What is happening to the flat rate VAT scheme?

If you are on the flat rate VAT scheme, you will have received a letter from HMRC letting you know that The VAT Flat Rate Scheme is changing. So what on earth is going on?

Flat Rate VAT

This is a change that was announced quite recently in the Chancellor’s Autumn Statement on 23 November 2016 and comes into force from 1 April 2017.

Why is it changing?

The changes are being introduced because the government feels that businesses are using the flat rate scheme to reduce the amount of VAT that they have to pay, which was not their aim in setting up the scheme.

The original aim of the flat rate VAT scheme was to offer an option that simplifies the VAT process for businesses.  

With normal VAT, businesses work out the total of the VAT on their sales and total of the VAT on their expenses and then pay over the difference between the two figures every three months. This means keeping track of all your expenses as you go along and making sure you are recording the correct VAT amount for each expense.

The flat rate scheme allows businesses to effectively “ignore” the expenses side of things for the VAT return. They still charge 20% VAT on their sales, the same as before, but now instead of working out the difference between sales and expenses VAT, they just have to work out a percentage of the gross sales (sales including the VAT). The percentage is fixed depending on the industry sector that applies to the business e.g. for accountancy it is 14.5%. There is also a 1% discount on the rate that is applicable in the first year of the scheme.

The only expenses that can be included are assets (capital expenditure) over £2,000.

The flat rate scheme has been quite popular with business. The adopt it for the “right” reasons, because it is easier, but also for what the government considers to be the “wrong” reasons, because the amount of VAT due on flat rate often works out lower than using the normal scheme.

The government publication that deals with these changes is called “Tackling aggressive abuse of the flat rate scheme”. I do feel it’s unfair to say businesses have been “aggressively abusing the flat rate”. 

Most businesses have been doing everything by the book with no intention to aggressively abuse anything; they have joined a VAT scheme that is offered to them on rate that applies to their business and this rate is set by the scheme. Joining made sense because it was easier to administer and saved money, so for most businesses it was a no brainer.

What is changing?

HMRC are introducing the concept of  “Limited Cost Traders”. These are businesses which spend less than 2% of their gross sales or less than £1,000 per year total on “goods”.

The definition of goods does not include food or drink (unless you are selling it), motor expenses or motor repairs (unless this is your business) or assets (large equipment for use in the business). Spending on services is not included.

Limited Cost Traders will have to move to a flat rate of 16.5% from 1 April 2017.

[If you are currently on the first year 1% reduction then this will also apply the the 16.5% rate.]

The types of businesses this will affect include consultants, contractors and labour only construction businesses.

Example

John is a consultant on the flat rate scheme using the management consultant rate of 14%. His expenses are mainly travel and subsistence costs, postage, stationery and software subscriptions. He doesn’t buy a lot of “goods”, less than 2% of his gross sales.

If John makes £120 of gross sales (£100 net sales plus £20 of VAT) he currently pays £17.40 VAT to HMRC.

Under the new rules using 16.5% this would be £19.80 per £120 gross sales.

This would still be less than the £20 VAT on sales he would have to include on the normal scheme, however on the normal scheme he could offset the sales VAT with his expenses VAT.

When John was on 14.5% he would need more £2.60 of VAT from his expenses for every £120 gross sales to be better off leaving flat rate.

With the change to 16.5% he need just £1.20 of VAT on his expenses for each £120 gross sales. Add a few asset purchases, such as a new phone or laptop, and there is a definite advantage to leaving the flat rate scheme.

What do you need to do?

The first step is to work out whether you fall under the “Limited Cost Trader” definition. Your accountant or bookkeeper can help you with this and HMRC have made a tool available to help you decide whether this applies to your business.

https://www.tax.service.gov.uk/check-your-vat-flat-rate/vat-return-period

If it does turn out that you are a “Limited Cost Trader” you need look at your expenses and decide whether you might be better off leaving the flat rate scheme.

Should I stay or should I go?

Your decision is going to come down to that familiar balance of time and money.

The first thing to look at is how many VATable expenses the business has compared to the sales. How much expenses VAT (input VAT) do you have to potentially offset the sales VAT if you leave the flat rate scheme. The more VAT-able expenses, the more likely it is that you would be better off leaving flat rate.

On the money side, if you have relatively few expenses or few that include VAT e.g. less than £7.20 (including VAT) of VATable expenses per £120 of gross sales, then you might be better off staying on flat rate.

On the time side, if you don’t have the time or inclination to worry about inputting all your expenses on a monthly basis and it’s not going to make a lot of difference, then you might be better off staying on flat rate.

On the money side, if the difference is going to be small and you don’t want to pay your accountant and bookkeeper more for the extra time involved in a normal VAT return, you might be better off staying on flat rate.

If you are using an accounting systems and inputting all your expenses on a regular basis then a change would be reasonably painless as you’ll already have everything you need for the quarterly returns. If you save all your expense receipts in a carrier bag until year end then leaving flat rate would make a lot of difference to you.

This is definitely an area to discuss with your accountant and bookkeeper but don’t just base your decision on what saves the most money, don’t forget the bigger picture.

How do I leave?

If you want to leave the flat rate scheme you need to write and tell HMRC. This is normally done at the end of a VAT period but can be done at any time.

Just send a letter to HMRC at this address, giving details of your business name, your VAT number, your relationship to the business and the date that you wish to leave the scheme.

HM Revenue and Customs
Imperial House
77 Victoria Street
Grimsby
Lincolnshire
DN31 1DB

Or send an email to  frsapplications.vrs@hmrc.gsi.gov.uk

Once you have left the flat rate scheme you must wait 12 months before you are eligible to rejoin.

If you do leave, you need to make sure that any accounting software is updated to start recording VAT on your expenses.

One tricky VAT return

Whether you stay or whether you leave, unless your VAT quarter falls at 31 March you are going to have one VAT return where the rate or the scheme changes during the return period.

If you leave from 31 March 17, then you will need to do a VAT return that is partly flat rate to 31 March 17 and partly normal VAT scheme from 1 April 17.

If you stay on flat rate then you will need to change VAT rate part way through the period, moving to 16.5%  from 1 April 17.

There are complications if you are using cash accounting. If your sales invoice was issued when you were on flat rate but the payment falls in the period when you are on normal VAT, which should apply? In this case, you can apply the flat rate scheme to those invoices that fell into the flat rate period (VAT Notice 733 – paragraph 9.6

If may cause problems if you submit your return via a cloud accounting system as it might not be able to deal with a mid-period change. It may be necessarily to calculate your figures manually and submit this return directly through your HMRC VAT online account.

Decisions, decisions and action!

This change is looming very close on the horizon, so now is the time to have a real think about what you want to do and to take some advice if necessary. It’s not something that can be put off and ignored because if it turns out that you are a Limited Cost Trader, you can’t just continue submitting your VAT returns at the previous rate. So bite the bullet, put some time aside now and take a look at your business so that you might the right decision for you and stay on the right side of HMRC.

Summary

HMRC feel that flat rate VAT scheme is being abused
New definition of “Limited Cost Trader” for businesses with low spending on goods compared to their sales (quite a narrow definition of what constitutes goods)
Limited Cost Traders on flat rate VAT scheme have to use 16.5% from 1 April 2017
Need to work out if you are a Limited Cost Trader
Need to decide whether to stay on Flat Rate of leave the scheme
Need to act now!

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