Is the VAT flat rate scheme still worthwhile for limited cost businesses?
The VAT flat rate scheme is a simplified VAT scheme for smaller traders which allows them to work out the VAT they pay over to HMRC as a fixed percentage of their VAT-inclusive turnover. The fixed rate percentage depends on the business sector in which they operate. The scheme reduces the need to record VAT on purchases separately and reduces the information that must be held digitally under Making tax Digital for VAT. However, for those classed as limited cost businesses, there are potential pitfalls associated with using the scheme.
Who can join the scheme?
The flat rate scheme is open to VAT registered businesses whose VAT-inclusive turnover is not more than £150,000 a year. Once in the scheme, the trader can remain in the scheme as long as their turnover for the year is not more than £230,000 – although HMRC will allow the trader to remain in the scheme if they are satisfied that the turnover for the next 12 months will not exceed £191,500.
Who is a limited cost business?
Special rules apply to limited cost businesses. A business is a limited cost business if the amount it spends on relevant goods is either:
- less than 2% of the business’s VAT flat rate turnover; or
- greater than 2% of the VAT flat rate turnover but less than £1,000 a year (£250 per quarter).
The calculation is performed separately for each VAT quarter; consequently, a business may be a limited cost business for one VAT but not for the next.
What are relevant goods?
Relevant goods are goods used exclusively for the business. Examples of relevant goods are stationery and office expenses, gas and electricity used for the business, stock for a shop, standard software and food used in meals for customers.
However, the list of relevant goods does not include:
- vehicle costs, including fuel (unless the business operates in the transport sector);
- food and drink for you and your staff;
- capital expenditure;
- goods for resale, letting or hiring out where this is not your main business activity;
- goods for disposal such as promotional items, gifts or donations; and
- any services.
Thus, not all purchases on which VAT is suffered are taken into account in assessing whether a business is a limited cost business.
The fixed rate percentage for limited cost businesses
A business that meets the definition of a limited cost business must use a flat rate percentage of 16.5% rather than the one for their business sector.
Doing the maths highlights a potential problem – 16.5% of VAT inclusive turnover is 19.8% of net turnover (16.5% x 120)/100 = 19.8%), so the business will pay almost all the VAT it charges customers (20% of net turnover) over to HMRC, with virtually no margin to cover the input tax suffered.
If the nature of the business is such that its expenditure on relevant goods is low, so that it is classed a limited cost business, but the business has relatively high expenditure on non-relevant goods, such as fuel, the flat rate scheme may not be worthwhile as the business will not recover all its input VAT.
Limited cost businesses should review their position to ascertain whether the flat rate scheme remains worthwhile. If they are not recovering their input tax (with the result that it is costing them to use the scheme), they can consider leaving the scheme and using traditional VAT accounting instead. This will be more work, but depending on the amounts involved, may be worthwhile.
Alternatively, if turnover is below the de-registration limit, set at £83,000, the business can consider de-registering and coming out of VAT.
Guidance on the flat rate scheme can be found in VAT Notice 733.