VAT: Flat rate dilemma for hospitality businesses

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Many businesses in the tourist and hospitality industry will now be charging 5% VAT on some or all of their sales following the Chancellor’s announcement on 8 July. To recognise this situation, the legislation was amended so that reduced FRS percentages will apply in the following trade categories between 15 July 2020 and 12 January 2021:

  • Catering services including restaurants and takeaways: reduced from 12.5% to 4.5%
  • Hotel or accommodation: 10.5% to 0%
  • Pubs: 6.5% to 1%

Rules for leaving the scheme

Before looking at the maths in two specific situations, there are important rules that need to be met if your business decides to leave the scheme (see VAT Notice 733, section 12):

  • You can leave on any date, it doesn’t have to be at the end of a month or VAT period. Those who wish to leave would logically choose 14 July, ie the day before the reduced rate took effect.
  • Once you leave, you cannot rejoin for 12 months. Decisions to leave or remain in the FRS must, therefore, consider the 12-month period up to 14 July 2021 ie not just the six-month window to 12 January 2021 where the 5% rate is relevant.
  • To leave the scheme, you have to notify HMRC in writing and also reapply if you decide to join again after 12 months or later.
  • Leaving the scheme means that you will need to keep full input tax records, and also divide sales for output tax purposes been those that are subject to 0%, 5% or 20% VAT. In other words, the simplification benefits of the scheme will be lost.

Business with mainly 5% sales

Jim’s café does not sell alcohol and has no take away sales. All sales, therefore, qualify for the temporary 5% reduced rate. He has used the FRS for many years and his annual turnover is £150,000 including VAT. The VAT paid on his expenses over 12 months is £4,000.

For the six months to 12 January 2021:

  • If Jim stays in the scheme, his VAT bill will be £75,000 x 4.5% = £3,375
  • If he leaves the scheme, the VAT bill will be: output tax £75,000 x 1/21 = 3571, less £2,000 input tax = £1,571
  • Saving from leaving scheme = £1,804

Note: 1/21 is the fraction for 5% rate of VAT.

From 13 January 2021:

The VAT rate increases to 20% and the FRS rate returns to 12.5%. Jim will pay extra tax of £1,125 in the six-month window until 15 July 2021 before he can rejoin:

  • Output tax: £75,000 x 1/6 = 12,500 less input tax of £2,000 = £10,500 with normal VAT accounting
  • £75,000 x 12.5% FRS percentage = £9,375 within the FRS
  • Cost of leaving scheme: £1125

Net savings from leaving the FRS: £1804 – £1125 = £679

The dilemma for Jim is whether the extra time and effort needed to leave the scheme and revert to normal VAT accounting for a year is worth the net saving of £679, possibly not.

Business with mainly standard-rated sales

Janet’s pub only sells alcohol drinks – it is a real-ale venue. All of her sales will still be subject to 20% VAT because of the exclusion of alcoholic drinks from the 5% rate. Her annual sales are also £150,000 including VAT but the annual VAT paid on her expenses is £12,000 because her stock purchases are all standard rated. She uses the FRS.

If Janet leaves the scheme, her VAT bill for the six-month period to 12 January will be £75,000 x 1/6 output tax less input tax of £6,000 = £6,500.

If she remains in the scheme, the VAT bill will be £750 ie £75,000 x 1%.

This is a massive saving, caused by the fact that she has no 5% sales in the window where the temporary rate cut applies. The temporary 1% rate obviously assumes most pubs will have some sales at 5%. Janet’s decision to stay in the FRS is very easy!

It’s all about the numbers

As the examples show, each business needs to do its own calculations but also take into account the time-saving benefits of the flat rate scheme as well. In some cases, it might be worth a business joining the scheme if it is eligible and then leaving after six months, such as pubs similar to the Janet example.

You can ask HMRC to backdate your application to join the FRS to the beginning of the current VAT period as long as a return has not already been submitted (VAT Notice 733, para 5.5). There is no minimum period that a business must stay in the scheme.