When the Flat Rate Scheme (FRS) for VAT was introduced, it was intended to make completing accurate VAT returns easier for small businesses. Rather than a) adding up all the VAT that they'd received from customers, b) adding up all the VAT that they'd paid out to suppliers and then c) paying over the difference to HMRC, they could just add up their gross income from customers and then pay over a fixed percentage of that income to HMRC, the percentage being dependent upon their industry sector.
The idea is that the percentages for each business sector should pretty much reflect how small businesses in those sectors typically operate. In industries (say management consulting) where businesses have minimal VATable costs, their VAT payments tend to be quite high, and so the FRS gives them a high percentage. In businesses with greater VATable costs (say a shop), VAT payments tend to be low, and so the FRS gives them a lower percentage.
That sounds fair enough in theory, but in practice there's only one real reason why some businesses sign up to the scheme, and that's to pay over less VAT to HMRC each quarter. There's a big problem with the table of percentages, which is that it's really poorly put together. It's pretty likely that there will be two categories which seem appropriate, and very likely that there are none. It's often the case that sloppy drafting means that a rate that's plainly intended for one type of business can be used by another. Plus, since many pretty common types of business are omitted entirely, they can choose the "Other" category where that really gives a lower percentage than is really appropriate for their business model.
No blame should be attached to businesses that go for as low a percentage as is realistic, of course - they'd be mad not to. This thread shows an accountant who's been able to claim (somewhat implausibly, to my mind) that he's not really an accountant, and he appears to have persuaded HMRC to agree. The problem lies with the conception and execution of the scheme itself. Keeping accurate records under the traditional system is no big deal - you've got to track your costs in the end, in order to get your year-end accounts done - and, apart from anything else, to know how much money you're making. So the scheme wasn't really needed. But what makes it worse is that hopeless table of rates.
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