VAT flat rate scheme
Friend or foe? The flat rate scheme was introduced in 2003 with a great deal of anticipation – mainly because the Chancellor had been wetting everyone’s appetite in advance about the great time-saving benefits it would offer a small business in terms of administration.
However, nearly five years later, the conclusion of the profession is that the time-saving benefits are not great – but there are some taxpayers that can save significant amounts of VAT by adopting the scheme. In this article, I will focus on the potential tax savings of the scheme but it must not be forgotten that the flat rate scheme is just like football…..for every winner, there will also be a loser!
Background to flat rate scheme
- To recap the basic principles of the flat rate scheme:
- It is only available to small businesses with VAT exclusive annual taxable turnover of up to £150,000 and VAT exclusive annual total turnover (i.e. including exempt and non-taxable income) up to £187,500.
- Instead of paying VAT on each quarterly return based on output tax less input tax, a business will apply a given flat rate percentage to its gross income – the percentage is based on the category of business to which it belongs. However, a business still charges VAT on its sales invoices issued to customers in the normal way i.e. 17.5% if the supply is standard rated, 0% if zero-rated.
- A business applying the flat rate scheme does not reclaim input tax, unless it relates to capital expenditure exceeding £2,000 including VAT.
Should your client join the scheme.…..could be a good result
I highlight three flat rate categories that could give many businesses a tax-saving outcome – “investigation or security” at 10% and “secretarial services” at 11%. I also think that the “hotel or accommodation” rate of 9.5% offers great potential. The reason for the potential savings is because many businesses in these categories tend to have very little input tax to reclaim – so a flat rate percentage of 11% or less is quite generous. See example 1 to illustrate this point.
John is a successful private investigator who earns £149,000 per annum (eligible for the flat-rate scheme). He is VAT registered and all of his income is standard rated.
The nature of John’s work means that he has negligible input tax – a total of only £500 per year for accountancy fees and a small amount of printing/motoring costs.
By adopting the flat rate scheme (10% flat rate), his annual VAT bill is calculated as follows:
Gross turnover (£149,000 x 1.175) x 10% flat rate = £17,507.50
Under normal VAT accounting, his VAT bill would be:
Output tax (£149,000 x 17.5%) = £26,075
Input tax = £500
Payable = £25,575.
The net VAT saving to John is £8,067.50 per year.
Do clients qualify to use the 10% or 11% flat rates for activities not listed elsewhere
HMRC sensibly limited the total number of different categories within the flat rate scheme to 55. It would be a minefield of bureaucracy if a small business had to go through a list of 500 different categories, all with different flat rate percentages, to see where it belonged.
As a result of the limited number of categories, HMRC include two categories that can prove an absolute winner for many businesses:
- any other activity that is not listed elsewhere 10%
- business services that are not listed elsewhere 11%
As with my calculations at example 1, the above percentages are very favourable for any qualifying small business that has negligible input tax.
In reality, the nature of the global economy and the emphasis of the UK economy on service trades means that many business activities will fall into the 10% category (or at worst the 11% category for business services that are not listed elsewhere). And unless these businesses have a high amount of input tax, then the flat rate scheme should prove a winner.
Do any clients have more than one business activity…..the scheme could save a lot of tax
The rules of the flat-rate scheme state that where a business has turnover generated from two or more activities, then the chosen flat rate percentage should be based on the activity with the greatest percentage of turnover. See example 2.
Jim is a sole trader with two main activities – he owns a pub which earns him £76,000 per year from wet sales and a bed and breakfast establishment attached to the pub that earns him £74,000 per year. As the pub is the greater percentage of his activity, he can use the flat rate scheme percentage that applies to pubs, namely 5.5%. This is an excellent result because he will apply this percentage to his bed and breakfast income as well. The normal flat rate percentage for bed and breakfast accommodation is 9.5%
Caution – in this example, Jim’s pub does not sell food, However, be aware that the flat rate percentage for restaurants and catering is 12%. This means the flat rate scheme would be a poor option for a pub where the majority of sales are food – because the 12% rate would be applied to the wet sales as well.
Flexible use of flat rate percentages
A taxpayer has the responsibility to identify his own flat-rate category. HMRC has confirmed that it will not challenge this decision as long as the choice made was reasonable and records are kept as to why it was chosen. In choosing the category, the words should be given their ordinary meanings.
In reality, any situation where decisions are based upon words and the interpretation of words means different people will reach different conclusions on the same situation. In such situations, it is important that tax advisers look very carefully at the flat rate percentages and make sure they choose the correct one for their clients, which could be the most favourable as well.
Consider the following example:
Steve is a self-employed tax consultant, registered for VAT and wishing to use the flat rate scheme. He reviews the list of business categories and decides that the most appropriate rate to apply is the 13% rate for accountancy services. But is he correct?
In reality, saying that the work of a tax adviser is the same as the work of an accountant is a bit like saying that a cricketer is the same as a footballer because they are both playing sport!
The correct classification for a tax adviser would be 11% – as “business services not listed elsewhere”. The result is a 2% VAT saving on gross income – if Steve had gross annual turnover of £176,250 (i.e. £150,000 plus VAT), that would be a saving of £3,525.
Construction industry concession…..labour or materials
Most practitioners have a number of builder clients on their books, and builders have the unusual situation of having two different categories within the flat rate scheme. This depends on whether their business is making labour only supplies (13.5%), or supplies involving labour and materials (general builder rate of 8.5%).
The decision as to which category to apply is clarified by HMRC in its flat-rate scheme leaflet: “Use ‘labour only’ if the value of materials supplied is less than 10% of your total turnover. If the value of the materials is more than this, builders should use the ‘General building’ flat rate.”
Consider the following example:
- John is a bricklayer with annual turnover of £150,000 (VAT exclusive – all standard rated). He employs direct labour of £100,000; buys materials costing £16,000 (VAT exclusive); pays overheads of £4,000 (all subject to VAT) – these costs leave a profit of £30,000.
- Michael is a bricklayer with annual turnover of £150,000 (VAT exclusive). He employs direct labour of £100,000; purchases materials costing £14,000 (VAT exclusive); pays overheads of £6,000 (all subject to VAT) – these costs leave a profit of £30,000.
Under normal VAT accounting, John and Michael would both pay VAT of £22,750 per annum (output tax of £26,250 less input tax of £3,500) – but what about the flat rate scheme?
The option of the flat rate scheme is excellent for John because he can use the lower percentage of 8.5% because his material purchases of £16,000 exceed 10% of his turnover. However, Michael would have to apply the labour only rate of 13.5% because his business is classed as providing labour only building services. This is because his material purchases are less than 10% of his turnover.
The outcome? John’s VAT bill under the flat rate scheme would be £14,981.25 (£150,000 plus VAT of £26,250 x 8.5%), a saving of £7,768.75 per year compared to normal VAT accounting. Not such good news for Michael – his VAT bill of £23,793.75 under the flat rate scheme (£150,000 plus VAT x 13.5%) means he would be £1,043.75 worse off using the scheme. Sorry, Michael, it’s not for you unless you take on more jobs with material costs!
Extra 1% discount for newly registered businesses……a useful sum
When the flat rate scheme was first introduced, many of the percentages were unattractive to users – the result being that the scheme was even less popular than the England football manager. HMRC sensibly revised the rates from 1 January 2004, and these revised rates have created many of the possible tax savings I have mentioned in this article.
Another “carrot” offered to potential users is a 1% discount in the first year that a business is VAT registered. This means, for example, that a tax consultant using the 11% flat rate for “other business services” would be able to use a 10% rate in his first year of VAT registration. This benefit is worth £1,762.50 for a business making sales of £150,000 per year (£150,000 plus £26,250 VAT x 1%).
Review benefits of flat rate scheme each year…….circumstances change
In this article so far, I have mainly focused on the opportunities for practitioners to consider the benefits of the flat rate scheme for potential users. This final section emphasises the importance of ensuring the scheme is still appropriate for existing users.
Consider the following situation: our bricklayer John in the above example is delighted with the savings offered by the flat rate scheme. However, one year later, a review of his accounts shows that the majority of his work is now on new residential buildings, zero-rated as far as VAT is concerned. This means he is paying 8.5% VAT on his income through the flat rate scheme – even though no VAT is being charged to customers because of zero-rating. If zero-rated work is the main focus of John’s efforts, it would be sensible for him to withdraw from the flat rate scheme as soon as possible.
Another possible situation that could occur is where a business with two sources of income sees a change in activity levels so that the secondary source of income becomes the most prominent. It is a requirement of the flat rate scheme in such circumstances that the chosen category is reviewed each year on the anniversary date of when the trader joined the scheme. The following example is a situation that could affect many publicans:
- Jean trades as a publican using the flat rate scheme. Her turnover includes food and drink sales – she has always applied the 5.5% rate for a publican because wet sales have always been dominant. However, since the smoking ban was introduced on 1 July 2007, the food sales now exceed drink sales. On the anniversary of when she joined the flat rate scheme, it will almost certainly be appropriate for her to apply the 12% flat rate percentage relevant to catering services. This will produce a big increase in her VAT bill!