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KEY POINTS
- A brief review of the scheme and its thresholds
- The different measures of 'turnover'
- HMRC's view — is it correct?
- What does the legislation say?
- Time for some clarification?
The Government and HMRC are often telling us that, in addition to wanting a 'fair' tax system, they also want a 'simple' system.
A recent Reader's Forum query, VAT's flat?, raised the question of exactly what is the measure of 'income' for determining whether a trader can remain in the flat rate scheme.
Now one would have thought that this would be a fairly simple matter. As we will see, it seems simple as far as HMRC are concerned, but I am not quite so sure about the rest of us — and I include the VAT experts here.
But for the non-VAT specialists amongst us (come on, it can't just be me), perhaps a brief recap is called for. In a nutshell, a trader charges VAT at the appropriate rate on goods or services that he sells.
He can set against that 'output' VAT the 'input' VAT on his purchases and the difference is either paid to or reclaimed from HMRC. Obviously some work is involved in these calculations.
Assuming that sales and purchases remain at approximately the same levels relative to each other over time, the net amount of VAT being paid would be approximately the same percentage of turnover.
The VAT flat rate scheme replicates this by allowing traders to simply pay a VAT charge calculated by reference to a percentage of their turnover; different percentages applying to different types of business.
The advantage to the trader should be a saving in administrative costs, although — as HMRC point out — the flat rates are averages and there may be winners and losers.
Who's in, who's out?
To be eligible to join the scheme, the trader must satisfy two tests. First, that 'your taxable turnover (excluding VAT) in the next year will be £150,000 or less' and secondly that 'your total business income (including VAT) in the next year will be £187,500 or less'.
VAT Notice 733 (Flat rate scheme for small businesses) explains that 'you may stay in the scheme provided your total turnover (including VAT) for the year just gone does not rise above £225,000. Make this check on each anniversary of your business joining the flat rate scheme'.
This then is the $64,000 question — or perhaps we should say the £225,000 question: exactly how is this turnover limit measured?
The query referred to above raised the problem of a trader (who was also using annual accounting) who had invoiced sales of £230,000 during the preceding year, but who had only been paid £210,000.
Now, some may say that it's the invoiced sales that are taken into account as the default VAT rule is that it is 'taxable supplies' that are the relevant measure.
Although some businesses can adopt a 'cash accounting' scheme whereby the output and input VAT is calculated by reference to 'cash' received and paid for sales and purchases, paragraph 2.7 of Notice 733 (and all future reference to paragraphs refer to that notice) notes that the cash accounting scheme cannot be used with the FRS.
However, paragraph 2.7 then notes that: 'the flat rate scheme has its own cash-based method that is very similar to the cash accounting scheme'. The notice goes on to explain that flat rate scheme users can adopt one of three measures of turnover as shown in Table 1.
Using cash
With regards to the cash-based turnover method, paragraph 9.1 et seq. explains that a trader must 'apply the flat rate percentage to the VAT inclusive supplies for which you have been paid in the accounting period' and then goes on to explain the exact meaning of 'paid' as it relates to cash, cheques, Giro, standing order, credit card, etc. payments.
So what measure of turnover is to be used when one carries out the annual test as to whether the upper limit for staying in the scheme has been reached? This was the question in the VAT's flat query.
Logically, one would assume that it is the same measure as is being used in the normal flat rate scheme (FRS) calculations and both respondents to that query, S.G. and Neil Warren, suggested that as the cash-based system was being used to determine the flat rate charge, the cash-based turnover figure should also be used in calculating the annual turnover limit.
Neil argued that this was supported by HMRC's internal guidance at FRS4400 which refers to the figure 'most readily to hand'.
HMRC's view
Coincidentally, Mike Thexton was also dealing with a similar case and he explained his experiences.
'I have come across the same situation, and like the querist have struggled to find a clear statement in the regulations or in Notice 733. I was worried by the Tribunal's decision in CE, EM & PC Evans (t/a Coney Leasing) (17510) in which it was held that turnover to determine the requirement to leave the cash accounting scheme should be measured on an invoiced basis rather than a receipts basis, and I suspected that the same principle might apply to the FRS.
'I thought that the National Advice Service was unlikely to be able to clarify such an obscure point, so I wrote to the client's VAT office. The advice came back that the officer had to refer to Policy Section in Liverpool to find the answer, and Policy were quite clear: the cash basis (under both cash accounting and the FRS) affects the time that the trader is liable to account for the VAT to HMRC, but it does not affect the value of supplies nor the true tax point for those supplies.
'As eligibility for the schemes depends on the value of supplies, this should be tested on an invoiced basis, not on a received basis. I have to admit that I suspected this was the correct answer even before I wrote, and I cannot fault it in logic or in consistency with the rest of the regulations and the precedent case.
'This is an issue that will potentially affect many growing businesses at some point, and it is disturbing that the published information is so sketchy that both respondents to the reader's query came to a different conclusion from HMRC Policy. Perhaps HMRC should publicise their policy more widely.'
Not so fast…
Thinking that HMRC's policy should receive an airing, especially as it contradicted the views expressed in the Readers' forum column, we intended to print this on our Feedback page.
However, I thought that I would run this by Neil Warren — a regular VAT contributor — first. His response was as follows.
'I think the officer is going against the policy in HMRC's Internal Guidance, which clearly refers (FRS4400) to the turnover figure “most readily to hand” and also to the “leaving test as being inclusive as a simplification measure”. It also clarifies that “this differs to the joining test and from turnover tests in other schemes”, so I don't think he can quote the cash accounting tribunal case as a parallel.
'The cash accounting scheme has “cash flow” as its main benefit whereas the main aim of the flat rate scheme is “simplification”. It would be totally impractical to expect, say, a builder using the cash-based turnover method, to revamp his records with debtor adjustments to see if he is over the limit on an accruals basis.
'This is a contradiction with the “simplicity of record keeping” aim of the scheme — I think the aim of the policy makers writing the internal guidance was always to create a situation where the exit decisions are based solely on the Box 6 entries (which are VAT inclusive) on the previous four VAT returns. Any variation from this approach creates a level of complexity for a small business that is totally contradictory to the aims of the scheme.
'To conclude, I still think that the client in “VAT's flat” has a strong case to stay in the flat rate scheme until 1 June 2009.'
Neil suggests that HMRC could clarify this issue with one sentence added to Notice 733, along the lines of: 'the turnover figure relevant to deciding whether you should leave the scheme will be based on the method you have been using since joining the scheme (or most recent method if you have made a change)'.
A look at the legislation
On the basis that the question is not really about eligibility, but about whether the taxpayer has ceased to be eligible for the flat rate scheme, I took a look at the legislation.
The EC Directive 2006/112/EC, Art 281 provides that Member States may 'apply simplified procedures, such as flat rate schemes, for charging and collecting VAT', but adds little further.
The UK regulations relating to the scheme are set out in the VAT Regulations SI 1995 No 2518 at Reg 55A et seq.
The doubt creeps in because Reg 55M states that, when determining whether eligibility for the flat rate scheme has ceased one must consider the level of 'the total value of his income' which is the same measure in test 2 in 55L for joining the scheme.
However, Notice 733 uses the term taxable turnover for test 1 (which must be included in the test 2 calculation) rather than 'the value of taxable supplies' in Reg 55L.
So the limits relating to withdrawal from the scheme are based on 'income', not turnover and this blurring continues in Notice 733 with references to 'total turnover' (paragraph 3.6), 'total value of tax inclusive supplies' and 'total value of your turnover' (paragraph 12.2).
Also unhelpful is the fact that there does not appear to be any legal definition of 'income' in the Regulations. With the aim of resolving that question, I searched DeVoils and although I found 79 references, unfortunately none related to a definition of the term. Similarly, neither Notice 733 nor Notice 731 which refers to the cash accounting scheme shed any great light on the subject.
What does it mean?
It has been suggested to me that there is a good argument that 'income' means 'what you've actually received' rather than 'what you expect to receive' and if this argument is correct, the limit has not been exceeded.
On the other hand, it seems that the way 'income' is used in the statutory instrument is intended to distinguish between taxable supplies and total income (i.e. including exempt and non-business income).
There is also the argument that, if 'push came to shove', Customs could always withdraw approval for use of the scheme on 'protection of the revenue' grounds.
Some support for a cash-based turnover figure would seem to be in section 7.8 ('How do I prepare business accounts for income tax purposes while I am using the flat rate scheme?') which states that 'it is expected that accounts for businesses who are using the scheme will be prepared using gross receipts, less the flat rate VAT percentage, for turnover and that expenses will include the irrecoverable input VAT.
'For both VAT and income tax purposes, there is a requirement to keep a record of sales and purchases. But, for businesses using the scheme, that record does not have to analyse gross, VAT and net separately. The records need only be complete, orderly and easy to follow.'
HMRC's Business Income Manual at BIM31585 refers to the scheme and notes that the requirements of the two tests 'apply at the point of entry into the scheme. Businesses check turnover each anniversary of joining the scheme, if it is over [£225,000] VAT inclusive they must leave the scheme'.
This again begs the question of the exact definition of 'turnover' and it would therefore seem to be perverse if a record of taxable turnover had to be maintained simply to calculate whether eligibility for the scheme was continuing.
I think that the situation can best be described as unsatisfactory.
HMRC say
Not that I was disbelieving the advice given to Mike Thexton, but I contacted the HMRC press office for the official line and received the following reply.
'If you use the basic turnover method for working out VAT due on the flat rate scheme, you normally have to pay VAT when you invoice your customer. However, under the cash based turnover method, you only account for VAT when you have received payment from your customer.
'Although the cash based method alters when you have to pay the VAT, it does not change the time of supply, or the value of supplies for determining when you must leave the scheme. The rules for determining when you must leave the scheme are the same for all businesses.
'HMRC intends to update the Notice when it next comes up for review to make this point clearer.'
This seems to match the advice received by Mike, although whether it is correct or not is another question. Whatever, it does seem to confirm that HMRC appreciate that the point is unclear.
However, there is a hint of light at the end of the tunnel. I made the comment to HMRC that it seemed a little odd that one could use a simple scheme to record VAT and for direct tax, but then have to keep the same records that would have been required if the scheme had not been used, just to see if the business were still eligible to be in it each year.
This did not seem much of a simplification to me. HMRC gave the following reply.
'The current rule is legislatively the most simple and avoids the need for a further anti-avoidance rule to prevent potential manipulation of the leaving rules. However, HMRC recognises the difficulty that you have described and will re-examine the rule, as part of the Simplification Review of VAT, which includes a review of the thresholds that apply to VAT business schemes.'
HMRC subsequently advised that 'the review is in progress and HMRC is working towards a Pre-Budget Report 2008 timetable'.
Time for review?
In his article celebrating five years of the flat rate scheme, Neil Warren suggested that it might be a good occasion for HMRC to review the operation of various aspects of the scheme.
It seems that we are not the only ones to find that the scheme has some 'niggles' and in Tottel's Value Added Tax core annual, the author, A St John Price, says that 'the scheme is not simple… In its third version the Notice [733] remains, in my view, poorly written and with various ambiguities'.
In addition to clarification of the above point relating to the exact measure of turnover, a couple of other suggestions for treatment have arisen.
Neil has suggested that it is wrong in principle that the scheme includes sales of goods to other EU businesses, where the customer accounts for acquisition tax on an intra-Community supply.
This could be seen as double taxation in that the same supply is also treated as income within the flat rate scheme — a similar problem exists for traders in gold — where the customer accounts for output tax, but the supplier appears to have a flat rate liability as well.
Mike believes that some clarification as to what goes on the VAT return would be useful.
'My understanding of the Notice is that you put the VAT-inclusive turnover in Box 6, but that is flatly contradicted by what it says on the return, and there is no note on the return to say “flat rate traders do it differently”. It's also not obvious why or whether you ought to put a figure in box 7. I'm just filling in a FRS return as we speak with bad debt relief of £70 in box 4, which looks very odd with inputs of £13,000 in box 7.'
As a separate point, scheme users could also benefit from more detailed advice about when income is classed as private (outside of the scheme) or business (in the scheme) — e.g. when does a buy-to-let activity for a sole trader (who is in the scheme with another activity in his own name) become a business rather than an investment?
The final question is whether the psychology of HMRC's policy may be relevant. Does the fact that the scheme has low thresholds (£150,000, £187,500, etc.) mean that it has very little interest from the big firms of accountants because there is no significant fee income to be obtained from it?
And does this mean that HMRC can give rulings that give the greatest amount of tax, on the basis that the scheme is unlikely to be the subject of many tribunal cases or 'big gun' attacks from the big four?
The conclusion must be that the scheme is due for some clarification. What would be good would be for HMRC to invite some comments on the scheme before they proceed to 'clarify' or 'simplify' the scheme unilaterally.
Perhaps this article will start the ball rolling. I'll send a copy along to 100 Parliament Street.
