By Emily Coltman ACA, FreeAgent Central

On 4th January 2011 the standard rate of VAT will increase from 17.5% to 20%. While this may not seem too problematic, VAT is inherently full of traps that can catch the unwary business owner out, and the change will likely drop a few more.

Here are three such traps, and how best to avoid them:

1) Cash accounting — which rate to use?

Let’s say you’re using the cash accounting scheme for VAT.

You issued an invoice to a customer in December 2010, which of course had VAT on it at 17.5%. So if the invoice was for services worth £1,000, the final amount you charge your customer would be £1,175.

The customer then pays you on 6th January 2011 — after the change of VAT rate.

How much would you pay HM Revenue? What VAT rate would that receipt use?

Not 20% - 17.5%!

You’d always use the VAT rate in force at the time when the invoice was issued, even if you’re cash accounting.

That means that, on this receipt, you pay HM Revenue £175.

2) Retail — which fraction to use?

If you sell goods on a retail basis, you’ll quote your prices inclusive of VAT.

That means that, when the VAT rate changes, you’ll either need to put your prices up, or take a profit hit because you get to keep less of what your customers pay you, because more of it is VAT.

But how do you work that out?

Let’s say you’re a painter of ceramic mugs and you sell mugs with painted characters on at £7.99 a time. That price includes VAT.

When the VAT rate is 17.5%, how much VAT is there in that £7.99?

You can use the VAT fraction to work that out. The VAT fraction, which is set by HM Revenue, is 7/47 for a rate of 17.5%. So a sale of £7.99 including VAT of 17.5%, contains VAT of £7.99 x 7/47 = £1.19, and you get to keep the rest, which would be £6.80.

But when the VAT rate changes, so does the VAT fraction. It’ll be 1/6 for a VAT rate of 20%.

So a sale of £7.99 including VAT of 20%, would contain VAT at 1/6 x £7.99 = £1.33, and you only get to keep £6.66.

A loss of 14p doesn’t sound much, but when you add that to the losses on all your other sales…

So, do you put your prices up, or do you take the hit?

That’s up to you — but don’t forget to use the new fraction!

3) Sales that span the change — which rate to use?

If you sell services, you might be part-way through making a sale when the VAT rate changes.

There’ll be a lot of work for emergency plumbers in early January 2011 unless the weather gets warmer!

Our local plumber Scott may well have to go and thaw a customer’s frozen sink pipe on 1st January 2011, then go back to the same customer on 5th January 2011 to thaw the boiler inflow pipe.

He won’t want to issue two invoices to the same customer within the space of a week. So how would he cope with the change?

HM Revenue say he could either create an invoice after 4th January 2011 and use 20% for the whole invoice, or apportion the invoice between the two rates on a fair basis.

Scott carried out the first piece of work before the VAT rate changed, and the second afterwards, so he would be absolutely fine to invoice the customer for the first repair at 17.5% and the second repair at 20%.

You can create an invoice with two different standard rates on, that’s absolutely fine.

So you do need to be careful to avoid the new issues the VAT rate change creates — but there is help available out there. HM Revenue publish detailed guidance, and if you’re stuck, then do speak to an accountant for advice specific to your own business situation.

FreeAgent Central's Emily Coltman is a qualified Chartered Accountant who speaks to small business owners every day and understands their worries as they face next month's change in VAT. FreeAgent is an online accounting application that helps small business owners manage their books easily and keep on the right side of the taxman. In this blog Emily offers her suggestions about how to avoid some of the traps created by January's VAT increase.