A simplification that now costs many businesses money. Since the limited cost trader rule, almost any service business buys too little in the way of goods to qualify for its sector rate, and the test has to be run every single period.
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How the Scheme Works
The VAT flat rate scheme lets a small business account for VAT by applying a single percentage to its VAT-inclusive turnover, instead of calculating output tax less input tax in the normal way. The business still charges VAT to customers at the normal rate; it simply pays over a flat percentage and generally recovers no input tax.
The percentage depends on the trade sector, and there is a reduction in the first year of registration. Input tax is not recoverable except on certain capital expenditure goods above a threshold.
The Limited Cost Trader Rule
The most consequential change to the scheme was the introduction of the limited cost trader category, carrying a much higher percentage than any sector rate.
A business is a limited cost trader in a period if its expenditure on relevant goods is either:
- less than a specified small percentage of its VAT-inclusive turnover; or
- above that percentage but below a fixed cash floor for the period.
What counts as relevant goods
This is where the errors are. Relevant goods are goods used exclusively for the business, and the exclusions are extensive:
- Services of any kind: accountancy, subcontractors, software subscriptions, rent, advertising, telephone.
- Capital expenditure goods.
- Food and drink for the business or its staff.
- Vehicles, vehicle parts and fuel, subject to a limited exception for transport businesses.
- Goods for resale, leasing or hiring out, unless that is the main business activity.
- Goods used for entertainment.
The test is applied every period
A business can be a limited cost trader in one quarter and not the next, depending on what it bought. That means the percentage has to be tested each period rather than fixed at the start of the year, and the record-keeping has to support the test.
Where HMRC Assesses
- Failure to apply the limited cost trader rate in periods where it applied, by far the most common assessment.
- The wrong sector percentage. HMRC expects a business to choose the sector that most closely describes what it does. Where a business has selected a lower-rated sector on a strained reading, HMRC will reallocate it and assess the difference across every period.
- Turnover not properly included: the flat rate applies to VAT-inclusive turnover including exempt and zero-rated supplies, which businesses routinely omit.
- Eligibility. The scheme has a joining turnover threshold and a higher exit threshold, and there are exclusions including for businesses associated with another.
- Input tax recovered when it should not have been, outside the capital goods exception.
Leaving the Scheme
- A business may leave voluntarily, normally with effect from the start of a period.
- It must leave if it exceeds the exit threshold, or if it becomes ineligible for another reason.
- HMRC can withdraw the scheme retrospectively where it has been used incorrectly or where its use is regarded as abusive.
- A retrospective change of basis produces adjustments in both directions, and the arithmetic should be checked rather than accepted.
Practitioner Application
- Run the limited cost trader test for every client on the scheme, for every period. For a services business the answer is usually that they should not be on it at all.
- Model the alternative annually. Compare the flat rate outcome with normal accounting on actual figures, not on assumptions made at registration.
- Document the sector choice and the reasoning at the time. A contemporaneous note that the sector was chosen as the closest description is the answer to a reallocation assessment.
- Check the turnover base includes everything it should.
- On an assessment, test the arithmetic period by period. The limited cost trader test is applied per period, so a blanket reallocation across every period should be challenged.
- Fight the behaviour category. A wrong sector choice made in good faith on a genuinely arguable description is careless at worst. Under HMRC v Tooth a deliberate finding requires knowledge of the error and an intention that HMRC rely on it.
Frequently Asked Questions
What is a limited cost trader?
A business whose expenditure on relevant goods in a period is either below a specified small percentage of its VAT-inclusive turnover, or above that percentage but below a fixed cash floor. Limited cost traders pay a much higher flat rate percentage than any sector rate, and the test is applied every period rather than fixed annually.
Why are consultants and contractors always caught?
Because almost nothing they buy counts as relevant goods. Services of every kind are excluded (accountancy, subcontractors, software subscriptions, rent, advertising, telephone) as are capital goods, food and drink, and vehicles and fuel. A one-person consultancy or IT contractor is therefore a limited cost trader in almost every period, and the scheme is almost certainly costing it money.
HMRC says I chose the wrong sector. What now?
HMRC expects the sector that most closely describes what the business does, and where it disagrees it will reallocate and assess the difference across every period. The answer is a contemporaneous record of why the sector was chosen. Where the description was genuinely arguable, the choice is careless at worst rather than deliberate.
Does the flat rate apply to zero-rated and exempt income?
Yes. The percentage applies to VAT-inclusive turnover, which includes zero-rated and exempt supplies. Businesses routinely omit them, which produces an under-declaration across every period. This is a common assessment and it is usually not contestable on the principle, only on the figures.
Should my client be on the scheme at all?
It is an arithmetic question that should be revisited annually, not a decision made once at registration. The scheme is a simplification rather than a relief, and since the limited cost trader rule it costs many service businesses more than normal accounting. Model both on actual figures each year.