How to fix the VAT flat rate scheme
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.
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.
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.