited cost trader each period, and compare the resulting VAT cost against simply using standard VAT accounting instead, since the 16.5% limited cost trader rate often eliminates most or all of the cash flow/administrative benefit the Flat Rate Scheme was originally designed to provide.

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