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VAT threshold has resulted in UK tax system kinks

VAT threshold has resulted in UK tax system kinks

By Vanessa Houlder

Government adviser says many small business owners seek to keep turnover below £85,000

The passenger lists of cruise ships are swollen with entrepreneurs taking time off to avoid being snared by the value added tax system, says a government adviser.

Many small business owners go to extreme lengths to keep their turnover below the £85,000 threshold at which they have to charge 20 per cent VAT on all their sales, said an expert advising Whitehall how to simplify the system.

Paul Morton, tax director of the Office of Tax Simplification, said the steps taken to keep turnover below £85,000 often included shutting shop for a month, deciding not to let an extra room in a bed and breakfast and going on holiday. “We hear that cruise ships are full of people staying below the VAT threshold,” he said.

Mr Morton said companies selling to consumers often had to absorb the extra VAT charge as they competed with rivals whose sales were below the threshold. He described the situation, which could leave a trader £17,000 worse off after crossing the threshold, as an “impediment to growth”.

A study of tax audits in 2000-10 by the Institute for Fiscal Studies found that bed-and-breakfast owners typically failed to disclose more than half their income.

The OTS, an independent office of the Treasury, will shortly publish a report setting out three options for reform.

A significant increase in the VAT threshold would stop it being a barrier to the growth of small businesses, but the UK already has one of the highest VAT thresholds in the world, except for Singapore.

If the UK were to increase its VAT threshold to Singaporean levels of about £500,000, the OTS estimates this would cost £3bn-£6bn in tax revenues.

Another option would be to slash the threshold to near that of other European countries — but a reduction to £26,000 would bring a million businesses into the VAT system, increasing their administrative burden.

A third option would be to introduce a smoothing mechanism that would allow businesses that crossed the threshold to retain some of the revenues they collected.

Mr Morton warned, though, that this may not be viewed as a simplification. “We are keen not to become known as the Office of Tax Complication,” he said.

He said it was the first time VAT had been looked at since 1973, even though VAT had become more complex since.

Most problems arose because the UK has four VAT treatments: the 20 per cent rate, the 5 per cent reduced rate, a zero-rate and exemption. Mr Morton said the strangest quirk he had come across was the decision to zero-rate children’s clothes made of goats’ skin, unless it came from Tibetan goats.

Another notable anomaly was the zero-rating for gingerbread men for VAT purposes if they had chocolate eyes. But if the gingerbread was covered with more chocolate, including, say, chocolate trousers, it would be standard rated. The distinction is rooted in an idea that everything sold by the local baker should be zero rated. Decades ago, high street bakers did not have the technology for complicated decorations.

Some extra complexity arose because VAT was built on the foundation of the former purchase tax, introduced during the second world war. Mr Morton said this was why strawberry drinking powder was taxable while drinking chocolate was zero rated.

“We think those are very good illustrations of how VAT has not kept pace with the world,” Mr Morton said.

He said Brexit would give the government more options for reform.

Changing VAT rates is likely to be difficult because people think that zero rates on children’s clothing and some basic foods help consumers with low incomes. But Mr Morton said zero-rated goods often had similar prices to the items next to them. “You wonder if the tax differential benefits anyone other than the producers.

”There have been several disputes with companies keen on favourable VAT treatment. The most famous was a 1991 dispute over Jaffa cakes. Jaffa maker McVitie’s successfully defended its classification as tax-free cakes by arguing that Jaffas went hard when stale like a cake, while biscuits, which are taxable, go soft.

Another dispute involved Pringles. Procter & Gamble said their “mouth melt” taste, and “regular shape” were not found in nature, so they should not be taxed like potato crisps, However, the appeal court ruled that it had “more than enough potato content” to qualify for the tax. 

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