FSB’s new paper, “VAT for Small Businesses”, suggests revamping the VAT system could be the key to unlocking billions in trapped economic firepower. The business group pushes for a rise in the turnover threshold from £85,000, where VAT currently starts biting, to £100,000.

This would give firms stepping into the VAT-paying ring crucial breathing space, and an incentive to grow their turnover without fear of having to charge customers an extra 20% overnight.

FSB is also suggesting bringing in a smoothing mechanism, to ease the transition for small firms, owner-managed companies and some of the self-employed who go just over the threshold.

At the moment, many small firms – estimated to hit 44,000 by 2025 – keep their turnover just below the £85,000 threshold, according to the Office for Budget Responsibility, which also thinks that hundreds of millions of pounds of potential economic activity could be lost due to this ‘bunching’ just below the threshold.

Increasing the threshold and smoothing mechanisms

The £85,000 threshold was fixed in 2017 – but had it kept pace with inflation, that figure would top £100,000 today. Rocketing inflation pushed small firms to hike prices and inadvertently increase turnover without fattening profits, unwittingly ensnaring many into the VAT net, piling on extra burdens in time, money, and complexity.

FSB’s recommendations come after firms with a turnover of between £75,001 and £100,000 said the £85,000 threshold:

• Is a barrier to growth (38%).
• Would encourage them to invest in their business if it was raised (29%).

Meanwhile:

• A fifth of small firms (19%) say a discount to the amount of VAT payable after reaching the threshold would incentivise them to invest and expand in their businesses.
• This rises to 41% in the hospitality sector and 23% in the wholesale and retail industry.

Alongside a higher threshold, FSB wants the transition from not paying VAT to being subject to the tax to be less of a sudden shock to small firms. To that end, we want the Government to bring in a smoothing mechanism, so small firms aren’t left out in the cold if they go a penny over the threshold, as is currently the case.

FSB sets out two possible ways a smoothing mechanism could work:

• VAT allowance option: HMRC could allow eligible small businesses to reduce their annual VAT liability by a set amount (i.e., £5,000), similar to the existing Employment Allowance, which can be offset against small firms’ National Insurance bill.
• Rebate option: HMRC could administer a rebate proposal where small businesses with a turnover up to £20,000 higher than the threshold level can apply for a rebate on their net VAT paid. The rebate would reduce the overall VAT liability a small business pays, and would decrease as turnover increases.

Under the rebate option, and assuming a threshold of £100,000, FSB is proposing that businesses with turnover of £100,000-£109,999 be given a 20% discount on their net VAT, while firms with turnover of £110,000-£119,999 would get a 10% discount.

Simplifying the rules

There are many infamous examples of the quirks in the VAT system when it comes to deciding what is and isn’t subject to the full rate of VAT.

For example, a notable court case has been fought over whether a certain kind of sweet treat counts as a cake (not subject to VAT) or a biscuit (VAT-able if wholly or partly covered in chocolate), with judges deciding the outcome based on whether it went stale (like a cake) or soggy (like a biscuit) over time.

The complex rules on what is and isn’t VAT-able cause headaches for small firms, who don’t have the same level of resources to devote to keeping track of differing VAT levels as large corporates.

Tax compliance costs small firms £25 billion every year, with each firm devoting seven working days to it annually.

Being caught in the VAT net also means having to switch over to paying taxes via Making Tax Digital, which costs small firms nearly twice as much to comply with than filing manually.

And we’re calling for the recent decision that taxi passengers should be charged 20% VAT on each ride they take to be reversed.

Adding this extra expense will mean higher costs for people travelling to hospitals, women trying to get home safely at night, elderly people who require door to door transport, and many other groups.

Our paper shows that if the rules were streamlined:

• 18% would be incentivised to invest and expand.
• 30% of hospitality firms would be incentivised to invest and expand.
• 27% of small manufacturers would be incentivised to invest and expand.

Tina McKenzie, FSB’s Policy Chair, said: “VAT compliance flattens small firms by stifling their growth and emptying their coffers. It’s crying out for a modern makeover to match today’s economic landscape.

“We can’t let it squash the ambitions of small businesses, strivers, and budding entrepreneurs. The flaws in our current system are glaringly obvious. We are at a breaking point – a drastic overhaul of VAT is needed.

“Raising the threshold to reflect inflation, introducing a buffer to soften the blow for those just over the limit and demystifying the rules to save small business owners from a VAT-induced headache could unlock hundreds of millions in extra economic activity.

“As a country, we need to think about how to take VAT to the future. Our paper sets out a way forward that will help small firms and sole traders, from B&B owners and independent shops to plumbers and hairdressers.

“If the government wants to show that it’s really on the side of small firms, a commitment to look at our suggestions and ease the VAT burden would go a long way towards that.”

Richard Wild, head of tax technical at the Chartered Institute of Taxation, said: “We welcome this report which takes a fresh look at the challenges faced by small businesses by virtue of the VAT registration threshold and the complexity of the VAT rules. In particular, the idea of a smoothing mechanism to reduce bunching just under the VAT threshold deserves serious investigation by government.

“It’s six years since the Office of Tax Simplification undertook its review of VAT, and with the government’s emphasis on growth, it’s time to take the issue out of the too-difficult box.”