Sarah Barron – VAT Specialist
HMRC made a major change to the VAT Flat Rate Scheme (FRS), which affected many businesses using the scheme, when introduced on 1 April 2017.
What is FRS?
The FRS is a simplification which allows small businesses to account for VAT based on a flat rate percentage of their VAT inclusive income, rather than separately declaring VAT on sales and purchases. The flat rate percentages vary between 4% and 14.5%, depending on the type of business and are intended to make an allowance for VAT on costs that the business would otherwise be allowed to claim under the normal rules.
Prior to the rule change, businesses using the FRS with low costs may have gained a VAT advantage from using the scheme, compared to normal VAT accounting. HMRC considered this to be an abuse of the FRS and the changes are intended to tackle this. These measures are expected to save the Treasury £195m per year, so clearly HMRC believe that many businesses will be caught by the new rules.
What has changed?
From 1 April 2017, all FRS businesses must check whether they meet the definition of a ‘limited cost trader’ (LCT), each time they prepare a VAT return. If they do, they must apply a flat rate percentage of 16.5%. This change primarily affects small ‘service based’ businesses and means that affected businesses will pay more VAT to HMRC by continuing to use the scheme.
An LCT is defined as a business where the VAT inclusive cost of goods purchased in the VAT return period is either:
- Less than 2% of the VAT inclusive turnover for the period; or
- Greater than 2% of the VAT inclusive turnover, but less than £1,000 per annum (i.e. £250 for a VAT quarter)
For the purpose of the above tests, ‘goods’ excludes capital expenditure, food or drink for consumption by the business or its employees, vehicles (and related costs) and costs which do not exclusively relate to the business.
HMRC introduced ‘anti-forestalling’ rules to prevent businesses gaining a VAT advantage by invoicing in advance for transactions due to take place after the new rules came into force.
Businesses using the FRS should consider whether they are caught by the new rules. If so, they may have to pay more VAT to HMRC than they would do under the normal VAT accounting rules, if they continue to use the FRS .
The particular circumstances of the business will need to be considered in order to determine the best course of action. It may be beneficial for LCT businesses to withdraw from the FRS scheme and account for VAT under the normal rules instead. LCT businesses that are trading below the VAT registration threshold may wish to consider cancelling their VAT registration.