Frozen VAT Threshold – The Chilling Effects on SMEs and HMRC’s Stalemate – Just the Tip of the Iceberg

Frozen VAT Thresholds and what they mean for your business

As we usher in 2024, the economic landscape echoes with the strains of change. However, amidst rising costs of living, inflation, and a general uptick in expenses, a stalwart aspect remains frozen in time – the VAT threshold.

The VAT threshold has historically risen in line with inflation. However since its introduction at £85k in April 2017, it has remained frozen. Initially set for two years until 2019-20 in the Autumn Budget 2017, this freeze was extended for two more years in Budget 2018, then another two years in Spring Budget 2021, and most recently, two more years stretching it until 2025-26 in Autumn Statement 2022.

The prolonged freeze fails to account for the escalating costs of running a business, pushing profit margins to their limits, thus becoming a barrier for businesses aspiring to expand, invest, or adapt the evolving market dynamics. In essence, the freeze inadvertently hampers the very essence of entrepreneurial spirit, posing a formidable challenge to the sustained growth and vitality of these small enterprises.

The Office of Budget Responsibility (OBR)’s March 2023 report notes 44,000 businesses will cap their turnover to avoid reaching the VAT threshold. This indicates a significant increase from the 23,000 reported by The Office of Tax Simplification (OTS) in 2017-18, highlighting the issue of ‘bunching,’ where businesses deliberately restrict growth to remain just below the £85,000 turnover threshold.

The impact of inflation extends beyond the visible price hikes, affecting the VAT Threshold. The £85K trigger point now holds an equivalent value of only £73K compared to just a year ago. In practical terms, for a business to match its earnings in inflation-adjusted terms from the previous year, the turnover must reach £115K. However, this surpasses the VAT registration threshold, necessitating a turnover of £138K.

Chancellors tactically employ fiscal drag to quietly generate additional revenue for the Treasury, a method supported by studies from the OBR. The VAT Threshold freeze, a manifestation of this approach, poses challenges for SMEs grappling with rising costs of materials and utilities. Absorbing these expenses prompts businesses to adjust prices, hastening their approach to the VAT registration threshold.

While the UK’s at £85k VAT threshold is significantly higher than the EU and OECD (Organisation for Economic Co-operation and Development) averages, altering it risks revenue loss for HMRC, or, conversely, a sudden imposition on smaller businesses. Striking a balance is essential, as freezing the threshold offers a longer-term solution but requires years to address the current challenges.

The UK’s notably high VAT threshold is commonly touted as an advantage for small businesses, allowing them to offer more competitive prices compared to their VAT-registered counterparts. The observed clustering of businesses below this threshold does indicate a competitive edge, but the question arises: at what cost does it transform into a hindrance, impeding future growth? Furthermore, does it lead to a scenario where these businesses neglect maintaining comprehensive business records for purposes beyond VAT compliance, such as income tax or corporation tax?

Once businesses breach the threshold and register for VAT, they gain the ability to reclaim VAT on eligible costs. However, the challenge arises as they may not feasibly add a 20% increment to their prices, necessitating them to absorb a portion of the VAT cost themselves. This predicament is most pronounced in the business-to-consumer (B2C) sector, notably affecting domestic service providers like plumbers, hairdressers, small restaurants or Bed & Breakfasts.

Businesses of this nature may actively resist VAT registration to avoid potential loss of customers that could result from a 20% increase in sales prices compared to their smaller, non-registered competitors, such as not accepting contracts at the end of the year, closing the shop for a month or even go as far as not recording their sales correctly (and illegally!).

HMRC may be grappling with the challenge of striking a balance to make the VAT threshold palatable for both themselves and small businesses. Even in a healthier economy, relinquishing substantial revenue as a disincentive to growth, regardless of business size, may not seem an appealing option. Simplifying the VAT system and mitigating the ‘cliff-edge’ effect when surpassing the threshold could be avenues worth exploring.

For businesses reaching dangerously close to that cliff-edge, finding a solution is likely a pressing concern. Fortunately, options are available for those in this predicament, but proactive planning is essential. Especially with no imminent changes anticipated for the future, the most prudent course of action is to plan ahead and be patient. If you would like to better understand your options, do not hesitate to get in contact, and we will do our best to advise you with a solution.

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