Brace yourself for a VAT hike

Amid the furore over the proposed changes to national insurance in the recent budget, the fact that thousands of self-employed workers and small businesses are just days away from another painful tax increase has been widely overlooked. From 1 April, reforms to the flat-rate VAT scheme will cost businesses ranging from accountants to hairdressers almost £200m a yearand saddle them with an unwanted administrative headache.

The flat-rate scheme, which was introduced in 2004, is intended to make life simpler for the smallest VAT-registered businesses (only those with an annual turnover of less than £150,000 can apply to use it). Businesses charge their customers VAT at the normal rate of 20%, but then hand over a flat rate of VAT to HM Revenue and Customs based on their gross sales, including the VAT charged. This flat rate varies by trade for example, printers pay 8.5%, cleaners pay 12% and accountants pay 14.5%.

Imagine an accountants charging a customer £1,000 for a service, plus £200 of VAT. It would then owe VAT of 14.5% of £1,200 that is £174 rather than the £200 of VAT charged. The accountant keeps this £26, but is not entitled to reclaim any of the VAT it incurs when making purchases, as businesses not on the flat-rate scheme would do.

Subscribe to MoneyWeek

Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE

Get 6 issues free

Sign up to Money Morning

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Don't miss the latest investment and personal finances news, market analysis, plus money-saving tips with our free twice-daily newsletter

Sign up

The scheme is valued by many businesses for the small gains they make from it, but also because they don't have to keep complicated records of spending in order to make VAT reclaims, simplifying their administration.

However, Philip Hammond announced changes to the scheme in November, claiming that they were necessary to tackle businesses engaging in "aggressive abuse" via the flat-rate VAT scheme. The chancellor did not say how many companies he suspected of such tactics.

Under the revised scheme, all businesses that do not spend more than 2% of their turnover on qualifying goods (subject to minimum spending of £1,000 per year) will no longer be entitled to use the flat rate currently designated for their profession. Instead these "limited-cost" businesses move on to a higher rate of 16.5%. If you submit a VAT return quarterly, as most do, the assessment of whether yours is a limited-cost business or not must be made every quarter so you can fall under limited-cost rules in one quarter and not the next.

As well as being very fiddly to administer (see below), the new rules will cost many companies. In the example above, assuming the accountant does not meet the 2% threshold, it would now owe HMRC £198 of tax, reducing its buffer from £26 to just £2. Across the economy as a whole, HMRC expects to raise an additional £195m in the 2017-18 tax year from the change.

How to cope with the new rules

If your business is on the flat-rate VAT scheme, tread carefully to stay on the right side of the new rules:

Keep detailed records to establish whether you are spending more than 2% of turnover on goods.

Understand what spending counts towards the 2%. Only spending on goods not services can be included. The distinction isn't always clear. Buy a piece of software in a computer shop and it's a good. Download it each year online and it's a service. The rules are littered with exclusions and qualifications.

At the point of introduction, the rules are especially fiddly. Most businesses will find that 1 April is right in the middle of their accounting period. They'll need to split the period in two and calculate their liability according to the current system for the first part, and then the new system for the second part.

Review your VAT arrangements. If your turnover is beneath the threshold at which VAT must be charged, currently £83,000, it might be worth deregistering to avoid all the hassle. At or above the threshold, leaving the flat-rate scheme may make sense. Look at the value of the VAT on spending you're missing out on reclaiming compared with the buffer you're now collecting.