Flat Rate Scheme changes

…for Limited Cost Traders

The changes that are being made to the Flat Rate Scheme (FRS) which may mean that the scheme is less attractive to some businesses and this may result in these businesses deciding to no longer operate under the FRS. It is important to understand these changes especially if you already operate the scheme or are considering using the FRS.

Background to the FRS

VAT FRS changesUnder the FRS a set percentage, determined by the business trade sector, is applied to the VAT inclusive turnover of the business as a one-off calculation instead of having to identify and record the VAT on each sale and purchase the business makes. Turnover will include any exempt supplies and it is therefore not generally beneficial to join the scheme where there are significant exempt supplies.

The aim of the FRS for small businesses is to reduce the administrative burden imposed when operating VAT, however many small businesses who use the scheme are also better off as they are effectively able to keep some of the VAT charged to customers.

How the scheme operates

The percentage rates are determined according to the trade sector of the business and currently range from 4% to 14.5%.

In addition there is a further 1% reduction in the normal rates for businesses in their first year of VAT registration. If a business falls into more than one sector it is the main business activity as measured by turnover which counts.

Although those operating the FRS pay VAT at the FRS percentage they are still required to prepare invoices for customers showing the normal rates of VAT. This is so that their customers can reclaim input VAT, if appropriate.

Example of a Labour Only Building Contractor

Build-it-right is a labour only building contractor. If its results are as follows:

Standard Rate Building Work£70,000 plus VAT of £14,000 = Total VAT inclusive turnover £84,000
Purchases£2,700 (inclusive of VAT of £450)
VAT due under the FRS say 14.5% x £84,000 = £12,180

By operating the FRS, Build-it-right charges customers £14,000 of VAT but only pays over £12,180 of this VAT to HMRC. Build-it-right is unable to recover the input VAT suffered on purchases of £450 under the FRS. Input VAT on purchases is not generally recoverable by traders operating the FRS. The purchase of capital assets consisting of goods and costing more than £2,000 (including VAT) may be dealt with outside the scheme.

If they had operated the normal VAT rules then the amount due to HMRC would be £13,550 (being £14,000 output less input of £450).

Flat Rate benefits for those trading below the VAT registration scheme

For some very small businesses including those trading below the annual VAT registration threshold of £83,000, rising to £85,000 from April 2017, it has been worthwhile registering for VAT and operating the FRS. Effectively these traders charge their customers VAT at 20% on the services they supply but only pay over VAT at an effective maximum rate of 17.4%. They are therefore able to keep a minimum of 2.6% of the VAT paid by their customers. This is set out in the following example:

Amount billed to customer£1,000 plus VAT at 20% = £1,200
Amount due to HMRC under FRS using the current highest percentage of 14.5%£1,200 x 14.5% = £174
Effective rate on VAT exclusive amount billed to customer£174 / £1,000 = 17.4%
VAT which can be retained by trader£200 – £174 = £26 (2.6% of £1,000)

Where the relevant FRS percentage is lower than 14.5% the effective percentage of VAT which can be retained could be significantly more.

The change to the FRS

The change, described as an anti-avoidance measure, introduces a new 16.5% rate from 1 April 2017. This rate will be applicable for businesses with limited costs, such as many labour-only businesses. Businesses using the scheme, or considering joining the scheme, will need to decide if they are a ‘limited cost trader’.

So, taking the example above, if the trader is caught by the new anti-avoidance rules then they will be in the following position:

Amount billed to customer£1,000 plus VAT at 20% = £1,200
Amount due to HMRC under FRS using the current highest percentage of 14.5%£1,200 x 16.5% = £198
Effective rate on VAT exclusive amount billed to customer£198 / £1,000 = 19.8%
VAT which can be retained by trader£200 – £198 = £2 (0.2% of £1,000)

A limited cost trader will be defined as one whose VAT inclusive expenditure on ‘relevant goods’ is either:

  • less than 2% of their VAT inclusive turnover in a prescribed accounting period
  • greater than 2% of their VAT inclusive turnover but less than £1,000 per annum if the prescribed accounting period is one year (if it is not one year, the figure is the relevant proportion of £1,000 so for someone who completes their VAT return quarterly the limit is £250).

‘Relevant goods’, for the purposes of this measure, must be used exclusively for the purpose of the business but exclude the following items:

  • capital expenditure
  • food or drink for consumption by the flat rate business or its employees
  • vehicles, vehicle parts and fuel, except where the business is one that carries out transport services, for example a taxi business, and uses its own or a leased vehicle to carry out those services
  • payment for services, as these are not goods, this would include rent, accountancy fees, advertising costs etc

Examples of qualifying ‘relevant goods’ include stationery (and other office supplies), gas, electricity and cleaning products, but only where these are used exclusively for the business.

Businesses using the FRS will be expected to ensure that, for each VAT return period, they use the appropriate flat rate percentage, so the check to see whether a business is a limited cost trader will have to be carried out for each VAT return.

These rules come into force from 1 April 2017, so where a business has a VAT period that straddles 1 April 2017, the test to determine whether the business is a ‘limited cost trader’ will only apply to the period from 1 April 2017.

The government estimate that of the 411,000 businesses using the FRS, 123,000 have limited costs and will be affected by these changes. According to the statistics produced by the government the changes which are being introduced to the FRS will result in it no longer being beneficial to some current users of the scheme.

What happens now?

The introduction of the 16.5% rate for limited cost traders will result in affected businesses having to reconsider their position and may result in different outcomes. Some businesses will:

  • continue to use the flat rate scheme, checking for each VAT return period, whether they are affected by the 16.5% limited cost trader percentage and paying VAT at the 16.5% rate if appropriate
  • decide to leave the FRS. In order to leave the FRS you must write and let HMRC know. Generally businesses choose to leave at the end of an accounting period. However, you may leave voluntarily at any time during an accounting period. HMRC will confirm the date you left the scheme in writing. If you are considering this option we can advise the most appropriate time to leave the scheme but this will generally be before 1 April 2017
  • decide to deregister for VAT where the business turnover is below the VAT deregistration threshold. A business effectively leaves the FRS the day before they deregister for VAT.

How can Essex Abel help?

Essex Abel’s can help you to assess the impact of each option and provide guidance as to the best course of action for your business. For FREE consultation to discuss your business, please contact us.

The information contained herein is of a general nature and is not intended to address the circumstances of any particular individual or entity. Although we endeavour to provide accurate and timely information, there can be no guarantee that such information is accurate as of the date received or that it will continue to be accurate in the future. No one should act on such information without appropriate professional advice after a thorough examination of the particular situation. Neither Essex Abel Ltd nor the author accept any responsibility whatsoever for any action taken based upon the information included in this article.