The VAT Flat Rate Scheme (FRS) has been around for a long time and was introduced as a simplification measure for small businesses. A very welcome bonus for some was that use of the scheme left them slightly better off than standard VAT accounting….and it did genuinely simplify VAT reporting obligations. However since 01 April 2017 the introduction of new rules made it a very expensive scheme for some, those falling within the 'limited cost trader' classification.
How does the FRS work?
The FRS differs from normal VAT accounting, under which a VAT registered business will account for VAT on sales at the appropriate rate and collect this from customers. At the same time they will reclaim VAT on qualifying purchases. A return is submitted and the difference between VAT collected from customers and VAT paid to suppliers is then paid over to HM Revenue & Customs, or in the event that VAT paid to suppliers exceeds VAT collected from customers a refund will be made by HM Revenue & Customs to the business. All of this requires extensive record keeping for all transactions.
Under the FRS a business will select an appropriate business classification. The classification will determine the FRS percentage. In the course of business it will continue to charge customers VAT in the usual manner at the appropriate rate of VAT and collect this from the customer. However, when calculating how much to pay over to HM Revenue & Customs the FRS business will apply its FRS rate to its VAT inclusive turnover. So for example, a business with a FRS rate of 10% and net sales of £10,000 would have the following calculation:
Net sales - £10,000
VAT - £2,000
Gross Sales - £12,000
FRS - £1,200 (£12,000 @10%)
You can see from the example the business collected £2,000 in VAT but will only pay £1,200 on to HM Revenue & Customs. However it will not be able to reclaim VAT it paid on expenses.
If the business had only paid out £250 on VAT it would be financially better off as under standard accounting it would have collected the same VAT from customers but would have paid £1,750 on to HM Revenue & Customs.
An additional incentive can be opting into the FRS when first registering for VAT. Those within the first year of registration can apply a 1% reduction to the FRS rate they apply to sales. It's important to note this is not the first year on the scheme but the first year of VAT registration. So a business in it's 2 year of VAT registration and joining the FRS will not be entitled to the discounted rate.
There is also a provision to claim VAT on capital goods. These are items costing over £2,000 (including VAT).
Are There Any Drawbacks or Risks?
Some businesses will fall within the limited cost trader category. The rules are quite detailed in assessing but in short you would expect a business with very low overheads to be caught. The FRS percentage applied to limited cost traders is 16.5%. Using the above example would result in a payment to HM Revenue & Customs of £1,980.
The additional dangers creep in for businesses that also make zero rated and exempt supplies as the FRS percentage is applied to these as well even though no VAT has been charged on them. If a business selling cosmetic products in the UK (FRS rate 8%) began selling overseas (which is increasingly easier to do with the help on online marketplace platforms) the consequences could be eyewatering. Consider the following example:
Net UK Sales - £20,000
VAT - £4,000
Overseas sales - £45,000
VAT - £0
Total turnover for FRS purposes - £69,000
FRS @ 8% - £5,9520.
Quite easily a business could end up paying over more VAT than they have collected.
Before joining the scheme all business activity should be reviewed to minimize the risk of a negative position.
What Are Some Common Mistakes?
A common and expensive mistake is for the FRS percentage to be applied to the net turnover rather than the VAT inclusive turnover. Along similar lines, failing to include exempt and zero rated sales.
Another common error is attempting to reclaim VAT on all invoices in excess of £2,000 (including VAT). In the case of capital goods the VAT is recoverable, whereas services are not. Say for example an invoice for legal services is £3,000. As it relates to services and not goods there is no opportunity to reclaim the VAT.
Selecting the wrong business category and associated FRS percentage. If the mistake is genuine and it can be proven that appropriate care was taken there should be little risk of penalties. However if appropriate care was not taken the resulting underpayment and penalties could be very expensive.
The VAT FRS can be very useful in reducing compliance obligations and in some cases can generate a small profit. However care should be taken when determining if the scheme is appropriate and beneficial. If you would like to discuss your VAT compliance and if you could benefit from the FRS please give us a call or send us a message.
