VAT flat rate scheme: End of an era
Neil Warren shares his thoughts on the new category of “limited cost traders” who will use FRS percentage of 16.5% from 1 April 2017.
The alteration of the VAT flat rate scheme (FRS) categories to include a ‘limited cost trader’ has been widely criticised by advisers. Those businesses will be required to use the FRS percentage of 16.5%, which will affect a large number of honest traders, although the aim of the new rate is to supposedly tackle aggressive abuse of the scheme by labour-only agency workers.
The new category will be introduced by secondary legislation and will represent a major change to 123,000 FRS users, according to HMRC.
HMRC issued a policy paper on the proposed changes titled “VAT: tackling aggressive abuse of the Flat Rate Scheme”. This paper recognises that the new rate “will remove the cash advantage for those businesses with limited costs”, i.e. all businesses are affected and not just the supposed tax avoiders.
It also revealed some interesting statistics:
- The new limited cost trader category will increase the annual tax yield by £130m
- Two thirds of FRS users are registered for VAT on a voluntary basis (annual taxable sales are less than £83,000) and HMRC anticipate that the new category will mean that “many of them may decide to deregister”
- The limited credit for input tax that is evident with the 16.5% rate means that an estimated 4,000 FRS users will revert to normal VAT accounting, i.e. output tax less input tax
- HMRC quote an average figure of £390 in cost savings for a business that chooses to deregister after 1 April 2017
What does the change mean?
Everyone agrees that the new 16.5% category will not assist the ‘simplification’ aims of the FRS. Life will definitely get more complicated.
A business will check its actual spending on goods each quarter and identify whether it can submit the return based on its normal trade sector category (e.g. accountant 14.5%, other services 12%) or whether its VAT inclusive expenditure on ‘goods’ is less than 2% of its gross sales or £250, and the 16.5% rate will therefore apply.
For the definition of goods; vehicles, road fuel and motor parts are excluded (unless the expense relates to a transport business such as a taxi firm), as well as food, drink and capital goods. Supplies of gas and electricity are classed as goods and included in the calculation, whereas rent, telephone and Internet charges are services, and so are excluded.
For VAT quarter ending 30 June 2017, an accountant had gross sales of £10,000 including VAT. His VAT inclusive spending on qualifying goods for the same period was £240. The business must adopt the 16.5% rate and pay £1,650 of VAT if the £240 spending on goods is:
- Less than 2% of sales (£10,000 in my example ie £200)
- Less than £1,000 a year i.e. £250 in a quarter
So a total goods figure of £240 including VAT passes the first bullet test but not the second – so the 16.5% rate must be adopted.
A question I have been asked is whether a business must review its actual spending on goods for each VAT quarter after April 2017, as in my example, or whether it only reviews the relevant rate on an annual basis. The answer is that it must be reviewed at the time each VAT return is completed; ie on a period by period basis.
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The technical guidance was updated on 5 December 2016. This guidance (which is not law) adds an extra layer of complexity by saying that only goods with 100% business use can be included in the 2% calculation. So an electricity bill with part business and part private use is excluded completely. This is supported by the draft legislation, which refers to an expense being "used by a flat rate trader exclusively for the purpose of the trader's business."
What about builders?
The FRS already has a ‘goods’ twist for builders (or building materials to be precise). If a builder spends more than 10% of his gross turnover on materials, he can use a lower FRS rate of 9.5%. If the material purchases are less than this figure, the FRS rate is 14.5%.
The new 16.5% rate means that if the material purchases (plus spending on other goods) are also less than 2% of total sales or more than 2% of total sales but less than £1,000 a year, the builder must apply the 16.5% rate. Of course a newly VAT registered builder will also get a 1% discount on his relevant category in his first year of registration.
If my calculations are correct, a builder might end up with one of six different FRS rates: 8.5%, 9.5%, 13.5%, 14.5%, 15.5% or 16.5%. So much for simplification.
Bob the builder registered for VAT on 1 January 2017 and joined the FRS on 1 April 2017. So he qualifies for a 1% discount on his chosen FRS category until 31 December 2017, i.e. his first year of VAT registration.
The only goods Bob buys in his business are building materials. In the VAT quarter ended 30 June 2017, his material purchases were 15% of his gross sales so he used the FRS rate of 8.5%, i.e. 9.5% less 1% discount.
In the following quarter, his material purchases were only 8% of total sales, so he used the rate of 13.5% i.e. 14.5% less 1%. But in the quarter ended 31 December 2017, he only supplied labour (0% material purchases) so he applied the rate of 15.5% ie the new rate for limited cost traders less his 1% discount.
In 2018, his material purchases were again 15%, 8% and 0% of total sales in the first three VAT periods of the year, so he applied FRS rates of 9.5%, 14.5% and 16.5% in these periods.
Bob has been required to use six different FRS rates in his first six quarters of VAT registration.
HMRC’s policy paper confirms that an online tool will enable current and prospective FRS users to determine whether they must use the new rate, which is very welcome. But I suspect that many current users will either deregister or revert to normal VAT accounting.
On refection, I have the same thoughts regarding FRS as fellow Manchester United supporters did when Sir Alex Ferguson retired as manager in 2013: “We’ve had a good run… but nothing lasts forever.”
This article has been amended following the release of the draft VAT regulations and explanitory notes.
Neil Warren is an independent VAT consultant and author who worked for Customs and Excise for 14 years until 1997.