Small Businesses - Thanks, But No Thanks?

MALCOLM GUNN FTII, TEP examines the new VAT flat rate scheme for small businesses with turnover of £100,000 or less.

IN CASE YOU missed it, a wonderful new piece of tax simplification emerged like a butterfly from a chrysalis on 24 April 2002. We all complain about complexity in tax matters and the impossibility of the average man in the street understanding even what the basic rate is (10 per cent? 20 per cent? 22 per cent?), so this genuine attempt at making tax totally straightforward is to be applauded.

Or is it? Some say that what has actually emerged from the chrysalis is not so much a Red Admiral but more a Cabbage White with only one wing - it is of limited interest and will never fly! John Price examined the new scheme in question, the VAT flat rate scheme for small businesses, in Taxation 19 September (see 'Design Flaws' at pages 669 to 670) and concluded that it would fall flat on its face. My initial conclusion was much the same, although, like people who love Citroen 2 Cvs and holidays in the Sahara Desert, there are bound to be some out there who will find the scheme to be absolutely wonderful. I have illustrated on page 59 two hypothetical cases which are as true to life as I can get them from my knowledge of actual taxpayers and the scheme works nicely for one of them (which came as a surprise) but not for the other.

Since Taxation is systematic in its coverage of new developments in tax, this could well be an article which no one in a major firm needs to read! All the same, what I plan to do is to set out the salient features of the new scheme in a style suitable for readers to skim through, ready for any questions coming from smaller clients seeking guidance.

A table of the flat rates was published at the foot of John Price's article in the 19 September issue. I understand that Customs may wish to respond to both that article and this one shortly.

Who can apply?

Although the scheme is described as being for small businesses, this is something of a misnomer. It is for very small businesses.

Anyone applying for the scheme must have anticipated taxable supplies (these being standard rated, zero rated and reduced rate supplies for VAT purposes) not exceeding £100,000 (exclusive of VAT) for the period of one year then beginning. That must surely knock out of the running all but the smallest of businesses. The VAT registration limit is only £55,000 so this scheme is for those who are not making much of a go of their VAT registered businesses.

Perhaps that is a little uncharitable. Those supplying labour only services, such as web designers and specialist consultants in a particular area will be doing very nicely if they are earning up to £100,000 and they could opt in for this new scheme paying a flat rate of 14.5 per cent VAT on their turnover. Their inputs might be minimal, or zero rated paper and stationery, and so they could possibly be better off.

There is however a supplementary test. This is that the total value of anticipated income in the same future one year period must not exceed £125,000. As far as I can see, the regulations leave it to the imagination what the meaning of 'income' is for this purpose and Customs, in their Notice 733 have stepped in to prevent wild fantasies taking over. They say it is the value of all business supplies, including exempt supplies, plus in addition 'any other income received or receivable by' the business. This includes, so they say, technically non-business income such as income arising from charitable or educational activities.

Perhaps the most common example of income which is added in towards the £125,000 test is rent from surplus business premises.

Who may not apply

There is a long list of people who are stated to be not eligible for the scheme. These are the following, in what I see as descending order of importance.

Businesses in the capital goods scheme

Any business which has an asset within the VAT capital goods scheme is excluded from the flat rate scheme.

It will be recalled that the capital goods scheme, in broad terms, embraces businesses which have purchased computer equipment with a value of not less than £50,000, or which have purchased buildings or premises under a taxable (and not zero rated) supply to a value of £250,000 or more.

Margin schemes

Those operating profit margin schemes, such as second-hand car dealers, cannot operate the flat rate scheme in addition. They must choose one scheme or the other and it is generally thought that those within a margin scheme are best to stick with it but I guess it is worth doing the sums in any particular case.

Group companies

Any company eligible for VAT registration in the name of a group, or which has been eligible for such registration in the last two years, cannot join the scheme.

Likewise, divisions of a company registered for VAT in the name of the division, or which has been so registered in the last two years, are also not eligible.

Associated businesses

Applicants for the scheme must not be 'closely bound' to another business by financial economic and organisational links. Readers will recognise this terminology having been transported in from the familiar provisions as regards directions by Customs under paragraph 1A to Schedule 1 of the VAT Act 1994. A common application of this provision is where separate businesses are operated by husband and wife respectively but Customs regard the two as being too closely interlinked or not sufficiently segregated.

However, the definition of associated businesses does not quite end there. It is also provided that it applies where the business is 'under the dominant influence of' another business. The exact scope of this second test remains to be determined. Is a freelance computer consultant working at home for only one client, a major group of companies, under the dominant influence of that group of companies? One might hope that the second of these two tests is little more than a restatement of the first and more well known test, but this appears not to be the case. Customs Notice 733 says that 'businesses will be associated if one of the companies (I take it we are to read this in broad terms!) has the right to give directions to the other or if in practice one company habitually complies with the directions of another. The test here is a test of the commercial reality rather than of the legal form.' Quite where this statement leaves us with people such as a freelance computer consultant with only one client may be a matter for personal interpretation.

Nevertheless Customs have stated that associated persons may be admitted to the scheme if they obtain Customs' agreement in writing beforehand.

VAT offences

Those who have been convicted of offences in connection with VAT, assessed to a penalty for conduct involving dishonesty or who have made a compound settlement with Customs under section 152, Customs and Excise Management Act 1979 need not apply, if any of these eventualities has occurred in the previous one year period. They have blotted their copybooks and are considered untrustworthy until a year of good behaviour has passed.

Those having second thoughts

Any business which left the VAT flat rate scheme in the past year cannot reapply until after the year is up.

Tour operators

Tour operators have their own margin scheme and they must stick with it.

How does the scheme work?

The flat rate scheme is simplicity itself. There is a selection of appropriate percentages specified for a list of different categories of business. That percentage is applied to the turnover of the business and the quarterly VAT liabilities will in many cases be simply the appropriate percentage of the turnover figure.

For example, therefore, if a public house with a quarterly turnover of £20,000 including some exempt rent from an outbuilding opts to go into the flat rate scheme, its quarterly VAT liability will be £1,300, this being 6.5 per cent of £20,000. All identification of specific inputs and outputs is rendered unnecessary.

The flat rate scheme does not cover VAT to be accounted for on acquisitions from other EU member states. This tax must be paid in addition and is not recoverable as input tax within the flat rate scheme.

There is also a possibility of VAT liabilities arising on disposals of capital items, as to which see further comments on page 58.

What is turnover?

There are three ways of calculating turnover for the purposes of the scheme.

The invoice basis

The basic turnover method is the normal VAT rule, namely date of invoice or earlier time of payment is the VAT tax point. Turnover in this case equals all standard-rated, reduced or zero rate supplies which have a tax point in the particular quarter concerned as well as exempt supplies. The flat rate is applied to the VAT inclusive amount. Supplies outside the scope of VAT are not included.

Cash basis

An alternative turnover calculation is similar to the normal VAT cash accounting scheme. All payments within the quarter concerned are treated as supplies during that quarter. The date of receipt of a cheque, so long as it is not post dated, is the relevant date for the cash basis, so businesses cannot delay VAT liability by holding onto cheques until the start of a new VAT quarter. If a cheque bounces, the VAT liability is then no longer due and can be adjusted if already paid.

Sums received net of deductions, such as commission, must be included at full value before the deductions. Barter and part exchange deals must be included at the value effectively received.

The retailer's method

Retailers can operate their turnover by reference to the till roll of daily takings, but can adjust this for all the hazards of shop life such as counterfeit notes, dishonoured cheques, foreign currency and refunds to customers. Notice 733 also states that 'receipts recorded for exempt supplies' may also be deducted, although I am not sure that this means exactly what it says as normally exempt supplies form part of flat rate turnover.

Pre registration purchases

The VAT rules allow for input tax recovery in respect of goods in hand at the date of first registration, so long as they were purchased within 3 years of that date, and also in respect of services received within 6 months of that date. There are detailed conditions for these reliefs. However they are not affected by a simultaneous application to operate under the flat rate scheme, so these input tax recoveries can still be made in full.

Invoices

Customers may require a VAT invoice to be issued by a trader within the flat rate scheme and if so the VAT to be shown on this is the normal rate for the supply concerned, not the flat rate figure.

Reverse charges

Mercifully businesses within the flat rate scheme do not have to worry about reverse charges ( for example under Schedule 5 to the VAT Act, with its delightfully enigmatic title 'services supplied where received').

Change of business category

The regulations allow for the possibility that traders might change their line of business and embark upon a new enterprise, whilst wishing to remain within the flat rate scheme. The date upon which the change of activity occurs is known as the 'change date', and turnover after that date must bear the new appropriate percentage for the activity then being carried on.

The regulations speak in stark terms of ceasing and commencing a business activity as if such things happen in the twinkling of an eye, but in the real world there will no doubt be much ground for dispute about when a new activity actually started.

Mixed businesses

Some registered businesses will no doubt look down the list of categories of business (which was reproduced in Taxation, 19 September, at page 670) and reached the conclusion that they fall within several of the categories. Which one applies then?

The answer is that the particular category which produces the highest turnover wins the day and the flat rate percentage for that category of business is then applied to all the activities carried on. The important point is that each registered trader within the flat rate scheme can have only one appropriate percentage; it is not possible to segregate the turnover for different categories of activity with a view to applying lower percentages to parts of the business with smaller amounts of turnover.

Equipment purchases

The flat rate scheme caters for the situation that major items of capital expenditure deserve special treatment outside the scheme. Any capital expenditure on goods with a VAT inclusive cost of £2,000 will permit a claim for input tax relief in respect of the VAT element of the cost. Capital goods are defined as any goods of a capital nature, but excluding those acquired for resale or in corporation into goods to be supplied, those which will be consumed within one year or those purchased to generate income by being leased.

Once again this sounds simple in theory, but in practice various assets might be purchased together, for example a computer for £2,500 and a printer for £500. Is this a single purchase of £3,000 of equipment or does only the computer qualify? If so, must they both be on the same invoice? Customs Notice 733 offers no guidance here.

If a claim for the input tax relief is paid, on a subsequent disposal of the equipment, VAT must be charged on the sale price in the normal way and accounted for in addition to VAT due under the flat rate scheme. The same applies to equipment sales where the original purchase was before the date of entry into the flat rate scheme.

Bad debt relief

Unpaid supplies receive bad debt relief in the normal way for flat rate traders. It must be remembered that the appropriate percentage of VAT for a flat rate trader is a sort of composite rate tax comprising output tax at the normal rate applicable to the supply less input tax paid on purchases etc. Therefore bad debt relief for a standard rated supply remains due at 17.5 per cent. For those operating the flat rate scheme under the cash based turnover method, the relief is limited to the excess of the standard rate (assuming that to be the applicable rate) less the flat scheme rate. This is because the tax under the flat rate scheme would not have been paid where a cash basis is being operated.

Withdrawal from the scheme

Once going in for the flat rate scheme, one is not stuck with it forever after. A registered business will have to withdraw from it if it ceases to be within the qualifying conditions for entry into it already mentioned; for example, in the case of a company if it becomes eligible to be registered for VAT in the name of the group then it must notify Customs and withdraw from the scheme.

Businesses must also continue to satisfy a turnover test in order to remain within the scheme. As already mentioned there is a total business income test for entry into the scheme (maximum of £125,000 anticipated in the forthcoming year), and the same income test applies for compulsory withdrawal from the flat rate scheme. If at the anniversary of any start date for going into the scheme, the total value of income in the year to date exceeds £150,000, the business must withdraw from the scheme. Alternatively, if there are 'reasonable grounds' for anticipating income in excess of £150,000 in the thirty days commencing on any particular date, not necessarily an anniversary date, again withdrawal from the scheme is mandatory.

Notice 733 allows for the disregard of a one-off increase in turnover at the discretion of Customs.

A self supply is treated as taking place on the date of withdrawal in respect of any capital expenditure goods where a claim for input tax relief was made under the special rules already mentioned during the time when the business was within the flat rate scheme. Obviously, this will only impact on exempt or partially exempt traders.

Stock adjustment closing

Upon leaving the scheme, if trading stock held has increased as compared with the figure upon entry into the scheme, subject to one or two detailed conditions, it is possible to make a one-off adjustment for VAT on the difference between the two stock figures. The thinking is that stocks on entry will have qualified for input tax relief when purchased, but the increase will not have qualified for input tax relief, nor can it be said that the stock concerned has formed part of the flat rate turnover. So the figure for increase in stock value, exclusive of VAT permits a one-off input tax credit of 17.5 per cent of that figure.

Example 1

Mr Dinky sells children's toys. Toys r Us is not far away so it is a bit of a struggle and his turnover is only £90,000 per annum. Mark up is 100 per cent. His overheads are £30,000 per annum all but £5000 of which includes standard rate VAT.

At present his annual VAT position is as follows:

If Mr Dinky opts to go in to the flat rate scheme his annual VAT liability will be 7 per cent of £90,000, which is £6,300. Accordingly if he were to do this, he would probably be better off stacking the shelves at Toys r Us.

Example 2

Jimmy Archer writes paperback books in unusual places but they are very popular and are strong sellers. His United Kingdom copyright royalties amount to about £80,000 per annum and his only inputs are agent's fees at 10 per cent plus VAT. At present his annual VAT position is as follows:

If Mr Archer opts to go in to the flat rate scheme his flat rate percentage would presumably be either 11 per cent as 'activity not elsewhere listed' or 12 per cent under the heading of entertainment. These percentages produce liability of between £10,340 and £11,280, calculated on the VAT inclusive turnover of £94,000. So he could improve his lot by going in to the scheme.

Practical impact

I doubt whether the scheme will be of interest to high street shops, at least those in the south east where a turn- over of less than £100,000 is normally insufficient for a viable business. However, Example 1 sets an illustration of the how the scheme would work out for small shop selling general goods at a mark up of 100 per cent.

Example 2 illustrates a case where the flat rate scheme will be advantageous. The example is probably rather simplistic. Anyone with copyright income at the level given will have his or her agent marketing the books internationally. Royalties from outside the European Union are outside the scope of VAT and not therefore part of flat rate turnover, but the existence of this income will be relevant in deciding whether Jimmy is eligible to join the scheme in the first place. Total business income must not exceed £125,000.

The winners under the new flat rate scheme are likely to be those with minimal input tax, perhaps because they are labour only and based at home. If Jimmy Archer in Example 2 was engaged in information technology consulting, his flat rate under the scheme would be 14.5 per cent. This would be applied to his gross VAT inclusive turnover, billed to include 17.5 per cent. One would expect that the flat rate scheme would therefore produce excessive liability, VAT being paid on VAT with no input tax relief. In fact he could be better off. The flat rate charge on £94,000 would be £13,630, which is £370 less than his normal output tax liability. Customs argue that there would also be a saving in professional fees, but I would not encourage clients to regard this as an opportunity to cut corners.

The examples show that it is not safe to assume that the flat rate scheme is a dead duck which no client will find to be financially beneficial. It will be essential to carry out a review of the possible impact of the scheme for all VAT registered clients who may be within the limits and see what the arithmetic produces.

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