HMRC announce major change to VAT Flat Rate Scheme (FRS)

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Robert Facer – VAT Director

HMRC have announced a major change to the VAT Flat Rate Scheme (FRS), which is expected to affect 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.

Businesses using the FRS with low costs may gain a VAT advantage from using the scheme, compared to normal VAT accounting. HMRC consider this to be an abuse of the FRS and the changes announced are intended to tackle this. These measures are expected to save the Treasury £195m in the first year, so clearly HMRC believe that many businesses will be caught by the new rules.

What is changing?

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 will primarily affect small ‘service based’ businesses and will mean that affected businesses will pay more VAT to HMRC by continuing to use the scheme.

An LCT is defined as a business where the 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 have introduced ‘anti-forestalling’ rules to prevent businesses gaining a VAT advantage by invoicing now for transactions which will take place after the new rules come into force.

What now?

Businesses using the FRS should consider now whether they are likely to be 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 after 31 March 2017.

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 before 1 April 2017 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.

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VAT Director

For further advice on how the changes to FRS may impact your business, please contact Menzies VAT Director Robert Facer.