Significant changes to the VAT Flat Rate Scheme (FRS) have been announced by the UK government. The changes take effect from April 2017 and will result in higher VAT liabilities for thousands of small UK businesses.
What is the VAT Flat Rate Scheme?
The VAT Flat Rate Scheme was brought in by the UK government during 2002 with an aim of reducing the administration burden for small VAT registered businesses in the United Kingdom. Specifically, instead of having to calculate all allowable input tax suffered on the business’ expenses, before offsetting it against the output tax charged to customers – arriving at a VAT liability that the business then pays over to HMRC (as is done under the standard VAT scheme), the business owner would charge their customers 20% VAT as normal – but would only pay over the relevant flat rate percentage (determined by business sector) of the gross sales to HMRC.
Why is the VAT Flat Rate Scheme changing?
There is no doubt that the FRS achieved it’s original goal of simplifying the process of calculating the small business owner’s VAT returns. However, the government applied a ‘one size fits all’ FRS percentage rate to all businesses within a particular sector. As a result, each business was faced with a decision on whether joining the FRS would be beneficial for them in terms of the actual VAT payable to HMRC each VAT period. Some businesses would pay more VAT if they joined the FRS, some would pay significantly less VAT. Essentially, businesses with very little in the way of input VAT on expenses tended to benefit greatly under the FRS. The government has decided that, given the prevalence of ‘labour only’ contractor businesses nowadays, the original flat rate percentages do not reflect the input tax versus output tax make-up of the average service business.
What is changing from April 2017?
From April 2017, every business which operates the FRS must decide whether they are a ‘limited cost trader’. A ‘limited cost trader’ is a new term devised by the government in order to describe businesses who make small amounts of expenditure on goods/products.
The government defines a limited cost trader as a business 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 £1000 per annum if the prescribed accounting period is one year (if it is not one year, the figure is the relevant proportion of £1000)
The government state that in order for the physical purchase of items to apply as ‘goods’, they must be used exclusively for the purpose of the business, and must not include the following items:
- Capital expenditure – i.e. the cost of any goods which are bought to be used in the business over a period of more than 1 year. Examples given are Computers, mobile phones, office furniture, tablet, printer
- Food or drink used within the business or by its employees
- Vehicles, vehicle parts and fuel
If a business is deemed to be a limited cost trader, based upon the criteria above, then it must apply a flat rate percentage of 16.5% to their gross sales, regardless of the industry in which the business operates.
How will the changes affect my business?
Essentially, any business operating the FRS which does not spend the greater of £1,000 and 2% of gross turnover on ‘goods’ (as defined above) will pay significantly more VAT over to HMRC from April 2017.
Take for example, a wedding photographer who travels around his/her local area providing photography services. Currently, the photographer would pay a flat rate of 11% on their gross sales over to HMRC each quarter. Therefore, assuming an annual gross sales figure of £85,000, the photographer currently pays £9,350 in VAT to HMRC each year. The photographer has very little expenditure in terms of ‘goods’ as defined by the government (above) – perhaps binders, paper, letterhead and stationery. The photographer would need to spend at least £1,700 (2% of gross sales – as greater than £1,000) on ‘goods’ in order to be eligible to retain their existing FRS percentage of 11%. Therefore, if they did not spend this amount on ‘goods’ – and therefore they would be classified as a ‘limited cost trader’, they would need to apply the new 16.5% FRS rate to their gross sales figure in calculating their VAT liability form April 2017. This would result in an annual VAT liability of £14,025 – an increase of £4,675.
What are my options?
If you are still reading this article it is fairly safe to assume that you have provisionally accepted that you will fall under the ‘limited cost trader’ umbrella when it kicks in in April 2017. In determining what a business’ options are going forward from April 2017 we must bring your attention to a caveat that the government, at this point in time, have given very little guidance on how the the new FRS rate will be applied – in terms of what is classed as ‘goods’.
The numerically endowed readers out there may have spotted that the theoretical photographer (see above) could ‘top up’ their expenditure on goods to the 2% threshold of £1,700. Lets say they naturally spend £800 on goods. Therefore if they purchase £900 of blank photo albums and sell them on at a slight profit each year then they will no longer be a ‘limited cost trader’ and therefore will be able to apply their existing FRS percentage of 11% to sales going forward. They will spend £900 (which they may well recoup through sales of the photo albums) in order to save £4,675 in additional VAT payable.
Putting aside the above apparent loophole in the changes to the FRS scheme, the options available to a limited cost trader appear to consist of the following:
- Remain on the FRS and suffer the additional VAT liability as a limited cost trader. All good things must come to an end?
- Remain on the FRS, diversify into the sale of ‘goods’ in order to ensure that there is no doubt that the business will avoid the status of limited cost trader – leaving you with the ability to retain your current FRS percentage rate.
- Move across to the standard VAT scheme whereby you offset the input VAT on expenses against the output tax charged to your customers.
- Reduce your turnover level to the VAT deregistration threshold of less than £81,000 per annum and get out of the VAT game altogether.
How we can help
We will be watching for further announcements from the government as they refine the legislation in order to provide more clarity.
If you would like e-ccountant to take a look at how the FRS changes will affect you from April 2017 please do get in touch by emailing us or calling us on 0203 3226630.