VAT: Closing a loophole in the FRS
Neil Warren considers the latest significant change to the limited cost trader rules which will affect flat rate scheme users from 1 April.
HMRC has closed the stable door on an easy way for a business to escape being a limited cost trader (LCT) within the revised flat rate scheme (FRS) rules which apply from 1 April 2017. I shared this method in my article ‘Limited cost trader category for FRS users’, which involved creating a secondary activity buying and selling goods. What has HMRC done?
The draft regulations issued by HMRC on 5 December 2016 listed certain exclusions from the class of “relevant goods” with the LCT category. For example, capital items, road fuel and motor parts, and food and drink for employees are all excluded from the definition of relevant goods. In a webinar on the new FRS scheme rules, HMRC clarified that road fuel and motor parts are classified as relevant goods only where they are used by a business in the transport sector, such as a taxi or road haulier. But those items are excluded from relevant goods for all other businesses, including for vehicle repair businesses.
In the same webinar HMRC emphasised that goods must be used exclusively for the business purposes with no private use, to be treated as relevant goods. Gas and electricity are treated as goods, but those supplies must be used exclusively for business to be included as relevant goods.
An office printer is used for private as well as business purposes. All the paper and ink for that printer must be excluded from the definition of relevant goods.
All other goods purchased by a business are treated as relevant goods. The total cost of the relevant goods bought in a VAT quarter is tested to see whether it is either; less than £250, or less than 2% of VAT inclusive sales for the period. A “yes” answer to either of these tests means the business must apply the FRS percentage of 16.5% for the VAT period in question. However, the list of exclusions on the draft regulations did not include any goods bought by a business for resale – that has now changed.
HMRC issued a revised VAT Notice 733 on 1 March 2017, with LCT issues analysed in new paragraphs 4.4 to 4.6. Paragraph 4.6 defines “relevant goods” and extends the exclusions to:
- goods for resale, leasing, letting or hiring out if your main business activity doesn’t ordinarily consist of selling, leasing, letting or hiring out such goods
- goods that you intend to re-sell or hire out, unless selling or hiring is your main business activity
In the HMRC webinar the following new exclusion from relevant goods was also listed:
- goods for disposal as promotional items, gifts or donations
It is assumed that the above changes will be given force of law in the final regulations to be passed by Parliament before 1 April 2017.
John trades as a limited company with the following sources of annual income:
- football coaching: £90,000 including VAT
- buying and selling footballs and kits: £10,000 including VAT (50% gross profit margin i.e. £5,000 cost of sales figure)
Until the amendment to the definition of “relevant goods”, John would never have been a LCT because the £5,000 cost of stock clearly exceeds both the £1,000 annual deminimis figure and 2% of his gross annual sales of £100,000. Now he must hope that his other purchases of goods (for example stationery, books) exceeds the thresholds. He can’t include his stock for resale in the test of relevant goods, because it does not relate to his “main business activity”, which is clearly football coaching.
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What does the change mean?
I don’t blame HMRC for making this amendment. The previous loophole put advisers in a very difficult position. If we had encouraged clients to introduce a secondary activity of buying and selling goods, this would carry a sniff of tax avoidance. Other advisers would have played the game with a very straight bat on the basis that a new secondary selling activity would be stretching the rules, and would go against the spirit of the legislation. The former approach would, in many cases, have meant that the VAT savings made by keeping clients out of the LCT category would have exceeded the potential losses of the new activity, even if goods were sold at a massive loss.
The latest change shows that HMRC is determined at all costs to cut out the tax avoidance it has identified in relation to agency workers using the FRS, even if it captures genuine FRS users such as John in example 2.
Neil Warren is an independent VAT consultant and author who worked for Customs and Excise for 14 years until 1997.