UK Contractors: should you switch off the Flat Rate Scheme?Published: 2017-03-26 :: [ history ]
With the new fiscal year just a few days ahead, as a contractor you've probably heard about the Budget changes. And if you are like me up until a few days ago, you might not be sure whether you should take action or not.
Let's try and bring some clarification to these changes.
Note: if you are new to the contracting world and/or some of the terms below are unknown to you, you might want to read my UK tax breakdown as well.
Table of contents
- A brief summary of the new Budget
- The Flat Rate Scheme's change
A brief summary of the new Budget
There are a few things that are effectively going to change between April 1st and April 6th 2017, some of which affect contractors, and which can be summarised in three bullet points:
- The income tax allowance is raised from £11,000 to £11,500 (April 6th)
- The Corporation Tax is reduced from 20% to 19% (April 1st)
- A new 16.5% VAT flat rate category is introduced (Limited Cost Trader - April 1st)
You might also have heard about the dividend tax allowance being reduced from £5,000 to £2,000, around which there seems to be some confusion. No need to worry about it just yet - it will actually come into effect in the 2018/19 tax year.
The Flat Rate Scheme's change
The one big change that should get your attention here is the one related to VAT's Flat Rate Scheme (FRS). I will assume you already know what the scheme is, and if you don't, I invite you to read the section dedicated to VAT from my previous article about taxes.
The current state of things
The way the FRS currently works is, on an invoice of £2,000, you charge 20% of VAT, corresponding to an amount of £400, so a total of £2,400. Then, you must apply the flat rate corresponding to your trade sector to the total, the result being the VAT you pay back to HMRC.
As an IT Consultant for example, the rate applying to my business is 14.5%, so I'd need to pay £2,400 * 0.145 = £348 back to HMRC.
This is quite interesting, since the difference of VAT, called the VAT Credit, becomes part of my company's profit. Or to put it differently, I charge £400 VAT and pay back £348, keeping the remaining £52.
The new Limited Cost Trader category
In order to "tackle aggressive abuse of the VAT Flat Rate Scheme" (I won't go into details here, follow the link for more info), the Government is introducing a new category called Limited Cost Trader, with a fixed 16.5% rate for whichever business falls under it, regardless of the trade sector.
To be affected by this new rate, your business expenditure must represent less than 2% of its VAT inclusive turnover, or less than £1,000 per annum if it is greater than 2%.
Now if you are like me, looking at your business expenses you might think you are way above the threshold and thus not concerned by this at all.
That was before I realised only certain kinds of expenses qualify.
Basically, everything including food, transport, phone, computer (capital expenditures), etc doesn't qualify and, this list accounting for 95% of my expenses, it turns out my business automatically falls under the Limited Cost Trader category.
But how bad is it?
If we look at the same example again, I now need to pay £2,400 * 0.165 = £396 back to HMRC.
That's a VAT Credit of £4.
The Standard VAT Scheme
If your business falls under the new category, the VAT Credit it benefits from becomes very low. So should you switch to the Standard Scheme instead?
Let's review how it works first. You still charge 20% VAT to your client, which you must entirely pay back to HMRC.
However, you can claim the VAT on any VAT inclusive expense related to your business, when you could only do so for expenses greater than £2,000 with the FRS.
Food and transport usually don't qualify, but capital expenditures do (computer, phone), and so do accountancy fees, for example.
Let's take an example and consider your accountant costs your business £90 per month. They charge the VAT as well, which accounts for £90 - (£90 * 100 / 120) = £15.
That means that you could claim £15 of VAT per month.
Note that with the Standard Scheme, you need to keep track of the VAT you charge and the VAT you claim, which is a bit more work.
Should you make the switch?
To make that decision, you need to assess whether you'd be better off being able to claim VAT on VAT inclusive business expenditures (Standard Scheme) or applying the 16.5% rate and keeping the VAT Credit (Flat Rate Scheme's Limited Cost Trader category).
You should be able to do so looking at how much you invoice in an average month as well as the nature of your usual expenses, and use the calculations above to determine what works best.
If you are planning on buying hardware this year, it is very likely that the Standard Scheme would be better for you. Personally, with accountancy fees alone, I'm better off de-registering from the FRS. And since these fees are directly managed by my accountant, I don't even need to keep track of the claimed VAT, as they automatically do it for me.
No extra work.
I hope this will help you assess whether you are affected by these changes at all, and if you need to do something about it.
Bear in mind that I am not an accountant and that you should talk to yours before taking any action. If you do so and decide to switch off the FRS, you should also remember that you won't be able to register for it again for another twelve months.
- Tax and tax credit rates and thresholds for 2017-18
- Corporation Tax: main rate
- Income Tax: dividend allowance reduction
- 'This is grossly unfair': self-employed readers react to NICs increase
- Budget U-Turn As Chancellor Scraps National Insurance Hike On Self-Employed
- Tackling aggressive abuse of the VAT Flat Rate Scheme - technical note
- What are capital expenditures?
- VAT Flat Rate Scheme - Join or leave the scheme