New Restrictions on Flat Rate VAT

Wednesday December 7, 2016

New restrictions on the VAT flat rate scheme are bad news for small business.

If you're enjoying the simplicity and financial boost of the Flat Rate scheme (FRS) to sort out your VAT, you're going to need to pay attention to what HMRC's doing with it. Chances are, you're not going to like it much.

Quick refresher: the Flat Rate scheme is generally regarded as a low-hassle way of sorting out your VAT obligations. Once you're registered for it, you go ahead and charge the normal rate of VAT to your customers. However, instead of sending all of that to HMRC and claiming back VAT on your business purchases, you use the Flat Rate system. Under this, you keep a chunk of the VAT your customers are paying, sending the rest to the taxman. The percentage you keep depends on what business you're in. Up to now, it's been a pretty good system for smaller businesses. It  takes a big bite out of your paperwork - and can actually work out better financially. HMRC set the scheme up specifically to encourage businesses that don't hit the VAT turnover threshold to register anyway.

The problem the taxman's unhappy at how successful it's been.

You see, smaller businesses might not actually have a huge number of expenses to pay VAT on. If they operate in industries with a low FRS rate, they may actually be banking quite a decent amount of cash by using the scheme. So, by joining up to FRS (which is what they wanted you to do) and using the scheme correctly (which is exactly what they intended), you're now somehow "abusing" the VAT system (by doing precisely what they've been encouraging). Got it? Good. Now here's what they're doing about it.

Normally a business will deduct the VAT on inputs (what it buys) from the VAT charged on outputs (what it sells)

The Flat Rate Scheme VAT aimed to simplify record keeping by making it easier for businesses to work out the VAT they have to pay. To acheive this, that two stage process is simplified to one step.

For example, the flat rate percentage for a clothes shop is 7.5% - so if the owner of that shop sells a dress for £120 including VAT of £20 he will pay a flat rate of £9 (£120 x 7.5%) to HMRC.  The rates differ depending on your industry. The flat rate percentage for a detective agency is 12%, for a hairdresser it's 13% and for a labour only contruction firms it's 14.5%. You can see a full list of the current rates by sector on the governement website.

It does get more complicated as not all sales count for the scheme, but we're here to advise you if you are on the Flat Rate Scheme.

Flat Rate VAT was designed to deliver roughly the same amount in VAT revenue to the government, but be much easier to work out. However, because it's an estimate, some businesses will end up paying more, and some less. The government has become concerned that some businesses are using the Flat Rate Scheme rules to pay less VAT than they should be.

From the first of April 2017, the Flat Rate Scheme is changing. If HMRC classifies your business as a "low cost trader", you'll be paying a whopping 16.5% FRS percentage to HMRC. It might not sound like a huge change, depending on what you're used to paying, but it's going to make the Flat Rate Scheme a lot less appetising for many small businesses.

So, what exactly is a low cost trader? Well, if you're spending under 2% of your gross turnover on goods (services don't count), then the answer is you are! Also, if your goods expenses are below £1,000 per year, then you also fall into the low cost trader category. When you're making either calculation, you don't count expenditure on:

  • Capital items.
  • Motor costs.
  • Food and drink your business uses.

This will affect businesses that use the VAT Flat Rate Scheme but which spend very little on goods, including raw materials - such as firms providing services. The biggest impact will be on labour-intensive businesses where very little is spent on goods. For example, this may affect IT contractors, consultants, hairdressers and accountancy firms. There is likely to be a significant change for construction workers with small firms who provide labour, but where the raw materials are provided by the main contractor.

Depending on how your numbers shake out, if you're under the VAT threshold it may be worth opting out of the system altogether. If you can't deregister for VAT, then switching out of the Flat Rate Scheme may be worthwhile.

Mike Cherry, national chairman of the Federation of Small Businesses, said: "Many small businesses rely on the optional VAT flat rate scheme to simplify the management of their tax affairs. We welcome the government's attempts to clamp down on any misuse of this scheme by a small minority of businesses that use it. However we would be concerned if any small businesses who play by the rules now end up having to pay more to remain within the scheme. Following these reforms, it is important HMRC now produces clear guidance so that small firms understand whether or not to join the scheme."

So, that's the situation in a nutshell. It's not great news for small businesses, but it's not going to hit everyone equally. Remember that RIFT is here to talk you through your best options, and to keep you on the right side of HMRC. In the meantime, keep watching the skies for more Voices from the RIFT...

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