Limited Cost Trader Test - how it affects Flat Rate VAT

‍Flat Rate VAT schemes may not be the first thing you think of when you wake up. But you may want to take a closer look if you’re a VAT registered small business.

‍VAT is a tax paid on most goods and services. VAT registered firms have to charge VAT on their sales and can reclaim VAT on their purchases. This involves careful record-keeping of all transactions and the rate of VAT they were charged at.

Before we get going...

If you're in need of further accountancy support, check out Crunch's online accounting software. We combine state-of-the-art accountancy software with real human beings, you can always access your accounts and the advice you need. Our software is fully compliant with the Government's Making Tax Digital rules for VAT.

What is the Flat Rate VAT scheme?

To reduce the burden of this record-keeping on smaller firms, HMRC offers a Flat Rate Scheme. With this scheme, rather than having to pay HMRC what you’ve collected in VAT on your sales minus the VAT you’ve claimed for on expenses, you simply need to pay HMRC a set percentage of your sales. This means small firms generally don’t need to track VAT on purchases.

You can learn more about Flat Rate and Standard Rate VAT in our "Flat Rate or Standard? VAT registration explained" article.

Why did it change?

The growing numbers of self-employed have been cited by the Treasury as a cause for declining tax revenues. However, our experience and research shows that people run their own companies for commercial reasons, not to avoid tax. The Treasury clearly thought these VAT schemes were too generous and that too many firms were using them.

What is the Limited Cost Trader Flat Rate VAT scheme?

Since April 2017, there's been a 16.5% flat rate VAT scheme that many ‘labour-only’ businesses, such as contractors, need to use. This increased the rate at which VAT is paid under the Flat Rate scheme for many businesses, meaning that the advantages of flat rate VAT over standard rate VAT was diminished. Please speak with your accountant, who'll be able to advise on the appropriate VAT scheme for you. It might even be in your interest to deregister from VAT if your turnover is below the threshold.

Who exactly does this apply to?

‘Limited cost traders’ are ‘labour-only’ businesses that have to use the 16.5% rate when using the Flat Rate VAT scheme. A limited cost trader is defined as one that spends less than 2% of the value of its sales on goods (not services) over the period you submit a VAT return (HMRC call this 'the accounting period' for VAT - it is usually quarterly).

When working out the amount you have spent on goods, you cannot include purchases of:

• capital goods (such as new equipment used in a business)
• food and drink (such as lunches for staff)
• vehicles or parts for vehicles (unless running a vehicle hiring business).

If a firm spends less than £1,000 in their accounting period (if the period was a year), they also count as ‘labour-only’ even if this is more than 2% of your sales. If your accounting period is longer/shorter than 12 months, the £1,000 threshold is pro-rated accordingly.

Q&A about the limited cost trader test and the Flat Rate VAT scheme

We’ve put together a Q&A based on questions we’ve received to explain the limited cost trader test further.

Do I still get the 1% discount in the first year of VAT registration when on the Flat Rate scheme?

Yes – HMRC have confirmed this is still available.

How often do you have to apply the limited cost trader test?

When on the flat rate scheme you need to apply the limited cost trader test every VAT period.

Are these tests incorporated into the Crunch app?

Yes, on an ongoing basis, we’ll review each VAT return for our clients, and an accountant will contact you if we believe that you are not a limited cost trader for that VAT period.

The limited cost trader rules generally affect contractors with low outgoings. How can contractors avoid being classified as such and keep the flat rate VAT rates?

This depends on whether you have any goods purchased in the relevant VAT period. If the total of goods bought is less than 2% of turnover in the same period, or less than £1,000 a year, then you’ll have to use the limited cost trader rate.

Currently, my trade sector falls under printing, which is set at a flat rate of 8.5%. Can you tell me will these rules apply?

If you meet the criteria for a Limited Cost Trader, the rate would be 16.5%. However, for the printing industry, we expect this type of trade to have quite a lot of ‘applicable goods’. This could include the ink or paper for printing. So for most printers, this would mean the cost of goods would be more than 2% of turnover, meaning the rules would not apply.

As a limited cost trader will you be able to claim VAT back on goods costing over £2,000. I’m thinking of purchasing a new Mac.

The rules state that a business on the flat rate scheme can reclaim VAT on goods that cost more than £2,000.

Does the cost of a subcontractor count as a capital good when applying the Limited cost trader test?

Unfortunately not – services are not included.

My company expenses consist of salary, accountancy, some travel costs, the odd subsistence expense, software rental, and telephone costs. How would I see if I currently meet or fall foul of this test?

It’s likely you’ll be affected. Ultimately, the majority of service-based companies are likely to be affected. Here are some examples of items that won’t be included as applicable goods:

• Accountancy fees;
• Advertising costs;
• Hiring of equipment (this counts as services);
• Food and drink for you or your staff;
• Fuel for a car (this is excluded unless operating in the transport sector using your own, or a leased vehicle);
• Laptop or mobile phone for use by the business (excluded as it is capital expenditure);
• Anything provided electronically, for example, a downloaded magazine;
• Rent;
• Software you download;
• Bespoke software designed specifically for you (this is a service even if it is not supplied electronically).