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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Preparing for 1 January 2010

On Friday 1 January 2010, the VAT rate for standard-rated goods and services changes back to 17.5% from the temporary rate of 15%. This posting summarises the general principles you’ll need to consider, especially as apply to your financial systems.

Whilst there are similarities to the reduction in rate in December 2008, the increase does raise some new practical issues. Errors could be costly.

How and when you change the rate therefore needs careful consideration. In many cases you will only need to make a configuration change to your software. But in some cases you will require a change or upgrade to your software, especially if you trade with other EC countries due to other rule changes on 1 January.

Advice from HMRC on the tax rules is given at http://www.hmrc.gov.uk/vat/forms-rates/rates/rate-changes.htm . Detailed advice is given at http://www.hmrc.gov.uk/vat/forms-rates/rates/rate-rise-guidance.pdf . If you are unclear or uncertain about specific situations, advice should be sought from HMRC or your professional advisors.

The key points are:

1. SALES

• You will need to charge 17.5% on standard-rated supplies made on or after 1 January.
  
• If you have received a cash deposit prior to 1 January, you provide continuous services, or the sale / service in some way spans that date, consult the HMRC advice above.


• Pricing, pricelists, terms and conditions, and quotation systems will need amendment as appropriate.
  
• VAT-inclusive prices will need to rise by 2.17% (=1.175/1.15), rather than 2.5%, if you simply want to pass the increase on to customers.
  
• Retailers and etailers who account for a proportion of VAT-inclusive sales as VAT will need to account for 7/47 (=0.175/1.175) on sales from 1 January
  
• For sales invoices, if VAT is added at 15% in error, HMRC suggests a credit note needs to be issued and a new correct invoice raised at 17.5%. If it is not practical to recover the extra VAT, this will cost you some 2% of your revenue, depending on how the situation can be best resolved.
  
• Credit notes should be issued at 15% when applying to earlier invoices raised (correctly) at 15%. The same applies to cash refunds and bad debt relief, where the sale was originally at 15%.
  
• Special rules apply to certain businesses and the VAT accounting schemes such as cash accounting. Check HMRC's guiidance above to see which apply to you.
  
  

2. PURCHASES AND EXPENSES

• In early 2010, you’ll be receiving a mixture of invoices at 15% and 17.5%. Ordinarily you will claim the amount on the invoice.
  
• For till receipts where the amount or the rate of VAT is not specified, VAT should be claimed at only 3/23 on those dated up to 31 December 2009, and 7/47 thereafter.
  

3. VAT RATES ON YOUR FINANCIAL SYSTEMS

• In some systems you can enter the rate that will apply for specific date ranges. Otherwise there are usually two ways of adjusting the VAT rate on a financial transaction system:
  (a) Changing the rate against the existing 15% VAT code
  (b) Using a different VAT code.
  Each method has pros and cons. Advice should be sought from your software supplier as to how and when the change should be made. This advice may have changed since the introduction of the 15% rate, and will depend on how the 15% rate was implemented on your system.
  
• Where uninvoiced or invoiced sales are passed from one system to another, the right approach will need particularly careful attention.
  
• If you are using web-based/hosted financial software, check whether you or the host will be making the relevant changes, and that the changes will be made appropriately at the right time
  
• Watch out for sales orders entered in 2009 that are not supplied until 2010, to ensure the 17.5% rate will apply. Your software supplier may need to provide you with a software utility to automate this process.
  
• For recurrent charges, check what needs to happen for sales invoices, direct debits, etc. Likewise what will happen to costs set up as recurrent.
  
• For 24x7 online webshops, the method and timing of making the VAT rate change will need particularly careful consideration
  
• Watch out in 2010 for the other special situations mentioned above, such as raising credit notes against 2009 invoices, and claiming VAT on 2009 purchases (including staff expenses systems)
  
• Check that VAT reports show the correct VAT amount for transactions before and after 1 January. If necessary manual adjustments will need to be made to VAT reports used for VAT returns.
  
• For businesses trading with other EU countries, the rules for VAT on the supply for services is changing from 1 January, as is the format, content and frequency of the EU sales list. You may need a software upgrade.
  

4. MANAGEMENT REPORTING

• Many management reports will be unaffected by the rate change, but all should be checked for any VAT rate implications
  
• In particular any reports, such as spreadsheets, that back-calculate revenues and costs from VAT-inclusive figures will need a different rate for different time periods.
  

5. FORECASTING

• Likewise cash flow and other forecasts that span the forthcoming year-end should ideally have two different VAT rates
  

Further notes written for the rate change to 15% in December 2008 are given in the 2008 postings below.

If I can be of further help, do contact me (see "About Me" to the right).

Impact on reporting

If you've changed the VAT rate in a system by over-typing, as distinct from setting up a new rate, there's a key risk. VAT figures and associated revenue and costs prior to 1 December could get re-calculated.

Worth checking - what impact has there been in:

1. VAT reporting in core transaction system(s)?
2. Reporting in spreadsheets and other user-written systems?

One week on

Now the new 15% standard rate of VAT has been in place for a week, what does a business need to do?:

1. Have all transactional accounting systems been updated, such as invoicing, order processing, tills, staff expenses and accounts payable systems?
2. Have all reporting and planning systems been updated?
3. Have VAT-inclusive prices been adjusted, or otherwise dealt with, wherever they appear?
4. Have existing orders, recurrent sales invoices and recurrent costs been adjusted?
5. Have orders and services paid for but not supplied in full by 30 November been identified and addressed?
6. Have items supplied before 1 December but not invoiced been identified and addressed? Likewise cash receipts not receipted?
7. As a supplier: Have any invoices (as distinct from till receipts) been produced at 17.5% when they should be at 15%? A credit note for the difference should be produced and sent to the customer. Otherwise the full 17.5% will need to be paid over to HMRC.
8. As a customer: Have you spotted supplier invoices with 17.5% VAT that should have been with 15%? HMRC suggests requesting a credit note in each case and only claiming the 15%. If the error isn't spotted, then HMRC will usually accept a claim for the VAT amount on the invoice.
9. But till receipts issued on or after 1 December should only have VAT claimed at 3/23 (15/115) of the total amount paid for standard-rated items, regardless of what is detailed on the receipt.

Further details below.

VAT on supplier invoices - processing incorrect VAT

Over the next few days and weeks, businesses will receive invoices with a mixture of 17.5% and 15% VAT. In general the VAT amount analysed on the supplier's invoice should be recorded, to match the supplier's record of invoices raised .

But what if you spot that 17.5% has been charged when only 15% is appropriate?

HMRC have said:

1. Only 15% should be claimed as input tax. You may ask your supplier to provide you with a credit note for the over charged VAT.
2. But when auditing businesses, they will usually accept a claim of 17.5% as they "will assume that the supplier has followed the accounting documents unless there is good reason to suppose otherwise "
   

Pending receipt of a requested credit note, one option is for the customer to record a dummy credit note to reduce the amount claimable, and reduce the amount payable to the supplier. This can be reversed if the original invoice is found to be correct.

Likewise if a supplier notices that invoices were raised at 17.5% which should have been 15%, they should raise a credit note and notify their customer. Otherwise the full 17.5% should be accounted to HMRC as output tax.

Clearly it is in everyone's interests to avoid such problems. It's worth raising invoices right first time.

Existing sales orders and recurrent invoices

When using a system to add products or services onto a sales order or recurrent invoice, the VAT code and possibly applicable VAT rate are often recorded automatically ready for invoicing.

For sales orders and recurrent invoices set up prior to 1 December, this can result in subsequent invoices being raised with VAT of 17.5% instead of 15%.

Depending on how the system works, and whether a new VAT code has been set up for the new rate, you may need to adjust un-invoiced sales orders and recurrent invoices set up prior to 1 December.

Sales spanning 1 December

HMRC have published new guidance, including further detail on sales that span 1 December. See http://www.hmrc.gov.uk/pbr2008/measure1.htm

Key points:

(1) Will you be invoicing in December for goods and services provided (or cash received) before 1 December?

There are specific rules, including an extention from 14 to 30 days for certain invoices.

(2) Did you invoice or receive cash for products or services that hadn't been supplied in full by 30 November?

In this case you can optionally refund the change in VAT, often just by issuing a credit note.

Where you supply "continuous services" such as maintenance or membership that have been prepaid or invoiced in advance, the relevant portion of the VAT can be optionally refunded.

(3) Do you provide services under quarterly or monthly instalments?

If these qualify as "continuous services", instalments on or after 1 December should be at the new rate of 15%. Recurrent invoices and direct debits should be changed.

Items dated 1 December may well be incorrect, and require adjustment.

(4) When you claim VAT on till receipts issued on or after 1 December, this should be at 3/23 of the VAT-inclusive value of relevant items regardless of the VAT amount shown on the receipt. This is because HMRC acknowledge that not all retailers will have been able to adjust their tills by 1 December.

You can continue to claim 7/47 on receipts dated prior to 1 December.