British shoppers may be bemoaning the rise in value added tax (VAT) last week from 17.5 per cent up to 20 per cent.
But experts say the increase has highlighted the benefits of a little-known scheme that many self-employed workers and small businesses could use to their advantage.
The flat-rate scheme, which was introduced in 2002 to little fanfare, is designed to simplify tax accounting for small businesses. Those with a turnover excluding VAT under £150,000 can register for the scheme with HM Revenue & Customs (HMRC) and pay a fixed rate of tax which is considerably lower than the standard 20 per cent. For business owners in their first year of VAT registration, there is the added benefit that HMRC offers a 1 per cent reduction in the flat-rate percentages.
Most business owners have to be meticulous in filing records of what they purchase so that they can reclaim VAT to offset against what they have charged clients. However, under the flat-rate scheme this is not necessary as a flat-rate percentage is applied.
"The aim is to take some of the administration out of the filing of VAT returns for smaller businesses," says Stephen Herring from accountancy firm BDO Stoy Hayward.
As well as simplifying tax calculations, the scheme enables businesses to charge clients the higher standard rate while giving a lower rate to the taxman and keeping the difference.
Businesses that do not rely heavily on stock, and therefore have few VAT-chargeable expenses, have the most to gain. For example, companies that house or care for animals, such as kennels and catteries, attract a flat rate of 12 per cent under the scheme for the current tax year.
"HMRC might assume you are buying a lot of bedding materials which attract VAT, but if you're not having to do that – if you're not a typical kennel – you might find that 12 per cent is a good deal for you," says Stephen Coleclough, a VAT partner at PricewaterhouseCoopers.
Under the standard model, the VAT paid or claimed back from HMRC is the difference between the VAT which a business charges to its customers and the VAT it pays on purchases. With the flat-rate model, VAT liability is processed as a fixed percentage of inclusive turnover which means less of a headache with paperwork – as there is no need to record the VAT charged on every sale and purchase – and the peace of mind that comes from knowing exactly what percentage of your takings will be handed over to the taxman.
The fixed rate differs widely from one profession to another. For example, a rate of 10.5 per cent applies from this tax year for business owners who work in the computer repair services sector, lawyers and IT consultants can expect to pay 14.5 per cent, and journalists pay 12.5 per cent.
The calculations for these fixed rates are based on industry standards, which take into account the input tax – the VAT charged when you buy goods or services from another supplier – that businesses in particular sectors typically reclaim. So, as long as you have lower than average expenses charged at the standard rate, you should be able to reduce your VAT liabilities significantly under the scheme.
Mr Herring uses the example of two hairdressers, one of whom has a salon and the other who does only home visits. Both incur VAT on the usual consumables such as shampoo and tools of the trade, but the former is also likely to incur VAT on the property rental, power and other associated costs while the latter has no premises to pay for and uses her customers' home power supply.
If both hairdressers turn over £100,000, inclusive of VAT, under normal VAT accounting, their outgoing tax would be £16,666. However, they can offset this output tax with the VAT they incur on business costs.
If the salon owner has higher VAT-able costs of £10,750 plus £2,150 VAT, her net VAT would be £16,666 minus £2,150, which comes to £14,516. The mobile hairdresser has much lower VAT-able costs of £4,250 plus £850 VAT, therefore her net VAT due is £16,666 less £850, a total of £15,816.
With the flat rate at 13 per cent from 4 January 2011 for hairdressers, both would pay less (£13,000) under the scheme, but the mobile hairdresser is the real winner, paying £2,816 less VAT, with the salon owner managing only £1,516 less VAT.
Before diving in, it is important to assess whether the scheme is suited to individual requirements. The flat rate applies to all income, so this scheme may not work out well for you if exempt and zero-rated items make up a large proportion of your sales. This can cause problems with cash flow if your business has an unpredictable level of exempt income as you end up paying tax on income where no VAT has been passed on to customers.
"If you're in IT and you do all your consultancy work for people in America, there is no VAT anyway, volunteering to pay the flat rate of 14.5 per cent to Customs would seem excessive," says Mr Coleclough.
Anther factor to consider is that the VAT increase affects the prices set by your suppliers too, and if you are on the flat-rate scheme you are unable to reclaim the VAT on any goods and expenses bought for your business. There is, however, an exception to this rule: you can reclaim VAT on capital purchases over £2,000. So, if you bought a computer and printer totalling over £2,000, you could claim the VAT back as long as both items were on the same receipt.
For the bulk of expenses, however, this is not an option. If you spend more on business expenses charged at the standard rate of VAT than HMRC considers typical for your sector, the net VAT saving from a lower flat rate may be insignificant once you take into account your inability to reclaim the VAT on inputs. It may even be that the scheme will increase rather than reduce your VAT liabilities.
Stephen Herring, BDO Stoy Hayward
'Most traders need to keep accurate records of what they buy so that they can reclaim the VAT and offset it against what they've charged customers. But the flat-rate scheme does away with the need to keep records as it just applies a flat-rate percentage.'Reuse content