Neil Warren has summarised the top ten pitfalls to be aware of when using the flat rate scheme (FRS) for small businesses.
1. Capital goods which are hired out
In my article flat rate scheme bites back, I considered the case of Apex Vehicle Management Ltd (TC06911). This case illustrated an exception from the opportunity for FRS users to claim input tax on capital goods costing more than £2,000, including VAT, when the asset acquired is being either rented, leased or hired out.
2. Discount on relevant flat rate percentage
There is an automatic one percentage point discount on the relevant flat rate percentage, but it only applies for the first year of VAT registration. This rule even caught out the judge in the Apex case. He noted in his report that the company registered for VAT on 1 June 2012 and joined the FRS on 1 March 2013. He then commented:
“The rate applicable to such activities was 9.5% and the appellant was entitled to a 1% reduction to 8.5% from 1 March 2013 to 28 February 2014.”
Can you spot the error? The 1% discount is only available in the first year of registration ie until 31 May 2013 for Apex, and not the first 12 months that the trader uses the scheme. (VAT Notice 733, para 4.7).
3. No need to record all purchase invoices
The rules for recording invoices digitally under the new Making Tax Digital (MTD) rules are essentially the same as already exist. The only time that purchase invoices need to be recorded digitally by FRS users, under the MTD rules, is if input tax is being claimed on an expense. This will only apply in the case of capital goods costing more than £2,000 including VAT, or for pre-registration input tax.
4. Pre-registration input tax can be claimed
An FRS user can claim input tax on pre-registration expenses on its first return, subject to the usual rules:
- Goods must have been bought within the four-year window before registration, used by the business during that time and are still owned on its first day of registration.
- The purchase window for services is restricted to six months before the registration date.
5. The joining threshold is about future sales
The FRS joining threshold anticipates the expected taxable sales in the next 12 months; the historic level of sales is irrelevant. If this figure is less than £150,000 excluding VAT, you can join. There is usually no problem if your estimate proves pessimistic and you exceed this figure, as long as you had a logical basis for your calculations at the time of applying.
6. Rental income is drawn into VAT
The FRS captures both exempt income and zero-rated sales made by the business, but not income that is outside the scope of VAT – the latter would include many business-to-business services supplied to overseas customers.
Example: Nicky is a sole trader hairdresser and is VAT registered, using the FRS. He also lets out a residential property in his own name, which would normally be exempt from VAT as it is not holiday lettings. However, as the trade and the letting are both conducted by the same legal person the exempt rental income is subject to the FRS percentage, so Nicky must effectively pay over VAT on the gross value of his rental income.
7. Jointly owned land is a partnership
Extending the previous example, it would not be a problem if Nicky the hairdresser owned the let property jointly with his wife. For VAT purposes, the letting is now classed as a partnership and therefore the income is received by a different legal entity to his VAT registration. Having the property in joint names means it is not caught up in the FRS operated by Nicky as a sole trader.
8. Leaving test is only made once a year
A business does not need to leave the FRS until its gross annual sales including VAT have exceeded £230,000. For a business with only standard-rated sales, this figure is £191,666 plus VAT. The good news is that a business must only undertake the exit test once a year, on the anniversary date of when it first joined the scheme (VAT Notice 733, section 12).
9. Limited cost trader test
The limited cost trader (LCT) category was introduced on 1 April 2017, and its draconian rate of 16.5% gives minimal credit for input tax. It has wiped out many FRS gains enjoyed by service-based businesses that spend less than £250 a quarter on goods, or less than 2% of their gross turnover. Don’t forget that a business needs to consider whether it is an LCT each time a VAT return is completed.
10: You can leave at any time
The FRS has undoubtedly suffered a reduction in popularity since the introduction of the limited cost trader rules in April 2017. However, a business can withdraw from the FRS at any time. This will usually be at the end of a VAT period, but it can also leave during a period. The mid-period withdrawal could be a useful tax saver in some cases eg before a big zero-rated sale is captured by the calculations.
About Neil Warren
Neil Warren is an independent VAT consultant and author who worked for Customs and Excise for 14 years until 1997.