What is the VAT Flat Rate Scheme?

The VAT Flat Rate Scheme (FRS) is a simplified accounting scheme for small business. It was designed to reduce administration for small businesses by simplifying the VAT administration required in relation to the records of sales and purchases. The scheme allows businesses to apply a fixed flat rate percentage to their gross turnover (i.e. sales price plus 20% VAT) to arrive at the amount of VAT due to HMRC. The flat rate percentages are set by HMRC and vary according to industry sector; they currently range between 4% and 14.5%.

HMRC has introduced changes to the FRS effective from 1 April 2017 with a new 16.5% VAT flat rate for business with limited costs, such as consultants. The FRS requires relevant businesses to pay VAT at a higher effective rate than other flat rate scheme traders.

The new rate reduces the financial benefits of operating the FRS such that relevant businesses may benefit from switching away from the FRS to the ‘normal’ VAT accounting regime.

What’s changed?

The new flat rate of 16.5% will apply from 1 April 2017 to businesses in any sector where they are regarded as having limited costs. In calculating the VAT due on their sales, the new FRS percentage is applied to the gross or VAT inclusive value of sales. It is important to note that this translates to 19.8% of the net value of supplies made. In other words, affected traders will be accounting for VAT on their sales at close to 20% but with no right to recover input tax (save for some capital items). We expect that the effective credit for VAT of 0.2% is unlikely to compare well to using standard VAT accounting, where businesses can claim back VAT on all purchases of goods and services related to their taxable business activities.

All businesses are required to assess whether they are a Limited Cost Trader every VAT period. For those that do not meet the tests, the existing flat rates won’t change as these will still continue to be available.

What is a Limited Cost Trader?

A Limited Cost Trader is defined as a business where either:

  • the VAT inclusive cost of goods is below 2% of total VAT inclusive turnover
  • the VAT inclusive cost of goods is greater than 2% but less than £1,000.

Where the VAT return is for less than one year then the figure should represent the relevant proportion of £1,000 i.e. £250 for quarterly VAT return.

The calculation is based on all goods bought for the purposes of the business. However, the following items are excluded for the purposes of the calculation:

  • any services e.g. website design, marketing expenses or advertising
  • capital expenditure such as office equipment, laptops, mobile phones and tablets
  • food or drink that is consumed by businesses or employees
  • motoring cost including vehicles, vehicle parts and fuel
  • goods such as promotional items, gifts or donations
  • items used for business and private use e.g. stationery including printer ink.

What are the options?

The FRS changes will have a direct impact on service oriented businesses. For relevant businesses, they may:

  • be required to use the Limited Cost Trader flat rate
  • benefit from moving to the normal VAT return regime
  • be eligible to de-register if turnover is below £83,000.

Some examples

A TV presenter who has income just above the compulsory VAT registration threshold but expenses relating primarily to bought in services is likely to be caught by the new Limited Cost Trader rules. They may be better off switching to the normal VAT accounting and compliance rules rather than using the new rate of 16.5%.

Similarly, an IT consultant is likely to be subject to the Limited Cost Trader rules as we would expect them to have purchases below 2% of total turnover. Whereas a market retailer whose cost of goods is likely to be more than 2% of their turnover and over £1,000 a year and as a result could benefit from a lower Flat Rate VAT.

What needs to be done?

Businesses who are now subject to the Limited Cost Trader provisions should consider whether there may be a financial benefit were they to switch to the standard VAT scheme. Some businesses may also have the option of de-registering from VAT if their turnover is below the de-registration threshold.