Changes to the VAT Flat Rate Scheme

Changes to the VAT Flat Rate Scheme

As we have noted in previous blog postings, Philip Hammond announced a significant change to the VAT Flat Rate Scheme (FRS) from 1 April 2017.

To join this scheme, businesses need to have turnover excluding VAT of under £150,000. VAT payable to HMRC is based on a fixed percentage of turnover including VAT. The percentage rates vary for different business sectors, and obviously the lower the rate, the lower the quarterly VAT bill.

Many users of the FRS have discovered that using the scheme means that they make a cash profit. This happens when the appropriate FRS rate produces a VAT bill that is lower than the cash collected from the VAT output tax added to sales (which FRS traders are required to do), less any input VAT added to goods and services purchased.

HMRC have decided that this is not the outcome they intended when setting up the scheme.

Accordingly, from 1 April 2017, users of the FRS scheme will be obliged to use the higher rate of 16.5% if they are classified as a “limited cost trader” (LCT). The LCT classification will apply to users of the FRS whose VAT inclusive costs are:

  • lower than 2% of their VAT inclusive turnover in an accounting period
  • greater than 2% of their VAT inclusive turnover but less than £1000 per annum if the prescribed accounting period is one year (if it is not one year, the figure is the relevant proportion of £1000).

Goods, for the purposes of this measure, must be used exclusively for the purpose of the business but exclude the following items:

These exclusions are required to prevent traders buying either low value everyday items or one-off purchases in order to inflate their costs beyond 2% and thus continue to pay VAT at a rate lower than 16.5%.

Existing users of the FRS are advised to seek advice before 1 April next year to determine if they are affected by these changes. In some cases, traders may need to discontinue use of the FRS and switch to the use of the standard VAT scheme.