Changes to the VAT flat rate scheme: A quick win or a minefield?

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Donald Drysdale By Donald Drysdale for ICAS

19 May 2016

Donald Drysdale explains the background to recent changes to the VAT flat rate scheme for small businesses.

What is the flat rate scheme?

The VAT flat rate scheme is an option designed to help VAT-registered businesses whose turnover does not exceed £150,000 a year, excluding VAT. It offers a simplified way of accounting for VAT – allowing such a business to calculate the VAT due to HMRC by multiplying its VAT-inclusive turnover by a fixed flat-rate percentage which depends on the type of business.

The scheme is designed to provide administrative savings, but is quite complicated to apply and can lead to inadvertent errors and expensive mistakes.  It is not designed to reduce the VAT payable to HMRC but in some cases it may do so; in others it may increase the VAT payable. Factors affecting the outcome will be the type of business and therefore the flat-rate percentage that applies, and the particular nature of sales made and purchases incurred.

How the scheme works

The flat rate scheme is governed by the VAT Regulations 1995 (SI 1995/2518), regs 55A–55V. HMRC publish guidance on the scheme in VAT Notice 733, which was last updated on 4 May 2016 and contains certain legally binding statements regarding business records.

A business that opts for the scheme must charge VAT according to the normal rules, and must provide its customers with VAT invoices as required. However, except on the purchase of capital assets costing £2,000 or more including VAT, no deduction is claimed for input VAT incurred on purchases. Furthermore, even if input VAT incurred exceeded output VAT charged to customers, the business would not be entitled to claim a refund from HMRC.

Instead of accounting to HMRC for output VAT charged to customers less input VAT claimed, the business pays a sum calculated by multiplying its VAT-inclusive turnover (including zero-rated and exempt turnover) by a fixed flat-rate percentage which varies according to the business sector. Currently the rate ranges from 14.5% down to 4%, as prescribed by SI 1995/2518, reg 55k. HMRC publish what is no more than their interpretation of flat rate percentages by trade and sector.

A business opting into the scheme or subsequently changing the nature of its activities must take care in choosing the business category which most closely reflects its business. If it makes sales in more than one sector, it may choose the sector in which its sales are largest. At each anniversary of joining the scheme, it should ensure that it is using the sector in which it expects to make the largest sales in the succeeding year.

Optionally, the VAT flat rate scheme may be combined with VAT annual accounting to simplify administration by requiring only one VAT return each year.

What can go wrong?

Care is needed in determining what to include in turnover when applying the flat rate. The scheme involves special rules on the tax point for supplies made. There are specific provisions dealing with stocks and assets held at registration and on leaving the scheme. A limit of £230,000 on actual or anticipated turnover applies as a trigger point requiring a business to leave the scheme. In exceptional circumstances businesses may apply retrospectively to join or leave the scheme or change their business category.

A business opting for the scheme should recognise that there are complications in the way the scheme applies. For example, the scheme is unlikely to help businesses who export much of their turnover as it applies the flat rate to all sales including exports. Even HMRC, who often seem keen to exclude the professional agent, suggest that businesses considering the scheme should seek advice from an accountant or tax adviser.

Many businesses have encountered difficulties in choosing their appropriate business sector. Some have discovered that HMRC’s online VAT registration facility does not always allow them to select the most suitable category. VAT Notice 733 warns: ‘If you have made a mistake choosing an incorrect sector you may pay too much tax or too little. Paying too little could mean that you are faced with an unexpected VAT bill at a later date.’

In the case of Idess Ltd [2014] UKFTT 511 (TC03638), a mechanical engineering and design consultancy had registered for the flat rate scheme under ‘any other category not listed elsewhere’, for which the current flat rate is 12%. HMRC decided to re-categorise it under ‘architect, civil and structural engineer or surveyor’ (14.5%) and sought a 15% penalty for a careless error. The First-tier Tribunal rejected HMRC’s argument that the company’s choice of category was unreasonable because it was not made in accordance with VAT Notice 733, and held that the choice the company had made was reasonable based on the VAT regulations.

The case of SSL Subsea Engineering Ltd [2015] UKFTT 43 (TC04256) was similar. The company, which provided mechanical engineering services in the subsea environment, had also registered for the scheme under ‘any other category not listed elsewhere’. HMRC tried to re-categorise it under ‘architect, civil and structural engineer or surveyor’. The First-tier Tribunal rejected this, holding that HMRC were wrong to regard their own guidance as authoritative; HMRC should have looked at the legislation and given it its ordinary meaning. The company had been diligent and reasonable in selecting the category that was chosen, since its business activity was not listed elsewhere.

How have HMRC responded?

The latest update to VAT Notice 733 reflects recent Tribunal decisions by stating helpfully at paragraph 4.1 that businesses should ‘use ordinary English’ in categorising their business activity.

HMRC have also clarified the treatment of consultants by removing from VAT Notice 733 the previous paragraph 4.4. This had advised consultants to choose the category for ‘management consultants’ (for which the current flat rate is 14%) even if they did not ‘fit the traditional idea of management consultant’. Where appropriate they should now choose the category ‘business services not listed elsewhere’ (12%).

Paragraph 4.4 had also advised engineering consultants and designers to choose ‘architect, civil and structural engineer or surveyor’ (14.5%). Where appropriate – for example, in the case of mechanical engineering consultants such as Idess and Subsea – they should now choose ‘business services not listed elsewhere’ (12%).

VAT Notice 733 now provides the following reassurance: ‘HMRC will not change your choice of sector retrospectively as long as your choice was reasonable. It will be sensible to keep a record of why you chose your sector in case you need to show HMRC that your choice was reasonable. Note: Some business activities can reasonably fit into more than one sector. So changing your sector does not automatically make your original choice unreasonable.’

Following the changes that have been made, it may be opportune for some businesses to reconsider the categorisation of their activities.

Article supplied by Taxing Words Ltd

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