If you are a contractor with a limited company, you are probably well aware of the government’s planned new changes to the VAT Flat Rate Scheme, as announced in the November 2016 Autumn Statement. What does it mean for limited company contractors who are registered on the scheme?
With most of the publicity on legislation changes focused on IR35 changes for off-payroll public sector workers, the proposed change to the new Flat Rate Scheme came as a surprise for many contractors.
From the 1st of April 2017, a new category of the Flat Rate Scheme will be introduced for businesses with ‘limited costs’.
What is a ‘limited cost trader’?
Defined by HM Revenue & Customs, a limited cost trader is one whose VAT inclusive spend on goods (not services) is either:
- Less than 2% of the company’s VAT inclusive turnover (in an accounting period)
- Greater than 2% of the company’s VAT inclusive turnover but less than £1000 per year (if the given accounting period is one year) or £250 per quarter (if the accounting period is one quarter)
‘VAT inclusive’ turnover means the sum of your limited company turnover plus the associated VAT from selling your contractor services.
‘Goods’ must be used exclusively for business purposes, and does not include capital expenditure, food or drink consumption, or vehicles and fuel.
HMRC has specifically arrived at this change in legislation to reduce ‘aggressive abuse’ of the current Flat Rate Scheme by Personal Service Companies (PSCs).
What is the new flat rate?
For businesses which are FRS registered, those who apply to the ‘limited cost trader’ category will pay a 16.5% flat rate of VAT on their gross turnover to HMRC on their quarterly VAT returns.
Previously, the flat rate you pay was based solely on the type of services you offered as a contractor; for example, IT freelancers and accountants typically paid 14.5% VAT back, social workers paid 11%, and so on.
However, if you are a contractor whose sole business function is to provide services, and you spend very little on goods, you may be subject to the new 16.5% rate.
How does this affect contractors on the Flat Rate Scheme?
Assuming that plenty of service-based contractors could fall into this new flat rate category, the previous advantage of being on the Flat Rate Scheme will not be as great for many contractors in the UK. We explain this in the following calculation.
E.g. John is an IT contractor, whose annual company turnover, exclusive of VAT, is £96,000. He does not need to spend any money on equipment. He’s had to be VAT registered because his company’s VAT taxable turnover is over the £83,000 threshold, but he is currently registered onto the VAT Flat Rate Scheme due to the added cash benefit.
Before 1st April 2017, his VAT payments would look like this:
John has invoiced his client for £2,000 and has charged his client 20% VAT for his services. This means his total invoice amount is 2000 + (.20 x 2000) = £2,400.
Based on this figure alone, his flat VAT payment to HMRC would be 2400 x 0.145 = £348. He gets to keep the difference of VAT he didn’t have to pay to HMRC due to the scheme, meaning he gets to take an extra £52 per week as limited company income (subject to Corporation Tax).
After 1st April 2017, his VAT payments would look like this:
Now that the new rules for the VAT FRS are in place, John has to pay a flat rate of 16.5% of VAT to HMRC. He invoices his client for £2,000 plus VAT as normal: 2000 + (.20 x 2000) = £2,400.
Based on this figure alone, his flat VAT payment to HMRC would be 2400 x 0.165 = £396*. He still gets to keep the weekly difference of VAT that he didn’t have to pay to HMRC, however he now only gets to take an extra £4 per week, which is also classed as limited company income.
In the above example, John still got to take an extra £184 per year from the Flat Rate Scheme as limited company income (based on 46 working weeks per year), however this small benefit may not be enough for many contractors to remain on the new VAT Flat Rate Scheme.
*This does not take into account HMRC’s 1% rate discount for new registrants.
What’s the alternative?
There are two alternatives to being registered to the Flat Rate Scheme:
1. Deregister from the FRS and remain on the standard VAT scheme
2. Deregister from VAT altogether (your company’s expected turnover for the next 12 months must be less than £81,000 for you to be able to do this)
For some contractors, the standard VAT scheme may be a better option once the changes come into place, depending on what they want to get out of it. If you are standard VAT registered, you can reclaim some of the VAT you pay on goods and services used for your limited company.
For example, these could include:
- Mobile phone used for work
- Computer equipment
- Materials, printing and stationery
- Accountancy fees
In short, on the standard VAT scheme you can claim some of the VAT back on some goods and services for which you hold a valid VAT receipt. This is subject to conditions and usage of the goods or services.
Going back to the previous example with John, the collective VAT he may be able to reclaim on the standard VAT scheme after 1st April could potentially be higher than the £184 he would receive on the new 16.5% rate.
If you choose to deregister from VAT and remain on the standard VAT scheme, you must keep records of your VAT-applicable purchases, including receipts, on paper or electronically for at least six years. However, it is recommended you keep receipts for all of your expenditures, regardless of which VAT scheme you are registered to, in case HMRC ask to see them.
One of the core benefits of the VAT Flat Rate Scheme was significantly less paperwork than the standard VAT scheme, however where maximising take home pay is concerned, it could be time to consider a change. A contractor accountant can assist with VAT registration and returns so paperwork on the standard VAT scheme can be kept to a minimum.
If you are registered on the Flat Rate Scheme, seek the advice of a contractor accountant, who can discuss your best options moving forward.
HMRC ran a consultation for eight weeks from the draft publication of the new legislation, allowing businesses and industry bodies to comment and put forth their concerns over the changes. The eight weeks have since passed and we are now awaiting HMRC’s final response, and the introduction of what HMRC says will be an easy-to-use, online tool to help businesses decide if the new flat rate of 16.5% will apply to them.
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