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How to fix the VAT flat rate scheme

16th Jan 2017
Tax Writer Taxwriter Ltd
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The government is attacking the VAT flat rate scheme (FRS) with a sledgehammer to remove perceived abuse, but there is a better way to solve the problem.

Fix needed

The FRS is certainly open to abuse. There is evidence to suggest that agencies set up workers in personal service companies (PSCs) and register each PSC for VAT in order that the FRS scheme can be used. A company with a turnover of £30,000 (including VAT), which provides only the labour of the director and uses a FRS percentage of 12%, will make around £1,400 per year from using the scheme.

In para 7.4 of explanatory notes to the draft VAT regulations HMRC says it received 30,000 extra applications in bulk for the FRS between January and August 2016. In the same notes HMRC estimates that there are 411,000 FRS users, and in the policy document they admit that two thirds of those traders (approximately 274,000 businesses) have an annual turnover below the VAT registration threshold.

It is rational to assume that those 274,000 traders would not be registered for VAT if they did not gain a significant financial advantage from using the FRS. It is not reasonable to assume that all of those 274,000 traders are abusing the FRS.

Costing the solution  

I believe HMRC want a quick solution to this problem - one which costs the department very little to implement, but will also stop the abuse of the FRS. 

HMRC’s proposal, to require “limited cost traders” to use a FRS percentage of 16.5%, will cost the department £415,000 in capital costs and ongoing costs of £4,000 per year (per the policy paper). Those amounts are chicken feed compared to the expected extra tax revenue of £695m over five years to 2021/22. The capital expenditure covers the cost of changing the online VAT registration system, and providing an online calculator to help traders determine whether they fall into the limited cost trader category.

The administrative burden of the limited cost trader solution falls almost entirely on the small business. HMRC estimates the additional cost for each trader who switches to normal VAT will be a one-off amount of £180. I believe this figure is far too low, as businesses who remain VAT registered after coming out of the FRS may well need to pay for help to complete and file their quarterly VAT returns.

In the cost impact assessment for traders HMRC has not considered the loss of revenue by ceasing to use the FRS. That additional income is taxable, so a company which makes £3,500 under the FRS will pay corporation tax of £665 (assuming CT rate of 19% from April 2017) on that income. It is not clear from the impact assessment whether HMRC has netted-off these direct tax losses against the VAT gains.      

Use trader data

HMRC is keen to boast how their Connect computer system can create a financial profile of individual taxpayers, and compare that to the data HMRC holds from tax returns. I would like HMRC to turn this computing power inwards, to interrogate the information it holds on FRS users.

HMRC knows which trade category each FRS trader has chosen, so it should be able to see which are the heavily used trade categories. Each VAT registration certificate shows a trade classification (SIC code), and that could be compared to the trade category picked for FRS. The combination of these two factors should allow HMRC to focus its attention on the trade categories and the SIC codes most commonly used, and help to identify exactly the types of businesses for which bulk registrations have been made.

Once identified, the descriptions for those "high volume" FRS trade categories could be further refined and subdivided, so that the commonly used SIC codes fall into trade categories which carry higher FRS percentages. This technological solution is more precisely targeted at the problem than the cluster-bomb limited cost trader proposal.

In the longer term the descriptions for every FRS trade category should be reviewed against the SIC codes of businesses using those categories. More FRS categories should be defined. Having a greater number of categories should not be a problem if the online FRS registration procedure helps the trader choose the right category by means of key words. 

Other partial solutions

I suggest that the 1% discount in the FRS percentage for newly registered VAT traders is removed. This would dull the incentive for agencies to register large numbers of newly formed PSCs.

HMRC does have the power (SI 1995/2518, Reg 55P) to remove traders from the FRS if it believes the trader is abusing the FRS scheme. It can also prevent the trader from registering to use the FRS if the trader is associated with another person, or has been within the last 12 months (SI 1995/2518, Reg 55L).

If the HMRC Connect computer system is so powerful, surely it can search out associations between traders who are abusing the FRS and block them all from using the scheme.

Action

You can submit comments on the draft VAT regulations which would bring into effect the limited cost trader conditions from 1 April 2017. Send your views to: itpt.vatregistration&[email protected], but please be polite. HMRC is collecting views until 29 January 2017.

You can also provide feedback on these proposals through your professional body. If you don’t know who to contact, leave a comment below and I will pass it on. 

Replies (23)

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By ireallyshouldknowthisbut
16th Jan 2017 11:51

Thanks Rebecca, in particular for highlighting that there will not be a consultation on this.

I will send a detailed email this week.

Fellow A-webbers may I suggest you do the same?

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By ireallyshouldknowthisbut
16th Jan 2017 12:24

One thought on this is if they simply make "business services not listed elsewhere" 16.5%, and added 1% to the rest it would be "problem solved"

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By adam.arca
16th Jan 2017 12:59

I would be a bit more radical: my solution to this problem is simply to abolish the FRS completely.

Completing a VAT return the "normal" way is hardly onerous even for the most numerically challenged client. Abolition of the FRS would eliminate a complication and put all VAT traders on a level footing.

(And before anyone points out that there would still be the complication of cash vs standard accounting, I would also in my dream world abolish that distinction: compulsory cash accounting below say £1m and compulsory standard accounting above).

I'm not instinctively in favour of compulsion but to my mind VAT is an area riddled with un-necessary complication absolutely screaming to be standardised one way or another.

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Replying to adam.arca:
By cfield
18th Jan 2017 15:11

adam.arca wrote:

And before anyone points out that there would still be the complication of cash vs standard accounting, I would also in my dream world abolish that distinction: compulsory cash accounting below say £1m and compulsory standard accounting above.

You obviously don't have any clients in the construction industry then. If they had to pay VAT up-front instead of on cash accounting, cash flow would be even more on a knife edge than it already is.

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Replying to cfield:
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By adam.arca
19th Jan 2017 09:47

cfield wrote:

adam.arca wrote:

And before anyone points out that there would still be the complication of cash vs standard accounting, I would also in my dream world abolish that distinction: compulsory cash accounting below say £1m and compulsory standard accounting above.

You obviously don't have any clients in the construction industry then. If they had to pay VAT up-front instead of on cash accounting, cash flow would be even more on a knife edge than it already is.

I do and your point is, of course, a fair one.

I prefer a simple system but the consequential problem is one of rough edges.

You can go the other way, which is the way the UK tax system has gone, of trying to micro manage everything and then you end up with the complicated mess we have.

It's about finding the right trade off and, to my mind anyway, the FRS is an unnecessary complication ripe for abolition.

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Replying to adam.arca:
By cfield
19th Jan 2017 10:08

adam.arca wrote:

It's about finding the right trade off and, to my mind anyway, the FRS is an unnecessary complication ripe for abolition.

Yes we do need a trade-off between simplicity and the "fairness" that complexity aims to achieve, but the FRS was meant to be a simplification in itself, and was a rare example of simplicity benefiting the taxpayer (the reverse is usually more likely).

It's only these new rules that are complicating it, and we have all those agencies who sent in mass-applications for small companies well below the VAT registration threshold to thank for that.

Not for the first time, the big boys have poisoned the well for the rest of us.

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Replying to adam.arca:
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By North East Accountant
19th Jan 2017 08:48

adam.arca wrote:

I would be a bit more radical: my solution to this problem is simply to abolish the FRS completely.

Completing a VAT return the "normal" way is hardly onerous even for the most numerically challenged client. Abolition of the FRS would eliminate a complication and put all VAT traders on a level footing.

(And before anyone points out that there would still be the complication of cash vs standard accounting, I would also in my dream world abolish that distinction: compulsory cash accounting below say £1m and compulsory standard accounting above).

I'm not instinctively in favour of compulsion but to my mind VAT is an area riddled with un-necessary complication absolutely screaming to be standardised one way or another.

Totally agree with the above. Stop complicating it.

If we think it's complicated now wait until we get Scotland, Wales and Northern Ireland with their own different VAT systems in years to come.

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By Ruddles
16th Jan 2017 16:38

One aspect of the change that should be given due consideration is the restriction to 'goods'. I know of at least 2 consultants that will almost certainly have to leave FRS based on the draft proposals. They have little expenditure in the way of goods but do have significant VATable costs on sub-consultants. Their FRS saving will not justify additional expenditure on goods in order to hit the 2% mark, and so remaining in FRS will cost them. Question is - what is the rationale for excluding 'genuine' service costs from the calculation?

And I've also already made the point that HMRC already have the power to remove traders from the Scheme, for protection of the Revenue. The proposed change is wholly unnecessary.

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Replying to Ruddles:
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By chaccountant
18th Jan 2017 18:29

Have I misunderstood the definition of limited cost trader? From this link (https://www.gov.uk/government/publications/tackling-aggressive-abuse-of-...) I understood that to stay in the new FRS you have to be a limited cost trader (LCT). An LCT is someone who spends less than 2% of their vat inclusive turnover on goods (excluding capital items, food/drink, vehicles). So someone with £80k of vat inclusive turnover has to incur less than £1,600 on goods, which I see, for your service providing clients, as quite likely.

Yet I read your responses as the consultants will have to leave FRS as they spend virtually nothing on goods.

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Replying to chaccountant:
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By garethgreen
19th Jan 2017 19:45

@chaccountant
The point is that if businesses find themselves reclassified as LCTs, it won't be financially viable to stay in the FRS.

The idea of the FRS was to set rates so that the resulting VAT liability would be roughly the same as if the business was paying standard rate and claiming input VAT.

The flat rate for LCTs has been set so that this is true only for agency workers who will have almost no input deductions at all. Almost all other service companies will reluctantly decide to leave the FRS, so that they can claim input deductions for the VAT they pay on the various services that they are supplied.

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By ireallyshouldknowthisbut
16th Jan 2017 17:30

@Ruddles, I will have almost no clients left on the flat rate scheme, as we deal mainly with small service business and none of them buy any 'goods' that are not excluded. Eg IT kit is probably the only thing. This is small software co's, professional service providers, writers, you name it, they are coming off!

I am on it myself as my turnover is just under the de-reg threshold and we don't qualify either, we simply don't by much 'stuff' other than paper and ink, and even that is going down rapidly.

infact the only two I think who will stay on are two 'consultants' who are sailing very close to the IR35 wind and book virtually no costs but our fee and will probably keep on it for simplicity.

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By JCresswellTax
17th Jan 2017 09:24

I agree Rebecca.

Get rid of 1% discount.

Also, up percentages by 1% across the board.

Job done!

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Chris M
By mr. mischief
17th Jan 2017 13:00

I agree that as usual HMRC have let the Numpty Department loose on the FRS changes, you really would think the Numpty Department would have their hands full with MTD but hey ho!

"Engineering 14.5%"

How hard is that? At a stroke thousands of people currently on 12% are no longer on it. By having many FEWER sectors like this, we:

Raise more tax
Simplify the UK tax code

This sort of thinking, of course, is entirely alien to HMRC. With them the solution to any problem is more silly rules, more red tape, more daft ideas, a longer tax code.

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By garethgreen
18th Jan 2017 09:22

There's another easy way for the government to fix this problem in a more targeted way, so that "legitimate" service businesses are not forced to withdraw from the scheme. Change the Low Cost Trader expenditure test to include expenditure on services and set a higher threshold of expenditure, at whatever level is necessary so that agency workers, who have little or no expenditure, are LCTs. (5% of turnover?)

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By Duggimon
18th Jan 2017 10:31

I've always felt it was unnecessarily confrontational and bombastic of HMRC to label these businesses as abusers of the system.

"Every man [sic] is entitled if he can to order his affairs so that the tax attracted under the appropriate Act is less than it otherwise would be."

It's the cornerstone of our profession and is undermined by the suggestion that anyone using the scheme they are legally entitled to use is an abuser.

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By richard.snape
18th Jan 2017 11:42

Ruddles, if service costs were not excluded then the agencies bulk registering consultants for the scheme could simply make sure they charged a fee of at least 2% of turnover in order to qualify. Garethgreen's suggestion of upping the threshold to 5% at the same time might work though as an artificial fee at that level would cost more than could be gained through the FRS.

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By gordon
18th Jan 2017 12:01

What is HMRC's rationale for ignoring input VAT on services?

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By garethgreen
18th Jan 2017 12:11

I don't think they have offered a rationale. I imagine it is nothing more sophisticated than an observation that the businesses that they consider to be abusers happen to have very little expenditure on goods. The problem is that they haven't recognised that this is also true for almost all service businesses.

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By BryanS1958
18th Jan 2017 13:12

it's interesting that using the laws of the land is considered 'abuse' when it leads to unintended consequences whereby the Exchequer is losing money, but is perfectly fine when it leads to unintended consequences that lead to more tax being collected.

Surely HMRC was fully aware of how the FRS legislation would be used when it was enacted? It's hardly rocket science that taxpayers will try to use the rules as advantageously as possible. Taxpayers are unpaid collectors or VAT and PAYE so why shouldn't they try and benefit?

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By fmuk
18th Jan 2017 14:06

An excellent article Rebecca, the most evident and sensible solutions to fixing the Flat Rate Scheme.
If only HMRC looked at the registrations for the scheme and disallowed the obvious abusers all would be fine. Were they all on holiday between January and August 2016, when 30,000 bulk applications were received.

I do hope you have forwarded this article to the policy team. Would it be too much to think they may consider such relevance?

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Replying to fmuk:
By Rebecca Cave
20th Jan 2017 06:55

I have communicated my ideas to both CIOT and Tax Faculty who are involved in face to face discussions with HMRC about the FRS.

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By kenny achampong
19th Jan 2017 14:58

That figure of 411,000 is a figure that I have always wondered about. Let's just take a wild guess that the average free money given to businesses is around £3,000 (that would be my guess based on my clients)

That would mean HMRC are throwing away £1.25 billion per year on the scheme.

But the scheme is totally irrational, and does not make things easier for most people. In fact it's totally the opposite, we are forever fiddling round with people's turnover going too high, and back down again, categories changing, calculating whether it's best to be in the scheme or not, and constant enquiries/investigations from HMRC. It was a total joke of an idea in the first place...but a nice little earner and so unfortunately we have been duty bound to do it for everybody.

So now it's out in the open and it would appear that finally somebody in charge has noticed that they are throwing away literally billions of £ (although luckily, to us) why don't they just abolish it ?

What on earth would make him, instead of doing that, decide to invent a libellous statement about us being agressive tax abusers (we would be negligent, and possibly get sued if we didnt use their stupid brainless scheme) and then he proceed to make it even more complicated.

FFS Hammond, just ABOLISH IT. After all, it is our taxes as well.

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7om
By Tom 7000
19th Jan 2017 18:16

you could just abolish vat # Brexit

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