IT contractors' Flat Rate VAT guide for April 2017

Autumn Statement 2016 unleashed a heap of anti-contractor measures, but the only one entirely of new chancellor Philip Hammond’s making -- a new Flat Rate VAT category -- threatens to hike the VAT bill for the typical limited company IT contractor from 14.5 % to 16.5% of gross turnover from April 2017.

Here, exclusively for ContractorUK, I will guide you through the real-terms affect that this blunt measure will have on the finances of those affected -- limited companies (or ‘PSCs’) that have limited outgoings, writes James Poyser, co-founder of inniAccounts.

Why you’re caught:  the "limited cost trader"

At the heart of the change is the introduction of a new, all encompassing entity, a "limited cost trader". The definition of which is one whose VAT “inclusive” expenditure on “goods” is either:

• Less than 2% of their VAT inclusive turnover, or
• Less than £1,000 in total, per year

The niggle here for anyone running a service-based business is that “goods” exclude any capital expenditure (i.e. asset purchases), food or drink, or vehicles and fuel. But unfortunately, there's even more to be exercised about.

In fact, undoubtedly, the most irritating and irrational part of this definition is the exclusion of purchase of services. If you're running a small consultancy firm and you're resolutely beyond the scope of IR35, you will be unfairly penalised. 

Like many of my clients, I have run a number of service-based companies over the years, with significant outgoings: SaaS apps, hosting, subscriptions to online journals, phones, email, insurances, accountancy fees, associate fees to name just a few. Despite these significant outgoings, I would not be able to escape being classified as a "limited cost trader".

So from this April, as a small service business-owner, you can enjoy the simplicity of Flat Rate Scheme (FRS) VAT like your fellow goods-based captains of industry, but you will be forced to pay handsomely for the privilege. Given that 78% of the UK's GDP is from service businesses, this measure is absolutely incongruous with fostering the next generation of small service businesses. 

The timing is also poor. As we break away from the EU, we need all hands to the pump to drive growth in the UK. While this blunt tool may raise immediate revenues for the chancellor, it will be regarded as yet another twist of the dagger for independent business owners who wish to thrive in the service economy.

What is the financial impact of being a "limited cost trader"?

If you're running a service business and you're charging, say, £350 per day, you can expect to be a hefty £2,016 a year worse off following the FRS changes, if you decide to stay on the scheme. Here's a breakdown for such typical day rates:

If you meet the definition of a "limited cost trader", and staying on the flat rate scheme means an increase in your VAT bill, then now is the time to consider moving to the standard VAT scheme.

As many ContractorUK readers will be aware, the FRS simplifies VAT as you just pay a percentage of your gross turnover in VAT. On the standard scheme however, you'll need to add up the VAT you've charged to clients, and deduct the VAT you've paid on goods and services you've purchased. The difference is payable to HMRC.

If this sounds like extra hassle, consider this for a moment: the Flat Rate Scheme was conceived in the accounting-technology Dark Ages, to simplify record-keeping for small businesses. Today, keeping accurate records using an online accounting app is now a matter of routine for many business owners. Calculating for flat rate or standard simply comes down to which button you (or your accountant) presses at the end of the quarter. This means that for most people the transition from flat rate to standard will be virtually painless. So should you make the move?

Should I leave the Flat Rate Scheme?

The yardstick for leaving the FRS is surprisingly simple:

• Do you spend more than 1% of your turnover on VAT-able goods and services?

If ‘yes’, it's likely you'll be better off moving to the standard VAT scheme.

It's going to come down to the type of business you're running. If you're flying close to IR35, with minimal outgoings bar mileage and sustenance, then the chancellor has you in his sights. You're unlikely to be better off on the standard VAT scheme, and you'll feel the brunt of April's FRS rate rise.

If, on the other hand, you're running a service business which looks, feels and acts like a consultancy firm, then you're likely to be better off moving to the standard VAT scheme. If I look at the client base of our accountancy practice, the majority of clients fall into this camp, with average outgoings approaching 9% of turnover.

As for the practicalities of leaving the Flat Rate Scheme, it's straightforward. Simply ask your accountant to write to HMRC; it's a quick and pain-free process. That's assuming you're using an app or online accountant to keep accurate records of outgoings -- if not, this could be the perfect (and financially beneficial) time to implement electronic record keeping.

Final thought

It might play to the gallery for Mr Hammond to say he wants to tackle "aggressive abuse of the VAT Flat Rate Scheme", as he said. But in reality and in practical terms, the sledgehammer he thinks is right for the job will unfairly harm the competitiveness of ensnared small service businesses.

However taken alongside the government’s other changes, notably those to IR35, contractors would be wise to transform their offerings -- and maybe even their attitude -- to become consultants or value-adders. If you don’t, we’d wager that you'll continue to be thumped by government chancellors each and every year.