Changes to be implemented from April 2017 could reduce the take home pay for many contractors using the VAT Flat Rate Scheme (FRS) by thousands of pounds.
This is due to the announcement in the 2016 Autumn Statement that the rate of VAT for ‘limited cost traders’ using the VAT FRS is set to increase to 16.5% in April 2017.
James Abbott, head of tax at contractor accountant Abbott Moore, warns that many contractors will take a considerable hit, with a typical contractor earning £100,000 per year likely to lose out on up to £3,500 of income as a result of the new rate.
Your best course of action will depend on your circumstances, including the amount of goods you currently claim VAT on. If you are using the VAT FRS, consult with your accountant now.
What is the VAT Flat Rate Scheme?
The VAT FRS aims to simplify record keeping and the VAT process for small businesses. Rather than deducting the VAT on a company’s inputs from the VAT charged on what is sold, users of the FRS calculate their VAT liability on a fixed percentage of their turnover including VAT.
The flat rate rate paid is sector dependant, with those in IT consultancy currently paying VAT at 14.5%.
The original rates were chosen to reflect the balance between input and output VAT of various types of business. But the new rate has been introduced to counteract perceived aggressive abuse of the scheme by firms offering managed service company solutions.
“Like many other schemes to tackle anti-avoidance, these measures have been targeted to tackle one particular problem but it’s so far reaching that many compliant contractors are set to receive a hit,” explains Abbott.
What is a limited cost trader?
This new rate applies to whom the Government is referring to as limited cost traders.
Limited cost traders are those who spend less than 2% of their annual turnover on goods, or alternatively less than £1,000 a year on goods.
The further hurdle is that there are several significant expenses that FRS users can’t claim VAT on, including:
- Capital goods (including business equipment such as computers)
- Food and subsistence
- Motoring and travel costs (such as fuel)
- Accountancy fees
Abbott points out that most contractors are likely to fall short as a result: “Once you take out these expenses, what physical items do you actually buy other than books and stationary? The excluded list is therefore critical.”
How does the VAT FRS work?
Under the FRS, an invoice for £2,000 would have 20% VAT added - £400. Under current rates, many contractors would then deduct VAT at 14.5% from the £2,400 received, meaning £348 is paid to HMRC.
With the new rate at 16.5%, a limited cost trader would pay £396 to the taxman, an almost identical fee to that charged to the client. "The key point is you are paying over the large majority of the VAT that you are collecting,” comments Abbott.
“Most contractors will have made a subsidy out of the flat rate scheme, so they benefit from having simplicity and a surplus. But because 16.5% is so close to the amount of VAT you are collecting, contractors will definitely be worse off than they were under the old rules.”
Abbott provides an example calculation to demonstrate how the changes are likely to impact on a typical limited company contractor earning £100,000 per year.
Example: VAT FRS before April 2017:
| Contractor's annual turnover before VAT | 100,000 | ||||
| VAT charged at 20% | 20,000 | 20,000 | |||
| Total revenue: | 120,000 | ||||
| Flat rate paid over to HMRC | 14.50% | -17,400 | -17,400 | ||
| Leaving in company: | 102,600 | ||||
| VAT on costs that could otherwise be claimed:
(if VAT registered but not in FRS) |
1,500 | 20% | -300 | ||
| Net benefit of using FRS | 2,300 |
Example: VAT FRS after April 2017:
| Contractor's turnover before VAT | 100,000 | ||||
| VAT charged at 20% | 20,000 | 20,000 | |||
| Total revenue: | 120,000 | ||||
| Flat rate paid over to HMRC | 16.50% | -19,800 | -19,800 | ||
| 100,200 | |||||
| Costs that that could otherwise claim
(if VAT registered but not in FRS) |
1,500 | 20% | -300 | ||
| Net cost of using FRS | -100 |
How contractors can plan for the VAT FRS changes
The most suitable approach will depend on your current spend on VATable goods.
Abbott warns that making additional purchases simply to clear the 2% mark won’t necessarily benefit your business and encourages contractors to consult with their accountants to assess their options.
“If you already spend 1.9% of your turnover on stationary, for example, it would be worth spending a bit more – providing it’s genuine – to then make significant savings.
“It’s unlikely those very short of the 2% will find increasing their spend on goods to be worthwhile. Each cost has to be a genuine business expense, and what’s not yet clear is whether benefits in kind will count. HMRC is due to consult on the measures in before April 2017 where there will be some clarity.”
How to respond to the VAT FRS changes
If your business generates less than £83,000 per year and you are voluntarily VAT registered, Abbott highlights that de-registering is a potential option, adding: "Some will value simplicity and may decide to carry on with the FRS. Other may prefer the idea of being VAT registered to be perceived as a more substantial business.”
Alternatively, another option is to revert to the traditional method of calculating VAT, but recording VAT collected and paid out, then paying the difference on a quarterly basis.
The Government has also published anti-forestalling legislation stipulating that any work carried out after 1 April will be subject to the new rate, regardless of the invoice or payment date. This means certain contracts already active may also be partly subject to the new rates.
All accountants will be able to provide contractors with an idea of how they are benefiting from the FRS, and how hard the changes will hit them.