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VAT Flat Rate and the new Limited Cost Trader

From 1st April 2017, if your business is on the VAT flat rate scheme (FRS), HMRC are making changes which may affect the FRS % you have to use.

The ‘standard’ VAT scheme is based on you paying or claiming back from HMRC the difference between the VAT on your sales and the VAT on your purchases. However under the flat rate scheme (FRS) you pay a fixed rate of VAT on your total gross sales (the rate is based on your trade) to HMRC and get to keep the difference between what you charge your customers and what you pay to HMRC. Using FRS means you cannot claim the VAT on your purchases but for many small businesses with few costs and using FRS, they would usually make a small gain in each VAT quarter when compared to being on the standard scheme.

So… what’s changing? From 1st April 2017 there will be a new flat rate of 16.5% (regardless of your trade) which will apply to limited cost traders. As a limited cost trader you will continue to charge your customers 20% VAT on your sales BUT you will now have to pay over VAT based on the new 16.5% rate of your total gross sales for the period.

HMRC advise that a limited cost trader is a business that:

  • Spends less than 2% of its VAT inclusive sales on qualifying goods, or
  • Spends more than the 2% but less than £1,000 per year in total on qualifying goods

In calculating your goods, it’s important to note that qualifying goods must not have any element of personal use and cannot include any of the following:

  • The cost of services provided such as accountancy or legal and professional fees
  • Food or drink
  • Vehicles, vehicle parts or fuel
  • Capital goods such as computer and office equipment

These new avoidance rules will prevent a business defined as a limited cost trader from continuing to use a lower flat rate beyond 1st April 2017.

If the majority of your expenditure items you normally incur are non-qualifying goods for the purposes of the limited cost trader, then these changes will affect your VAT returns and the amounts payable to HMRC each VAT quarter. Businesses most likely to be affected include Consultants, Cleaners, Solicitors, Labour only construction and hairdressers etc.


Example of the old FRS based on a rate of 14.5%

Income £1,000
VAT at 20% £200
Gross Income £1,200
14.5% FRS payable to HMRC £174
FRS Gain retained £26


Example of the new FRS based on 16.5% for a limited cost trader

Income £1,000
VAT at 20% £200
Gross Income £1,200
16.5% FRS payable to HMRC £198
FRS Gain retained £2


For businesses on the FRS scheme that engage their accountant or bookkeeper to prepare and file the business VAT return each quarter, they will carry out a review during their work on each VAT return, applying the tests and updating the % used if the business now qualifies as a limited cost trader. However with these new rules you may be thinking about the FRS scheme and if it is beneficial to remain on it. So what are your options?

Remain on the Flat Rate Scheme
There is no legal requirement for you to leave the FRS scheme if you are now a limited cost trader. Many small businesses recognise the benefit of using FRS and the reduced administration required with you not needing to claim the VAT on your purchases. And the first year reduction in the % by 1% will remain in place for business in their first year of trading. Remaining on the FRS scheme will suit businesses in the first year of trading, those that do meet the qualifying goods criteria or those who simply prefer the easy VAT administration on purchases and accept the VAT FRS gain will be reduced in each VAT period.

Leave FRS and operate the standard VAT method
You could choose to leave the FRS scheme and revert to operating the standard method. Under this standard method you’ll continue to charge your customers as usual but you will now need to keep a record of the VAT on all qualifying business purchases and then claim this VAT back against the VAT you have charged your clients. Remember that if you claim VAT on a purchase then you must have and retain a valid VAT receipt for this expense as HMRC will require this should hey open a VAT enquiry. This method is best suited for businesses that do not meet the qualifying goods criteria but do incur a high volume of business expenditure which does include VAT on the purchase.

De-register for VAT
Equally, for very small traders with turnover below the VAT de-registration threshold (currently £81,000), it may be appropriate to de-register from VAT altogether. This option is best for micro-sized businesses with a low turnover and very little in the way of business expenses.

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