VAT IS SUPPOSED TO BE a simple tax. It’s collected from clients on your sales (output tax) and is paid to your suppliers on your purchases (input tax). All you need to do is keep track of what you’ve collected and what you’ve paid, and send (or reclaim) the difference to HMRC. In theory it’s easy to understand, but Mike Thexton, a Chartered Tax Adviser specialising in VAT and a member of the Council of the Chartered Institute of Taxation, says in reality it’s not. Why? Because some sales (purchases) may be exempt from VAT, some may be zero-rated, and some may be taxed at 5% instead of 20%. Worse, as Thexton points out, “all those expenses should be backed up with a proper VAT invoice, or you’re not supposed to claim. And if you get any of that wrong, you might be charged a penalty, even though you’re acting as an unpaid tax collector for the government”.
Big help
Now anything that makes VAT simpler has to be a good thing and
one of Gordon Brown’s better innovations was the Flat Rate Scheme for small businesses (FRS). It’s open to businesses which
expect their VATable turnover in the next year to be up to £150,000
excluding VAT. Thexton considers it a boon as “it gets rid of two complications at once – distinguishing different types of sale, and complying with all the rules on expenses”. Quite simply, in exchange for not claiming input tax (which means there is no need for VAT receipts or dealing with “partial exemption”) you’re allowed to keep some of your output tax as compensation.
How to apply
You can apply online to join the FRS at the same time as you register for VAT; or if you are already VATregistered, and using the normal rules, you can mail a form (see www.gov. uk/vat-flat-rate-scheme). You will usually be allowed to use the FRS from the beginning of your current or next return period.
How it works
If you follow the website link above, you will find a list of business
categories, each with a flat rate percentage, for example “veterinary medicine – 11%”. You choose the description that best
matches your main source of income. You apply that rate to your gross, VAT-inclusive income, not bothering with the difference between the different categories. That’s the flat rate VAT you owe on sales: it goes in Box 1 of the VAT return instead of the normal output tax. It’s usually less than you would owe under the normal rules. The flip side of this is that you don’t get any credit for VAT on costs, unless you spend at least £2,000 VAT-inclusive on fixed assets – it has to be a single item of goods that is over the limit, and as usual, you can’t claim anything on cars. The rules allow all the bits of a new computer, for example, to be counted together if they are bought on a single invoice. Thexton says it’s essential to check whether you are better off before you apply. He offers the following example based on a firm’s annual figures (excluding VAT): It’s clear that putting yourself in the right category makes a big difference. HMRC may disagree with your choice, but as Thexton points out, “as long as you can show reasonable grounds for believing it applied to you, they won’t make you change it retrospectively”. He says that if they persuade you that you’ve got it wrong and you should change it, you can leave the FRS and go back to the normal rules if you will be better off. There is one note of caution: you are supposed to reconsider your category each year on your anniversary of joining the FRS, based on your expectations of what your main business will be in the year to come. If you think you will fall into a different category, you must change your rate.
Is it that simple?
Calculating FRS VAT is simple – total income, including VAT, multiplied by your rate. But if your clients are VAT-registered, they will want a VAT invoice so they can claim input tax. Your being on the FRS makes no difference to how your customers can reclaim the VAT you’ve charged. For Thexton, input tax is the big simplification: “You treat all your general expenses as gross, VATinclusive costs. You don’t have to worry about whether they were VATable or not, or whether the invoice meets all the VAT regulations. “You’ll still need an invoice in case HMRC wants you to justify a profit deduction for income or corporation tax, but there is less that can go wrong. “And you don’t need to make fiddly accounting entries to claim back VAT on small expenses – if you can keep some of your output tax instead, it’s a relief not to bother.”
But it’s not all plain sailing…
Big change: the LCT
In November 2016, Philip Hammond made a surprise announcement – to “counteract aggressive abuse of the FRS”, he made a significant change to the rules that took effect from 1st April.
Thexton says it turns out that HMRC had received thousands
of FRS applications from small companies set up to “supply” one
or two individuals to VAT-registered large businesses – in effect, acting as employees – in order to exploit the difference between the input VAT the customer can claim and the FRS VAT those companies have to pay. HMRC was effectively giving extra money
to the workers, who were not really running a “business” – they hardly had any accounting to simplify. Thexton expands: “The only way HMRC could catch all the abusers was to bring in a new category called ‘Limited Cost Trader’ (LCT).” An LCT is someone who spends less than 2% of their turnover on goods, with a long list of exclusions. Services (such as rent, advertising, accountancy, software, phone and internet) don’t qualify. This means that most businesses that sell services will be LCTs – stationery for use in the business is the only significant expense that counts towards the 2%. On the other hand, businesses that buy and sell goods will not be LCTs – retailers, wholesalers, restaurants, builders who supply materials as well as labour. For vets the calculation will turn on the volume of physical supplies they buy in compared to labour “sold”. If you’re an LCT your rate is now 16.5% and in our example above you’ll be paying HMRC £24,750 and so will be £7,750 worse off. Anyone who is likely to be an LCT should leave the scheme before they incur a significant amount of input tax, because they will be better off outside it.
Conclusion
The FRS has provided a relief from some of the intricacies of VAT for many small businesses. The LCT rule change is something that all FRS traders should think about. If you will be worse off, you
should take action now before filing your next VAT return. But if you spend enough on goods each quarter, you will still probably be better off – and enjoy simpler accounting – within the scheme.
