As usual, the 2017 Budget didn’t contain much about VAT, although it did include some small but significant changes designed to counter avoidance in specific business sectors. I’m sure you’ve all had lots of information from your accountants and other tax advisers.
New VAT Flat Rate Scheme rules
But by far the most important change on the cards is a change to the VAT Flat Rate Scheme (“FRS”) that takes effect from 1 April. This is one of the anti-avoidance measures and the intention is to prevent certain labour intensive services from using the scheme to save VAT. It introduces a new FRS rate of 16.5% for certain businesses who buy very small amounts of goods. Actually, this was introduced several months ago, but it is mentioned in the Budget documentation and there are now only a couple of weeks before it takes effect.
I’ll explain how it works later, but I thought it would be helpful if I explain the background to the change. It took me a little while to get my head round the reason for the change and I’m sure I’m not the only one confused!
Background to the FRS
The FRS was originally introduced as a “simplification” measure to help smaller businesses (those with turnover up to £150,000 per year) with their VAT returns. Instead of normal VAT accounting – i.e. calculating the net VAT payable as the difference between VAT on sales and VAT on purchases and expenses, businesses simply apply a fixed rate percentage to their gross income. They don’t have to keep records of VAT on purchases/expenses and the single VAT calculation is a very quick way of calculating how much VAT is payable to HMRC.
The effect of the FRS is that businesses charge VAT at 20%, 5% or 0% on their sales but calculate their actual VAT payable as a single percentage of their gross turnover. Sometimes the difference can be quite significant – in some cases, the FRS means that businesses pay less VAT than under normal VAT accounting; in others they may pay more. It’s up to the business owner to decide which method works best for them.
FRS change affects small, labour intensive businesses
Why the change?
The problem with the original FRS was that it was possible to use it in quite extreme circumstances to generate significant savings for larger businesses. This is particularly beneficial if the business is labour intensive and no goods/materials or very small amounts of goods/materials are used in the business.
How does the new rule work?
To prevent this “abuse” of the scheme, HMRC have introduced a “2% goods” test. The main principle is that businesses must purchase goods for exclusive use in the business that cost at least 2% of the FRS turnover; or at least £1000 per year if more than 2%. Otherwise their FRS rate will be 16.5%, which is about the same as normal VAT accounting.
The new rules are explained in VAT Notice 733: Flat rate scheme, section 4.4: http://tinyurl.com/h7qyogs. There have also been several articles and other comments explaining the new rules in more detail and how it works in practice, such as this recent excellent article on Accounting Web http://tinyurl.com/lvrdkq5.
FRS, small businesses and VAT registration.
In some respects, I agree that this was a sensible move as the FRS has clearly been abused by large businesses to reduce the cost of outsourcing work to self-employed consultants. Many other businesses simply took advantage of a scheme that enabled them to charge VAT at 20% while paying a much lower rate to HMRC. Businesses trading below the VAT registration limit can, of course, de-register, while many others will simply switch to normal VAT accounting.
However I wonder if HMRC have really thought through all of the implications of this change and particularly retail businesses. These are the businesses who are most affected by the VAT registration limit – in practice you go from paying no VAT on your sales to paying VAT on all of your sales when you register for VAT. Of course, this is often significantly offset by the VAT you can claim on purchases and expenses, but that doesn’t really help those whose business is labour intensive.
Labour intensive retail businesses
Many retail businesses who trade at just over or under the VAT registration limit (now increased to £85,000 from 1 April) have used the FRS as a way of minimizing the effect of VAT on their profit. For example, a high street hairdresser whose gross turnover is £87,000 would normally calculate their VAT liabilty at 20/120 x £87,000: i.e. £14,500. Suppose their input tax is probably in the £2,000 – £3,000 per annum range, so they’ll be paying about £12,000 VAT each year.
The FRS percentage for hairdressers is 13%, which on gross turnover of £87,000 is £11,310. Compared to normal VAT accounting, there is a small saving of just over £700 each year. It’s not a huge amount, but it makes a difference.
Of course, such businesses may still be able to use the FRS if they satisfy the new “goods” test, but this won’t apply in all cases. I can see a lot of situations where accountants are desperately hunting for receipts for goods used in the business every quarter to ensure that their client can continue to use the scheme.
HMRC says that this new rule is to level the playing field for businesses and prevent abuse. However it will also make life more expensive for those smaller businesses who follow the rules and are working harder and harder simply to pay their VAT bill.
Marie
March 2017