New rules are to be introduced from 1 April 2017 that will remove the VAT saving that many small businesses currently obtain through the use of the VAT Flat Rate Scheme.
Overview of the new rules
For VAT return periods starting on or after 1 April 2017, if your purchases are less than 2% of your turnover, or proportionately less than £1,000 per annum, you'll be required to use an FRS rate of 16.5%. If the new rules apply to you, you’ll probably be better off leaving the scheme before the start of your first VAT period after 1 April 2017.
The aim of the new rate is to supposedly tackle aggressive abuse of the scheme by labour-only agency workers.
In 2002, H M Revenue & Customs (HMRC) introduced the VAT Flat Rate Scheme (FRS) to simplify the VAT system and reduce administration. It reduced the detailed recordkeeping requirements and also the work required to prepare a VAT return and also to calculate the VAT due each quarter. The VAT FRS is available to businesses with VAT inclusive turnover of no more than £150,000 per annum.
Currently, businesses determine which flat rate percentage to use by reference to their trade sector.
HMRC stated that two thirds of FRS users are registered for VAT on a voluntary basis i.e. their annual sales are less than £83,000. The reason for this voluntary registration is quite clear; it creates a VAT saving.
The savings come in two main ways. Firstly, a business that trades with another VAT registered business can normally reclaim VAT on its own costs; with any VAT that it charges to its VAT registered customer being recovered by the customer. Secondly, the percentages used in the VAT FRS often generate a profit to a business, especially those with minimal costs. It is the second point that HMRC believe is being ‘abused’ by businesses.
In the Autumn Statement on 23 November 2016, the Chancellor of the Exchequer announced the introduction of a new 16.5% VAT flat rate for businesses with limited costs. This will take effect from 1 April 2017. From this date, businesses using the scheme, or thinking of joining the scheme, must also determine whether they meet the new definition of a ‘limited cost trader’.
HMRC issued a short technical note on the new changes titled ‘Tackling aggressive abuse of the VAT Flat Rate Scheme’. This document recognises that the new rate ‘will remove the cash advantage for those businesses with limited costs’.
After 1 April 2017, all FRS users will need to check, each time they complete a VAT return, if they are limited cost traders. They must calculate their total spend on ‘relevant goods’ for the quarter. If this is less than either £250 in a VAT quarter or less than 2% of gross sales, they must adopt a special 16.5% rate.
Businesses using the FRS will be expected to ensure that, for each VAT return period, they use the appropriate flat rate percentage i.e. their existing industry percentage or the new 16.5%. A business’s VAT FRS percentage could therefore change each quarter. It is expected that many VAT FRS users will either leave the scheme or deregister from VAT completely.
Business will need to focus on the cost of ‘goods’ purchased, rather than ‘services’ acquired each quarter.
For some businesses, for example, those who purchase no goods, or who make significant purchases of goods, the decision as to what to do will be obvious. Other businesses will need to complete a simple test.
What is a limited cost trader?
A limited cost trader is defined as one whose VAT inclusive expenditure on goods is either:
less than 2% of their VAT inclusive turnover in a quarter, or
greater than 2% of their VAT inclusive turnover, but less than £250 per quarter.
The rules actually refer to ‘prescribed accounting periods’ rather than quarters. The figure of £1,000 per annum must be reduced in proportion to the length of the VAT return period i.e. £250 per quarter or £83.33 for a period of month.
What are relevant goods?
Goods, for the purposes of this measure, must be used exclusively for the purpose of the business, but exclude the following items:
food or drink for consumption by the flat rate business or its employees
vehicles, vehicle parts and fuel (except where the business is one that carries out transport services and uses its own or a leased vehicle to carry out those services).
These exclusions are part of the test to prevent businesses buying either low value everyday items or one off purchases in order to inflate their costs beyond 2%.
There appears to be no logic in why the new limited cost trader test focuses completely on goods. There are many ‘real’ commercial businesses that provide a service to their customers, but that buy very few goods for their own purposes e.g. a personal service company. These types of businesses may spend thousands of pounds a year on office rent, subcontractors, travel, light & heat, software, telephone and internet, training, online resources etc. However, these are all ‘services’ and not ‘goods’.
What else is not included under the definition of goods?
Goods must be used exclusively for the purpose of the business. This means that a business must not include the cost of any goods that are used in full or in part for private use. For example, printer ink and stationery that are used for both office and your home would not be included. It would also exclude goods acquired with the intention of giving them away or donating them to a third party.
Capital expenditure relates to amount spent on the cost of any goods that are bought to be used in the business over a period of time, e.g. longer than a year. In accounting terms they are described as fixed assets. Examples include equipment such as a computers, mobile phones, office furniture, a tablet or a printer.
Suppose a consultant provides their personal business through a business. They may use the 14% rate for ‘consultancy services’ and generate income before VAT of £100,000. Their annual VAT bill will increase by £3,000 i.e. £120,000 x 14% less £120,000 x 16.5%. That’s a lot of money.
With a 16.5% flat rate, this only leaves the ability to claim 0.167% (20/120 less 16.5%) of a VAT registered business’s turnover towards the cost of VAT on its expenditure. E.g. a business with a net turnover of £100,000, producing a gross of VAT turnover of £120,000, will charge VAT of £20,000 to its customer. A ‘limited cost trader’ will pay VAT to HMRC of £19,800 i.e. 16.5% of £120,000. Therefore, in this example, any business with more than £200 of input VAT, i.e. costs including VAT of more than £1,200 a year, will be worse off staying in the VAT FRS.
The 1% discount continues
The new 16.5% rate for limited cost traders will be subject to the same rules that apply to the other 55 FRS categories. This includes the 1% discount that applies in the first year of VAT registration, if a limited cost trader uses the FRS. If the business joins the FRS part way through its first year of registration, they only get the 1% discount for the remaining period of the 12-month window
HMRC revealed some interesting statistics:
It will represent a major change to 123,000 FRS users.
The limited credit for input tax that is evident with the 16.5% rate means that an estimated 4,000 FRS users will revert to normal standard VAT accounting, i.e. output tax less input tax.
HMRC quotes an average figure of £390 in cost savings for a business that chooses to deregister after 1 April 2017.
The new limited cost trader category will increase the annual tax yield by £130m.
Everyone agrees that the new 16.5% category will not assist the ‘simplification’ aims of the FRS. Life will definitely get more complicated.
If a business expects its taxable sales in the next 12 months to be less than £81,000 (the deregistration threshold) then it may deregister. This will avoid having to worry about limited cost trader calculations. Many businesses will decide to deregister if they are limited cost traders every quarter because of the minimal input tax credit effectively given by the 16.5% rate.
Leave the FRS?
A business that is defined as a limited cost trader from 1 April 2017, with all standard rated sales, only needs to have input tax of more than £10 per £1,000 of output tax to be better off with normal standard VAT accounting i.e. adding output tax on all sales and deducting input tax on all purchase. This decision should take into account the time saving benefits of the FRS. Is it worth paying more tax to retain these benefits? A business must notify HMRC of its decision to leave the scheme. Once a business leaves, it cannot re-join for 12 months.
Paying for goods or raising sales invoices in advance, to avoid an increase in the FRS percentage will be stopped by legislation. New rules have been introduced designed to prevent any business, defined as a limited cost trader, from continuing to use a lower flat rate after 1 April 2017.
This will affect a business that supplies a service on or after 1 April 2017 but either issues an invoice or receives a payment for that supply before 1 April 2017.
Any services invoiced in advance, but not provided before 1 April 2017 must be treated, for VAT purposes, as taking place on 1 April 2017. Any invoice or payment that covers continuous supplies of services that crosses this date must be apportioned.
What action should you take now?
You should consider the 2% and £1,000 per annum tests now for your business and decide if you should:
stay in the scheme,
leave the scheme and move to standard VAT accounting,
or deregister for VAT
There is no need to wait until 1 April 2017 to leave the FRS; you can choose to leave any time before, though the benefits continue up to 31 March 2017.
If you stay in the scheme, and become a limited cost trader, then any part of a VAT quarter that straddles 31 March 2017 must be split into a period before 31 March (using the existing FRS rates) and that after 1 April (using potentially) 16.5%.
If you decide to leave the scheme, but remain VAT registered, then you must separate and record your sales, purchases and costs into gross, VAT and net for each invoice, receipt or purchase within your accounting records. If you use our firm’s Excel cashbook template then please feel free to ask for our Excel cashbook template for standard VAT accounting.
If you have any doubt as to whether you should be in the scheme, e.g. if you are on the borderline £250 pq purchase of goods then you should consider either leaving the scheme or deregistering for VAT with effect from 1 April 2017. Staying in the scheme could be more expensive than adopting the standard method of VAT accounting.
Some football fans with have the same thoughts regarding FRS as fellow Manchester United supporters did when Sir Alex Ferguson retired as manager in 2013; 'We’ve had a good run… but nothing lasts forever.’