Limiting the flat rate scheme

The flat rate scheme is intended to be an administrative simplification for smaller businesses (currently having an annual turnover of no more than £150,000).

What is the flat rate scheme?

Rather than determining the output tax liability on sales, the input tax on purchases and partial exemption calculations, the flat rate scheme only requires a single rate to be applied to the gross turnover, with no further requirement to consider input tax or the impact of partial exemption.

There are various rates listed by HMRC and taxpayers determine which is most appropriate for their business according to their main activity.

For example, a small business whose activity falls under the category “Business services not listed elsewhere” has a flat rate of 12%.  For every £1,200 it charges (£1,000 plus VAT of £200), it accounts for £144 to HMRC (12% x £1,200), but it can claim no input tax on its running costs.

What’s the issue?

Where a business charges £1,200 and has no or very few purchases, the flat rate scheme’s prohibition on recovering input tax has no impact on the business and it makes a profit from using the scheme.

This was not the intention of the flat rate scheme and the government has decided to close this loophole.

The changes

On 23 November 2016 changes were announced to the flat rate scheme in the Autumn Statement and on 5 December 2016 draft legislation was published.

From 1 April 2017, overriding the determination of the applicable flat rate according to the taxpayer’s activity, there will be a new flat rate (16.5%) for ‘limited-cost traders’.  Those businesses which do not have significant purchases of goods will be required to apply the new flat rate.

Suppliers of goods, therefore, will not generally be affected by the new rules and suppliers of services are being targeted.  Also excluded from the government’s targets with the new rules are taxpayers with activities involving transport services.

The new rules exemplified

Considering again the example of the business above which has no purchases of goods and qualifies as a ‘limited-cost trader’.  Instead of applying 12% as its flat rate, it will apply 16.5% from 1 April 2017.  For every £1,200 it charges (£1,000 plus VAT of £200), it will account for £198 to HMRC (16.5% x £1,200).

In effect the taxpayer is allowed £2 of input tax recovery on its purchases.  This is clearly not cost-effective for most small businesses which have large purchases of services (eg consultants), but do not purchase goods.

Although the new rules might catch those who abuse the flat rate scheme and make a profit from it, the rules will also catch genuine businesses which only have high service costs.  The rules therefore appear to be wider than they should be, but it remains to be seen whether amendments will be made.

If taxpayers, particularly service-providers and their advisers, wish to comment on this rule change, please contact Gabelle before Friday, 27 January 2017. Taxpayers should also be reviewing how their current position will be affected by the new rules and considering what action will be required from 1 April 2017.

For further information and help on VAT and the flat rate scheme, please contact the TaxDesk on 0845 4900 509 and ask for Kevin Hall.