Commercial and Systems Implications of the 20% VAT Rate - Making the Most of the Change

As George Osborne and the UK coalition has decided to raise standard VAT to 20% from next January, "usefully" on 4th January rather than on 1st , at least we have the chance to prepare properly for the rate change.

The situation is rather different from the previous reduction to 15% and reversal back to 17.5%. With only a few days' notice of the original 2008 reduction, retailers in particular took a number of short-cuts to avoid physically re-pricing their goods.

This time the increase comes first, and there's no current intention of a reduction during the remainder of this parliament. The increased VAT is by far the largest component of the tax increases to achieve debt reduction - see page 40 (page 47 of pdf) of the Budget 2010 "red book" - and is better in line with VAT rates around Europe

Commercially

For many businesses, VAT paid on purchases is recoverable in full. The rate increase only produces a small change in net cash flow, positive or negative depending on the relative levels of sales and purchases.

But VAT is an extra cost for:

• Consumers
• Small businesses that are not VAT registered or use something like the flat rate scheme
• Larger businesses that are exempt or partially exempt (as is common in the financial services and social housing industries)

Businesses selling to consumers (and businesses which cannot directly claim all the VAT) will need to make critical pricing decisions. It's worth noting:

1. If the seller passes on the full 2.5% VAT increase to customers, prices will increase by only 2.1% (120/117.5)
2. If the seller absorbs the increase in full:

• Revenue net of VAT will also fall by only 2.1%
• From a 30% current GP%, gross profit would fall 7% and GP% by 1.5% to 28.5%
• At lower margins, gross profit falls are far more significant - at a current GP% of 10%, GP would fall 21%, even though GP% would only fall 2% to 8%

In many cases retailers will split the difference in some way, especially if they use "phychological price points" such as £9.99 and 99p. The VAT rate change will be another factor in setting an appropriate price.

Furthermore the proportion of VAT in a VAT-inclusive value will increase from 14.9% to 16.7%, which is relevant when claiming VAT on purchases, especially in employee expenses systems.

Consequences for Systems

The UK software industry had been lulled into a false sense of security. The standard VAT rate had remained at 17.5% for so long, many financial and retail software packages had been written after the last change. Few if any financial packages had been properly designed to cope with either a reduction or an increase, especially if happening part way through a quarterly or monthly VAT accounting period.

The two main ways of applying a change in the standard VAT rate, both of which had significant drawbacks, were:

1. Add a new rate code - but this produced problems, such as with existing orders
2. Change the rate of an existing code - but this produced problems such as with VAT reporting, and with some existing orders
   

Where sales invoicing, accounts receivable and general ledger were in two or more different integrated systems, the problem was worse.

In retailing, many retailers such as M&S opted to apply an extra 2.1% discount at the tills to scale down standard-rated goods by 115/117.5, and avoid re-pricing goods on the shelves. An increase of 2.1% at the tills is not going to cut the mustard come next January.

At least this time the software industry and users have time to produce a more appropriate approach. Issues to tackle include:

1. Reporting at two different rates within a single quarterly or monthly accounting period
2. Applying the new rate to sales orders in progress (including where cash deposits have been received), monthly billing and billing of "continuous services" such as telecoms
   
3. Equivalent changes in purchasing, self-billing, standing orders and direct debits
   
4. In purchase invoice entry and employee expenses systems, apply different rates to VAT-inclusive costs during the transition period
5. Issuing and receiving credit notes
   
6. Sales pricing which is VAT-inclusive in retail and "etail" systems
7. Quotation systems, whether VAT-inclusive or VAT-exclusive, where words and/or prices will need amendment
   
8. Forecasting and budgeting systems to reflect pricing and rate changes
9. Management reporting, if VAT rate has an impact (such as back-calculating revenue from VAT-inclusive income)

Users will also need to look at:

1. User procedures, especially relating to the transition period in the weeks before and after January 2011
2. Checklists for the transition period
3. Readiness of any cloud SaaS services you use. VAT compliance remains your own responsibility. Errors can be expensive in terms of penalties! Who's going to do what?
   

Whilst the rate increase is somewhat different from the 2008 decrease and subsequent increase, both in terms of principles and practical actions, the articles below from those periods will give more of an indication of the types of issues to be addressed.

Future articles will be looking at commercial and practical issues of the forthcoming rate increase, especially where systems are involved.

If suppliers or users would like to leave a comment about how your specific software or SaaS service is going to help cope with the rate change, please do.

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