Not a Panacea

BARRY BRAIM discusses the proposals relating to a flat rate VAT scheme for small businesses.

A CONSULTATION EXERCISE seeking the views of businesses and representative bodies on the effects and level of the United Kingdom's VAT registration threshold was announced by the Chancellor as part of the 1998 Budget. This followed representations made to HM Customs and Excise that the high threshold distorted competition between registered and unregistered businesses.

A consultation document, 'Review of VAT registration threshold', was issued on 19 July 1998 which sought views on a number of potential options including increasing, freezing or reducing the threshold, separate thresholds for goods and services and the introduction of simplification measures. In March 1999, Customs published a summary of the representations received. The conclusions drawn were that distortion of competition was perceived to be a real problem and that registration imposed unfair administrative and financial burdens acting as a barrier to growth on business. There was no overwhelming majority in favour of any of the options floated, although many declared themselves in favour of financial and administrative easements. Since then, not much else appeared to be happening to address the issues highlighted during the consultation.

On 18 June, however, the Chancellor and Secretary of State for Trade and Industry set out the Government's latest proposals aimed at encouraging the growth of enterprise, and subsequently Customs issued a further consultation document, 'Easing the impact of VAT: Consultation on a flat scheme for small firms'. This proposes a simplified VAT scheme for small businesses.

Outline of the scheme

The first point to note is that the proposed scheme is optional. Businesses wishing to use the scheme will no longer be required to calculate the VAT payable or recoverable on individual sales or purchases. Instead, the net VAT payable will be calculated simply as a percentage of their total tax inclusive turnover, which includes all their standard rate, reduced rate, zero rate and exempt income (including the value of sales to other European Union states).

A record will need to be kept of the value of such sales to enable the calculation to be made. The record should be either the daily gross takings, a sales invoice listing, or cash book (where the cash accounting scheme is used).

The net VAT payable will be calculated by applying a flat rate percentage to the turnover in the VAT period in question, either quarterly or annually. The actual flat rate percentage to be used will depend upon which trade sector the business falls into.

The flat rate percentages are shown in the Table and range from five per cent to 15 per cent depending on the trade sector concerned. Customs state that the percentages have been set based upon a trade sector analysis of VAT declared on returns and are designed to generate broadly similar liabilities to those under the normal VAT system. An example of the basic calculation is shown below.

Table: Flat rate percentages by trade sector

Example

A partnership operates a café which makes standard-rated and zero-rated sales. In addition it rents out a flat on the first floor. In an annual VAT period, its income is as follows:

The business's main trade is that of a restaurant/takeaway and the flat rate percentage is therefore 13 per cent. The net VAT payable in the year therefore will be as follows:

(This compares to output tax under the normal VAT régime of £11,914.89 less credit for any input tax incurred.)

The current proposals will require businesses using the scheme to make their VAT payments by electronic means (e.g. BACS, CHAPS or bank giro credit) and the normal extra seven days will be allowed beyond the normal due date to render and pay the return.

Despite using the flat rate scheme, a number of the normal VAT procedures will continue to apply to businesses, including the retention of all business records for six years. Also, where a sale is made to a VAT-registered customer, a flat rate scheme business will still be required to issue a VAT invoice and this must show the correct VAT rate appropriate to the sale and not the flat rate percentage applicable to the business's trade sector.

VAT shown on the invoice will be recoverable in the normal way by the purchaser. Thus there was the potential scenario where, say, a newsagent sells stationery for £10 plus £1.75 VAT, but only has to account for VAT of £0.59 (i.e. £11.75 x 5 per cent) and the VAT-registered customer recovers £1.75. It is not difficult to work out that where standard-rated sales are made by a flat rate scheme user to a connected VAT-registered business, this could prove to be quite profitable. Needless to say, Customs have already realised this, and are proposing that they have powers not only to deny entry into, or removal from, the scheme so as to counter avoidance or abuse, but also to recoup any unfair tax advantage gained.

One of the attractions of the scheme is that businesses using it will effectively be deemed to be fully taxable and therefore, even though exempt supplies are made (or non-business activities undertaken), there will be no requirement to undertake any calculations to restrict deemed amounts of input tax by way of an increased flat rate percentage. The price for this simplicity is that the flat rate must be applied not just to taxable turnover but also to exempt turnover (though not non-business income).

Capital expenditure

The proposed flat rate percentages have been set at a level which assumes a low level of capital expenditure. Customs therefore propose that VAT can be recovered, and set against the flat rate liability calculated, on items of capital expenditure exceeding £2,000 inclusive of VAT. Given that a business using the scheme will be deemed to be fully taxable, even though exempt supplies might be made, the VAT on such expenditure will be fully recoverable.

Where such capital assets are subsequently disposed of, then VAT at the 17.5 per cent rate will have to be accounted for on their sale outside of the flat rate scheme. It is also proposed that a partly exempt business leaving the scheme will have to make some accounting adjustment on exit in relation to such assets, including capital goods scheme items.

Capital expenditure costing £2,000 or less (VAT inclusive) will fall within the flat rate scheme and no special credit for input tax will be allowed, since the flat rate percentage already makes an allowance for such purchases. Presumably, if these assets are disposed of during the period that the scheme is operated, their sales value will then form part of the scheme's turnover and VAT will be due at the flat rate percentage.

Foreign trade

The consultation paper proposes that sales to and purchases from other European Union states be dealt with as under the normal VAT régime. Hence acquisitions from another European Union state would require output tax and input tax entries on the return. It is not clear why this should be the case, since businesses using the scheme are deemed to be fully taxable and hence the output tax and input tax will always be of equal amounts. There would therefore be no tax loss in simply including European Union trade within the scheme's normal operation.

Businesses using the scheme can, however, ignore services brought in from abroad as there will be no requirements to account for VAT under the reverse charge mechanism.

Eligibility

The proposed scheme will be open to all businesses except those dealing in secondhand goods, auctioneers and those operating the tour operators margin scheme. In addition, VAT groups and divisional registrations will not be eligible. Repayment traders are eligible to use the scheme but would be foolish to do so unless the administrative savings outweighed the VAT costs of using the scheme.

To join the scheme, a business must have in its year of entry:

• annual taxable turnover, i.e. VAT exclusive, of no more than £100,000; or
• where exempt sales and/or non-business income are present, a total annual tax exclusive turnover of no more than £125,000.

Once in the scheme, a business will be able to continue to operate it until:

• its annual taxable turnover exceeds £125,000 in its accounting year; or
• where exempt sales and/or non-business income are present, its total annual tax exclusive turnover exceeds £150,000 in its accounting year.

A business will be able to volunteer to leave the scheme at any time provided Customs are notified in writing, although it would then be unable to rejoin the scheme for at least one year.

Commentary

At first sight the proposed flat rate scheme appears attractive and, given its relative simplicity and compliance cost savings, it will no doubt appeal to many small businesses.

Care will, however, need to be taken in comparing the likely net liability produced against that of the normal VAT regime, particularly where reduced rate, zero rate and exempt sales are made and capital purchases of less than £2,000 are anticipated. In addition, the proposals are silent on a number of issues such as the recovery of pre-registration VAT amounts and the nature of the adjustments required by partly exempt businesses leaving the scheme. Customs have, however, provided me with confirmation that disbursements will not form part of a business's turnover for the purpose of calculating the VAT payable (though out of country supplies will). These, and no doubt other, points will need to be clarified before an informed decision can be made about the scheme's adoption.

On closer examination some of the gloss is taken off the scheme by the apparently needless complexity of treating European Union supplies outside the scheme and the high flat rate percentages proposed. The 15 per cent flat rate to be applied by computer providers and information technology service suppliers, for example, when applied to the VAT inclusive sales value actually produces a net VAT liability above the output tax liability produced under the normal VAT régime (as 7/47 = 14.89 per cent according to my calculator). As such, information technology and computer suppliers are effectively being given a negative credit for foregone input tax. Clearly, trade bodies will need to make representations on behalf of their members to ensure the percentages to be used in their sector are fair.

The scheme's biggest disappointment is the fact that it is designed only to generate net liabilities broadly in line with those under the normal VAT system. As such, the 'cliff edge' effect of first registering for VAT is not addressed, nor the distortive effect on competition between registered and unregistered businesses. To give Customs their due, however, this is not their fault. To overcome these problems would have required a graduated VAT scheme and, because the United Kingdom did not have such a scheme in place at the time of the Sixth Directive's implementations, it is now not possible to introduce one. The only improvement allowed under Article 24 of the Directive is therefore simplification and, while Article 24(1) allows such methods, it does so only if they do not lead to a reduction in the amount of tax collected.

Anyone wishing to make representations to Customs regarding the proposed scheme needs to do so by 7 September 2001. Subject to receiving broad support in the United Kingdom and approval by the European Union VAT Committee, the scheme, in whatever form it finally takes, can be expected to be included in the Budget 2002.

Barry Braim is an associate at Clive Owen and Co, with offices at Darlington, Durham and York, and can be contacted on 01325 349700.

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