Despite HMRC’s intention to simplify VAT accounting for small businesses the Flat Rate Scheme is full of subtle intricacies that cause confusion for businesses and their advisors. Julie Green highlights how businesses can maximise the benefits of using the scheme and also some of the potential pitfalls.
The flat rate scheme (FRS) was introduced in 2002 with the aim of reducing the administrative burden for small businesses by simplifying the completion of VAT returns. Since then it has proved to be very popular with a large number of businesses now using the scheme. However, whilst in theory the scheme appears to be straight forward, subtle intricacies in the rules continue to cause confusion and problems for businesses and their advisors. This article sets out the basic rules behind the scheme, provides advice on how to maximise the benefits of the scheme but also highlights some of the potential pitfalls.
How the Scheme Works
The FRS is available to businesses with a taxable turnover (excluding VAT) of £150,000 a year or less.
A business charges VAT to its customers in the normal way, i.e. charging 20% for standard rated sales but instead of accounting for VAT based on output tax less input tax, a business applies a flat rate percentage to its gross turnover according to a table listing 55 different categories from ‘Accountancy’ through to ‘Wholesaling’. There is no input tax to be claimed unless it relates to capital expenditure goods (CEG) exceeding £2000 including VAT.
Choosing the correct category
One of the biggest problems for the taxpayer is selecting the correct category.
As mentioned above there are 55 different categories to choose from, and although this seems vast, there are many business activities that do not sit neatly in any of the categories and so it’s often the case of having to find the best fit or if there is no near match opting for the 12% rate for ‘Any other activity that is not listed elsewhere’.
HMRC’s published guidance (Public Notice 733 Section 4.2) states that HMRC will not change a business’s choice of sector retrospectively so long as the choice was reasonable. This should be of comfort to businesses as in theory so long as a business carefully and reasonably considers which category to choose and HMRC take an alternative view finding that a different category is more appropriate they will only change the category going forward.
The problem is it does not always work this way in practice. This was the case in IDESS Limited  UKFTT511 represented by Croner Taxwise’s Litigation expert Glyn Edwards and on which we have reported in previous editions of VAT Voice. In brief, IDESS was a mechanical engineering business and chose the category of 12% for ‘Any other activity that is not listed elsewhere’. HMRC disagreed and decided that the business should have been in the category for ‘Architect, civil and structural engineer or surveyor’. In addition they decided that the initial selection was not reasonable and issued a retrospective assessment. It is no surprise that the Tribunal decided HMRC were wrong and the assessment was withdrawn. The Tribunal concluded that the category for ‘civil engineer’ is only linked to services involving land, whereas the IDESS activity was linked to machinery.
Identifying which sources of income should be included in flat rate turnover
A disadvantage of the FRS is that the percentage is applied not only to standard rated income but also zero-rated and exempt income. It is exempt income that seems to be the most common cause of errors.
The following examples illustrate how easily mistakes can be made:
Example 1: A business buys a car before joining the FRS. The input tax is blocked because the car is available for private use. The business then joins the FRS and sells the car. Should the sale of the car be included in FRS turnover?
Treatment: The sale of the car is exempt under VAT ACT 1994 Schedule 9 Group 14 (Supplies of goods where input tax cannot be recovered) and so must be included in the business’s flat rate turnover.
Example 2: A husband and wife run a hair salon as a partnership and also have rental income from a jointly owned residential property. Should the FRS be applied to the rental income?
Treatment: The rental income is treated as business income for VAT purposes and is exempt and so must be included in flat rate turnover. The VAT registration of the partnership covers all of their activities (it is the partnership rather than the business that is registered). In such cases it may be advisable to avoid the issue by separating the property and the business into different legal entities.
Consider the position of the husband and wife in example 2 above if they sold their property (an exempt supply) but did not appreciate that the sale should be included in their FRS turnover.
The good news is that HMRC would more than likely accept that the EU concept of proportionality can apply in this case and allow the partnership to leave the scheme retrospectively to avoid accounting for VAT on the sales proceeds. Proportionality gives HMRC the opportunity to override the legislation when it gives an outcome that is unfair and unintended. Don’t forget though that the partnership would also have to recalculate their VAT from the period they retrospectively withdrew from the scheme to a current date and that once a business leaves the FRS it must stay out for at least a year before it can re-join.
The Treatment of International Trade Transactions
International trade transactions often catch businesses out because there are different rules for goods and services.
The sale of goods to another EU business is zero-rated so long as the VAT number of the customer is obtained and shown on the sales invoice and proof that the goods have left the UK has been obtained. The sale of goods therefore has to be included in flat rate turnover. A logical conclusion is that if the sale of goods to other EU businesses should be included in flat rate turnover then supplies of services to other EU businesses should also be included. However, this is not always the case. Where the services provided are subject to the business to business (B2B) general rule and the customer is an EU business the supplies are outside the scope of VAT. Outside the scope supplies are excluded from flat rate turnover.
There is also a difference in the treatment of purchases of goods and services from EU businesses. Goods purchased from VAT registered businesses in the EU are subject to acquisition tax. Acquisition tax must be accounted for in Box 2 of the VAT return at the standard rate and not the flat rate. Generally however, the corresponding input tax is not recoverable in Box 4 of the VAT return (unless the purchase is of CEG). In contrast, if a business purchases services from the EU to which the reverse charge applies they will be in a better position. Reverse charges are dealt with outside of the FRS. Output tax should be accounted for in Box 1 of the VAT return at 20% but is also recoverable in Box 4 of the VAT return leaving a nil net effect.
Purchases where input tax is recoverable
Capital Expenditure Goods (CEG)
A business can reclaim input tax on a single purchase of CEG where the amount of the purchase, including VAT, is £2000 or more.
It is important to note that there are some specific exclusions and these include goods that are intended for resale, goods that are consumed within one year, goods that are leased or hired out and goods subject to the capital goods scheme.
A claim for input tax can only be made for goods and not services. For example, if a business buys a website for £5000, even though this expenditure may be capitalised in the company’s accounts the VAT cannot be reclaimed because the supply of the web site is a supply of services and not goods.
It is also important to note that the limit applies to each asset. This was the key point in the case of Eventful Management Ltd  BVC 4,009. The company built an extension to its offices. The Director purchased building materials from several suppliers and then engaged a builder to do the work. The invoices ranged from a few pounds to just under £1,000 and the business sought to reclaim the VAT. HMRC assessed to recover the VAT on the ground that these were not CEG. The company accepted that at the time of purchase, the goods were not CEG, but contended that when they were put together they formed a building which was. The Tribunal decided that the materials bought were not CEG and, in any event, there was not a single purchase of more than £2,000, but a multitude of invoices from separate suppliers.
Interestingly, if an item qualifies as CEG there is no need to restrict input tax or account for output tax on any private or non-business use. For example, if a business buys a van and it is available for the private use of employees all of the input tax can still be reclaimed.
Pre-registration and Post de-registration Input tax
A fairly straightforward but important point is that although a business cannot reclaim input tax whilst using the scheme (unless the purchase is of CEG) a business that adopts the FRS from its date of registration can still claim input tax on pre-registration expenses in the same way as a non-scheme user. In addition, there is more goods news when a business de-registers from VAT. A business leaves the scheme the day before the de-registration date. This means it is also entitled to recover input tax on services received after de-registration so long as the services relate to taxable supplies made whilst registered in the same way as a business not using the scheme. Claims should be made using a VAT 427 form.
Is the business closely linked to another business?
This rule is less well known and in some cases prevents businesses from joining the scheme if it is associated with another business. And if a business already using the scheme forms an association with another business then it might need to withdraw from the scheme.
The definition of association is in Regulation 55A(2) of the VAT Regulations 1995; ‘A person is associated with another person at any time if that other person makes supplies in the course or furtherance of a business carried on by him and – (a) the business of one is under the dominant influence of the other, or (b) the persons are closely bound to one another by financial, economic and organisational links.’ Part A seems fairly straightforward. This would apply if, for example, a company has a subsidiary company. Part B only applies if all three links are present. Despite this HMRC has had success in the Tribunals on this point. This was the case in Welshback Exercise  BVC 4,011. Welshback was an exercise club. HMRC ruled that it was associated with another company WB Clubs Ltd (WB) and withdrew their authorisation to use the scheme with retrospective effect. There were organisational links between the companies in that they had the same shareholders with one director playing a significant strategic role in both companies. There were close financial links; WB leased the equipment and property to Welshback but charged no rent and WB often bought goods for Welshback without expectation of repayment. There were also close economic links with the companies securing mutual benefits from their association. The Tribunal upheld HMRC’s decision to impose an assessment in the sum of £21,489.
Retrospective use of the Scheme
We are frequently asked on the Advice Line if a business can apply to use the scheme retrospectively because it could have paid less VAT by using the scheme.
Regulation 55B(1)(b) of VAT Regulations 1995 does allow for a start date that is earlier than the date of application but only in ‘exceptional’ circumstances. This was the case in Geoffrey Seeff t/a TPL Associates TC027378 (2013). He was successful in his appeal on the basis that at no time during the period of VAT registration had his turnover reached the mandatory registration threshold, his management consultancy business was severely affected by the financial crisis of 2008, his failure to secure expected turnover and the economic downturn had caused immense financial difficulty and Mr Seeff disadvantaged himself and exacerbated his financial difficulties by not converting to the FRS.
However, HMRC’s general approach with adopting the scheme retrospectively is that the aim of the scheme is to save time and administration in dealing with VAT and therefore if a return has already been completed based on normal VAT principles, then recalculating VAT under the FRS does not save time.
The flat rate scheme has certainly simplified the completion of VAT returns for small businesses and for many businesses there are significant gains to be made by using the scheme.
But there are numerous pitfalls that businesses and their advisors need to be aware of where things are not quite as straight forward as they seem. Without knowledge and awareness of these subtle issues the FRS may be simple but may also be costly.