Last month, the Office of Tax Simplification (OTS) published its long overdue report on modernising the VAT system. The report suggests that significantly reducing the VAT threshold could bring in an additional £1.5 billion revenue each year but this might this lead to an unexpected and nasty surprise for smaller businesses as John Craig explains in this article.
VAT is the third largest source of tax revenue collected by HMRC, after income tax and National Insurance Contributions. £120bn of VAT was collected in 2016-17, representing 22.5% of all taxes in the UK.
This is the first OTS review to focus specifically on VAT and the dominant issue that has come out of it is the level of turnover above which a business is required to pay VAT, known as the VAT threshold.
The VAT Registration threshold
The UK’s £85,000 VAT registration threshold is the highest in both the EU, where the average is just £20,000, and the highest general threshold in the whole of the OECD. The UK’s high threshold is often seen as a tax simplification measure, as most businesses can operate without needing to be registered for VAT, for example many largely labour based business owners are content to operate on the basis of a turnover below the threshold.
But this does mean that there is currently significant ‘bunching’ of businesses whose turnover is just below the threshold. Particularly smaller businesses with lower levels of inputs relative to their supplies to consumers, such as labour-intensive businesses and businesses operated by sole proprietors, for whom this bunching effect has the definite appearance of a cliff edge.
The bunching in front of the threshold and the very significant fall-off in business numbers immediately after it, does reflect the significance to a business of crossing the threshold, as when this happens customers can obviously expect an increase in sale price by up to 20%.
For example, compare a business with a turnover of £84,000 which is not registered for VAT with a VAT-registered business having a turnover of £85,000. If VAT applied to the whole of the turnover, the VAT-registered business would be liable for an additional £17,000.
Clearly, many small businesses will not be able to pass this increase on to their customers, especially when competing with unregistered businesses. Whilst others will fear the administrative impact of VAT registration.
Making Tax Digital
If a change were made from April 2019 there could be additional impacts to factor in. For example, a business with a turnover of £50,000 might not only have to deal with VAT registration and possible additional compliance costs, but would also have to pass the VAT cost onto its customers, thus increasing prices by 20%.
But perhaps more worryingly is that the compliance date for Making Tax Digital (quarterly reporting etc.) would immediately be accelerated by twelve months and this would potentially present a very short space of time to prepare for it.
Potential smoothing mechanisms
Given that any threshold creates an incentive to operate below it, the OTS has also considered ways in which the distortive effect of a threshold might be reduced by introducing some form of smoothing mechanism.
Options considered included:
• Smoothing the cash impact of becoming registered
• Smoothing the administrative impact
• Smoothing both cash and administration
• A time-limited reduction in the VAT flat rate scheme rate for newly-registered businesses and a financial taper
Any such mechanism could be considered to increase the overall complexity of the system, but it could also offer businesses a way to pass more easily across the threshold and as a result have a positive impact on economic growth and productivity.
This problem is more acute in the UK than in other EU countries because of the high level of the UK VAT Registration threshold. Indeed, it is clear that there are many businesses which currently take steps to reduce their business levels to avoid crossing the threshold and the report concludes that this is not good for our overall economic growth or productivity levels.
This report also explores other ways to address the bunching issue, whatever the level of the threshold, including smoothing the ‘cliff-edge’. Developing a workable mechanism that balances the risk of fraud, revenue loss and potential complexity against the benefits of smoothing entry to the VAT system and reduce business burdens is challenging, but the OTS considers there is merit in examining this for the future.
Let’s hope that when the Government examines its approach to the level and design of the VAT Registration threshold, that it includes the considerable benefits of a smoothing mechanism.
As ever, if you are a small business operator and would like to discuss the issue and how it might impact on you and your business then please do not hesitate to get in touch with JRW.