MONTHLY FOCUS: VAT AND THE FLAT RATE SCHEME

If a business wants to simplify its VAT reporting, why might the flat rate scheme be worth considering?

MONTHLY FOCUS: VAT AND THE FLAT RATE SCHEME

GENERAL PRINCIPLES

What is the flat rate scheme?

The flat rate scheme simplifies VAT accounting for small businesses, but it may also reduce VAT liabilities. The VAT payable to HMRC is based on a percentage of turnover.

The scheme avoids the need to:

  • calculate or record output and input tax, except for a few items not covered by the scheme;
  • consider complicated rules regarding input tax deductibility for certain items; or 
  • carry out partial exemption calculations.

The scheme is not suitable for traders who regularly receive VAT repayments, and also would probably not benefit businesses which:

  • make more zero-rated or exempt supplies than the average for that trade sector;
  • incur more input tax on purchases and expenses than the average for that trade sector; or
  • sell a significant amount of second-hand goods.

Traders within the scheme will charge their customers the normal VAT rate for the supply. It is the amount of the VAT payable to HMRC which is calculated using the flat rate scheme percentage.

 

How is the benefit measured?

The appropriate flat rate percentage depends on the trade sector to which the business belongs. The rate for each sector is designed to produce a VAT liability similar to that which would result under normal VAT accounting, taking into account average input tax claims. If a higher liability would arise under the scheme, a business might nevertheless still choose to use the scheme because of the time and cost savings. A full list of the appropriate percentages can be found here.

Example

A Ltd sells a mixture of standard-rated and zero-rated goods. Assume that the flat rate for its trade sector is 8.5%. Its latest annual results were as follows:

 

Total

VAT

Sales

£100,000

£14,500

Purchases and expenses

£70,000

£6,500

 

There were no sales or purchases of items outside the flat rate scheme.

The VAT liability for the year, using normal VAT accounting, is £8,000. (14,500 - 6,500). If A Ltd used the flat rate scheme, the VAT liability would be £8,500. (100,000 × 8.5%). A Ltd must decide whether the simplified accounting arrangements justify the higher VAT liability.

 

Who is eligible for the scheme?

A VAT-registered person can use the scheme if, on reasonable grounds, they expect that their taxable supplies in the next 12 months will not exceed the scheme limit. Taxable supplies include standard-, reduced-, and zero-rated supplies, but disposals of capital assets are excluded, as is the value of services received under the reverse charge rules.

Flat rate traders should review annual turnover on each anniversary of joining the scheme, to ensure that they can remain within it.


Example

Mr B's expected income for the next 12 months is as follows:

 

£

Standard-rated normal sales, excluding VAT

140,000

Sale of a capital asset, excluding VAT

20,000

Exempt supplies

30,000

 

Mr B is eligible to join the flat rate scheme, as taxable supplies are £140,000 (below the scheme threshold). The exempt supplies are not included.

 

How is turnover estimated?

Estimates must have a reasonable basis, such as accounts or VAT returns for previous periods. A person who has been VAT-registered for less than 12 months may use the estimate given in the VAT registration application. Other acceptable methods include estimates based on business plans, or business information from a previous owner.

HMRC has stated that it will not penalise anyone for incorrectly estimating that taxable supplies would not exceed £150,000 if there was a reasonable basis for the estimate. If, however, HMRC considers that there was no reasonable basis for an estimate, it may immediately exclude a business from the scheme. Records supporting an estimate should therefore be kept in case of any enquiry.

 

Are any businesses excluded?

Yes – the following table summarises the circumstances in which a person will not be eligible to use the scheme:

Reason for exclusion

Details

Business circumstances

Eligible for a VAT group registration within the last 24 months

Part of a VAT divisional registration within the last 24 months

Associated with another person within the last 24 months

Tour operators

Offences in relation to VAT

Convicted of any offence in connection with VAT in the previous 12 months

Made a payment to settle proceedings in relation to a VAT offence in the previous 12 months

Been assessed to a penalty for dishonestly evading VAT in the previous 12 months

Protection of revenue

HMRC believes that tax revenues are at risk

Previous use of the scheme

Ceased to use the scheme in the previous 12 months

 

 A person is regarded as associated with another person for these purposes if:

  • one is under the dominant influence of the other (for example, where one business has the right to give directions to another business, or where a business generally complies with the instructions of another business); or
  • they are closely bound by financial, economic, and organisational links.

Persons are not associated by reason only of normal business relationships. So a business is not associated with its customers simply because it supplies goods in the form that they request them. As another example, if a husband and wife are, for example, separately VAT-registered as an architect and an antiques dealer respectively, and he rents the upper floor of her shop at a market rate to use as his office, they will not be associated.

JOINING THE SCHEME

How does a business join?

A business can apply to join the flat rate scheme, whether at the time it registers for VAT or subsequently, by using form VAT 600FRS. If it is also applying to join the annual accounting scheme form VAT 600AA/FRS should be used instead. Applications may be made online, or by post, email, or phone.

In addition to the name, address, and VAT number of the business, the application must specify the:

  • main business activity; and
  • flat rate percentage for the trade sector to which the business belongs.

The application may specify a chosen start date, which can be the VAT registration date.
If an application is accepted, HMRC will notify the business, normally within 30 days, of the appropriate start date.

If HMRC refuses an application the business can ask HMRC to reconsider, and can appeal against the decision to a tribunal.

 

When does the business start using the scheme?

A business will normally start to use the scheme at the beginning of an annual accounting period, or the next VAT return period after HMRC processes the application to join the scheme, unless some other date was specified in the application. If the start date is not the beginning of a VAT period, two separate calculations for that period will be required.

HMRC may allow a retrospective start date. However, HMRC's policy is to refuse retrospection for any period for which the business has already calculated its VAT liability using a different accounting method (unless there are exceptional circumstances).

Example

In a real case, a trader was refused permission to join the FRS retrospectively, but argued that he should have been permitted to do so, as he would have saved VAT. In addition, he had not been informed about the scheme in person, despite visits by an HMRC officer.
The tribunal held that, although the trader had been made aware of the scheme by way of published leaflets, HMRC had acted unreasonably in not permitting the trader to join the FRS retrospectively, as he had not previously been informed about it in person. The tribunal deemed this to be an exceptional circumstance

However, in a similar case, the tribunal approved HMRC's policy not to allow retrospective entry to the scheme once VAT for an accounting period had been calculated using another method, since use of the flat rate scheme is not a beneficial simplification if the calculation has already been carried out. The tribunal also considered it rational for HMRC to consider that paying less VAT is not of itself a good reason for retrospective entry. This differs from the earlier case as HMRC no longer favours retrospective entry into the scheme as a means of encouraging its use.

 

OPERATING THE SCHEME

How does the business account for VAT?

Flat rate traders must still charge VAT to customers in the normal way, and issue VAT invoices showing VAT at the standard, reduced or zero rate where required. VAT returns and payments must also be made in the normal way, but the VAT payable to HMRC for each VAT period consists of:

  • a percentage of turnover using the appropriate rate; and
  • separate output and input tax adjustments for transactions which are outside the scheme.

 

What is included as “turnover” here?

The turnover to which the flat rate percentage is applied includes and excludes the following:

Included

Excluded

VAT

Supplies on which output tax is accounted for separately

Standard-rated supplies

Recharges of qualifying disbursements

Reduced-rated supplies

Supplies which are outside the scope of VAT 

Zero-rated supplies, including exports

Reverse charges on services received from other countries

Exempt supplies

Certain supplies of investment gold where the supplier has opted to tax

Sales of capital assets, if no input tax was claimed when they were acquired

Bank interest

The full sale price of any second-hand goods

 

For a Northern Ireland business, the value of goods despatched to EU member states

 

Amounts received where the supply was made under the cash accounting scheme, and the trader has left that scheme and started to use the cash turnover method of the flat rate scheme

 

Excise duty, as this forms part of the consideration received which is subject to VAT whether or not the flat rate scheme is used

 


Example

Ms C, a flat rate trader who is not a Northern Ireland business, made the following supplies in a VAT period:

 

Total (£)

VAT (£)

Standard-rated sales

24,000

4,000

Exempt sales

2,000

 

Sale of a capital asset on which no input tax had been claimed (including VAT)

1,200

200

Supplies outside the scope of VAT

500

 

Total

27,700

 

Less: Supplies outside the scope of VAT

(500)

 

Flat rate turnover

27,200

 

 

What rate is used?

The rate to be used depends on the trade sector to which the business belongs, unless the business is treated as a limited cost trader. If it is not clear which trade sector is appropriate, the sector with the lower flat rate may be chosen, provided that there is a reasonable basis for such a choice. For the avoidance of doubt, a business can ask HMRC to confirm that the chosen rate is acceptable, and it may also be useful for the business to retain a record of why a particular sector was chosen. If none of the sectors seem appropriate, a business may use the category “Any other activity not listed elsewhere”.

If a trader expects to carry on more than one category of business, they should use the rate for the category which they expect will have the higher or highest turnover. The chosen rate will apply until each anniversary of the scheme start date.

One of the main opportunities to save tax under the flat rate scheme is where a business with two or more activities has a lower flat rate percentage for its main activity.

 

Example

D Ltd provides bookkeeping and secretarial services. In the past 12 months turnover consisted of £75,000 for secretarial services and £25,000 for bookkeeping services. As the majority of turnover derives from secretarial services, the rate for that category of business is applied to the total turnover of £100,000, and the rate for bookkeeping services is not used.

If a business starts to use the scheme within a year of registering for VAT, the flat rate percentage is reduced by 1% until the day before the VAT registration anniversary. The reduced rate normally applies from the scheme start date.

 

Example

Ms E registers for VAT on 1 January and joins the flat rate scheme on 1 July. She may use the rate applicable to her business, less a 1% reduction, from 1 July to 31 December, and the normal flat rate subsequently. If a person registers for VAT late, and HMRC allows a retrospective scheme start date, the reduced rate can only be used from the date HMRC was notified or became aware of the requirement to register. If a person registers for VAT more than a year late, they cannot therefore use the reduced rate at all.

 

What is a limited cost trader?

Since 1 April 2017, all traders, whether already within the flat rate scheme or seeking to join it, must use a 16.5% scheme rate if they are limited cost traders. This is equivalent to accounting for VAT at 19.8% on all supplies, with no credit for input tax suffered.

A limited cost trader is defined as one whose VAT-inclusive expenditure on goods is either:

  • less than 2% of their VAT-inclusive turnover in a prescribed accounting period; or
  • greater than 2% of their VAT-inclusive turnover but less than £1,000 per annum if the prescribed accounting period is one year in length (if it is not one year the figure is the relevant proportion of £1,000).

Goods must be used exclusively for business purposes but exclude:

  • capital expenditure;
  • goods for disposal, such as promotional items, gifts, or donations;
  • goods for resale, leasing, letting, or hiring out, if the main business does not ordinarily consist of selling, leasing, letting, or hiring out such goods;
  • food or drink for consumption by the flat rate business or its employees; and
  • vehicles, vehicle parts, and fuel (except where the business is one which carries out transport services, such as a taxi business, and uses its own vehicle (or a leased vehicle) to carry out those services).

The exclusions are part of the test in order to prevent traders buying low-value everyday items, or one-off purchases, in an attempt to inflate their costs above the 2% threshold.

 

Does a business ever need to change the percentage it uses?

A change in the flat rate percentage will occur where:

  • there is a change in the activities carried on by a business; or
  • HMRC alters the published rates.

A change of flat rate percentage by a business must be notified to HMRC within 30 days of the change taking place.

If a trader carries on two or more business activities which belong to trade sectors with different percentage rates, the position should be reviewed on each anniversary of joining the scheme. The flat rate should be changed if the balance between the activities:

  • has changed in the year just ended; or
  • is expected to change in the year about to commence.

The new rate should be applied from the start of the VAT period in which the scheme start date anniversary falls.

Example

F Ltd, a flat rate trader, sells cars and also repairs vehicles. It makes VAT returns for calendar quarters, and its flat rate scheme start date anniversary is 1 September. In previous years its flat rate was that appropriate to car sales, as the turnover from car sales had been higher than that from vehicle repairs. However, in the latest year to 31 August, this balance of activities changed (turnover from repairs exceeded turnover from car sales). A flat rate at the repairing vehicles rate should be applied to all turnover from 1 July (the start of the VAT period in which 1 September falls).

If a trader fails to review the position, and applies an incorrect rate following a change in the balance of activities, HMRC can raise assessments for the additional VAT which would have been due if the correct rate had been applied.

Example

The owners of a pub/restaurant joined the flat rate scheme and accounted for VAT at the rate applicable to pubs. Following a refurbishment of the premises, food sales increased and accounted for the majority of the turnover, but the position was not reviewed, and the previous rate continued to be used. HMRC raised assessments based on the rate applicable to restaurants, which was higher, and this rate was upheld at tribunal.

 If the trade sector for a business changes due to an activity ending or a new activity starting, the new rate must be applied from the date of the change, and HMRC must be notified (using the address in within 30 days of the date of the change.

If the published rate for a trade sector changes, the new rate must be applied from the date specified by HMRC.

 

Does Brexit affect use of the scheme?

The UK’s transitional deal with the EU ended on 31 December 2020. From 1 January 2021, all movements of goods to and from EU countries are classed as imports and exports. The previous descriptions of acquisitions and disposals are no longer relevant, the exception being for a business based in Northern Ireland, which is still part of the EU single market. This means that all sales of goods are zero-rated if they are exported from GB and all imports from both EU and non-EU countries are subject to VAT and duty.

A business using the flat rate schemecan still use the new Postponed VAT Accounting scheme for imported goods that took effect on 1 January 2021. This means that it does not pay VAT when the goods arrive in GB and  can declare tax on the next VAT return by doing a reverse charge calculation. However, the reverse charge is different for flat rate scheme users. The business should include the same figure within the output and input tax boxes of their return.

The only exception where the business will make a Box 4 entry with a reverse charge entry is for imported goods that relate to capital goods exceeding £2,000 including VAT, e.g. a new machine bought from a French supplier.

There are no changes for goods sold by a business to VAT-registered customers in other EU countries, so they continue to be zero-rated as before. The business must include zero-rated and exempt sales in the calculations. However, sales to non-VAT registered customers in the EU are also zero-rated now that we have left the EU. 

If there are a relatively high number of zero-rated sales subject to  tax under the scheme, it might be worth withdrawing f and reverting to normal VAT accounting, i.e. output tax less input tax.

 

What transactions are outside the scheme?

The flat rate percentage does not apply to certain transactions which are outside the scheme. Output tax and input tax on these transactions must be accounted for separately in the normal way.

  1. Output tax is not due on the private use of goods or services where no input tax has been claimed on the cost. As a result, flat rate scheme users do not account for the fuel scale charge.
  2. Partial exemption does not apply to flat rate scheme traders, so any allowable input tax is regarded as wholly attributable to the making of taxable supplies.
  3. HMRC will include income from any source received by the same legal entity (such as rental income received by a sole trader) as being income within the scope of the scheme. This potentially could bring otherwise exempt income within the flat rate scheme. However, income received by a legal entity which is separate from the flat rate scheme business is not aggregated as scheme income.

 

What about capital assets?

Subject to the special rules below, input tax incurred when acquiring a capital asset is not deductible. Sales proceeds are included in the amount on which the flat rate VAT is calculated, even if the sale is exempt, as in the case of a car where input tax recovery was blocked.

For this purpose, capital assets are those that would fall within the usual definition, but also specifically exclude any goods covered by the capital goods scheme, and any goods bought to:

  • resell;
  • incorporate into other goods for onward supply;
  • consume (or completely use) within one year; or
  • generate business income by being leased, let, or hired.

If a capital asset with a value of over £2,000 (including VAT) is purchased, acquired, or imported, input tax can be claimed no matter whether the asset is used for exempt or non-business purposes.

For this purpose, it is a single purchase of capital goods which is important when comparing to the value threshold. HMRC has given the following examples of such a single purchase:

  • computer package (computer, printer, camera, scanner, speakers, etc) bought as one transaction; or
  • items of kitchen equipment (a pizza oven, a fridge, and a dishwasher) bought for a restaurant. If all the items are from one supplier at one time, they count as one purchase of capital expenditure goods.

If input tax was claimed when a capital asset was acquired, output tax at the appropriate VAT rate (not the flat rate percentage) must be separately accounted for on disposal.

 

How does bad debt relief work under the scheme?

The normal rules for claiming bad debt relief apply, unless the cash turnover method is used.

Under the cash turnover method, partial relief at the flat rate percentage is given automatically, as VAT is only accounted for if payment is received. If the normal bad debt relief conditions are met, further relief may be claimed on the difference between VAT:

·         at the rate charged to the customer; and

·         which would have been paid to HMRC at the flat rate.

Example

Mr B, whose flat rate percentage is 10% and who uses the cash turnover method, suffers a bad debt of £1,200 including £200 VAT. He may claim bad debt relief as follows:

VAT charged to customer

£200

VAT which would have been payable at flat rate (£1,200 × 10%)

-£120

Bad debt relief

£80

 

 

How does using the scheme affect direct taxes?

The flat rate tax is deducted from gross sales for income tax and corporation tax purposes.
Non-deductible input tax is included in the cost of the item. On disposal of a capital asset, any VAT which is not accounted for separately is included in the sales proceeds.

Example

 Mr C, whose flat rate percentage is 8.5%, had the following results:

 

 

Total (£)

VAT (£)

Sales

120,000

20,000

Purchases and expenses

84,000

14,000

VAT liability under flat rate scheme (£120,000 × 8.5%)

10,200

 

 

Mr C's accounts for income tax purposes, compared with those which would result from normal (20%) VAT accounting, are as follows:

 

 

Flat rate scheme

Normal VAT accounting

 

£

 

£

 

Sales

109,800

(120,000 - 10,200)

100,000

(120,000 - 20,000)

Purchases and expenses

-84,000

 

-70,000

(84,000 - 14,000)

Net profit

25,800

 

30,000

 

 

What VAT records need to be kept?

Businesses must keep a record of flat rate calculations for each accounting period, showing the:

  • flat rate turnover;
  • flat rate percentage used;
  • amount spent on goods for limited cost trader purposes; and
  • VAT due.

Businesses should also record details of assets on which input tax has been claimed, to help check whether output tax should be accounted for when they are sold.

 

What about leaving the scheme?

A business can leave the scheme at any time by notifying HMRC in writing. HMRC will confirm the leaving date, which will normally be the end of a VAT period. However, there are circumstances where leaving is compulsory.

A business must notify HMRC within 30 days, and leave the scheme, if turnover exceeds either of the scheme limits.

For this purpose, turnover includes VAT and all business supplies except sales of capital assets, and should be calculated in accordance with the trader's usual method of accounting for VAT, i.e. either cash received or invoices paid. Flat rate traders should normally review annual turnover on each anniversary of joining the scheme, to ensure that they can remain within it. If a business is growing rapidly, it may be advisable to check turnover on a more regular, perhaps monthly, basis.

The following table gives further details:

Condition

Date business must leave

Exceptions

VAT-inclusive turnover for a year ending on an anniversary of joining the scheme has exceeded £230,000

End of VAT period in which anniversary falls

A business can remain in the scheme if the limit was exceeded because of a one-off increase in turnover, and it can show that:

Turnover in the coming year will not exceed £191,500;

The increase was due to unexpected business activity which has not previously occurred and is not expected to recur; and

The increase arose from a genuine commercial activity

VAT-inclusive turnover in the next 30 days is expected to exceed £230,000

Start of the 30-day period

 

 

Example

Ms E is a flat rate trader who makes VAT returns for calendar quarters, and has a scheme start date anniversary of 1 September. Turnover for the latest year to 31 August is £240,000 including VAT. She must leave the scheme on 30 September, being the end of the VAT period in which 1 September falls.