VAT’s flat – or is it?
VAT should, in theory, be easy to understand. The problem is that it can be quite complex. Here’s why
VAT is supposed to be a simple tax. It’s collected from clients on your sales (output tax), and is paid to your suppliers on your purchases (input tax). All you need to do is keep track of what you’ve collected and what you’ve paid, and send (or reclaim) the difference to HMRC.
In theory, it’s easy to understand, but Mike Thexton, a chartered tax adviser specialising in VAT and a member of Council of the Chartered Institute of Taxation, says in reality it’s not. Why?
Because some sales (purchases) may be exempt from VAT, some may be zero-rated, and some may be taxed at 5% instead of 20%.
Worse, as Thexton points out, ‘all those expenses should be backed up with a proper VAT invoice, or you’re not supposed to claim. And if you get any of that wrong, you might be charged a penalty, even though you’re acting as an unpaid tax collector for the government’.
The Flat Rate Scheme for small businesses (FRS) is open to businesses which expect their VATable turnover in the next year to be up to £150,000 excluding VAT.
Thexton considers it a boon as ‘it gets rid of two complications at once – distinguishing different types of sale, and complying with all the rules on expenses’.
Quite simply, in exchange for not claiming input tax (which means that there is no need for VAT receipts or dealing with ‘partial exemption’) you’re allowed to keep some of your output tax as compensation.
How to apply
You can apply online to join the FRS at the same time as you register for VAT; or if you are already VAT-registered, and using the normal rules, you can mail a form (see www.gov.uk/vat-flat-rate-scheme). You will usually be allowed to use the FRS from the beginning of your current or next return period.
How it works
If you follow the website link above you will find a list of business categories, each with a flat rate percentage, for example ‘General building or construction services – 9.5%’.
You choose the description that best matches your main source of income. You apply that rate to your gross, VAT-inclusive income, not bothering with the difference between the different categories. That’s the flat rate VAT you owe on sales: it goes in Box 1 of the VAT return instead of the normal output tax. It’s usually less than you would owe under the normal rules.
The flip side of this is that you don’t get any credit for VAT on costs, unless you spend at least £2,000 VAT-inclusive on fixed assets – it has to be a single item of goods that is over the limit, and as usual, you can’t claim anything on cars.
The rules allow all the bits of a new computer, for example, to be counted together if they are bought on a single invoice.
Thexton says it’s essential to check whether you are better off before you apply. He offers the following example based on a firm’s annual figures (excluding VAT):
- Sales – standard rated £100,000, zero rated £20,000, exempt £10,000.
- Expenses chargeable to VAT (no fixed assets) – £15,000
- ‘Under the normal rules, you would owe output tax of 20% x £100,000 = £20,000, less input tax of 20% x £15,000 = £3,000, net due to HMRC: £17,000.
But under the FRS, you have to apply the flat rate to all your gross receipts including VAT – that’s £120,000 + £20,000 + £10,000 = £150,000. With a 9.5% rate, you will owe HMRC 9.5% x £150,000 = £14,250. Your life is simpler and £2750 less expensive.
So, you look at the list again and you find something you missed because ‘construction services’ isn’t the main part of your business – let’s say ‘Retailing not listed elsewhere’ at 7.5%. Now you owe 7.5% x £150,000 = £11,250, and the FRS leaves you £5,750 a year better off.
It’s clear that putting yourself in the right category makes a big difference. HMRC may disagree with your choice, but as Thexton points out, ‘as long as you can show reasonable grounds for believing it applied to you, they won’t make you change it retrospectively’.
He says that if they persuade you that you’ve got it wrong and should change going forward, you can leave the FRS and go back to the normal rules if you will be better off.
There is one note of caution: You are supposed to reconsider your category each year on your anniversary of joining the FRS, based on your expectations of what your main business will be in the year to come. If you think you will fall into a different category, you must change your rate.
Is it that simple?
Calculating FRS VAT is simple – total income, including VAT, multiplied by your rate. But if your clients are VAT-registered, they will want a VAT invoice so they can claim input tax. Your being on the FRS makes no difference to how your customers can reclaim the VAT you’ve charged.
But it’s not all plain-sailing.
Big change: 1 April 2017
In November 2016, Philip Hammond made a surprise announcement – to ‘counteract aggressive abuse of the FRS’, he made a significant change to the rules that took effect from 1 April 2017. Thexton says it turns out that HMRC had received thousands of FRS applications from small companies set up to ‘supply’ one or two individuals to VAT-registered large businesses – in effect, acting as employees – in order to exploit the difference between the input VAT the customer can claim and the FRS VAT those companies have to pay.
HMRC were effectively giving extra money to the workers, who were not really running a ‘business’ – they hardly had any accounting to simplify.
Thexton expands: ‘The only way HMRC could catch all the abusers was to bring in a new category called ‘Limited Cost Trader’ (LCT).’
An LCT is someone who spends less than 2% of their turnover on goods, with a long list of exclusions. Services (such as rent, advertising, accountancy, software, phone and internet) don’t qualify. This means that most businesses that sell services (say fitters) will be LCTs – stationery for use in the business is the only significant expense that counts towards the 2%.
On the other hand, businesses that buy and sell goods will not be LCTs – retailers, wholesalers, restaurants, builders who supply materials as well as labour. For fitters, the calculation will turn on the volume of physical supplies that they buy in compared to labour ‘sold’.
If you’re an LCT your rate is now 16.5% and in our example above you’ll be paying HMRC £24,750 and so will be £7,750 worse off.
Anyone who is likely to be a LCT should leave the scheme before they incur a significant amount of input tax, because they will be better off outside it.
The FRS has provided a relief from some of the intricacies of VAT for many small businesses. The LCT rule change is something that all FRS traders should think about. If you will be worse off, you should take action now before filing your next VAT return. But if you spend enough on goods each quarter, you will still probably be better off – and enjoy simpler accounting – within the scheme.