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VAT inspections by HMRC are less frequent than was once the case and in fact many are now carried out purely by telephone. Nevertheless HMRC is adept at homing straight in on areas where mistakes commonly occur, and they will often magnify the fault several times over by assuming that the same error will have been made in previous years. The end result can be a large and unexpected VAT bill plus interest and a penalty.
This memorandum focuses on some areas of VAT which will commonly be misunderstood by smaller businesses and will therefore help to prevent any such unexpected problems with HMRC.
Although retailers can issue simplified invoices, businesses should include their own full details and the customer’s full details (name and address in both cases) on invoices issued as well as a description of what has been supplied and the rate of VAT charged. It is also now a requirement that invoices should bear a consecutive numbering system, with the invoice number marked on each one.
Except for businesses in the cash accounting system, once an invoice has been issued showing the VAT charged, that VAT is then payable to HMRC, whether or not the customer has paid. The invoice must therefore be included in the total outputs for the quarter in which it is issued. If your customers habitually pay late, you should consider opting for the cash accounting scheme so that VAT is then only payable to HMRC as and when customers make a payment of the invoices issued to them.
When the rate of VAT was 17.5%, the VAT amount expressed as a fraction of the total VAT-inclusive amount was 7/47. With the change to a 20% rate, the fraction is a much more straightforward 1/6. You should always check your VAT total for each quarter by reference to this fraction – HMRC’s computer will do this automatically and flag up any error. For example, if your purchase invoices total £1100, inclusive of the VAT, your recoverable VAT for the quarter is £183.33, being one sixth of £1100.
VAT on Expenses
You must hold a “tax invoice” from a supplier in order to claim back the VAT paid as input tax. It is not sufficient to hold only a statement of account from the supplier as this is not a tax invoice. Equally some businesses only issue a tax invoice upon request (for example electricity companies) and the bill which you receive to pay is marked to state that it is not a tax invoice. As a result the bills should not be used to justify claims for VAT input tax and it is necessary to ask for a tax invoice to be issued.
Till receipts issued by retailers are acceptable evidence for VAT purposes in respect of purchases of £250 or less.
Unless you are in the cash accounting scheme, it does not matter that you have not yet paid a purchase invoice. The VAT is recoverable in the quarter in which the date of the invoice falls, whether paid in that quarter or not.
Where one of your invoices issued to a customer remains unpaid, you may claim bad debt relief for VAT purposes in respect of it once it is over six months old, i.e. six months must have elapsed from both the date of the supply on the invoice and also the time when payment became due and payable in respect of it. After the six month period, the VAT on the invoice, which will already have been paid to HMRC for those not in a cash accounting scheme, may be reclaimed by deduction on the next VAT return due to be made. At one time it was also a requirement that the customer was notified that bad debt relief was being claimed, but this is now no longer the case.
Input Tax Claims: Miscellaneous Expenses
Sole traders need to be very careful about how much VAT they claim in respect of petrol and diesel expenses. If the fuel concerned is used for business motoring only, the business can claim all the VAT on it in its VAT returns. Commonly however there is some private use of a business car or van and in that event great care should be taken that VAT is not over claimed. This is a fruitful area for HMRC to find errors in such returns when a VAT inspection is carried out. If detailed mileage records for each vehicle are maintained, so that the business and private mileage in the vehicle concerned is tabulated, it is acceptable to claim a fraction of the VAT paid on fuel purchases for that vehicle. The fraction is the business mileage in the quarter concerned, divided by the total mileage. As an alternative, all the VAT can be claimed as input tax, but in that event fuel scale charges must be applied and output tax is due on a scale figure (published and revised from time to time by HMRC) for the vehicle concerned. The scale charges invariably result in a higher VAT liability and normally are therefore best avoided.
It will be apparent that where the business use of the vehicle is relatively low and it would be onerous to keep detailed mileage records, then probably the simplest answer is not to claim any VAT on fuel purchases in that case. This is a judgement call for the trader to make.
HMRC allows VAT recovery in respect of fuel bought by employees wholly or partly for the purposes of their employer’s business. The employer must reimburse the employee for the business proportion. It will be necessary for the employee to keep detailed records so that the business portion can be accurately established. The employee must hand the till receipts for the fuel to the employer so as to justify the VAT claims.
Often employees are reimbursed for business trips by a car mileage allowance and the VAT on the fuel element of the allowance may be claimed without the need for till receipts so long as proper car mileage records are maintained.
If a sole trader or a partner carries on a business from home and uses a particular room as an office or work area, any VAT incurred on expenses which relate to that room or workplace can be claimed as input tax. This would, for example, cover decorating costs relevant to it and the VAT incurred on fixtures and fittings for the business. VAT on general expenditure in relation to the property may be apportioned and the fraction which can be attributed for the room or workspace may then be claimed. One should however be careful for claims of this type, and input tax should not be claimed on expenditure which has no relevance to the business room or workplace. Moreover, one should be careful of any potential Capital Gains tax implications.
Full time working farmers enjoy the benefit of a special agreement made with the National Farmers Union, by which they may claim as input tax 70% of the VAT incurred on repairs, maintenance and renovations of the farmhouse. This is clearly quite generous, and HMRC will be likely to refuse to apply it where farming is not a full time activity. Instead, those who run a farm business and a non-farm business from a “farmhouse” may claim a lower percentage of input VAT calculated according to the percentage of the property used for business and a percentage of total time that is relevant to the business use.
Where a company buys a computer to be used by a director or employee at home, all the VAT on the purchase may be reclaimed as input tax where the computer is necessary for the director or employee to carry out his or her work. This implies that any private use will not be significant. In other circumstances, a fraction of the VAT may be recovered as input tax, this fraction to be calculated on any reasonable basis.
Although there is no income tax benefit in kind charge on the provision of a mobile phone to an employee, the position for VAT is slightly different. All the VAT incurred in respect of charges for the phone can only be recovered if there is no private use of it. If however, private calls are permitted without charge to the employee, the VAT incurred on the call charges must be apportioned between business and private by any reasonable method, and only the business element reclaimed. On the other hand, if private calls are permitted but charged for, the charge made by the business to the employee is subject to VAT and the tax collected must be declared as output tax.
If an employee is paid a flat rate for subsistence expenses whilst away on business, none of the VAT on the expenses can be claimed as input tax. If however, the business pays the actual cost of meals etc whilst the employee is away on business, the input tax incurred can be reclaimed. A similar rule applies for partners and sole traders, in that the VAT incurred on meal expenses whilst away from the normal place of work can be reclaimed as input tax.
The VAT incurred on the cost of special events for staff such as parties, outings, dinners and lunches to maintain good staff relations is deductible as input tax. It is not therefore within the normal prohibition which applies to business entertainment expenses for which VAT cannot be recovered – business entertainment in this context meaning the entertainment of customers of the business. Any parties or special events provided only for directors, partners or sole proprietors of a business (ie, not staff generally) equally falls within the category of business entertainment and the input tax is not reclaimable.
VAT can be reclaimed on the cost of uniforms, including Court wear of barristers, stage costumes of entertainers and protective clothing of workmen, but ordinary clothing worn by TV presenters and the like will normally be treated as a part private/part business expense for VAT.
HMRC do not normally query VAT recoveries in respect of ordinary accountancy and legal costs of a business even though it may be said that the personal tax return of a sole trader or partner is non-business, but the VAT on similar costs which are clearly not related to a VAT-related business, such as personal inheritance tax planning, should not be reclaimed.
Sole traders need to be particularly aware of the partial exemption rules. These apply where some of the goods or services supplied are exempt from VAT. The important point to note, is that an individual’s VAT registration covers all his or her business activities, business in this sense being interpreted widely to include matters such as letting residential properties. Such lettings are exempt supplies and can therefore cause the sole trader to fall into the VAT partial exemption rules.
However there is a useful escape from the rules which applies in any VAT quarter where the input tax attributed to exempt supplies is not more than £625 per month and one half of all input tax for all the period concerned. This is known as the de minimis limit and it can often exclude from partial exemption those with limited exempt supplies, such as letting a residential flat. However where the de mimimis limit is exceeded, partial exemption calculations must be carried out.
The partial exemption rules require that input tax incurred exclusively for taxable supplies and that incurred exclusively for the exempt supplies must first be identified and only that relevant to the taxable supplies must be reclaimed. For example, if decorating costs are incurred for a let flat, that will relate wholly to the exempt supplies (the residential letting) and none of the VAT on the costs can be claimed as input tax. If however the decorating costs relate to two rooms at home, one of which is used only as an office, the VAT on cost of decorating that room alone may be reclaimed. The VAT on some expenditure will not be referable wholly to either the VAT standard rated business or to the exempt business; this unallocated VAT is described as residual input tax and must be apportioned according to the portions of standard rated and exempt supplies. Only the standard rated proportion must be reclaimed.
In the case of partnerships, property letting by the partners individually will be of no concern, since the partnership itself is registered for VAT and that registration does not apply to activities of the partners individually. In this case, therefore property letting will only cause partial exemption where a partnership property is let as residential accommodation and the de minimis limit mentioned above does not apply.
Flat Rate Scheme for Small Businesses
A simplified VAT scheme is available for small businesses, being those with annual VAT exclusive turnover of up to £150,000 for standard-rated, reduced rate and zero-rated supplies. Once accepted for the scheme, the business charges VAT in the normal way on its invoices and out of that to be paid to Customs is a smaller percentage applied to the invoice total. For example, for those supplying computer repair services, the fraction is 10.5% and so the VAT to be paid to customs in respect of a customer invoice for £100 plus VAT is 10.5% of £120, being £12.60. In itself, this is clearly favourable to the business rather than HMRC, but the downside is that normal input tax on business expenses cannot be claimed at all. The exception as regards expenditure is that input tax may be claimed on a single purchase of capital expenditure goods where the amount of the purchase including VAT is £2,000 or more. However, small businesses with very low levels of business expenditure can find the flat rate scheme not only easy to operate in terms of calculations and record keeping, but also quite favourable in financial terms in that the amount of VAT collected is not all paid over to HMRC.
But there is another trap. As already mentioned, that registration applies to all the registered persons business supplies in its widest sense and under the flat rate scheme that has to be paid on both exempt and standard rated business supplies. This means that if a sole trader in the flat rate scheme has a let residential property, he must include on his VAT return flat rate VAT on the rents received. Even worse, if he or she sells the flat, the full proceeds of sale will equally be liable to the flat rate of VAT. (This principle would not of course apply to the sale of the individual’s own home, as that would not be a business supply). It is possible to withdraw from the flat rate scheme before a let property is sold so as not to incur liability to VAT in respect of the sale proceeds. Steps can also be taken to deal with the problem of private property letting by a flat rate trader, for example by putting the let property into a trust which then conducts the letting.
At one time HMRC took the view that VAT is due under the flat rate scheme on interest received on the business bank account. However one business recently appealed this point and won at the Tax Tribunal.
FOR GENERAL INFORMATION ONLY
Please note that this Memorandum is not intended to give specific technical advice and it should not be construed as doing so. It is designed to alert clients to some of the issues. It is not intended to give exhaustive coverage of the topic.
Professional advice should always be sought before action is either taken or refrained from as a result of information contained herein.