Article by Stanley Dencher and Neil Owen published in the August 2002 issue of Tax Adviser.
A detailed analysis of the new VAT flat rate scheme: Article published in the August 2002 issue of Tax Adviser. Stanley Dencher BCom, FCA, FTII is a Senior Technical Editor with CCH. Neil Owen BA, FTII, AIIT, MBIAC is Director of VAT Services at chartered accountants James & Cowper and a contributing editor to a number of CCH publications.
The title of this article is not the score from sports event, but the flat-rate percentage for two types of business category which can use the new, optional, value added tax (VAT), flat-rate scheme (FRS) for small businesses. The FRS aims to cut the annual, compliance burden for over 300,000 small businesses by up to £1,000. After exceeding a VAT registration threshold, some persons have problems complying with the VAT system.
Now persons can elect (apply for authorisation) to join the FRS for a VAT return ending after 25 April 2002 by sending Form VAT 600FRS to the local Customs & Excise registration unit (Value Added Tax Act 1994 (VATA 1994) s. 26B(1), as proposed to be inserted by Finance Bill 2002, cl. 23). The form is not available on its own. Applicants must either download it from the web or use the copy printed in the explanatory publication on the scheme, Notice 733.
For those familiar with the agricultural FRS, it is important to observe at the outset that the FRS for small businesses does not operate in the same manner. It is not an alternative to VAT registration, but a form of VAT registration. Essentially, it merely alters the way in which a VAT-registered person’s liabilities are calculated.
Conditions for FRS authorisation
The conditions for a person being eligible to be authorised to use the FRS include:
(1) there are reasonable grounds for believing that:
(a) the VAT-exclusive, annual, taxable (being zero and positive-rated) turnover will not exceed £100,000; and
(b) the VAT-exclusive, annual, total turnover (being not just taxable, but also exempt and other non-taxable income) will not exceed £125,000 (Value Added Tax Regulations 1995 (SI 1995/2518), reg. 55L(1)(a)). Exempt supplies includes lottery commission and certain rent. Other non-taxable income includes non-business income such as that arising from charitable or educational activities. However, a supply is disregarded if it is a capital asset of the business or a reverse charge on a supply from abroad.
Generally, future turnover may reasonably be forecast from past results and projections which supported applications for loans. The calculation of future turnover should be in writing and retained as Customs may query the matter using hindsight;
(2) the person is not a tour operator;
(3) the person is not required to carry out adjustments in relation to the capital goods scheme;
(4) the person does not intend to opt to use a margin scheme;
(5) in the previous 12 months, the person has not operated the FRS and has a satisfactory compliance record, for example as regards certain penalties and convictions; and
(6) in the previous 24 months, the person has not been eligible to be group-registered, VAT registered in the name of a division, or associated with another person unless Customs are satisfied that authorisation poses no risk to the revenue.
The FRS aims to help those running a stand-alone business, i.e. the business is not part of a larger undertaking. A person is associated with another if that other person makes supplies in the course or furtherance of a business carried on by him, and the business of one is under the dominant influence of the other, or the persons are closely bound to one another by financial, economic and organisational links. Thus, association is a question of fact and the tribunals are likely to have to consider this issue in the same way they have for directions by Customs to counter splitting of a business to avoid registration.
Clearly Customs have learnt from their experience with the disaggregation provisions. The requirement to notify Customs on application of any associated businesses will enable them to identify potential business-splitting measures in advance and prevent the use of the scheme to reduce VAT liabilities in such circumstances.
Calculation of VAT due to Customs
Flat rate scheme users can avoid accounting internally for VAT on all their purchases and supplies. Instead they calculate the VAT due to Customs by applying the appropriate, flat-rate percentage for the trade category to the VAT inclusive turnover, including all reduced-rated, zero-rated and exempt supplies. This figure also includes the value of any supplies to other member states.
Persons using the FRS can choose:
(1) whether to account for VAT on a quarterly basis; and
(2) whether to combine the FRS with the annual accounting scheme.
The record of FRS turnover is based on:
(1) cash receipts;
(2) daily gross takings; or
(3) invoices issued.
Although Customs’ view is that the invoice basis will be the most obvious for most users, it may well be that the majority of non-retail users elect for the cash basis. Not only is this more consistent with simplified book-keeping, where the cashbook may the central record of the business, but it also provides automatic relief both from bad debts themselves and the complex bad debt provisions of the scheme.
Flat rate scheme users:
(1) still issue the usual VAT invoices to customers who are VAT-registered, showing VAT at the normal rate for the supply, i.e. not at a flat rate. Such customers treat these invoices as normal VAT invoices and are unaffected by whether they deal with an FRS user; and
(2) still retain all sales and purchase invoices for six years.
Persons with exempt income are treated as fully taxable, because the flat-rate calculation for their trade category takes irrecoverable VAT into account.
Wendy is a computer consultant whose clients, like her, are all VAT-registered.
Generally, she works from home and decides not to work more hours than are necessary to earn an annual turnover excluding VAT of £70,000. The flat-rate percentage for computer consultants is the top rate of 14.5 per cent.
If she uses the flat-rate scheme (FRS), she pays Customs each year £11,926 in VAT, being 14.5 per cent of her VAT-inclusive turnover of £82,250 (being 117.5 per cent x £70,000).
However, with normal accounting, she pays Customs £12,250 output tax (being 17.5 per cent x £70,000 VAT-exclusive turnover) minus any recoverable VAT on her business expenses, which in this case primarily relate to equipment leasing, telecommunications, professional fees and motor expenses. In a typical year, such input tax is likely to total much more than £324, being the difference between £11,926 payable as an FRS user and £12,250 output tax due with normal VAT accounting.
Thus, she is unlikely to use the FRS unless she is sufficiently keen to avoid maintaining the extra records required to comply with normal VAT accounting.
In Wendy’s case, the decision will not be a difficult one to make. However, not all businesses will find that the answer is so clear-cut. There are seventeen flat rate percentages, and descriptions of those businesses to which they all apply. Some of these descriptions are clearer than others. Confectioners, tobacconists and newsagents are self-evident; the distinction between ‘other business services’ and ‘services not elsewhere specified’ is arguably more difficult to divine. Since the rates for these are, respectively, 12.5 per cent and 11 per cent, it makes a material difference.
Indeed, lesser factors may make a difference to two traders in one category whose circumstances are otherwise identical. The simple fact as to whether a business pays VAT on its rent or not will affect the ratio between turnover and net tax due (which is essentially what the flat rate is meant to approximate to). The trader incurring VAT on rent is less likely to benefit financially from using the scheme or be subject to a greater disadvantage from using it. The ratio of newspapers to other supplies for a confectioner, tobacconist or newsagent (CTN) will influence the impact of using the scheme. Or a handful of exports for a manufacturer may render the scheme impossibly disadvantageous.
For the return period current when starting to use the FRS, the appropriate percentage is that for the category of business that the person is expected, at the start date, on reasonable grounds, to carry on in that period, or if the start date is not the first day of the period, in the remainder of the period. For subsequent periods, current at an anniversary of the start date, the appropriate percentage is that for the category of business that the person is expected, on the first day of that period, on reasonable grounds, to carry on in the period. For other periods, if any, the appropriate percentage is the same as that applicable for the prescribed accounting period that was current at his start date, or the most recent anniversary of his start date, whichever is the later.
An FRS user may start a new business or cease to carry on an existing business. For the part of the period in which the change occurs starting with the change date and ending on the last day of that period, the appropriate percentage is that for the category of business that the person is expected at the change, on reasonable grounds, to carry on in that period. For any period that falls between the period current at the change date and the period current at the next anniversary of the start date, the appropriate percentage is that applicable for the non-lapsed portion.
If an FRS user carries on business in more than one category in a period, he is treated as carrying on that category of business which is expected, on reasonable grounds, to be his main business activity in that period.
The choice of the appropriate percentage is of critical importance. It has already been pointed out that this may affect the tax due (and therefore the perceived benefit or otherwise of joining the scheme). It is also a decision which is initially taken by the trader on application. A description of the business activities and a declaration of the correct rate are made by the applicant on Form VAT600. It will undoubtedly be advisable to describe the business activities in some detail, sufficient for Customs to determine if they believe the correct rate has been chosen and to challenge it at the time. If little real detail is disclosed and the declared rate is accepted by Customs, they may be in a position at a later date, on examining the business in greater detail (typically on a control visit) to determine a different rate to apply and assess for any shortfall. If a full description has been provided on application, it will be far more difficult for them to apply a different rate retrospectively at a later date.
Input tax and capital goods
The calculation of the FRS rates allows for low-value capital purchases. However, subject to the usual conditions, VAT on VAT-inclusive expenditure over £2,000 is recoverable outside the FRS. Traders reclaim this by declaring the input tax in Box 4 on the VAT return and declaring the value of the capital purchase in Box 7. Such separate treatment does not cover items such as cars where the VAT on purchases is blocked.
However, where capital purchases were dealt with outside the FRS, output tax on their disposal (or deemed disposal in the case of an asset held as at the time of de-registration) is also dealt with outside the FRS. In these circumstances, the output tax due, together with that due under the flat-rate calculation, is declared in Box 1 of the VAT return and the value of both in Box 6.
These provisions are necessary in order to avoid a situation where the flat rate scheme is too costly for any business.
It can also be seen that the timing of joining the scheme can be of importance. An intending trader, incurring capital expenditure before starting to trade, should probably register for VAT in the normal way and delay any application to join the FRS until business begins in earnest, in order to maximize input tax recovery.
Leaving the FRS
Generally, a person ceases to be authorised to use the FRS:
(1) at any anniversary of his start date, if his income in the one year then ending totals more than £150,000 (the past turnover test) unless Customs are satisfied that the total value of his income in the one year then beginning will not exceed £125,000;
(2) there are reasonable grounds to believe that the total value of his income in the 30 days then beginning will exceed £150,000 (the look-ahead test). These tests are similar to those for registration as a result of making taxable supplies in the UK;
(3) he becomes a tour operator;
(4) he intends to acquire, construct or otherwise obtain a capital item within Value Added Tax Regulations 1995, regulation 112(2);
(5) he opts to account for the VAT chargeable on a supply made by him using the profit margin (VAT Act 1994, section 50A);
(6) he becomes:
(a) eligible to be group-registered;
(b) registered in the name of a division; or
(c) associated with another person;
(7) he opts to withdraw from the FRS; or
(8) Customs terminate his authorisation to protect the revenue or because a false statement was made in relation to his application for FRS authorisation.
In determining the value of a flat-rate trader's income for the purposes of deciding whether he must leave the FRS, supplies of goods or services that are capital assets are disregarded.
If a person has reason to believe that the turnover will exceed the limit in the accounting year, for example because he obtains a large business contract, he should in writing notify Customs who should terminate authorisation to use the FRS.
Although any business with an eligible turnover may join the scheme, it is more appropriate for those businesses which expect to remain with a turnover at or below about £100,000. Growing businesses which commence below the threshold, but expect eventually to exceed it, are likely to find the process of joining and then leaving the scheme too disruptive to be a realistic proposition.
The FRS does not aim to affect significantly the VAT amount Customs collect. Thus, depending on the trade category, the range of flat-rate percentages varies from five per cent to 14.5 per cent. The 13.5 per cent rate applies to accountancy, bookkeeping, lawyers and legal services. Generally, the percentage for a trade category is based on the VAT declared on VAT returns for that category compared to the value of supplies declared.
However, because no two businesses are the same, even in one trade category (indeed, the set flat rate is bound to be an average of all such businesses), it follows that, in each category, there will be those for whom it creates a significantly higher liability than ordinary VAT accounting and those for whom it creates a significantly lower one.
The true impact of the scheme can only be known by carrying out dummy calculations. In most cases, it will be clear that use of the scheme will either save money or cost money. Those who would lose are unlikely to see the cost as worth bearing for the sake of simplified records. Those who would gain are likely to opt for the scheme for financial reasons, rather than for the benefit of simplicity.
To follow the fine detail practitioners must consider the new provisions in VATA 1994, s. 26B the Value Added Tax Regulations 1995, Pt. VIIA and the tertiary legislation in Customs Notice 733, which in places has the force of law. It will be interesting to see how many use the FRS and use it correctly.
Some accountants do not want their clients to use the FRS because the regular discipline of complying with detailed quarterly VAT accounting helps some people keep better records. Some argue that the FRS percentages are too high.
The issue of whether to use the FRS must be faced by tax practitioners. Arguably, failure to advise on FRS could amount to professional negligence. Before recommending the FRS, an accountant would want to be confident that the client would be better off by using the FRS, but usually that is difficult without reliable projections.
There will be winners and losers, especially as traders cannot decide whether to use the FRS on a return-by-return basis.
By removing fiddly adjustments like scale charges, retail scheme workings and partial exemption calculations, the scheme may bring a welcome simplification for some. However, the only way to be sure whether a person is winning or losing is to monitor the position, but keeping the necessary records would negate a major benefit of the FRS.
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August 2002 by