Cruel dilemmas for small businesses over frozen VAT threshold

The Chartered Institute of Taxation (CIOT) says that the announcement that the Government will freeze the VAT registration threshold of £85,000 until at least March 2026 will put more pressure on small businesses.

The VAT registration threshold historically increased every year in the Budget,¹ broadly in line with inflation, but has remained stagnant at £85,000 since 1 April 2017. This changed directly following the 2017 Office of Tax Simplification (OTS) VAT simplification report² which highlighted a ‘bunching’ of businesses,³ particularly sole proprietors, just below the VAT threshold, with a drop off in business numbers just above the threshold. In summary, some business owners choose not to grow, rather than go above the threshold.

This change of policy has led to a steady increase in the number of businesses in the VAT system.⁴ Had the inflationary increases continued, the threshold from April 2023 would be around £103,000, some 20 per cent higher.

Gabby Donald, Chair of CIOT’s Indirect Taxes Committee, said:

“The Government faces a dilemma over the VAT threshold. A higher threshold costs significant revenue and is a deterrent to growth. But a lower threshold imposes the full rigours of VAT compliance on very small businesses – remember we are talking about £85,000 turnover, not profit.

“Freezing the threshold means moving slowly from a higher real threshold to a lower one – stealthily, and at a rate largely determined by the rate of inflation. While this process lasts, there is an uncertain mix of both sets of problems. This in turn creates a dilemma for some of our smallest businesses. Freezing the VAT threshold means more small businesses will have to register for VAT, while others will be deterred from growing, lest they breach the threshold.

“While the actual number affected is difficult to estimate, in 2020-21 there were around 31,000 businesses with a turnover between £80,000 and the VAT threshold, and around 66,000 businesses with a turnover between £70,000 and £80,000.⁵ This backs up anecdotal evidence that some businesses manage their turnover in order to remain below the VAT threshold. This has the unwelcome effect of deterring business growth, as well as impacting on business owners’ living standards.

“While businesses breaching the threshold and registering for VAT will be able to recover VAT on eligible costs, they may not be in a position to simply add 20 per cent to their prices, meaning they may have to absorb some of the VAT cost themselves, so would be worse off as a result. This issue is the most acute in the business to consumer (B2C) space, particularly domestic service suppliers such as plumbers, electricians, hairdressers etc.

“It is not just the cost of the VAT itself which deters VAT registration. The VAT system can be complex, creates additional administration, and all VAT registered businesses must now comply with Making Tax Digital for VAT (a requirement that did not exist in 2017), all of which can bring additional compliance costs.

“What can be done to make these dilemmas faced by government and small businesses less unpalatable? Even if the economy were healthier, forgoing significant revenue to create a disincentive to growth – at whatever size of business – does not seem an attractive option. Can anything be done to make the VAT system simpler and reduce the ‘cliff-edge’ effect of going above the threshold?

“The OTS identified several potential smoothing mechanisms in its 2017 VAT Simplification Report⁶, which also contained other ideas for simplifying the VAT system, but we should not be limited to these. The Government should for example look closely at other countries who manage to operate a much lower VAT threshold than we do to see if there are things we can learn about how the burden of VAT administration on the smallest businesses can be minimised.

“When the previous Chancellor announced the abolition of the Office of Tax Simplification, he said that simplification would be ‘embedded’ in the Treasury and HMRC. VAT simplification for very small businesses is an early and urgent priority for these words to be translated into action.”