Businesses using the Flat Rate VAT scheme with few or no expenses – so-called ‘limited cost traders’, will have to pay more in VAT from April 1st 2017 as part of new rules introduced by HMRC.
Why have the rules changed?
The rules, which were announced by the Chancellor in the 2016 Autumn Statement, are designed to tackle apparent abuse of the existing Flat Rate VAT Scheme and will require affected businesses to pay a higher fixed percentage VAT rate of 16.5 percent from the beginning of April 2017.
The Flat Rate VAT Scheme (FRS) was designed to be a simplified method of accounting for small businesses. Under the scheme, businesses are assigned a flat rate percentage according to the sector that they operate in, but under the new rules, all businesses that fit the definition of a limited cost trader – such as a large number of contractors – will have to pay the 16.5 percent rate.
Are you a limited cost trader?
Businesses currently using the FRS or those considering joining it will have to determine whether they are considered to be limited cost traders. Some business owners will find this easy to work out, but if you’re unsure whether you meet the definition or not, you can use this online HMRC test.
Under the new rules, a limited cost trader is defined as a business that has a VAT inclusive expenditure on goods of less than 2% of its VAT inclusive turnover in the relevant accounting period, or greater than 2% of its VAT inclusive turnover but less than £1000.
The definition of goods includes items used solely for the purposes of the business but does not include capital expenditure, food and drink, and vehicle-related costs (for businesses involved in transport). These exceptions were introduced to prevent businesses from buying everyday items or one-off purchases to raise their costs above the 2% level.
Annoyingly, HMRC have stated that the following classic contractor services are excluded, as they are not ‘relevant goods’:
- Accountancy fees
- Advertising costs
- ‘Anything provided electronically’ – e.g. downloads!
- Software you have downloaded, or bespoke software
- Office rent
HMRC have issued some guidance that might be helpful in determining what items qualify as goods. For example, any item that is used fully or partly by a business owner or employee in their private capacity, such as stationery that could be used in the office or at home, cannot be considered to be goods.
In the case of capital expenditure, this can include the cost of any goods that have been purchased for use in the business over a reasonable period of time, such as, for example, a piece of office furniture, a mobile phone, a computer or printer. These items can be considered as goods for the purposes of the FRS scheme, even if they are not treated as capital assets for wider accounting purposes.
Anti-forestalling rules in place
Additionally, the government has taken steps to prevent the practice known as forestalling, which involves paying or invoicing well in advance in an attempt to avoid a tax increase. Anti-forestalling legislation has been in place since November 2016 and is designed to ensure that those businesses defined as limited cost traders cannot continue to use a lower rate from April.
These anti-forestalling rules will apply to any business that provides a service subsequent to 1st April 2017, but issues its invoice or takes payment for that service prior to April. For the purposes of the FRS Scheme, any such service will be treated as having taken place on 1st April 2017, and additionally, any payment or invoice involving the provision of a continuous service that crosses this date will be apportioned accordingly.
How are contractors affected?
These changes are likely to have a significant effect on many small businesses, particularly service-related contractors, as the emphasis on goods discriminates against contractors who incur VAT on services.
Under the new scheme, many contractors, who were previously using flat rates of between 12 and 14.5%, depending on their sector, are likely to find themselves at the new 16.5% rate.
In financial terms, this represents a significant tax hit for many – but the Government will argue that those affected have been using the FRS purely to save tax, rather than due to the simpler accounting the scheme provides.
For example, if your turnover for the year is £75,000, your VAT-inclusive turnover would be £90,000. If you’re a typical contracting company, you would repay 14.5% x £90,000 = £13,050.
Under the new rules, if you’re a ‘limited cost trader’, you will now pay 16.5% x £90,000 = £14,850 – an increased tax hit of £1,800.
What should you do next?
- You can read the full details of the new rules here.
- If you think that the new rules may apply to you, you can use the HMRC online calculator, which will tell you whether you should be using the new rate.
- We strongly advise you talk to your accountant to decide whether you are affected, and if your company will be better off using the Standard VAT scheme