Part One: What’s all the fuss about?
Last year I went on a bit of a rant about HMRC’s decision to pursue Garsington Opera Company about their application of the standard partial exemption method. This is, of course, the fall back method for all partly exempt businesses and in many cases provides a very simple way for establishing that most of them are entitled to recover all of their input tax without much hassle. And so it should be.
The problem is that this method is so full of potential difficulties that many accountants assume that because it’s the “standard” method, it’s also the “simple” method. Nothing could be further than the truth. And why is this? There are two main reasons.
• First the legislation is full of subjective terminology that can lull taxpayers into a false sense of security – as an example the meaning of the term “incidental” has been the subject of several VAT Tribunal cases over the years.
• And second, even when you think that something is factually very straightforward in practical terms, such as direct attribution, HMRC might just disagree.
The final part of the mix is that if the normal value based standard method for apportioning residual input tax doesn’t produce a result which is “fair and reasonable”, the legislation requires businesses to use an apportionment based on “use”. So what does “fair and reasonable” mean and what on earth is a “use-based” method?
As a VAT consultant with over 25 years experience, I find the subject of partial exemption challenging. What really concerns me is that many businesses – and their accountants – follow the “simple” standard partial exemption method without appreciating just how many potential pitfalls lie within it. Of course you can’t allow yourself to get too bogged down by the theory and details every time you do a VAT return or a partial exemption calculation, but you have to be aware of the potential problem areas in case they could apply to your situation.
In this article, I’ll be looking at the main partial exemption principles of direct attribution and the standard method for calculating the recoverable proportion of residual input tax. I’ll explain the potential problem areas in what would seem to be straightforward situations.
Back to basic principles
Let’s start with the basic principles of partial exemption and how the standard method works.
Any partial exemption method begins with the overriding principle that wherever possible, input tax should be directly attributed to taxable or exempt supplies. Input tax that is attributable to taxable supplies can be recovered, whilst input tax which is directly attributable to exempt supplies (ie “exempt input tax”) is, in principle, irrecoverable unless the amount incurred by the VAT registered person falls within the “de minimis” limit – of which more later – or falls into certain limited categories that can be disregarded.
Input tax that cannot be directly attributed to either taxable or exempt supplies must be split between the two classes of supplies by using either the values based standard method or by a special method based on other criteria which is agreed in advance and in writing with HMRC. So the difference between the two methods is simply the way in which the residual input tax is apportioned.
Special methods can involve anything from a slight variation on the standard method to a complex cost/profit centre approach with different calculations for different parts of the business. My favourite was always the one based on different colour bunny tails – a staff count method used in a casino to differentiate between taxable food and drink and exempt gaming income! Probably the only colour or animal based method I’ve come across over the years, although I am sure that there are others based on similarly unusual criteria!
Standard or Special?
So how do you decide whether to use the standard method or apply to use a special method? It’s not necessarily the size of the business that matters. In fact I’ve known many very large businesses who successfully use the standard method because their accounting systems allow them to directly attribute most input to tax to either taxable or exempt supplies, so the residual input tax is a relatively small amount and the values based method in their business is very straightforward.
Businesses typically opt for a special method if they have had repeated problems with the use of the standard method. Ask any VAT consultant and they will have clients using the standard partial exemption method who have been in dispute with HMRC about the application of the method several times over the years. It’s one of the main reasons that we recommend the use of special methods for businesses with anything other than a very simple partial exemption profile. Applying to use a special method minimises ambiguity as any terminology can be defined in the written agreement method so there are less areas of potential dispute. Of course there is an upfront cost in terms of time and professional fees, but it can save an awful lot of hassle in the longer term.
But most businesses should not have to go to the time and cost of agreeing a special method. The standard method should be fine, as long as you and your accountant are aware of the potential pitfalls.
Some Other Partial Exemption Issues
So where do we start?
• Directions and Overrides
HMRC have certain powers to deal with taxpayers whose use of the standard partial exemption method does not, in their opinion, produce a “fair and reasonable” result. These include directing taxpayers to use a special method, or, more commonly for larger businesses, the use of the “standard method override” where the law gives them special power to remove entitlement to use the standard method and use a method which gives a more “fair and reasonable” for the year in question.
The override applies when the input tax recovered using the standard method differs substantially from the input that would be recoverable if the business applied a “use based” method instead. “Substantial” means either £50,000 or 50% of the residual VAT incurred and £25,000 in the VAT year in question.
The problem for all businesses is how to establish whether or the use of the standard method gives a result that is “fair and reasonable”. HMRC does give examples of when they consider that a result isn’t “fair and reasonable”, but I’m betting that most accountants of SME businesses wouldn’t be aware of when such an issue might arise. These articles are written with you in mind, to help you to be aware of such situations.
• Developing Caselaw
The next point is that partial exemption – including the application of the standard method – is one of those areas of VAT which is the regular subject of appeals to the Tribunal and Courts. Accountants can’t be expected to keep on top of this subject in any detail but if you have a difficult situation it may be worth taking some advice from a VAT consultant to find out if there have been any recent developements that could affect your approach to the issue.
• Industry Sector Agreements
Finally, several different industry bodies in specialist sectors have agreed partial exemption methodologies with HMRC – including Opticians, Universities, Social Housing, Leasing sectors and others so it’s always worth finding out if you could save time and money dealing with industry specific issues by using one of them. These are very helpful for the sectors concerned, see VAT Notice 700/57: Administrative Agreements with Trade Bodies for further information: http://tinyurl.com/39y7gwa
HMRC Guidance
And what about the HMRC guidance on partial exemption?
The HMRC guidance on the subject is concerned in VAT Notice 706: Partial Exemption. It is a good document, well written and with lots of helpful information. But like a lot of tax guidance you really need to have a good basic knowledge of VAT to be able to follow the guidance and know which bits are relevant to your circumstances. And as so much practice relating to the partial exemption standard method is based on developments in caselaw, a lot of the guidance really has to be “handled with care”.
And finally a few words about the “De Miminis” rule.
The Least Cost Effective Tax Calculation in the World?
In my opinion, the “De Minimis” rule has got to be the least cost effective bit of tax legislation in the world. If your exempt input tax is less than £7,500 and 50% of all input tax in a VAT year, you can claim it all back. That’s the rule. But what a palava you have to go through to work it out.
First comes direct attribution. Once you’re established the value of directly attributable exempt input tax, then you have to carry out the residual input tax apportionment calculation to work out how much of this input tax is attributable to exempt supplies.
So where do you start? Here’s the basic rule: residual input tax is apportioned according to the proportion that the business’s taxable supplies bears to the business’s total supplies.
So we all know the basic principle, but are you certain you know what should or shouldn’t be included in the figures? Income from certain “incidental” supplies can be excluded, but how do you know what “incidental” means?
The “de minimis” rule is supposed to be a simple rule but many accountants, particularly those who only occasionally have to deal with partial exemption, aren’t particularly confident with the subject. They might end up paying for advice from a VAT consultant to decide what should or should not go into the residual input tax calculations and then end up finding that the exempt input tax exceeds the de minimis limit, so they loose the input tax concerned AND end up with a bill for sorting it out! And sometimes in more complicated situations, the cost of the consultant’s time is more than the input tax involved never mind the time involved for the businesses themselves.
• Not worth the cost of getting it wrong?
Partial exemption and in particular the apportionment of residual input tax can be most difficult for those businesses who aren’t “large” in partial exemption terms, generally those whose annual exempt input tax is £50,000 or less a year. There is no typical partial exemption “profile” for such businesses, but a good example would be manufacturing groups who lease old properties and have to work out whether their exempt input tax falls within the “de minimis”, or financial advisors whose income is made up of taxable consultancy fees and exempt commissions.
So I’m never surprised when accountants tell me that some businesses don’t even bother to carry out the standard method apportionment and don’t recover any residual input tax at all because it’s not worth the hassle of getting it wrong.
This is a ridiculous situation for a business to be in – not even bothering to consider claiming input tax simply because of the potential hassle of getting the calculation wrong.
So that’s our starting point for the subject. The method is straightforward in principle, but you need to be aware of the potential pitfalls when using it.
In the next couple of articles, I’ll be discussing direct attribution, what’s fair and reasonable, use-based methods and what’s incidental for the purposes of the standard method.