On 1 April 2017, changes being made to the UK’s VAT Flat Rate Scheme (FRS) will add another category of business to the existing 54 in the scheme. This will result in small businesses with low overhead costs in labour-intensive sectors having to pay a higher VAT flat rate of 16.5%. Tutoring agencies can fall into this category, so you should be aware of the changes. Also note that, depending on your VAT setup, these changes may make TutorCruncher 20% cheaper to current UK users.
How the FRS works
The flat rate scheme was introduced in 2004 to simplify accounting and administration for small businesses. It allows businesses with an annual turnover of less than £150,000 to decide between the regular 20% VAT or a flat rate ranging from 4 to 14.5%, depending on the sector the business is operating in. Businesses on the FRS charge their clients at the going VAT rate of 20% and pay a flat rate of e.g. 14.5% of gross sales to the taxman. So, if a business charges a client with £1,000 plus £200 in VAT, it would hand over £174 (14.5% of £1,200) to HMRC, resulting in a flat rate profit of £26 (£200 — £174).
What is changing and why
Initially, the flat rate scheme was designed to simplify accounting, administration, and VAT calculation for small businesses. However, the scheme has turned out to be susceptible to exploitation and a means of tax avoidance by bigger companies who manipulate their turnover to just slip under the threshold into the scheme. To tackle the abuse and lower the incentive to manipulation, Chancellor Philip Hammond has announced the following changes to the VAT flat rate scheme.
The new category of Limited Cost Trader will be introduced on 1 April 2017. HMRC will consider a business a Limited Cost Trader if its VAT inclusive expenditure on Relevant Goods is less than 2% of yearly turnover, or more than 2% but less than £1,000 annually. If the business is identified as a Limited Cost Trader the new rate of 16.5% will override the previous FRS rate, regardless of sector. It is important to stress that only Relevant Goods count towards the rate of 2% of turnover. These are defined as goods for exclusively business purposes such as stationery and office supplies and gas and electricity. Exclusions from Relevant Goods include capital expenditure and services like accounting, advertising, and rent.
Who it will affect
Most impacted by the changes will be small businesses who predominantly provide services, and whose main expenditure consequently goes towards labour without spending much on goods. These will range from dog walkers, gardeners, hairdressers, driving instructors, and cleaners to IT contractors, like TutorCruncher, private tutors, and tutoring agencies. Consequences of moving to the increased FRS will be higher tax amounts and lower profit margins.
How will it affect me?
The tax calculation of 16.5% on gross sales for Limited Cost Traders equals an effective rate of 19.8%. If a business charges £1,000 + £200 VAT, the application of the new rate results in £198 of tax for the business, reducing profit of previously £26 to only £2.
If your company has a turnover of £10,000 a month and £120,000 a year, you would have to spend over £200 every month on Relevant Goods to not fall into the Limited Cost Trader category and therefore having to calculate tax with the new 16.5% rate. For a tutoring company, this would mean that you would have to spend at least £200 on office supplies, cleaning products, and gas and electricity every month of the year. Expenses that will not count towards the 2% threshold include:
Phone and internet bills
Fuel for vehicles
Food & drink for employees
Leased or hired items
Any services, such as accountancy and administration fees, advertising, IT services, etc.
What are my options?
The first step is to determine whether your business will be categorised as a Limited Cost Trader. If your costs of Relevant Goods exceed 2% of your turnover, the changes will not affect how you calculate VAT.
If this is not the case and your business falls into the category of Limited Cost Trader, you should consider if switching to the Standard 20% Rate VAT scheme might be more beneficial to your business. The standard scheme allows you to claim VAT on business expenses, including goods and services that don’t count as Relevant Goods in the FRS, e.g. rent and accountancy fees. TutorCruncher charges its fees with VAT included. This means that if you switch to the standard VAT scheme, you will be able to claim VAT on our services and make TutorCruncher 20% cheaper. If your taxable sales are lower than £81,000 per annum, deregistration could also be an option up for consideration.
In case you decide to remain on the flat rate scheme, be aware of the anti-forestalling measures in place to prevent businesses from charging their clients in advance to avoid the higher tax rate for a little longer. Should you decide to cease using the FRS, be mindful not to miss the deadline to notify HMRC of that. As always, consult your accountant over the details of the changes and to find the most advantageous tax arrangement for your business.