For many of us running small and micro-businesses, HMRC’s VAT Flat Rate Scheme (FRS) has provided a helpful, simplified means of calculating and submitting our VAT returns and dues. For those with modest input costs to our business, there can even be a small tax advantage when using the scheme. However, this situation is changing from 1 April 2017, with new rules for “limited cost traders” as HMRC seeks to tackle “aggressive abuse” of the FRS.
If you are, or think you might be a limited cost trader, you need to get yourself prepared for the imminent change.
The coming changes were discussed and digested at the February monthly meeting of Consult Yorkshire (a friendly support network for Yorkshire based independent consultants and freelancers), and I thought it would be useful to share what I learned here.
What is FRS?
For those not already aware, FRS is a simplified VAT accounting scheme for smaller business with a limited turnover (currently businesses can join the scheme if turnover is not more than £150,000 a year excluding VAT, and subject to some other eligibility rules), and where VAT due in your accounting period - typically quarterly for participants in the scheme - is based on a simple percentage of gross, taxable income. There is no need to track and offset input VAT and output VAT. The percentage to be applied is dependent on your business sector, for example in my sector - management consultancy - the FRS percentage is 14%, for a printing business it is 9%. HMRC sets the rates to mimic the expected effect of the application of standard VAT, whilst providing a simple and less burdensome approach to VAT accounting for smaller businesses. In practice, there is often a small financial benefit for businesses with low input costs and, new joiners to the scheme are also entitled to a 1% reduction in their first year of FRS - an unusual small win from the taxman!
Why and how is FRS changing?
In his Autumn Statement on 23 November 2016, the Chancellor of the Exchequer announced the introduction of a new 16.5% VAT Flat Rate for businesses with limited costs, and which comes into effect on 1 April 2017. It seems that whilst HMRC like offering a simplified VAT approach to smaller businesses, they do not like what they consider to be abuse of the scheme which means that they collect less VAT than they consider appropriate. Sadly the changes will add complexity to what is meant to be a simple approach to VAT accounting, and it also means that many FRS users will be paying more VAT in the future; FRS may no longer be the best option.
From 1 April 2017, FRS users will need to first assess whether they are a limited cost trader for the VAT period they are accounting for. If they are, then the 16.5% rate applies, otherwise they can continue to use their normal business sector rate. The 16.5% rate is higher than all the current FRS business sector rates, and therefore limited cost traders who remain in FRS should expect to pay a higher rate of VAT.
So how do you know if you are a limited cost trader? HMRC has defined a test that should be applied for each VAT accounting period: limited cost trading applies when VAT inclusive expenditure on goods is either:
- less than 2% of VAT inclusive turnover in the VAT accounting period, or
- greater than 2% of VAT inclusive turnover, but less than £250 per quarter (or £1,000 pa, pro rata per the VAT Accounting Period).
The sting in the tail, is that these thresholds apply only to goods as defined by HMRC, and therefore exclude many of the costs of small and micro-businesses such as: accountancy fees, advertising, capital items such as office furniture, laptops, tablets and mobile phones (even when not treated as fixed assets), food or drink for your staff, rent, travel, hotel stays, any downloaded software or on-line services, bespoke software, and vehicle costs (unless you are operating in the transport sector).
You might well ask what does this leave to include for small and micro-businesses that can be included in your limited cost trading assessment? According to HMRC, allowable goods include: stationery and other office supplies (only where used exclusively by the business), shop stock, products for hairdressing services, and standard software provided on a disk (who still does that?)
What are our options going forward?
I am about to do the sums for my business, but like many I expect to come out as a limited cost trader and must brace myself for the change.
If you are using FRS for VAT, and you are, or think you might be a limited cost trader, my advice would be to look at past and likely future scenarios to assess whether the FRS scheme will still make sense for you in the future. It is also sensible to seek professional help and guidance from your accountant, but broadly the only options I can see are:
- If your VAT taxable turnover is below the VAT threshold you can consider taking your business out of VAT altogether. However, note that some customers / clients may prefer to work with VAT registered businesses.
- Move to standard VAT accounting. This will require more administrative effort when you make your VAT return and in tracking input VAT in particular, but you will be able to offset VAT on all VATable business purchases.
- Continue using FRS, assessing your limited trader status in each VAT accounting period, and using the higher 16.5% rate as needed. It may well be that FRS remains the best available option for you from 1 April 2017.
Further information can be obtained from HMRC, including via these links (please check on the HMRC site to ensure this remains up-to-date):
- VAT Notice 733: Flat Rate Scheme for small businesses
- Flat rates for different business sectors
- HMRC’s calculator to assess limited cost trading status
- HMRC’s VAT General Enquiry webchat service and help line numbers.
Good luck with your future VAT accounting!