The VAT Flat Rate Scheme is changing

What you need to know

Many contractors, micro-business consultancies and other small outfits will be affected by the government’s planned changes to the VAT Flat Rate Scheme, which were signalled last autumn without fanfare and are being brought in for April 2017.

The cash benefit offered by the flat-rate scheme has provided a lifeline to many small operations, as well as simplifying VAT treatment. What is there to know and understand about the scheme and its de facto removal for many?

What is the Flat Rate Scheme (FRS) for VAT?

The FRS is used by hundreds of thousands of small businesses to simplify VAT reporting. Lots of those businesses also gain a cash advantage from using the scheme, but this advantage is due to be cut back significantly from 1 April 2017. The FRS will continue but many businesses will not find it economical to use.

How does it work now?

When using the FRS the business ignores VAT incurred on purchases when reporting VAT payable, with the exception of capital items that cost £2,000 or more. The trader simply multiples gross turnover (including VAT charged at the normal rates) by the FRS percentage set for the relevant trade sector.

This FRS percentage is supposed to take account of the amount of VAT likely to be incurred on business expenses. The common percentages used by service-related businesses are:

  • Journalism or entertaining 12.5%
  • Accountancy and legal services 14.5%
  • Computer or IT consultancy 14.5%
  • Business services not listed elsewhere 12%
  • Estate agents and property management 12%
  • Management consultancy 14%

What this means is that service businesses with few expenses, and that operate in a sector with a relatively low FRS percentage, pay out less VAT to HMRC than they would outside the scheme. Many businesses register for VAT voluntarily before turnover reaches the VAT registration threshold, so they can use the FRS and bank the cash advantage.

Here’s an example. A business services company invoices a client £1,000 plus VAT at 20%. So £1,200 in all. When it comes to passing the VAT charged to the government the FRS calculation is 12% of the gross billing of £1,200 – £144 in this case. The business can bank the difference of £56.

Why is it changing?

The government believes small businesses have been abusing the FRS – particularly recruitment businesses setting up multiple companies to use the scheme.

The Guardian exposed the abuse in a piece last year and the government reacted by changing the rules and talking about the “aggressive abuse” of the scheme.

Unfortunately, the government has tarred all small businesses using the scheme by extension, despite most using it as the law intended. In any case, the government is now changing the terms of the scheme to make is less attractive and to reduce the cash advantage enjoyed by service-related businesses.

How will it work from 1 April 2017?

From 1 April 2017, a business will be required to use a FRS percentage of 16.5% if it is a “low cost trader” (see below). This is likely to adversely affect businesses in all of the trade sectors listed above and possibly many other similar businesses as 16.5% of the gross turnover is equivalent to 19.8% of the net leaving almost no credit for VAT incurred on purchases. It means the scheme is not viable for most services businesses that use it and most will be better off leaving the scheme if they turnover under the VAT threshold of £83,000.

What is a low cost trader?

A low cost trader, in the government’s newly minted definition for the FRS, is a business with expenditure on goods (not services) of less than 2% of its gross turnover or, if more than 2% of its turnover, where the amount spent on goods is less than £1,000 per year. Any expenditure on capital items, motor expenses or food and drink for consumption by the business is ignored when working out the 2% or £1,000 threshold.

This emphasis on goods discriminates against businesses that incur VAT on services such as rent, software licences, IT support, digital journals, sub-contractors, telecoms and so on. In VAT terms, a service is anything that is intangible or where the cost relates to a tangible asset it is the temporary use of that asset – such as hiring.

What happens next?

The government hasn’t provided a great deal of clarity to help businesses in deciding whether to remain in the FRS.  For some, it will be unclear what goods or services are included in the expenses – but every affected individual need to try to calculate the impact and decide on his or her status.

There is also further work to be done by the government to clarify the handling of dates and invoices in relation to accounting periods and the roll-out of the new scheme on 1 April 2017. We’ll keep you in the picture in the weeks ahead.

Information Source: UK Business Forums