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Flat rate scheme revelations by Neil Warren

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16th Mar 2009
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Neil Warren has been to see HMRC about issues with the flat rate scheme, along with colleague Mike Thexton. Some members will have caught his detailed study in an article in Taxation magazine dated 12 March 2009. Here, Neil provides a summary of one key issue for AccountingWEB.co.uk members.

A number of weeks ago, I wrote a feature for Accounting Web about important points to consider in relation to the flat rate scheme (FRS). There were a number of concerns raised by readers about how to deal with specific sources of income earned outside of the main trading sales of a business. In this feature, I want to alert practitioners to a potential pitfall in relation to buy to let income. I will explain with a practical example.

Example

Jean is an accountant earning £100,000 per year excluding VAT. She is VAT registered as a sole trader and uses the flat rate scheme. She also owns a flat in Bournemouth, which earns her rental income of £10,000 per year.

The income and expenditure on the flat is kept totally separate (different bank account etc) from the accountancy fee income. Does she apply the flat rate percentage (11.5% for accountants) to £115,000 (£100,000 plus VAT) or £125,000 (ie including rental income)?

Solution

If you had asked me this question six-months ago, I would have advised that the buy-to-let income is ‘private’ rather than ‘business’ income and the flat rate scheme percentage only needs to be applied to business income. My own interpretation of buy-to-let situations is that they are an investment mechanism for an individual, often linked to pension planning motives. And just as HMRC’s Notice 733 confirms that bank interest from private bank accounts is excluded, I felt the same principle would apply to property income unless it was linked to the business e.g. flat above a trading shop etc. However, my conclusion has now changed…..read on.

The legislation

The fact that rental income is exempt from VAT is not an issue because it is a stated fact that the flat rate percentage in the FRS also needs to be applied to exempt and zero-rated income earned by the same legal entity – this is one of the downsides of the scheme. But the business issue is a separate challenge.

My changed interpretation of the circumstances has been made by consideration of EU rather than UK law. As we all know, it is the former that wins the day in the world of VAT. The EU definition of an ‘economic activity’ (UK law prefers the alternative word of ‘business’) clearly includes rental income (Directive 2006/112/EC, Art 9(1).

To quote directly from Art 9(1):

‘Taxable person’ shall mean any person who, independently, carries out in any place any economic activity, whatever the purpose or results of that activity.

Any activity of producers, traders or persons supplying services, including mining and agricultural activities and activities of the professions, shall be regarded as ‘economic activity’. 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.”

Legal entity solution.

The above problem will only apply if the main business income of say accountancy in the case of Jean is within the same legal entity as the buy-to-let income. So no problem if you trade as a limited company and have buy-to-let income in your own name – or if you trade as a sole trader but your buy-to-let income is through property jointly owned with you and your spouse or civil partner.

It seems a contradiction in terms to publicise a planning tip in relation to a VAT scheme where simplification is the priority. But the easy way to avoid having to account for FRS tax on your exempt rental income is to create a separate legal entity between the business and rental income if this is not already in place. The alternative approach could be to withdraw from the FRS if the tax charge created by the rental situation is excessive.

As a final point, be aware of the anti-avoidance rules in place that prevent ‘associated’ businesses from joining the FRS in certain circumstances. Have a look at para 3.9 and 3.10 of HMRC’s VAT Notice 733 for further details on this issue. I think it would be difficult for HMRC to apply the ‘associate’ rules in cases such as Jean with her accountancy work and rental property – they are such diverse activities and it would therefore be difficult to prove financial, economic and organisational links.

HMRC view

Unfortunately, the flat rate policy team in HMRC have reached the same conclusion on the buy-to-let situation as I have explained in this article. I know this because myself and another VAT adviser Mike Thexton recently held a very productive meeting with the FRS team in Liverpool about the scheme. Hopefully future editions of VAT Notice 733 will incorporate the situation raised in this article – it is currently silent.

As a final comment, HMRC also take the view that a VAT registered sole trader using the FRS would need to account for FRS tax on rental income he received from renting out his own private residence. I would not disagree with this view having read the EC Directive again. In the current property market, with many owners being forced to rent out property they cannot sell, this is a potential situation that could apply to many people.

Neil is a writer, lecturer and consultant on VAT. He is current holder of the Tolleys Tax Writer of the year award.

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Replies (6)

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Rebecca Benneyworth profile image
By Rebecca Benneyworth
23rd Mar 2009 04:39

I agree, sole trader
Neil Warren has summarised the treatment of sale of assets for us this week. It doesn't make comfortable reading.

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By User deleted
18th Mar 2009 17:52

Rebecca
..in simple terms:does this mean that a sole trader using the FRS would have to ensure that title to the home property was in joint names before selling it - even allowing for proportionality or coming out of the FRS before selling?
crazy

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By User deleted
16th Mar 2009 17:09

@Michael
To be fair to Neil, he does cover this in his excellent article in Taxation magazine, but we asked him to give us a snapshot of the issue here.

One reason this is not such a disaster even for unrepresented taxpayers is that HMRC accept that under the principle of proportionality, the trader can retrospectively withdraw from the flat rate scheme to exclude the sale proceeds from the scheme. The downside of course is the retrospective return to "normal" VAT accounting - and probably consequent VAT liability. Not a good result but not quite the disaster that accounting for VAT on the proceeds would be.

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By johnkcound
16th Mar 2009 17:05

Think Positive!
I think these apparent nonsenses can be turned to an advantage in certain circumstances. Suppose the trader was in a low flat rate category eg a pub at 6.5%. If he had a commercial investment property (not related to his business) then if he opted to tax (permission required for an existing property) then he would be well in profit by applying the flat rate scheme percentage.

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By mikeyban
16th Mar 2009 15:31

Even more important
Yes but I believe there is an even bigger problem that has beeen missed by the author of this article.....

the eventual sale of the buy to let .....say £200,000 ......frs VAT will also be due!!!!!

Yes you can opt out before the sale and revert to the 'traditional method' but this does not help the unrepresented taxpayer who will carry on unaware of the consequences................. and lets not forget these were the people this scheme appeared to be aimed at!!!!!

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By shoshana
16th Mar 2009 13:32

EU vs UK Law
Neil

While agreeing with pretty much everything you said in your excellent article on FRS, I would just point out that if there is a discrepancy between EU law and UK law then the tapayer is able to rely on the UK law if it benefits them.

The fact that the UK law talks about a 'business' would still catch property letting in my opinion.

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