The VAT trap: why businesses put a brake on growth

What do seasonal businesses shutting during quieter periods, self-employed people working fewer days or shops cutting their opening hours have in common? They are all signs of people trying to escape the VAT trap.

This is the cliff edge when eligible turnover has reached £90,000 and firms must register for VAT. If companies don’t manage the transition carefully, regular customers can find they are suddenly paying another 20% and may take their business elsewhere. But if a company absorbs the VAT bill it can rapidly find itself trading at a loss.

For some owners who do not see their company’s turnover getting much above £90,000 staying below the threshold is the right move; however, registering for VAT does have some big advantages, and will often be the best course for more growth-focused businesses.

The important thing is that the decision about VAT registration is a strategic one rather than one that is more instinctive or reactive. This approach requires a clear understanding of the implications of being either side of the threshold and of how that affects trading partners, public perception and company finances. So let’s start by taking a look at what the VAT cliff edge actually is.

What is the VAT cliff edge?

Businesses that have eligible turnover of more than £90,000 have to charge VAT of 20% on sales. This is turnover that either exceeded this sum in the past 12 months or is going to in the next 30 days. In the former case the company must register for VAT within 30 days of the end of the month when turnover exceeded the threshold. In the latter case registration must be immediate.

Business owners should take great care not to cross the threshold without meaning to and also should ensure they do not include VAT-exempt turnover in the eligibility calculation.

How does the cliff edge change business behaviour?

Many companies that are faced with suddenly having to charge their customers 20% more will take avoiding action. Common ways of staying under the VAT threshold include:

• Turning down work late in the tax year.
• Reducing operating hours and marketing activities.
• Delaying invoicing.
• Seeking out more zero-rated customers or work that does not incur VAT.
• Restructuring the business into separate legal entities. However, if HMRC deems the split to be artificial it will tax the businesses as one entity and this strategy will fail.

Pricing, margins and strategic choices

The impact on pricing is what troubles many business owners most. They face the dilemma of either charging their customers 20% more for the same product or service or paying the VAT themselves and in effect cutting their profitability by 20%.

The most common way of addressing this problem is for businesses to increase their trading with other VAT-registered businesses, which can reclaim the VAT paid out on their costs. If this isn’t an option many companies try to absorb some of the VAT cost themselves while passing on as much as they hope they can get away with to customers.

Another strategy is to protect margins by other means, such as improving operational efficiency or making savings on stock and running costs.

Like incorporation, being VAT registered gives the impression that a business is established and of good standing. Other companies will like it as they can reclaim their input VAT costs when buying goods and services from you. And in turn you can recover your input VAT costs.

And of course once over the VAT threshold companies can pursue growth more aggressively, in particular, targeting other VAT-registered businesses to which they have suddenly become more attractive trading partners.

Lower margin, high-volume businesses such as retailers or those in hospitality are likely to be the ones that will find VAT registration the biggest problem. It is also often difficult for providers of personal services, such as hairdressers, and indeed any business that trades primarily with the public.

Their price-sensitive customers will not be able to tolerate a 20% jump in prices and the businesses do not operate with a high enough margin to absorb it themselves. They may also lack the capacity to deal with the extra administration needed for VAT registration.

It is typically these sorts of companies that are clustering below the £90,000 threshold. It may also be that as a sole trader or small enterprise they are running at near capacity just beneath the threshold and are better off staying there.

Adapting to being VAT registered

On the other side of the VAT threshold bookkeeping requirements become more onerous. Businesses must:

• Keep evidence to back up VAT invoices and receipts.
• Set up bookkeeping so VAT codes are consistent.
• Update accounts regularly – last minute or bulk updates to accounts risk mistakes.
• Enrol in Making Tax Digital.

Voluntary registration

This will not be on everyone’s radar but has some benefits. Companies investing heavily in equipment and start-up costs will be able to reclaim VAT on these purchases – up to four years before registration in the case of goods and for services up to six months before registration.

Another smart move is to register just before any major capital expenditure. The VAT can be recovered immediately after purchase.

How to make being VAT registered easier

HMRC offers a simplified VAT regime to smaller businesses. In most cases they can join the Flat Rate Scheme if annual taxable turnover is £150,000 or less excluding VAT but have to leave if income exceeds £230,000 including VAT.

The scheme is appealingly straightforward. Instead of VAT having to be calculated on every sale and purchase, a fixed percentage is applied to VAT-payable turnover.

Businesses are likely to benefit from it if:

• Their bookkeeping function is limited – the simplicity of the flat rate is beneficial.
• Their sector flat rate is favourable – some businesses do better than others under the scheme.
• Their input VAT costs are low – this means they are not giving up much recovery.

Companies that fall within the limited cost trader rules may well find the scheme less favourable as will those that often receive VAT refunds.

Businesses with a lot of slow payers could benefit from joining the cash accounting scheme by which they pay VAT when their customers pay them. Only companies with a taxable turnover of £1.35 million or less are eligible.

Going back under the threshold

You can deregister if turnover drops below £88,000. This could allow you to improve your margins or keep pricing stable. It is an attractive option if most of your customers are not VAT registered, also if you do not pay much input VAT. However, HMRC can challenge deregistration applications so make sure they are based on accurate figures.

When it is not worth deregistering

Scenarios when deregistering may not be a good idea include:

• Having VAT-registered customers. Charging them VAT will not have much impact on your business.
• Higher input VAT costs. If your business buys in a lot of stock or subcontractor help or VAT-rated services you won’t want to lose your ability to recover input VAT costs.
• Anticipated growth. If you think you will shortly go back over the threshold, the disruption and administration of changing VAT status is unlikely to be worth it.

Is the threshold likely to change?

The Office for Budget Responsibility estimated the annual lost turnover through the VAT cliff edge distortion was £350 million in 2023. In theory, therefore, adjusting the threshold would be beneficial – if it was raised businesses would be incentivised to grow and if reduced the government’s tax take would increase.

However, the Treasury is against raising the threshold because of the loss of tax revenue entailed.

And although a lower threshold, say £30,000, would remove the perverse incentive of the current threshold it would increase administration costs on those least able to bear them and discourage entrepreneurialism. Also, of course, many prices would immediately jump, which is bad for inflation and consumers.

A third possibility is a smoothing mechanism by which businesses just over the threshold would be able to keep back some of their VAT payments to HMRC. This also is unlikely because it would increase tax collection costs while reducing how much is collected.

However, at some point a policy response may be forced on the Treasury. Last year the number of firms earning under the VAT limit increased to 683,700 from 671,000 the year before, according to HMRC data. Over the same year, the number of companies earning above the threshold of £90,000 and up to £150,000 fell to 280,400 from 306,000.

The figures indicate behavioural distortions among business owners to avoid VAT registration. If these trends continue, the lost growth will become too big a problem for the government to ignore.

But, for now, it looks as if we will continue to see companies bunching under the VAT threshold, wrestling with the decision of going over it and registering for VAT or staying under it knowing they are choking off growth, and turning away orders and customers.

If this sounds like you and you would like expert, tailored advice on the pros and cons of registering your business for VAT, please contact Finsbury Robinson. We offer a full suite of tax, accounting and business advisory services, and our friendly and highly experienced team is available on 020 8858 4303 or via email at info@finsburyrobinson.co.uk