Enter Your E-mail

Andrew Needham, Director of VAT Specialists Ltd, highlights some tips and pitfalls in respect of the VAT Flat Rate Scheme. 

Introduction

Changes to the Flat Rate Scheme for small businesses have been covered in previous articles, however, we thought that it was time to point out many pitfalls of the scheme that can catch out the unwary.

Quick Recap

The basics are quite simple, providing that the taxable element of the total turnover should be less than £150,000 you can join the Scheme. Rather than calculate both input tax and output tax on every transaction you merely apply a predetermined percentage (the percentages range from 5% to 14.5%) to your turnover on a quarterly basis. This becomes the VAT due to the VATman. 

However, as in all things the devil is in the detail. The disadvantage of the scheme is that the flat rate percentage is also applied to exempt and zero-rated business income, and in the last six months there have been a few surprises on this score.

Pitfall 1 - Rental Income

Rental income from any source is classed as business income because it relates to the exploitation of land for a profit (an economic activity within EU law). This means that exempt buy-to-let income for a sole trader would also need to be included within the scheme. 

For example, James is a self employed management consultant earning £115,000 per year including VAT. He is VAT-registered as a sole trader and is on the Flat Rate scheme. He also owns a flat in London, which earns him rental income of £12,000 per year. The income and expenditure on the flat is kept totally separate (different bank account, etc.) from the consultancy income. Even though James keeps separate records and bank accounts for his buy-to-let activity, it is still classed as exempt business income and therefore within the scope of the Flat Rate Scheme. The Flat Rate Scheme percentage is applied to his gross income of £127,000 so James would pay an extra £1,320 in VAT (£12,000 x 11% flat rate percentage for management consultants).

Tip

If the property is held in a separate legal entity, for example a partnership with his wife or a limited company, then it would not be covered by his VAT registration and he would not have to account for VAT on the rents he received.

Pitfall 2 - Sale of Property

There could also be an issue with the sale proceeds of a buy-to-let property, which is also exempt from VAT. However, the positive point is that the VATman has confirmed that they will consider the issue of proportionality in cases where the application of the Flat Rate Scheme gives a result that was unintended by the legislation.

To illustrate the point about proportionality consider the pitfall if James decided to sell his buy-to-let flat for £400,000 (assuming he is able to sell it at all in the current climate).

The sale is exempt from VAT (sale of existing residential property) so potentially within the scope of the Flat Rate Scheme. However, it would be very unfair if James were to pay £44,000 of VAT on the sale (£400,000 x 11%) to the VATman. Assuming that James was unaware that he needed to account for VAT on the sale of the flat and the error was discovered on a VAT inspection he could face an assessment plus penalties and interest.

Tip

The VATman has confirmed that he would allow him to retrospectively withdraw from the Flat Rate Scheme to reflect the principle of proportionality, however the visiting officer may be unaware of this policy so don’t forget to remind him. On the down side he would have to recalculate his VAT from the period he retrospectively withdrew from the scheme to a current date.

Pitfall 3 - Interest Received

The VATman considers that bank interest received on a business bank account (but not dividend income) is exempt income and therefore within the scope of the Flat Rate Scheme.

Pitfall 4 - Sale of a Car

The sale of a car, which was bought new by a business (and where no input tax was claimed due to the input tax block on cars available for private use), is exempt from VAT but the proceeds from selling the car will still come within the scope of the flat rate scheme.

For details of the Flat Rate Scheme see VAT Notice 733 Flat Rate Scheme for Small Businesses on the HMRC website.