You are about to register for VAT, or you are already registered and wondering if you picked the wrong scheme. The Flat Rate Scheme sounds simpler and cheaper: one percentage, less admin, keep the difference. For a lot of online sellers, that promise no longer holds.
The reason is a rule called the "limited cost business" test. It was introduced in 2017 to stop the scheme being used as a tax saving, and it catches most product-based ecommerce businesses. If it catches you, your flat rate is 16.5%, and at that level the scheme almost always costs you more than standard VAT.
This guide walks through both schemes, shows the maths on a realistic month of online sales, and explains how to work out which one leaves you better off. Every rule and figure here is grounded in current HMRC guidance, with sources at the end.
How does each VAT scheme actually work? {#how-each-works}
Both schemes charge your customers the same 20% VAT on standard-rated sales. The difference is what you hand to HMRC and how much input VAT you can claim back.
Under standard (accrual or cash) accounting you do the full sum every quarter. You add up the VAT you charged customers (output tax, Box 1), subtract the VAT you were charged on business costs (input tax, Box 4), and pay HMRC the difference. You reclaim VAT on stock, on Amazon and marketplace fees, on packaging, software and overheads.
Under the Flat Rate Scheme (FRS) you skip most of that. You apply a single flat percentage to your gross VAT-inclusive turnover and pay that to HMRC. In exchange you generally cannot reclaim input VAT on your purchases at all. The one common exception is a single capital asset costing £2,000 or more including VAT, which everyday stock and fees are not (Flat Rate Scheme, VAT Notice 733).
You can only join the Flat Rate Scheme if your VAT taxable turnover is £150,000 or less excluding VAT, and you must normally leave once your total business income reaches £230,000 including VAT, checked on each anniversary of joining (VAT Flat Rate Scheme: eligibility). The standard registration threshold for VAT itself is £90,000 of taxable turnover (VAT registration thresholds).
So the trade-off in one line: the Flat Rate Scheme buys you simplicity and gives up your input VAT. The whole question is whether the flat percentage you pay is lower than the VAT you would otherwise have handed over after reclaiming costs.
What is the limited cost business rule, and why does it catch sellers? {#limited-cost-business}
This is the rule that changed the answer for most ecommerce sellers, and it is the one people miss.
A flat rate looks generous on paper. A typical retailer would use the "retailing that is not listed elsewhere" sector, which carries a flat rate of 7.5% (VAT Flat Rate Scheme: how much you pay). Pay 7.5% of gross turnover, charge customers 20%, keep the gap. That is exactly the saving HMRC moved to close.
Since 1 April 2017, if you are a limited cost business you must use a flat rate of 16.5%, whatever your trade sector would otherwise be (VAT Notice 733). You are a limited cost business if the amount you spend on relevant goods, including VAT, is either:
- less than 2% of your flat rate turnover, or
- more than 2% of your flat rate turnover but less than £1,000 a year (£250 a quarter).
The trap is in the words. Relevant goods means physical goods used in your business. It specifically excludes services, and it also excludes things many sellers spend the most on: capital items, food and drink for staff, vehicle and fuel costs, and crucially goods bought to resell, lease, let or hire out (VAT Notice 733, section on limited cost businesses).
That last exclusion is the one that bites. Your stock, the product you buy in to sell on, does not count as relevant goods for this test. Neither do your Amazon or marketplace fees, which are services. So a seller whose costs are mostly stock plus platform fees can spend tens of thousands of pounds a year and still fail the 2% test, because almost none of it is "relevant goods".
The result is that a large share of pure-resale ecommerce businesses are limited cost businesses, stuck on 16.5% rather than 7.5%. Whether you specifically qualify depends on what you actually buy each period, so it is worth testing your own numbers rather than assuming the headline sector rate applies.
At 16.5% of gross, the effective rate on your net sales is about 19.8%. You are handing HMRC almost the full 20% you collected and reclaiming nothing. That is why, for most sellers it catches, the Flat Rate Scheme stops making sense.
Flat rate vs standard VAT: which saves an ecommerce seller money? {#which-saves-money}
Talk to an e-commerce accountant →
The honest answer is that it depends on your cost base, but for typical product sellers standard VAT usually wins. Here is the logic without the arithmetic.
The Flat Rate Scheme only saves you money when the flat percentage you pay is lower than your real net VAT bill under standard accounting. Two things push you towards standard VAT:
- A high proportion of VATable costs. The more of your spending carries reclaimable VAT (stock from UK VAT-registered suppliers, Amazon fees, packaging, ads, software), the more standard accounting gives back. The Flat Rate Scheme hands none of that back.
- Being a limited cost business. A 16.5% flat rate leaves so little headroom against the 20% you charged that even modest reclaimable costs make standard VAT cheaper.
The Flat Rate Scheme tends to win only in the opposite case: low VATable costs, and a genuine sector rate well below 7.5% that you actually qualify for. That profile is common for some service businesses. It is uncommon for sellers who buy and resell physical products.
| Factor | Points towards Flat Rate Scheme | Points towards standard VAT |
|---|---|---|
| Reclaimable VAT on costs | Low (few VATable inputs) | High (stock, fees, ads, packaging) |
| Limited cost business? | No, you keep a low sector rate | Yes, you are forced onto 16.5% |
| Your trade | Service-led, low cost base | Buying and reselling physical goods |
| Admin appetite | You value simplicity highly | You can handle a normal VAT return |
For most ecommerce sellers, the right two rows describe the reality. The numbers in the next section show why.
Illustrative example: a month of online sales on each scheme {#worked-example}
Illustrative example. Aisha runs a homeware store selling on her own Shopify site and through a marketplace. She is UK VAT registered and past her first year, so no 1% discount applies. In one month her standard-rated sales and costs are:
| Item | Net | VAT at 20% | Gross |
|---|---|---|---|
| Sales to customers | £10,000.00 | £2,000.00 | £12,000.00 |
| Stock bought (UK VAT-registered supplier) | £4,000.00 | £800.00 | £4,800.00 |
| Marketplace and platform fees | £1,500.00 | £300.00 | £1,800.00 |
| Packaging, ads and software | £500.00 | £100.00 | £600.00 |
Standard VAT accounting. Aisha pays HMRC her output tax less her input tax:
- Output tax (Box 1): £2,000.00
- Input tax reclaimed (Box 4): £800 + £300 + £100 = £1,200.00
- VAT due to HMRC: £2,000 - £1,200 = £800.00
Flat Rate Scheme as a limited cost business. Her relevant goods are essentially nil for this test, because resale stock is excluded and platform fees are services. So she is a limited cost business on 16.5% of gross turnover:
- Gross turnover: £12,000.00
- VAT due to HMRC: £12,000 x 16.5% = £1,980.00
- She reclaims nothing.
The Flat Rate Scheme costs Aisha £1,980 against £800 under standard accounting. That is £1,180 more for the month, roughly £14,160 over a year at this level. The simplicity is real, but it is being paid for in full.
What if she somehow qualified for the 7.5% retail rate? Even then, 7.5% of £12,000 is £900, still £100 more than the £800 she pays under standard accounting, because her VATable costs are high. The Flat Rate Scheme only pulls ahead for sellers whose reclaimable costs are low.
When might the Flat Rate Scheme still win? {#when-frs-wins}
It is not always the wrong choice, so do not rule it out on reputation alone.
The scheme can still leave you better off when both of these are true: you genuinely qualify for a sector flat rate below 7.5% (so you are not a limited cost business), and you have few costs carrying reclaimable VAT. A maker who sells digital products or services with almost no VATable inputs, for example, can come out ahead.
There is also the 1% first-year discount. New VAT registrations get a 1% reduction on their flat rate until the day before the first anniversary of registration (VAT Flat Rate Scheme: how much you pay). That can tip a borderline first year, but it does not change the underlying picture once year two arrives, and it applies to the 16.5% limited cost rate too, taking it only to 15.5%.
The honest test is to run your own numbers both ways for a normal trading quarter. If you are a product seller buying stock to resell, the limited cost business rule usually settles it in favour of standard VAT. If your cost base is light and your sector rate is genuinely low, the Flat Rate Scheme deserves a proper look. This is exactly the comparison we run with sellers on our VAT services for UK businesses before anyone commits to a scheme.
How do I switch schemes if I am on the wrong one? {#how-to-switch}
You are not locked in. Sellers move between schemes more often than they expect.
To leave the Flat Rate Scheme, you write to HMRC, and you normally leave from the start of a VAT accounting period. From that date you go back to standard VAT accounting and start reclaiming input tax again on stock, fees and overheads in the usual way (VAT Notice 733). You cannot rejoin the Flat Rate Scheme for 12 months after leaving, so do not flip back and forth lightly.
To join the Flat Rate Scheme, you apply through your VAT online account, and your turnover must be within the £150,000 excluding-VAT joining limit. Whichever scheme you use, you must keep digital records and file through compatible software under Making Tax Digital for VAT, which is mandatory for all VAT-registered businesses (Making Tax Digital for VAT).
In practice, the mistake we most often see is a product seller who joined the Flat Rate Scheme years ago for simplicity, never re-ran the maths after the 2017 limited cost rule, and has quietly overpaid VAT ever since. If that might be you, it is worth a same-day check. We do this routinely for online sellers through our ecommerce accounting service.
Frequently asked questions {#faqs}
Is the Flat Rate Scheme good for ecommerce sellers?
Usually not, if you buy physical stock to resell. Resale goods do not count as "relevant goods" for the limited cost business test, so most product sellers end up on the 16.5% flat rate and reclaim nothing. At that rate, standard VAT accounting, where you reclaim input tax on stock and fees, is normally cheaper. Service-led sellers with low VATable costs are the main exception.
What is the limited cost business rate and who pays it?
It is a flat rate of 16.5% that applies if your spend on relevant goods, including VAT, is less than 2% of your flat rate turnover, or more than 2% but less than £1,000 a year. Relevant goods exclude services and exclude goods bought to resell, so many resale-based ecommerce businesses qualify as limited cost businesses and must use 16.5% rather than their sector rate.
Can I reclaim VAT on Amazon fees or stock on the Flat Rate Scheme?
Generally no. Under the Flat Rate Scheme you cannot reclaim input VAT on purchases such as stock, marketplace fees, packaging or advertising. The only common exception is a single capital asset costing £2,000 or more including VAT. Under standard VAT accounting you can reclaim all of that input tax in Box 4 of your VAT return.
Does the Flat Rate Scheme save me admin time?
Yes, that is its main appeal. You apply one percentage to your gross turnover instead of totalling input tax on every purchase. For some low-cost businesses the time saved is worth a small extra VAT cost. For most product sellers, the limited cost business rate makes the extra cost too large to justify, even allowing for the simpler return.
How do I switch from the Flat Rate Scheme to standard VAT?
You write to HMRC to leave, normally from the start of a VAT period, then account for VAT the standard way and reclaim input tax again. You cannot rejoin the Flat Rate Scheme for 12 months after leaving, so model both schemes on a typical quarter before you move. Keep filing digitally under Making Tax Digital for VAT either way.
Get your VAT scheme checked properly
Picking the wrong VAT scheme can quietly cost a product seller thousands a year, and the limited cost business rule means a lot of online sellers are on the wrong one without knowing it. If you want your scheme modelled both ways on your real numbers, your returns filed under Making Tax Digital, and your input VAT reclaimed where it should be, talk to us. Book a call with a Zmartly accountant through our VAT services for UK businesses and we will make sure you are on the scheme that actually saves you money.
