Data suggest UK businesses restricting growth to avoid VAT registration

Information obtained from HMRC suggests that an increasing number of UK businesses are intentionally restricting their growth to avoid crossing the VAT registration threshold of £85,000. This is the point at which they would need to charge VAT on the goods or services they sell.

According to data from 2018-19, the most recent tax year for which such statistics are verified, around 26,000 sole traders, companies, and partnerships are potentially holding back their turnover to remain outside the VAT system.

These statistics were acquired through a freedom of information request submitted by Dan Neidle, a tax specialist and founder of the independent think tank Tax Policy Associates.

The data shows a dramatic cliff-edge decline in the number of sole traders at the VAT registration point, dropping from over 8,500 to below 3,000. Similarly, the number of companies below and above the threshold plummets from around 10,000 to 6,500.

These figures represent a marked difference from four years earlier, when the VAT registration threshold was £81,000. In the 2014-15 tax year, there was a more modest decline of around 3,500 sole traders and 2,000 companies at the registration threshold.

Why do businesses avoid VAT registration?

The incentive to cap annual turnover just below £85,000 is due to the pricing consequences, complex compliance requirements, and administrative burden of being subject to the VAT regime. Whilst registration does offer significant benefits to many firms, it is simply more of a hindrance to others.

Upon reaching the threshold, businesses have two choices – increase their prices by up to 20% to account for VAT (and risk losing sales) or keep their prices the same and cover the VAT themselves. If customers are unwilling to pay the higher prices, their profits take a hit either way, so they choose to suppress turnover instead.

Research conducted by Ipsos MORI for HMRC reveals that 20% of non-VAT registered businesses take steps to avoid crossing the threshold. The HMRC report states that:

“Businesses restricted their turnover in several different ways (sometimes illegally), with the most common being closing the business or stopping advertising (47% of those restricting turnover admitted this), refusing or turning down work (21%), asking customers to purchase materials (16%), reducing prices of products to ensure the VAT threshold is not reached or splitting the business by operating as a separate legal entity or artificially separating the business by product or service (both 10%).”

Whilst avoiding VAT registration is undoubtedly worthwhile for some businesses, the volume of those doing so is causing the UK to lose out on a great deal of VAT revenue.

Perhaps more importantly, however, is that suppressing turnover limits the growth potential of these businesses and exacerbates the UK’s stubbornly low productivity levels.

Given that the VAT threshold is due to remain frozen until March 2026, the Office for Budget Responsibility (OBS) expects the number of firms capping their turnover to reach 44,000 in that time.

What’s the solution?

Rather than the smooth pattern one would expect to see, the current VAT regime distorts behaviour by creating a ‘bunching’ effect just before the £85,000 threshold, followed by a significant decline in business numbers just after that point.

Due to the high registration threshold, this issue is more acute in the UK than it is in other EU countries, where the average VAT threshold is around £30,000. In light of the resulting problems, there are numerous calls on the government to reform and simplify the UK’s current VAT regime.

Anita Monteith, tax technical lead and senior policy adviser at the Institute of Chartered Accountants in England and Wales (ICAEW), believes that lowering the current threshold would help SMEs and startups to cope with VAT registration.

However, to encourage suppressed economic activity, the Federation of Small Businesses (FSB) recommends raising the VAT taxable turnover threshold from £85,000 to £100,000. According to the FSB, this solution has the potential to facilitate the growth of 1.4m businesses.

In addition to this measure, the FSB supports the suggestion by the Office of Tax Simplification (OTS) to introduce some form of ‘smoothing mechanism’, which would ease the immediate VAT liability of businesses when they cross the registration threshold.

The reality is that there is no perfect solution. Gabby Donald, Chair of the Chartered Institute of Taxation’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.”

“The OTS identified several potential smoothing mechanisms in its 2017 VAT Simplification Report, 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.”