Neil has followed up on his article last week on problems with the VAT Flat Rate Scheme with a study on the impact of the scheme on those selling assets, including premises and business cars.

My previous Accounting Web article on the potential problems of the flat rate scheme (FRS) considered buy-to-let income. This article moves things on a stage further and looks at the situation when the asset that has produced that source of income (flat, house, bungalow etc) is sold. Does the income from the sale (which could be a massive figure, despite the current property market) need to be included in the FRS calculations? I will also look at dealing with the sale of a business car. Let me consider an example:

Example

John is a self-employed accountant, VAT registered and trading as a sole proprietor rather than a limited company. He uses the FRS and applies the 11.5% rate to his accountancy income.

John owns two buy-to-let investment properties that he has rented out for the last three years and runs a Mercedes car on his business. He bought the car brand new for £40.000 plus VAT three years ago and did not claim input tax (car available for private use).

For VAT period ended 31 December 2008, John sold one of the properties for £300,000 (no tenants in place) and the Mercedes car for £10,000. What are the issues with the flat rate scheme?

Note – for the purpose of this feature, we will not consider the issues on John’s rental income as these were considered in my earlier article.

Solution

Sale of property

The sale of the buy-to-let property is an exempt source of income and the FRS percentage needs to be applied to any exempt or zero-rated income earned by a business. This is one of the negative aspects of the scheme. We also established in my earlier feature that the definition of ‘economic activity’ within EU VAT law captures property income as business related:

Directive 2006/112/EC, Art 9(1) - “The exploitation of tangible or intangible property for the purposes of obtaining income therefrom on a continuing basis shall in particular be regarded as an economic activity.”
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However, the application of 11.5% FRS tax to a property sale of £300,000 would produce a very unfair result for John, a VAT bill of £34,500 that was not, in reality, intended by the legislation.

If John has already submitted his VAT return for December 2008, and not accounted for tax, then he has a problem. If he has not submitted the return, then the sensible and only option is for him to withdraw from using the FRS. He will need to stay out of the scheme for 12 months before rejoining again, and this would deny him any profit he makes on a quarterly basis by using the scheme (assuming he makes a profit). However, the important outcome is that he has avoided a massive VAT bill on the property sale.

Fortunately, there is a potential escape route if John has submitted the return. It has been indicated by HMRC that they will consider the EU principle of ‘proportionality,’ a situation where the application of the law produces an unfair and unintended outcome. They would almost certainly allow John to make a retrospective withdrawal from the scheme – the £34,500 tax bill was certainly not intended by the legislation!

Sale of car

VATA 1994, Sch. 9, Group 14 confirms that the sale of an item where input tax has not been reclaimed (a car available for private use being the main situation) is an exempt sale. And the sale of John’s Mercedes car will meet the business income test as well – it is not a private car that has been excluded from his business.

The key issue is that when the FRS legislation was drafted, the regulations excluded the sale of capital assets where input tax had been claimed (input tax can be claimed by scheme users on a capital asset if it costs more than £2,000 including VAT). In such cases, output tax needs to be accounted for on a VAT return based on 15% VAT rather than the relevant flat rate percentage of the scheme user (11.5% for John). But the legislation is silent on excluding any sales of exempt capital assets from FRS calculations.

In theory, John will need to pay VAT of £1,150 on the car sale (£10,000 x 11.5%).

Adding another twist to the tale, let us consider the situation where a taxpayer asks HMRC if he can withdraw from the FRS on a retrospective basis because he sold a car in a VAT period – and hadn’t realised that FRS tax should have been paid on his VAT return. Would HMRC allow retrospective withdrawal from the scheme on a ‘proportionality’ basis as they would with the property sale?

The answer is almost certainly ‘no’ because they would argue that the flat rate percentages for each trade category take account of the fact that some vehicles are sold by a business without VAT being charged. So withdrawal before the sale is made (if appropriate) is the only safe solution

As a final twist, what if John had originally bought his car as a second hand vehicle i.e. he was not charged VAT on the purchase price? In such situations, his eventual sale is standard rated rather than exempt from VAT (as there was no disallowed input tax involved with the original purchase) but VAT is only normally due on the profit margin under the second-hand margin scheme (which would be nil if the vehicle was sold at a loss). But here is the twist to the tale……the flat rate scheme cannot be used in conjunction with a margin scheme (VAT Notice 733, para 6.4) – so it is back to paying FRS VAT on the asset sale again!

Neil Warren is the 2008 Taxation Awards Tax Writer of the Year and an independent VAT consultant, author and lecturer. [1]