Everyone knows UK VAT is complicated and, for taxable persons, costly to comply with. But why is the tax so complex, and why does it often impose onerous compliance costs?

An international study conducted in 2018-19 by Australian and international universities working in collaboration with KPMG sheds some light on this question. It shows that the most significant sources of compliance burden in the UK lie in VAT policy goals incorporated in the legislation, rather than in its administration. The main areas of concern highlighted in the study include the widespread use of concessions and the simplification schemes for small businesses. 

Troublesome concessions

A major source of complexity in UK VAT is the widespread use of concessions in the form of reduced rates, zero-rate supplies and exemptions. The UK has a somewhat different rate structure from those used elsewhere in Europe, providing two positive rates (20% and 5%) plus, unusually for Europe, also extending the zero rate, commonly reserved for exports, to selected domestic supplies. In addition, the UK treats a wide range of supplies as exempt supplies, including some financial, medical and educational supplies, and some supplies of real estate, which was a mandatory requirement under EU law. 

Boundaries between supplies

The complexity and the resulting compliance burden are evidenced by the volume of costly litigation concerning the often bizarre distinctions and ambiguous boundaries between supplies subject to different rates or treatment (taxable vs exempt). The zero-rating of food has been the source of continual disputes considering arcane issues as to whether, for example, brownies, tea cakes and snowballs should be characterised as zero-rated cakes or standard-rated confectionery, or whether a manufactured potato snack, in contrast to a traditional crisp, is a type of zero-rated food. 

The definitional problems in the law are no doubt exacerbated by the constant development of new and innovative products that do not fit neatly into the pre-existing categories designed when the UK adopted VAT in the 1970s. 

Multi-element supplies

Additional costs may arise for taxpayers making bundled sales with multiple elements (with each element, had it been supplied separately, subject to a different tax treatment). In these circumstances, taxpayers have to determine whether multi-element supplies should be characterised as mixed supplies (supplies that can be severed into different components for VAT purposes) or composite supplies (supplies comprising different elements but considered to be single supplies for VAT purposes). 

Partial exemption

In addition to these costs, exemptions give rise to a further compliance burden in terms of calculating entitlement to input tax deductions when businesses, known as ‘partially exempt businesses’, make both exempt and taxable supplies. As deductions for input tax are only allowed where an input is used to make a taxable supply, these businesses must track the application of all inputs to apportion the use of inputs between taxable and exempt supplies. 

While UK VAT law provides a default standard method for apportionment, it allows, subject to the approval of HMRC, taxable persons to use an alternative method if they can show the alternative calculation will achieve a fair and reasonable result. This significantly increases compliance costs as businesses do multiple calculations to achieve the best result and the alternative methods devised by businesses are often challenged by HMRC, leading to expensive appeals. 

The Office of Tax Simplification suggested that there is scope to simplify rules regarding the standard method. But there is no easy solution to the continuing disagreements between HMRC and taxpayers over the alternative methods proposed by the taxpayers, apart from fully taxing the many exempt supplies that give rise to boundary and characterisation disputes in the first place. 

Special regimes for SMEs

Another key contributor to the compliance burden are the many special regimes in VAT designed, ironically, to simplify tax compliance for small and medium-sized enterprises (SMEs). The special regimes used in the UK fall into three main categories: 

1. less frequent filing and payments (to simplify filing and payment obligations);
2. optimal cash or payment basis accounting (to provide cash-flow benefits to small businesses); and
3. ‘presumptive’ regimes (to facilitate the calculation of VAT liability).

The flat rate scheme

As a tax simplification scheme, the third category, presumptive regimes, is particularly problematic. The flat rate scheme (FRS) is an example of such a scheme. The FRS is an optional presumptive regime that allows eligible enterprises to opt for a predetermined input tax entitlement, removing the need to record input tax on all acquisitions. A single flat rate is applied to the total (VAT-inclusive) turnover to determine the amount of tax to be remitted to HMRC. 

The rate varies across industries and is set by regulation on the basis of estimates of the average input tax entitlement of businesses making particular types of supplies in each industry. Set below the standard rate, the flat rates are designed to equal the tax that would be imposed under the standard rate less the input tax credits that each industry group would be expected to claim. A lower flat rate thus assumes an industry entitled to a greater level of input tax credits and a higher flat rate assumes that the industry would be entitled to fewer input tax credits.

The UK regime has 55 different flat rates based on different presumptive input tax entitlements. The more categories of supplies specified for presumptive input tax purposes, the more accurate the estimated tax may be. However, the greater number of categories also impacts on the complexity of the regime and the resultant compliance burden as taxable persons need to classify their supplies across many borderlines. Also, the proliferation of categories is more likely to give rise to complications for enterprises whose outputs fall into more than one industry classification or do not fall discretely into any one category. 

Because the rates are based on assumptions of average entitlements, the presumptive allowable credits are almost certain not to equal exactly the entitlement of any particular business. 

Enterprises with lower than average input purchases for their classification of business realise a benefit from the scheme while those with higher than average inputs would suffer if they adopted the simplified formula. Small businesses therefore have an incentive to calculate their liabilities both under the ordinary VAT system and the FRS, a process that inevitably increases their compliance burden, and opt in to the scheme only when it provides a financial advantage. 

The government estimated in 2016 that about 30% of the businesses that used the scheme enjoyed substantial cash benefits relative to the position they would have faced under the ordinary VAT system. In response to this, a new flat rate of 16.5% was introduced in 2017 for businesses with presumed entitlement to limited input credits. Not surprisingly, the introduction of this new rate, which aims to remove the fiscal benefits enjoyed by service providers with limited input costs, has led to a steady decrease in the take-up rate of the scheme – from 25.5% in 2016/17 to 13.7% in 2022/23.

The FRS provides an excellent example of a regime that is intended to simplify but in practice generates considerable complexity. 

Look to the future

UK VAT celebrated its 50th birthday last year. The tax was originally adopted to satisfy a condition of entry into the then European Economic Community, and to deflect political and voter opposition to the new impost, a multitude of concessions, including many rolled over from the predecessor purchase tax, were included in UK VAT. Five decades later, it has become clear that a concession-riddled tax system is particularly ill suited for a society and economy fundamentally different in all respects from that in place half a century ago. There is no doubt that removing concessions would significantly reduce the complexity of VAT. 

The complications around the use of special regimes require policymakers to take an all-round view and carefully balance simplification benefits and the additional compliance burden that would arise when considering designing simplification regimes. The UK’s experience with the FRS is largely unsuccessful and it might be worth considering abolition of the scheme in light of the low take-up by eligible businesses. 

As modern VAT systems such as those used in Singapore and New Zealand demonstrate, a largely concession-free broad-based VAT can be imposed at a much lower VAT rate. The abolition of multiple concessional regimes could open the door to a more economically efficient and less distortionary low-rate VAT complemented by a much more efficient targeted support regime for low-income persons who would be disadvantaged by a broader VAT system. 

There are, to be sure, political hurdles confronted by would-be reformers. But Brexit offers the UK a once-in-a-generation opportunity to effect real change and make meaningful reductions to the business compliance burden. 

Dr Yige Zu, Associate Professor in Tax Law, Durham University, and Richard Krever, Professor, The University of Western Australia