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VAT registration dilemma

James is very industrious gent’s hairdresser. He just manages to keep his turnover below the VAT registration limit. Apart from his rent, which was not subject to a VAT charge, his overheads are minimal.

He is considering the purchase of his first home and needs to raise a deposit. To do this he calculates that he can just about fit in enough additional clients to bring in an extra £5,000 a year in income without increasing his costs.

If he pursued this plan, James would need to register for VAT (the current VAT registration threshold is £81,000) and add 20% to his prices. This would be a problem. He works in a competitive market and if he had to increase his prices by 20%, to cover VAT, he would not be able to maintain his turnover: clients would go elsewhere. James was fairly certain that if he started to charge VAT he would lose more clients in the short term than he would be able to take on and therefore his profits would likely decrease.

The only solution seemed to be absorbing the VAT: keeping his prices at the present level and treating any VAT payable as an overhead. He decided he’d better have a chat with his accountant to see what effect this would have on his profits.

His accountant said that he could use the VAT Flat Rate Scheme and in his first year of registration he would pay over 12% of his VAT inclusive sales. As his turnover was planned to be £85,000, including VAT, (so he didn’t have to increase his prices) this would mean a payment to HMRC of £10,200. James was not impressed. By increasing his takings by £5,000 he was paying out £10,200 in VAT and would actually, be £5,200 worse off. His accountant advised that he would save on income tax but not enough to compensate for the VAT payable.

This example illustrates the value of planning. If James had gone ahead with his increase in sales without considering the VAT consequences, he would have taken a step back not a step forward financially.