If you sign up to HMRC?s flat rate scheme for VAT and find that it?s costing you money, can and should you opt out?

The flat rate VAT rate

The VAT flat rate scheme (FRS) allows companies and other businesses to pay VAT at a lower rate in exchange for agreeing not to claim back VAT on most of their purchases. HMRC pushes the virtues of the scheme as a way to reduce administration for the smaller business.

Joining and leaving the FRS

HMRC usually won?t allow you to join or leave the FRS retrospectively, although by concession it can in exceptional situations. This discretionary practice was at the heart of the tribunal hearing of Brian Reynolds v Revenue & Customs (BR v HMRC). BR had been using the FRS scheme for some time before he realised that it was costing him more in VAT than using the normal system. He therefore wanted to leave the scheme with backdated effect so he could recover the VAT he reckoned he had overpaid. But HMRC refused.

What?s the point of the scheme?

HMRC suggests the only point of the FRS is to reduce the administrative burden of VAT returns. But the general view is that the FRS will save VAT, and in practice that?s why businesses sign up for it. HMRC can?t offically accept that view and so had to refuse to allow BR to backdate his withdrawal from the scheme. The tax tribunal had to decide whether HMRC was right to do this.

Theory over practice

It didn?t take long for the tribunal to decide that paying extra VAT as a result of joining the FRS wasn?t an exceptional reason that would allow a backdated withdrawal. In its opinion the FRS was there to simplify VAT, and is intended to be VAT cost neutral. That doesn?t mean that you?re not allowed to gain an advantage, just that it?s not the purpose of the scheme. BR?s claim was dismissed.

So which is it?

The tribunal?s view is in contrast to HMRC?s policy which does allow for retrospective removal from the FRS where the financial disadvantage caused is disproportionately high.

Example. Eric is a surveyor using the FRS. The FRS VAT percentage for his type of business is 12.5%. He also personally owns a house that he rents out. He can?t charge his tenant VAT on the rent because this type of income is exempt, but the FRS rules mean Eric has to account for VAT on his entire turnover. Despite this he?s still better off using the scheme. But it also means that VAT would be due on the sale of the house, even though this too would normally be exempt. If he doesn?t realise this before the sale, for say £300,000, he?ll have to pay £37,500 in VAT (£300,000 x 12.5%). But as the VAT disadvantage is disproportionate, HMRC will allow Eric to retrospectively withdraw from the FRS and get his £37,500 back.

Tip 1. Don?t rush in. Before joining the FRS check the effect it will have on your VAT bill. Remember to take into account that VAT will be due on exempt income, e.g. residential letting.

Tip 2. Using a limited company to operate your business through will mean the FRS won?t apply to personal income such as from residential letting. It will only apply to the income of the company.

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