From April 2017, many small limited companies which have low annual costs will face a higher VAT liability if they use the Flat Rate Scheme (FRS). Here, we look at how the changes are likely to affect contractors.
One of the most eye-catching announcements contained in the 2016 Autumn Statement was a change to the way ‘labour-intensive’ businesses calculate their VAT liabilities each quarter. The rule change was confirmed in Budget 2017.
How does the Flat Rate VAT scheme work now?
Unlike the standard VAT scheme, which requires businesses to calculate their quarterly VAT liabilities by adding up all the VAT charged over a quarter minus all qualifying VATable expenditure, the FRS simplifies these calculations for those who use it.
Under the FRS, you calculate your VAT liability by applying a fixed-percentage to your turnover (including VAT). This percentage varies according to your trade/profession. For most contractors, the current percentage is 14.5%.
So, if you invoice a client for £1000 plus 20% VAT, you owe HMRC 14.5% x £1200 = £174.
Under the standard scheme, you repay the entire £200 charged on the invoice.
However, whereas those on the standard scheme can reclaim the VAT on any types of expenditure, those on the FRS are restricted. The percentages were chosen to reflect the typical balance between input and output VAT of various types of business.
What is the problem?
The Government believes that some trades have unfairly benefited from using the FRS, particularly small businesses with low costs (such as contractors), and hopes that a change to the way the FRS is calculated “will help level the playing field, while maintaining the accounting simplification for the small businesses that use the scheme as intended.”
What are the new rules?
From 1st April 2017, so-called ‘limited cost traders’ will use a new 16.5% rate when calculating their FRS liabilities. All other businesses will continue to use the current percentages used by HMRC.
So, limited company contractors who meet the definition of limited cost traders will be liable to pay hundreds, if not thousands of pounds in additional VAT liabilities each year.
What is a ‘limited cost trader’?
According to the HMRC technical note (and confirmed in VAT Notice 733), this is defined as a business which has a VAT-inclusive expenditure on relevant goods of either:
- less than 2% of their VAT inclusive turnover in a prescribed accounting period
- greater than 2% of their VAT inclusive turnover but less than £1000 per annum if the prescribed accounting period is one year (if it is not one year, the figure is the relevant proportion of £1000)
To prevent businesses incorporating everyday purchases to increase their costs above the 2% threshold, the following items must be excluded when working out whether or not your business is deemed to be a ‘limited cost’ one:
- capital expenditure
- food or drink for consumption by the flat rate business or its employees
- vehicles, vehicle parts and fuel (except where the business is one that carries out transport services – for example, a taxi business – and uses its own or a leased vehicle to carry out those services)
Unfortunately, HMRC have also decided to disallow a number of services from its definition of what ‘relevant goods’ are – and, as a result, many contractor companies will fit the description of a ‘limited company trader’ despite purchasing significant services, including:
- Contractor accountancy fees.
- Advertising costs.
- Any type of electronically downloaded service (such as a subscription to a professional magazine).
- Any downloaded software, or bespoke software.
- Office rental costs
You can work out if you are likely to be a ‘limited cost trader’ by using this HMRC Flat Rate VAT calculator.
How much will this VAT change cost me?
Clearly, the tax advantage afforded to many who have used the FRS will no longer be available if you are indeed a ‘limited cost trader’ – this is the whole point of the legislation.
For example, if your company had a turnover of £100,000 in the 2016/17 tax year, your VAT-inclusive turnover would be £120,000 (£100,000 + 20%). You would have to repay £17,400 to HMRC – meaning you made a net gain during the year of £2,600!
Under the new rules, using the same turnover, from 1st April 2017 you need to repay £19,800 to HMRC – leaving you with a net gain of a mere £200 compared to a business on the standard VAT scheme.
Should I leave the Flat Rate VAT scheme?
There are a number of things to consider here if your business is affected by this new rule:
- You can decide whether your company operates either the FRS or standard VAT scheme. It is up to you. There is no additional cost associated with either (aside from the tax differential).
- The FRS was designed to make calculating VAT easier, so you might decide to remain for this reason alone, especially if you incur very few business expenses.
- During your first year after registering for VAT, your company will still qualify for a 1% reduction in the flat 16.5% rate, so it is still advantageous for new companies to join the scheme – even just for the first year.
- Your accountant will be able to let you know which scheme is most suitable for your business from April 2017 onwards, based on your own accounts.
To prevent businesses invoicing in advance or taking other measures to avoid meeting the Government’s definition of a limited cost trader, anti-forestalling legislation was also published on 23rd November.
The Government published an extensive guide to the new Flat Rate VAT rules at the end of February 2017 – read it here.