Sarah Bradford examines whether the new flat rate percentage for limited cost traders means that some small businesses may be better off leaving the scheme.
The VAT flat rate scheme for small businesses is a simplified scheme which allows eligible traders to calculate the VAT that they pay over to HMRC by reference to a fixed percentage applied to gross (i.e. VAT-inclusive) turnover. It is open to business with VAT taxable turnover of £150,000 a year or less.
Prior to 1 April 2017, the flat-rate percentage was determined solely by reference to the trade sector in which the business operated. However, from 1 April onwards it is also necessary to consider whether the business meets the definition of a `limited cost business’. This modification means that for certain types of businesses, being in the VAT flat rate scheme may now be costing them money.
Limited cost business
From 1 April 2017, a flat rate percentage of 16.5% applies in place of the business specific percentage to any business which meets the definition of a `limited cost business’. This is a business which spends less than 2% of its VAT-inclusive turnover on ’relevant goods’ or one which spends more than 2% of its turnover but less than £1,000 a year on relevant goods. The figure of £1,000 is reduced proportionately for periods of less than one year, and as such equates to £250 a quarter.
This test is applied each time that the business completes its VAT return. Consequently, it is possible that a business may be a limited cost business in one VAT quarter, but not another. Where the position is marginal, it may be necessary to do the sums each time a VAT return is completed to check which percentage – limited cost business or sector specific – should be applied.
Tip:
In marginal cases, consider the timing of expenditure on relevant goods – accelerating or delaying expenditure may mean that in some quarters the business is not a limited cost trader and the lower percentage applies.
Relevant goods
It is only `relevant goods’ that are taken into account in determining whether the 2%/£1,000 a year test is met.
Relevant goods are goods that are used exclusively for the purposes of the business. VAT Notice 733 contains the following list of examples of goods that count as `relevant goods’:
- stationery and other office supplies 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 be used to provide hairdressing services;
- standard software;
- food to be used in meals for customers;
- goods provided to a subcontractor and itemised separately;
- goods brought into the UK if they are not otherwise excluded; and
- goods brought without VAT being charged, if they are not otherwise excluded.
Excluded items
Not everything on which the business has suffered VAT is taken into account in assessing whether the business is a limited cost business. As noted above, only relevant goods are included – this means that no account is taken on any spending on services. The following are also excluded, even if used exclusively for the purposes of the business:
- vehicle costs, including fuel (unless the business operates in the transport sector using its own vehicle or one that is leased);
- food and drink for the proprietor or staff;
- goods for resale, leasing, letting or hiring out where the main business activity does not ordinarily consist of selling, goods that the business intends to re-sell or hire-out, unless selling or hiring is the business’ main business activity; and
- goods for disposal, such as promotional items, gifts or donations.
16.5% or 19.8%?
At first sight a percentage of 16.5% does not sound too bad – after all, 16.5% is less than the VAT charged at 20%, isn’t it? Well, yes, but only just…
The problem is that the VAT flat rate percentage is charged on gross (VAT-inclusive) turnover, whereas VAT is applied to the net cost. For example, assume that a trader sells at item for £100 plus VAT. The cost to the consumer is £120 (£100 plus VAT at 20%). The associated output VAT is £20.
If the business is a limited cost business operating the flat rate scheme, when it comes to doing its VAT return, it will pay 16.5% of the gross amount of £120 over to HMRC, i.e. £19.80 (being 16.5% of £120).
This is virtually all the VAT charged on the item (bar 20p) – allowing no credit for any input VAT that the trader may have suffered.
Trap:
Under the VAT flat rate scheme, a business that is a limited cost business will pay virtually all VAT charged over to HMRC, effectively losing any credit for any input VAT suffered.
Not all VAT is equal
Since the introduction of the concept of a limited cost trader under the flat rate scheme, not all VAT is equal. There are many supplies on which a business may suffer VAT which are not taken into account in determining whether the business is a limited cost business. Common examples include:
- accountancy fees - excluded as services;
- advertising costs - excluded as services;
- leasing and hiring costs – excluded as services (the rationale being that the business will never own the item as ownership is not transferred);
- goods not used exclusively for the business (for example, the electricity or gas supply to the home where the business is based at home);
- food and drink for the staff – treated as excluded goods;
- fuel for a car (even if used for business purposes), unless the business is operating in the transport sector using their own or a leased vehicle;
- electronic devices, including laptops and mobile phones – excluded as capital items;
- anything provided electronically, such as a downloaded magazine – excluded as treated as a service;
- rent – excluded as treated as a service;
- downloadable software – treated as a service;
- bespoke software – treated as a service, regardless of how supplied; and
- stamps and other postage costs – treated as payments for services.
Trap:
Beware of trying to beat the system by buying goods specifically to escape the definition of a limited cost trader, where the quantities are such that they cannot reasonably be used by the business and would be stockpiled or thrown away. HMRC are wise to this, and there is a specific exclusion to counter this practice.
Better out than in
Many service sector businesses may now be better off out of the flat rate scheme. A business may incur significant amounts of VAT on items that are used exclusively for the business, but which are not taken into account in determining whether the business is a limited cost business. Consequently, virtually all VAT charged to customers will, under the flat rate scheme, be paid over to HMRC, allowing no relief for input VAT suffered.
Example: Limited cost business
Holly has a business providing management consultancy. In a particular VAT quarter, she invoices clients £30,000 plus VAT (£36,000). Prior to 1 April 2017, her flat rate percentage was 14%.
Her expenditure on relevant goods is £120 plus VAT (which is both less than 2% of turnover and £250 a quarter). Consequently, she is a limited cost business and her VAT percentage is 16.5%.
However, Holly also pays rent of £500 plus VAT for her office and incurs £1,000 plus VAT on accountancy fees. She also spends a further £3,000 plus VAT during the quarter on goods that are not relevant goods.
Her total input VAT in the quarter is £924 (£24 (relevant goods) + £100 (rent) + £200 (accountancy) + £600 (other)).
Under the flat rate scheme, Holly must pay VAT of £5,940 (16.5% of £36,000) over to HMRC. She has charged VAT of £6,000, leaving her with only £60 to cover the input VAT suffered of £924.
By contrast, under the standard VAT scheme, Holly would only pay £5,076 (£6,000 - £924) over to HMRC – a saving of £864. Interestingly, using the trade specific percentage of 14%, Holly would pay £5,040 to HMRC.
Leaving the scheme
While the flat rate scheme is administratively simple (depending on the nature of the business) this may come at a cost. Traders wishing to leave the scheme and revert back to the standard scheme must tell HMRC in writing. It is usual to leave at the end of a VAT period. However, once a trader has left, they cannot rejoin for a year.
Practical Tip:
Businesses that meet the definition of a limited cost trader but incur input VAT on items that fall outside the definition of relevant goods may wish to consider whether the flat rate scheme is still for them. Where turnover is below the deregistration limit, there is also the option to de-register.
