Flat Rate Scheme changes – Limited Cost Traders
Among the measures relating to business taxation in Autumn Statement 2016, Philip Hammond announced a change to the VAT flat rate scheme. From April 2017 this could have significant effects on the tax liability of small businesses that currently make use of the scheme.
Background to the FRS
Under the FRS a set percentage, determined by the business trade sector, is applied to the VAT inclusive turnover of the business as a one-off calculation instead of having to identify and record the VAT on each sale and purchase the business makes. Turnover will include any exempt supplies and it is therefore not generally beneficial to join the scheme where there are significant exempt supplies.
The aim of the FRS for small businesses is to reduce the administrative burden imposed when operating VAT, however many small businesses who use the scheme are also better off as they are effectively able to keep some of the VAT charged to customers.
How the scheme operates
The percentage rates are determined according to the trade sector of the business and currently range from 4% to 14.5%.
In addition there is a further 1% reduction in the normal rates for businesses in their first year of VAT registration. If a business falls into more than one sector it is the main business activity as measured by turnover which counts.
Although those operating the FRS pay VAT at the FRS percentage they are still required to prepare invoices for customers showing the normal rates of VAT. This is so that their customers can reclaim input VAT, if appropriate.
Flat Rate benefits for those trading below the VAT registration scheme
For some very small businesses including those trading below the annual VAT registration threshold of £83,000, it has been worthwhile registering for VAT and operating the FRS. Effectively these traders charge their customers VAT at 20% on the services they supply but only pay over VAT at an effective maximum rate of 17.4%. They are therefore able to keep a minimum of 2.6% of the VAT paid by their customers. This is set out in the following example:
Amount billed to customer £1,000 plus VAT at 20% = £1,200
Amount due to HMRC under FRS using the current highest percentage of 14.5%
£1,200 x 14.5% = £174
Effective rate on VAT exclusive amount billed to customer £174 / £1,000 = 17.4%
VAT which can be retained by trader
£200 – £174 = £26 (2.6% of £1,000)
Where the relevant FRS percentage is lower than 14.5% the effective percentage of VAT which can be retained could be significantly more.
The change to the FRS
The change, described as an anti-avoidance measure, introduces a new 16.5% rate from 1 April 2017. This rate will be applicable for businesses with limited costs, such as many labour-only businesses. Businesses using the scheme, or considering joining the scheme, will need to decide if they are a ‘limited cost trader’.
So, taking the example above, if the trader is caught by the new anti-avoidance rules then they will be in the following position:
Amount billed to customer £1,000 plus VAT at 20% = £1,200
Amount due to HMRC under FRS using the limited cost trader percentage of 16.5%
£1,200 x 16.5% = £198
Effective rate on VAT exclusive amount billed to customer
£198 / £1,000 = 19.8%
VAT which can be retained by trader £200 – £198 = £2 (0.2% of £1,000)
A limited cost trader will be defined as one whose VAT inclusive expenditure on goods is either:
● less than 2% of their VAT inclusive turnover in a prescribed accounting period
● greater than 2% of their VAT inclusive turnover but less than £1,000 per annum if the prescribed accounting period is one year (if it is not one year, the figure is the relevant proportion of £1,000 so for someone who completes their VAT return quarterly the limit is £250).
The technical note states that there will be exclusions from the calculation to prevent attempts to inflate costs above 2%. Goods, for the purposes of this measure, must be used exclusively for the purpose of the business but exclude the following items:
● capital expenditure
● 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, for example a taxi business, and uses its own or a leased vehicle to carry out those services.
These exclusions are part of the test to prevent traders buying either low value everyday items or one off purchases in order to inflate their costs beyond 2%.
Businesses using the FRS will be expected to ensure that, for each VAT return period, they use the appropriate flat rate percentage, so the check to see whether a business is a limited cost trader will have to be carried out for each VAT return.
The government estimate that of the 411,000 businesses using the FRS, 123,000 have limited costs and will be affected by these changes. According to the statistics produced by the government the changes which are being introduced to the FRS will result in it no longer being beneficial to some current users of the scheme.
What happens now?
The introduction of the 16.5% rate for limited cost traders will result in affected businesses having to reconsider their position and may result in different outcomes. Some businesses will:
● continue to use the flat rate scheme, checking for each VAT return period, whether they are affected by the 16.5% limited cost trader percentage and paying VAT at the 16.5% rate if appropriate
● decide to leave the FRS. In order to leave the FRS you must write and let HMRC know. Generally businesses choose to leave at the end of an accounting period. However, you may leave voluntarily at any time during an accounting period. HMRC will confirm the date you left the scheme in writing. If you are considering this option we can advise the most appropriate time to leave the scheme but this will generally be before 1 April 2017
● decide to deregister for VAT where the business turnover is below the VAT deregistration threshold. A business effectively leaves the FRS the day before they deregister for VAT.
Will you be affected by the changes? Contact me and I can advise you of the best course of action for you and your business.