Changes to the Flat Rate VAT Scheme

Flat Rate Scheme changes – Limited Cost Traders

Our latest blog post will advise you of changes that are being made to the Flat Rate Scheme (FRS) which may mean that the scheme is less attractive to some businesses and this may result in these businesses deciding to no longer operate under the FRS. It is important to understand these changes especially if you already operate the scheme or are considering using the FRS.

Background to the FRS

Under the FRS a set percentage, determined by the business trade sector, is applied to the VAT inclusive turnover of the business as a one-off calculation instead of having to identify and record the VAT on each sale and purchase the business makes. Turnover will include any exempt supplies and it is therefore not generally beneficial to join the scheme where there are significant exempt supplies.
The aim of the FRS for small businesses is to reduce the administrative burden imposed when operating VAT, however many small businesses who use the scheme are also better off as they are effectively able to keep some of the VAT charged to customers.

How the scheme operates

The percentage rates are determined according to the trade sector of the business and currently range from 4% to 14.5%.
In addition there is a further 1% reduction in the normal rates for businesses in their first year of VAT registration. If a business falls into more than one sector it is the main business activity as measured by turnover which counts.
Although those operating the FRS pay VAT at the FRS percentage they are still required to prepare invoices for customers showing the normal rates of VAT. This is so that their customers can reclaim input VAT, if appropriate.

Example

Build-it-right is a labour only building contractor. If its results are as follows:
Standard rated building work
£70,000 plus VAT of £14,000 = Total VAT inclusive turnover £84,000
Purchases £2,700 (inclusive of VAT of £450)
VAT due under the FRS say 14.5% x £84,000 = £12,180
By operating the FRS, Build-it-right charges customers £14,000 of VAT but only pays over £12,180 of this VAT to HMRC. Build-it-right is unable to recover the input VAT suffered on purchases of £450 under the FRS. Input VAT on purchases is not generally recoverable by traders operating the FRS. The purchase of capital assets consisting of goods and costing more than £2,000 (including VAT) may be dealt with outside the scheme.
If they had operated the normal VAT rules then the amount due to HMRC would be £13,550 (being £14,000 output less input of £450).

Flat Rate benefits for those trading below the VAT registration scheme

For some very small businesses including those trading below the annual VAT registration threshold of £83,000, it has been worthwhile registering for VAT and operating the FRS. Effectively these traders charge their customers VAT at 20% on the services they supply but only pay over VAT at an effective maximum rate of 17.4%. They are therefore able to keep a minimum of 2.6% of the VAT paid by their customers. This is set out in the following example:

Amount billed to customer

Amount due to HMRC under FRS using the current highest percentage of 14.5%
Effective rate on VAT exclusive amount billed to customer
VAT which can be retained by trader £1,000 plus VAT at 20% = £1,200
£1,200 x 14.5% = £174
£174 / £1,000 = 17.4%
£200 – £174 = £26 (2.6% of £1,000)

Where the relevant FRS percentage is lower than 14.5% the effective percentage of VAT which can be retained could be significantly more.

The change to the FRS

The change, described as an anti-avoidance measure, introduces a new 16.5% rate from 1 April 2017. This rate will be applicable for businesses with limited costs, such as many labour-only businesses. Businesses using the scheme, or considering joining the scheme, will need to decide if they are a ‘limited cost trader’.

So, taking the example above, if the trader is caught by the new anti-avoidance rules then they will be in the following position:
Amount billed to customer

Amount due to HMRC under FRS using the limited cost trader percentage of 16.5%

Effective rate on VAT exclusive amount billed to customer

VAT which can be retained by trader £1,000 plus VAT at 20% = £1,200

£1,200 x 16.5% = £198

£198 / £1,000 = 19.8%

£200 – £198 = £2 (0.2% of £1,000)

A limited cost trader will be defined as one whose VAT inclusive expenditure on goods is either:

● less than 2% of their VAT inclusive turnover in a prescribed accounting period
● greater than 2% of their VAT inclusive turnover but less than £1,000 per annum if the prescribed accounting period is one year (if it is not one year, the figure is the relevant proportion of £1,000 so for someone who completes their VAT return quarterly the limit is £250).

The technical note states that there will be exclusions from the calculation to prevent attempts to inflate costs above 2%. Goods, for the purposes of this measure, must be used exclusively for the purpose of the business but exclude the following items:

● capital expenditure
● food or drink for consumption by the flat rate business or its employees
● vehicles, vehicle parts and fuel, except where the business is one that carries out transport services, for example a taxi business, and uses its own or a leased vehicle to carry out those services.

These exclusions are part of the test to prevent traders buying either low value everyday items or one off purchases in order to inflate their costs beyond 2%.
Businesses using the FRS will be expected to ensure that, for each VAT return period, they use the appropriate flat rate percentage, so the check to see whether a business is a limited cost trader will have to be carried out for each VAT return.
The government estimate that of the 411,000 businesses using the FRS, 123,000 have limited costs and will be affected by these changes. According to the statistics produced by the government the changes which are being introduced to the FRS will result in it no longer being beneficial to some current users of the scheme.

What happens now?
The introduction of the 16.5% rate for limited cost traders will result in affected businesses having to reconsider their position and may result in different outcomes. Some businesses will:
● continue to use the flat rate scheme, checking for each VAT return period, whether they are affected by the 16.5% limited cost trader percentage and paying VAT at the 16.5% rate if appropriate
● decide to leave the FRS. In order to leave the FRS you must write and let HMRC know. Generally businesses choose to leave at the end of an accounting period. However, you may leave voluntarily at any time during an accounting period. HMRC will confirm the date you left the scheme in writing. If you are considering this option we can advise the most appropriate time to leave the scheme but this will generally be before 1 April 2017
● decide to deregister for VAT where the business turnover is below the VAT deregistration threshold. A business effectively leaves the FRS the day before they deregister for VAT.

We can advise you of the best course of action for you and your business. Please contact Steve Wiltshire on 01454 279886.

Residential property interest from April 2017

Residential property interest from April 2017

The restrictions on residential property interest will soon start to apply. As the legislation introducing these changes is now fully in place, our latest blog post will illustrate to you how the restrictions will work and what to particularly watch out for.

To whom do the interest relief restrictions apply?

The main group affected are UK resident individuals that let residential properties in the UK or overseas. Other people affected are:

• non-UK resident individuals that let residential properties in the UK
• individuals who let such properties in partnership
• trustee or beneficiary of trusts liable for income tax on the property profits.

Who won’t be affected?

UK and non-UK resident companies are not affected nor landlords of ‘Furnished Holiday Lettings’.

How do the restrictions work?

From 6 April 2017, landlords will no longer be able to deduct all of their finance costs from their property income. They will instead receive a basic rate reduction from their income tax liability for these finance costs. Finance costs include mortgage interest, interest on loans to buy furnishings and fees incurred when taking out or repaying loans or mortgages.

The restriction will be phased in with 75% of finance costs being allowed in 2017/18, 50% in 2018/19, 25% in 2019/20 and be fully in place for 2020/21. The remaining finance costs for each year will be given as a basic rate tax reduction but can’t create a tax refund.

Example 1 in the Appendix to this blog post (below) shows how the restrictions affect the tax payable over the next four tax years for an individual with mortgage interest which equals 40% of his rental income (after deduction of other tax allowable costs).

How much extra tax will this mean?

The additional amounts of tax arising will depend on the marginal rate of tax for the taxpayer. Basic rate taxpayers should not be substantively affected by the proposals. A higher rate taxpayer will, in principle, get 20% less relief for finance costs.

However the calculation method may mean that some taxpayers move into higher rate tax brackets. For example, individuals who consider themselves basic rate taxpayers as their total net income before deduction of income tax is below the higher rate threshold (£45,000 in 2017/18), may find that if interest is not fully deductible they would have total net income above the higher rate threshold.

Example 2 in the Appendix illustrates this effect.

Other thresholds to watch out for include:

• The threshold from which Child Benefit is clawed back (may apply if ‘adjusted net income’ of a person with children is above £50,000).
• The threshold from which personal allowances are reduced (applies if ‘adjusted net income’ is above £100,000).
• The threshold over which an individual’s pension annual allowance of £40,000 is tapered (applies if an individual’s ‘adjusted income’ is more than £150,000).

Highly geared property investments

There are special points to note if mortgage interest costs are substantial in relation to rental income.

Example 3 in the Appendix illustrates an individual, Derek, who will have an effective 100% tax rate on his rental income in 2020/21 when the full extent of the interest restrictions come into play. This applies where interest is equal to 75% of Derek’s property income after deduction of non-interest expenses.

If Derek’s interest to income percentage is higher than this, he will find the position gets even worse as he will not get immediate tax relief at 20% on all his interest. Example 4 illustrates this further restriction.

Is a property investment company the answer?

The new rules on finance costs do not apply to companies so it may be more attractive for landlords to acquire their new property investments in a company. Corporation tax rates are low compared to personal tax rates and so more funds may be available for reinvestment in additional properties.

Historically, mortgage finance for a company investing in residential property has been more expensive and more difficult to obtain but there is evidence that banks are becoming more amenable to the concept of corporate ownership of such properties.

There are however other tax issues to consider when holding investments in a company which include:

• The income tax charges if a significant amount of the rental profit will be distributed to the shareholders.
• A potential double tier of capital gain on any sale of a property. Corporation tax is payable on the capital gain (although the gain is reduced by an inflation adjusted base cost of the property). Then, if the gain is distributed to shareholders as a dividend there would be an income tax charge on the dividend paid.
• The different treatment of the assets held by the individual on death may affect the tax paid on subsequent capital gains if the properties are eventually sold. If properties are held directly by an individual, inheritance tax (IHT) liabilities will be based on the value of the properties at death and the value of the properties are uplifted to market value for calculating future capital gains. If the individual has a property investment company, the shares in the property company are valued for IHT purposes at market value but the properties themselves remain at their original base cost.
Transferring an existing property portfolio into a company requires even more careful consideration as it could result in capital gains and stamp duty liabilities arising on the transfer of the properties.

We would be happy to provide further advice on the impact of running a property investment company or any other aspect of the new rules. Please contact Steve Wiltshire on 01454 279886.

APPENDIX – examples of the operation of the interest relief restrictions

Annabel pays higher rate tax on all her income. Her net rental income before deduction of interest is £20,000. She has £8,000 of interest payments per year.

[table id=2 /]

Example 2 – how basic rate taxpayers can become higher rate taxpayers

Consider the 2020/21 tax year when the transitional period is over. Assume that the personal allowance is £12,000 and the basic rate band is £38,000 meaning that the higher rate band starts at £50,000.

Brian has a salary of £35,000, rental income before interest of £23,000 and interest on the property mortgage of £8,000.

Under the current tax rules, taxable rental income is £15,000. He will not pay higher rate tax as his total income is £50,000 – the point from which higher rate tax is payable.

With the new rules, taxable rental income is £23,000 and so his total income is £58,000. £8,000 is taxable at 40% – £3,200. Interest relief is given on £8,000 at 20% – £1,600. So an extra £1,600 tax is payable.

Example 3 – an individual with high interest costs relative to rental income

Derek pays higher rate tax on all his income. His net rental income before deduction of interest is £20,000. He has £15,000 of interest payments per year.

[table id=3 /]

Example 4 – an individual making a loss but taxed on a ‘profit’

Relief for finance costs may be restricted further where either of the following are less than the restricted finance costs:

• property profits – the profits of the property business in the tax year (after using any brought forward losses)
• adjusted total income – the income (after losses and reliefs, and excluding savings and dividends income) that exceeds an individual’s personal allowance.

For example, Derek in 2020/21 replaces a fitted kitchen on one of the properties and much of this expenditure qualifies as repair expenditure and is tax deductible. His net property income falls to £13,500 before interest of £15,000. He has therefore made a £1,500 loss.

Despite recording a loss the £13,500 is taxable. Tax at 40% is £5,400. Some relief for the interest is given but is restricted to £13,500 at 20% rather than £15,000 at 20%. The unrelieved interest (£1,500) is carried forward and may get tax relief in a later year.

So the tax liability is £5,400 less £2,700 (£13,500 at 20%) = £2,700.

Research & Development relief: Are you an Innovator?

There is a variety of tax reliefs available to small companies which are advocated by HMRC and can be used to save tax through clear and authorised methods. One such scheme is Research and Development (R&D) tax relief. This is a government incentive designed to encourage innovation by UK businesses. R&D tax relief can be equivalent to up to 33p for every £1 spent on qualifying expenditure.

This can be an extremely attractive taxation relief which is available to many trading companies which participate in activities meeting the definition of research and development. Many business owners have heard of this, but fewer actually realise that costs which have been incurred are eligible for relief.

What counts as R&D?
Whatever its size or sector, if your company is taking a risk by attempting to ‘resolve scientific or technological uncertainties’ then you could qualify.

This means you might be:
• Creating new products, processes or services
• Changing or modifying an existing product, process or service

R&D doesn’t have to have been successful to qualify, and you can include work undertaken for a client as well as your own projects.

What costs can I claim for?
An R&D tax credit claim might include staff costs, subcontractor costs, materials and consumables and even some software costs.

Is my business eligible?

There are various tests which are applied in determining whether a company has incurred R&D expenditure. Crucially, R&D activity is distinguished by the test of whether there is presence of an appreciable element of innovation. If the activity breaks new ground it is likely to be included. However, if the activity follows an established pattern it is normally excluded. If expenditure does qualify as R&D, and the company is eligible, the tax relief available is extremely generous. 230% of the total eligible expenditure is deductible for corporation tax purposes. In addition to this, if the company is loss making, the company can claim a tax credit immediately, thus improving cash flow. Here at Frost Wiltshire, we can talk through the company expenditure with you and establish whether we believe the company is eligible for R&D relief. We can then prepare and submit your claim for you, which will include a full report plus calculations.

We offer a range of services alongside R&D tax credit claims, and as such can take on all your business and personal compliance needs alongside this more specialist area if you would like us to. If you are interested, please contact Mel Hackney or Steve Wiltshire on 0117 304 8455 to arrange a free initial consultation.