The VAT Flat Rate Scheme (FRS) is a simplified VAT scheme used by many small businesses. It can be beneficial for a business to register under the flat rate scheme because less VAT is payable to HMRC than the total of VAT charged less VAT suffered by the business. Consequently, some businesses are VAT registered even though they are beneath the VAT threshold purely because there is a tax advantage.

Under the FRS, businesses determine which flat rate percentage to use by reference to their trade sector. However, from 1 April 2017, FRS businesses can only use that percentage if it falls outside the definition of a limited cost trader. If it falls under the definition of a limited cost trader, it must use a rate of 16.5%. This means that more VAT is payable to HMRC.

A limited cost trader is one whose VAT inclusive expenditure on goods is either:

• less than 2% of their VAT inclusive turnover in a prescribed accounting period or
• greater than 2% of their VAT inclusive turnover but less than £1000 per annum if the prescribed accounting period is one year (if it is not one year, the figure is the relevant proportion of £1000)

For this purpose, “goods” must be used exclusively for the purpose of the business but exclude the following items:

• capital expenditure
• food or drink for consumption by the flat rate business or its employees
• vehicles, vehicle parts and fuel (unless the business is one that carries out transport services)

These exclusions are part of the test to prevent traders buying either low value everyday items or one off purchases in order to inflate their costs beyond 2%.

Importantly, the test is of value of “goods” not “Services”, so costs of telephone, professional fees, etc do not form part of the 2% test.