VAT Flat Rate Scheme: What counts as a low cost trader?

  1. VAT Flat Rate Scheme
    Christian Annesley

    Christian Annesley Contributor Full Member

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    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 from 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 do small businesses think about the scorched-earth approach to the scheme from April?

    First, a cut-down reminder about the landscape (read the long version here):

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

    The FRS is used by many small businesses to simplify VAT reporting. Lots also gain a cash advantage from using the scheme, but this advantage is being all but removed 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.

    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 possible 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.

    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.

    What do people think?

    There are so many different takes, as you’d expect. Let’s take a look at a handful.

    Extra burden

    UKBF contributor Diesel says that many will just face extra administration now, which is what the scheme was created to avoid.

    “It’s punishing small (like really small...) businesses because we will have to work out all receipts and income every time there is a VAT return due. If a company has an accounts department and dedicated staff then that is fine and an ongoing process, but many small businesses will have to do this in-out admin themselves when they can fit it in around real work – or get the accountant to do it. On the FRS it was simply a matter of totting up income in and paying the percentage of VAT due – it takes ten mins.”

    Diesel adds that he suspects he’ll be able to keep using the scheme as his spend will be high enough to avoid the low-cost-trader designation, but says there was a reason the company wanted to avoid a full VAT return every quarter and now he’ll have to prove his spend on goods, adding work.

    American dream

    UKBF’s webgeek makes a very different point that might resonate with some.

    “Wouldn't this change encourage small UK firms to not early enrol for VAT, thus not charging VAT and then make purchases from international companies where they're not charged sales tax (in the case of American firms)?”

    He argues that change is an incentive to buy US goods –if you can find something that cost-competitive after shipping – and calls it “a strange message” indeed from the UK government.

    Too good to be true

    Another point admitted by webgeek and others is that the 14-year-old FRS was for some profiles of business almost too good to be true and closing the loophole was always a possibility, particularly given some of the more flagrant abuses of the system by recruiters.

    Defining goods to work out qualifying criteria

    The question of whether a company can stay in the scheme because it buys enough goods of a sufficient value to avoid the low-cost-trader designation is something that many are pondering, not only on UKBF but on its sister site Accounting Web.

    It’s been near-impossible to find useful guidance from HMRC so far (I’ve looked online to no avail and asked the question direct, but been met with silence or ignorance). But one user gives us this guidance, supposedly from HMRC, while warning it isn’t exhaustive:

    What counts as ‘goods’ in assessing low-cost-trader status:

    • Stationery and other office supplies to be used exclusively for the business
    • Gas and electricity used exclusively for the business
    • Fuel for a taxi owned by a taxi firm
    • Stock for a shop
    • Cleaning products to be used exclusively for the business
    • Hair products to use to provide hairdressing services
    • Standard software, provided on a disk

    Some supplies that aren’t good include:

    • Accountancy fees (these are services)
    • Advertising costs (services)
    • An item leased/hired to your business (this counts as services, as ownership will never transfer to your business)
    • Food and drink for you or your staff (excluded)
    • Fuel for a car (excluded unless operating in the transport sector using your own, or a leased vehicle)
    • Laptop or mobile phone for use by the business (capital expense)
    • Anything provided electronically, like a downloaded magazine (services)
    • Rent (services)
    • Software you download (services)
    • Bespoke software (service, however supplied)

    The FRS is supposed to be revenue neutral. But to achieve the simplification objective the government had to make it generous. Worse, not merely is it now having to remove that generosity but it must reverse it, which will make the simplification objective unattractive for many of the businesses that have grown used to both of the benefits.

    What now?

    The 1 April 2017 will roll around within hours. This is an important change for many small businesses because it is not something that is looming in the middle distance like Making Tax Digital – it is happening at once.

    There have been consultations to find an alternative, but HMRC sees no way of separating out the users of the system from those trying to play it, so everyone suffers.

    The message to small-business owners now is to look again at the scheme and how it works, and decide in advance what you need to do. Do you need to adopt standard VAT accounting – or is deregistration the best option if it’s available to you?

  2. Perfect Windows

    Perfect Windows UKBF Regular Full Member

    100 43
    As usual we have the government throwing the baby out with the bathwater. There's a loophole being abused by a certain group of people, so the government's solution is to impose a bureaucratic nightmare.

    It's no surprise, in my opinion. Decisions like these are made by bureaucrats who have no experience in the world of business. There seems to be a total lack of awareness that many, possibly most, businesses don't have an accounts department so every single layer of administration added is time away from the business owner's time being properly spent making a profit.
    Posted: Mar 29, 2017 By: Perfect Windows Member since: Mar 7, 2011
    Talay and Ltd Accountancy Ltd like this.