What are the key things to be aware of when you begin charging your customers VAT for the first time?
HMRC are making a significant change to the VAT Flat Rate Scheme (“FRS”) from 1 April 2017 to address a perceived abuse of the scheme by a few people.
Unfortunately, many businesses are going to find themselves unfairly impacted by these changes.
What is Changing?
HMRC are targeting businesses on the FRS that incur little or no business expenditure and have therefore been able to use the FRS to gain a tax advantage.
HMRC are referring to these types of businesses as limited cost traders.
With effect from 1 April 2017, a limited cost trader using the FRS must apply a flat rate percentage of 16.5%, rather than continue to use the flat rate percentage applicable to their trade sector.
Applying a flat rate percentage of 16.5% results in almost no “credit” being obtained for any VAT that is suffered on business expenditure incurred.
Most businesses finding themselves classified as a limited cost trader should consider moving off the FRS from 1 April 2017.
Are You a Limited Cost Trader?
From 1 April 2017, a limited cost trader is defined as one whose VAT inclusive expenditure on goods in a VAT reporting period is either:
- less than 2% of their VAT inclusive turnover for that period, or
- more than 2% of their VAT inclusive turnover for that period, but less than £250 (if the period is a quarter) or £1,000 (if the period is a year).
The test must be applied in each VAT reporting period that ends after 1 April 2017. (As a reminder, a VAT reporting period is the period covered by your VAT return; this is a period of three months for quarterly reporters, but it may be a monthly or annual period for others).
A business can only avoid being categorised as a limited cost trader by considering how much expenditure it incurs on certain goods.
As well as having to ignore spending on services, not all spending on goods actually counts when applying the new tests.
Not all Goods Are Good
Even some businesses that incur significant expenditure on goods may find that they are classified as limited cost traders.
This is because the following types of spending do not count as expenditure on goods for the purpose of the new tests:
- expenditure on goods that are not used exclusively for business purposes,
- purchases of capital items (usually taken, for this purpose, to be goods with a useful life exceeding one year),
- food or drink purchased for consumption by the business owners or employees, or
- vehicles, vehicle parts or fuel purchased, unless the business is carrying out transport services.
In addition, the following types of expenditure will also not count as expenditure on goods:
- any goods purchased for resale, leasing, etc where the main business activity of the trader is not the resale, leasing, etc of those goods, or
- any goods purchased to be given away as samples or promotional items.
These last two points are included by HMRC to prevent situations where a business with limited current spending on goods might be tempted, in order to avoid the limited cost trader classification, to begin purchasing:
- at least £250 of goods on a quarterly basis simply to resell them on (even at a loss), or
- at least £250 of goods each quarter to be given away, even as legitimate promotional items.
It remains to be seen what further amendments HMRC will need to make to this list of exclusions as businesses apply the new rules for the first time.
Many businesses, in particularly those that incur business expenditure mainly on services, may find themselves classified as a limited cost trader from 1 April 2017.
What If You Are a Limited Cost Trader?
For each VAT reporting period in which your business fail the tests outlined above, you must apply a flat rate percentage of 16.5% for the related period’s VAT return. This will almost certainly increase your VAT liability under the FRS for the period in question.
Since the new test is to be undertaken on a period-by-period basis, a business remaining on the FRS could be a limited cost trader in one VAT reporting period but not in another. Such businesses would therefore apply the 16.5% flat rate percentage in some VAT returns but could possibly revert to using their trade sector flat rate percentage in others.
Next Steps: Obvious Cases
Some businesses will clearly fail the tests because they incur little or no expenditure on qualifying goods.
Unless these businesses do not actually suffer any VAT on their business expenditure they should leave the FRS; this will mean returning to standard VAT reporting.
Details on how and when to leave the FRS are given below.
Next Steps: Borderline Cases
Other businesses are going to find themselves coming up close to the spending limits each VAT reporting period.
If they wish to remain on the FRS, they will need to perform the new tests at the end of every reporting period to determine if they are limited costs traders for that period.
These businesses must therefore choose between:
- remaining on the FRS and applying the 16.5% flat rate percentage for every reporting period that they are classified as a limited costs trader, or
- permanently leaving the scheme.
Since a business that leaves the FRS may not rejoin the scheme for a period of 12 months, permanently leaving the FRS may simply turn out to be the best option for many of these borderline cases.
Next Steps: Seasonal or Irregular Purchasers
Finally, some businesses may make significant purchases of qualifying goods in only one or two quarters of a year and then purchase very little in other quarters.
Taken on an annual basis these businesses might have easily passed the new tests, but where they are reporting their VAT on a quarterly basis, the new rules could force them to be treated as limited costs traders for one or more quarters.
These businesses should consider switching from quarterly to annual VAT reporting if they wish to remain on the FRS.
How to Leave the FRS?
If you decide that your business should leave the FRS, this can be done in writing to HMRC or by email to the following address: firstname.lastname@example.org.
It is also possible for your authorised VAT agent to request to leave the FRS on your behalf.
When to Inform HMRC
If you decide to leave the FRS before the new rules take effect you can inform HMRC immediately, or at any point before you are due to submit the first return that will have been impacted by the new rules.
Some borderline cases may wish instead to wait and see. A business cannot always know for certain whether they are to be classified as a limited costs trader until a particular VAT reporting period has ended. Accordingly, HMRC will always allow a business to make a backdated application to leave the scheme that will take effect from the start of a reporting period.
Such a retrospective application to leave the FRS can only be backdated to the start of a reporting period for which the relevant VAT return has not yet been filed.
VAT Reporting Periods That Straddle 1 April 2017
If a VAT reporting period straddles 1 April 2017, a business will need to apportion this reporting period into a pre-1 April period and a post-1 April period.
The new tests should then be applied to the post-1 April portion of your return data. The £250 quarterly limit will need to be scaled up or down to the actual number of months covered by the post-1 April period.
Some other points worth noting about the new test are:
- expenditure on goods purchased in relation to business vehicles can only be included in the test if the business is one that carries out transport services. For most businesses, therefore, such vehicle costs must also be ignored,
- expenditure on the provision of gas and electricity used exclusively for business purposes counts as expenditure on goods, and
- when determining how much expenditure on goods has been undertaken in a specific reporting period, use the same cash or accruals basis as you are using for the FRS scheme itself.
As always, this article is intended to give a general overview of certain VAT issues. It cannot be, and is not intended to be, a substitute for the specific advice that you should obtain when addressing your own situations. This specific advice can include reviewing HMRC guidance yourself or seeking professional advice.