Input tax – what’s the use?


This is the fifth in a series of articles on the Office of Tax Simplification’s (OTS) report on the simplification of VAT and looks at input tax recovery where businesses use costs for exempt or non business activities.

Partial exemption

One of VAT’s many complexities is partial exemption – the process for determining how much input tax can be recovered by a business engaged in both taxable and VAT exempt or non business activities. The central concept is to determine how each input is “used” or, in practice, to determine a “fair and reasonable” proxy for such use. The default mechanism is income in the year in which the cost was incurred but alternative approaches are possible. A business may opt to agree a “special method” with HMRC for example to deal individual with different divisions of a complex business. Furthermore, any business using the default “standard” method must each year test whether income does accurately measure “use” and make an adjustment if it doesn’t . This seems to run counter to the principle of the use of income as a proxy.

The OTS report noted the following areas of particular difficulty:

  • “De minimis provisions” – These allow businesses to ignore small amounts of irrecoverable input tax.
  • Special methods –  That these are hard and time-consuming to agree with HMRC

De minimis provisions

The UK’s partial exemption framework contains “de minimis” provisions to allow businesses with very little exempt activity or very small businesses with low monetary values of irrecoverable VAT  to recover all their input tax. However, in most cases the business still has to do the calculation in order to prove it falls within these provisions, thus defeating the object of the simplification. This is in part due to the fact that the monetary limits for full recovery have not changed since 1994.

The OTS makes a number of suggestions to address this:

  • Allowing levels of exempt activity of less than say 5% to be ignored by small businesses
  • Allowing businesses with small amounts of input tax to recover it all without then need for a calculation
  • Increasing the monetary de minimis limit in line with inflations
  • Allowing flat rate recovery rates based on sectors

These proposals are all helpful suggestions for small businesses where the complexity is out of all proportion to the tax impact.

However the report does nothing to address the practical issues faced by larger businesses which earn small amounts of exempt income – for example retailers or travel businesses which offer credit, insurance or foreign exchange to their customers and earn commission from the providers. This activity means that these businesses have to identify each amount of input tax and the cost to which it attaches so that a decision can be made as to which activity it relates.  This is something most accounting systems are not configured to do. For such businesses the result is often a very complex process resulting in very little disallowance of VAT.

Special methods

Currently a special method has to be individually negotiated – however small the business and even where it may contain only minor variations to the standard method. The OTS makes a number of suggestions to streamline this process. One is the increased use of published frameworks of what is acceptable for certain sectors so that a business could adopt this method with confidence that it would be acceptable. Another is to remove the approval process so that a business could adopt the method without approval but with the subsequent right of review by HMRC.

This has some parallels to the retail scheme framework where smaller businesses can use a published scheme and only the largest businesses have to agree a bespoke arrangement with HMRC.

Capital goods scheme

Partial exemption addresses recovery of input VAT based on activity in the year the cost was incurred. Where the VAT relates to a long life asset the capital goods scheme provides that recovery must be adjusted over the life of that asset. While it is hard to argue with the concept, the practice is far from straightforward.

The UK scheme in practice applies mainly to expenditure on land and buildings including refurbishments where use must be monitored over a period of 10 years. However because it applies separately to each project with a cost in excess of £250,000 one building could have several adjustments running in parallel.

The OTS suggests a number of simplifications:

  • increase the threshold so it applies only to larger projects, possibly only for owner 0ccupied properties
  • introduce a de minimis so adjustments would be required only where use changed by a significant amount or the value of the adjustment exceeded a certain value
  • require adjustment less frequently than annually
  • remove the formal scheme and replace with a general requirement to use a fair and reasonable approach

The OTS does not mention that HMRC did attempt to simplify the scheme in 2010/11 with the introduction of de minimis provisions so that no adjustments were to be made where used changed by less than 5% on assets costing up to £1m or 10% on assets costing up to £10m. This change was never implemented, apparently as they were not universally well-received.

The UK scheme also applies to yachts and aircraft costing in excess of £50,000 – a mechanism essentially designed to counter arrangements to recover VAT on assets used also for private purposes and to individual items of computer equipment costing in excess of £50,000 – which in practice never occurs. The OTS suggested that these provisions might be removed as they rarely apply in practice. However we note that the yacht / aircraft provision is a specific anti-avoidance measure.

Conclusion

This area of VAT is complex.  The OTS has focussed mainly on small businesses.

However on a practical level the impact on large businesses with small levels of exempt activity needs to be addressed. A further problem as that the interests of businesses with small levels of exempt activity and want simplification may be very different to those largely exempt businesses who want to maximise recovery, and whose systems are set up to do this.

Read the OTS report here.

VAT Threshold – To Increase, to decrease, to freeze, that is the question…


This is the fourth in the series of articles on the report issued by the Office of Tax Simplification (“OTS”). The OTS commented that the most significant issue identified in the report is that of the VAT registration threshold, currently set at £85,000 within the UK, costing the UK economy £2 billion a year. This is the highest threshold in both the EU and the OECD, with the global average being circa £15,000.

Registration threshold

Once a business reaches the VAT registration threshold, it must register for VAT but businesses with turnover below the threshold may choose to voluntarily register.. Although 55% of UK small businesses are not registered for VAT or PAYE, 44% of VAT registrations are voluntary. This may be for a number of reasons, one of which might be to create an impression of substance and credibility to the business venture.

Bunching

There is a significant “bunching” of businesses whose turnover is just below the VAT registration threshold, in labour-intensive businesses and businesses operated by sole proprietors. Where this happens, the OTS says there is a “cliff-edge”.  Compare a non-VAT registered business with turnover of £84,000 supplying to consumers and a business with a taxable turnover of £85,000, The latter is required to register for VAT and account for £14,167 to HMRC leaving net turnover of £70,833 (assuming it cannot increase prices). Research evidence suggests that businesses (especially sole proprietors) manage their turnover to remain below the VAT registration threshold. This appears to be due to the comparatively high threshold where labour-intensive businesses can generate a profit, which the owners regard as sufficient. This therefore acts as a disincentive to economic growth.

Competitive distortions

The OTS identifies two potential approaches exist in dealing with the competitive distortions caused by the current VAT rules.

The first would be to raise or lower the threshold to exclude a larger number of smaller businesses or to include all but the very smallest businesses. The second option would be to smooth the financial / administration costs of crossing the threshold. However, there are certain constraints on what may be possible while the UK remains subject to EU law in this area.

A. Threshold – To reduce / To increase

The OTS said that reducing the threshold to £25,000, similar to the national average minimum wage (£26,000), could yield as much as £2 billion for HMRC, but would mean up to 1.5 million more businesses collecting the tax. Should this occur, some might opt to cease trading or to structure themselves differently. In addition, this would result in a significant rise in HMRC administrative overheads. However it would also make it harder for businesses to evade VAT.

Raising the threshold level significantly to Singaporean levels of about £500,000, could impact 800,000 businesses. Although approximately 50% of such businesses may choose to remain voluntarily VAT registered, this could be said to reduce revenue intake by £3 – £6 billion per annum. It is unlikely than any increase above inflation would be possible under current EU law.
A more moderate approach would be to make a smaller change to indicate a direction of travel but would have a limited impact.

B -Smoothing

Having identified that the threshold creates a “cliff-edge”, the OTS has considered a number of options which may smooth the impact of the registration threshold such as retention of a proportion of VAT collected in the first few years of registration as well as administrative simplification. At present, many such mechanisms are likely to be incompatible with EU law. However, should the UK no longer be constrained by EU legislation, these options could be considered in further detail.

Summary

While the OTS report contains some useful evidence, its recommendation is for a review of the level and design of the VAT registration threshold, with a view to setting out a future direction of travel and it falls short of making any concrete recommendation. It remains to be seen as to how the government might implement the recommendations made above and in what time frame these can be achieved. It is understood from the OTS, that it considers such recommendations may be progressed in the short (1 year) to medium (2 -5 years) term. However, while there seems to be compelling evidence for a significant reduction in the threshold, anything seen as a tax on the growing self employed population would be politically risky (as evidenced by the difficulties encountered in raising self employed national insurance).

Follow this link to the OTS Report.

VAT takes the biscuit (or is it a cake?)


If there’s one thing most people know about VAT it’s that Jaffa Cakes are cakes, not biscuits. Not everyone is sure why this matters – of course its because “biscuits wholly or partly covered in chocolate” are an exception to the general zero rate for food. The Office of Tax Simplification report on simplifying VAT (published on 7 November) gives a more colourful example of the same principle, that a gingerbread man with chocolate eyes is zero rated (they are really chocolate chips) but if he has chocolate trousers he is standard rated! There are further anomalies in many, many areas of VAT both around rates and exemptions.

The report suggests that these can only be addressed in the medium to long term, citing the constraints of EU law. However, this is to overlook the fact that many (if not most) of the UK’s zero rates have their roots in the UK’s Purchase Tax and in HMRC’s custom and practice.

It’s fair to say that the current EU legislative framework does place some constraints on the application of the reduced rate and also that where the UK’s zero rate is as a result of a derogation (exception) from the core framework it’s a one-way street – its scope cannot be extended and once given up cannot be reintroduced. However the current EU regime permits member states to apply a reduced rate to a wide range of supplies including many currently zero rated by the UK, such as food.

Furthermore, the EU’s VAT Action Plan published in April 2016 and its follow up in October 2017, proposed giving greater freedom to EU member states around rates. Legislative proposals are to be expected in 2017. So long as the UK remains in the Single Market this remains relevant to us. Two options are being considered:

1.       A more regular review of the list of permitted reduced rate items and extension of derogations to all EU member states to allow a level playing field together with a maintenance of the minimum 15% standard rate.
2.       Allowing member states complete freedom as to the scope, level and number of reduced rates, with overriding controls on distortion of competition.

Regardless of the developments at EU level, the UK could modernise the taxation of food which is most definitely the area of greatest complexity. It could, for example, eliminate many of the anomalies particularly in the area of snacks, confectionery and beverages where some healthy items such as nuts,  healthy beverages (fruit / vegetable smoothies), muesli bars are standard rated and other less healthy / unhealthy items are zero rated. It could also apply a reduced rate of VAT to catering currently taxed at the standard rate. The modern lifestyle means that eating out / hot takeaway food is seen less as a service and more as a substitute to home cooking. Many other EU member states apply a reduced rate to such supplies.

I understand that any wholesale review of rates will have “winners” and “losers”. But the current complex regime serves no-one (except perhaps VAT advisers!). Retailers face potentially significant VAT bills from making the wrong call on a product’s VAT liability which can turn on a subjective interpretation of matters such as the “potatoness”  of a product. Decisions on the design of food products can be driven by VAT rather than nutritional factors.

This is one of a series of articles on the OTS report. We have focussed mainly on food – other areas have been / will be covered in other articles. See also our earlier post which outlines the main OTS recommendations.

Read more about the OTS study here.


 

Making VAT a simple(r) tax…?


On 7 November the Office of Tax Simplification published its first report devoted to VAT. When VAT was introduced the then chancellor stated that his objective was to have “the simplest VAT in Europe”.  In my view he failed. While in many respects HMRC has sought to minimise the burden of VAT, in so doing it has created a regime combining the overarching EU framework with many hangovers from the old purchase tax regime which are now outdated and anachronistic. The fact that the report runs to 85 pages and covers only 8 topics is testament to the enormity of the task. The recommendations are wide ranging and not all will be of interest to every reader. This article summarises the recommendations and we’ll look in more depth at each area in coming days.

The report makes 8 core recommendations (and a further 15 subsidiary ones):

1.       Registration threshold – the UK’s registration threshold of £85k is the highest in the EU and the OECD. Although this can be seen as a simplification taking many small businesses out of the VAT regime, there is evidence that it acts as a disincentive to businesses to grow beyond the threshold. The OTS considers the case for a significant reduction (say to the average wage) accompanied by some measures to mitigate the impact or a significant increase. While all would agree that tax should not stifle business growth, there is a debate to be had about the best mechanism to do this.
2.       Rulings and guidance – the OTS recommends that HMRC improves its written guidance to reduce the need for rulings and is more responsive to written requests. This is an uncontroversial finding.
3.       Penalties – the OTS suggests a review of the penalty regime to provide greater certainty – particularly around voluntarily disclosed errors where in practice a penalty is rarely levied, and to increase the threshold for written disclosure for larger businesses. Again a finding which seems sensible and uncontroversial.
4.       VAT rates and exemptions – the evolution of the UK VAT system over 40 years has resulted in an excessively complex regime of VAT rates riddled with exceptions and exceptions to the exceptions and anomalies which the average taxpayer often finds baffling. Whilst to some extent this is governed by EU law many of the UK’s more ridiculous rules could be ironed out within the current legal framework.
5.       Partial exemption –  there is little tolerance within the system for businesses which have very limited exempt activity and simplification is suggested for those at the margin. The OTS proposes simplification and this is to be welcomed for large and particularly small businesses.
6.       Partial exemption – for those businesses with more significant exempt activity the standard method should be simplified and the mechanism for agreeing special methods streamlined.
7.       Capital goods scheme – this scheme designed to smooth VAT recovery on long term assets (in practice limited to buildings) is cumbersome and ripe for modernisation as the threshold for the scheme has not changed since its inception in 1990.
8.       Options to tax – the record keeping and notification process needs to be modernised. This is vital as the options have an indefinite life and businesses now wishing to revoke options need to be able to evidence an act made 20 years ago.

There is plenty of interesting material in the study which we will comment on in coming days. We look forward to seeing what happens next.

If you can’t wait – read the OTS report here.

 

 

Compound interest – another common law claim defeated


The Supreme Court has ruled against Littlewoods’ claim for £1.25bn of interest in relation to a settled claim for overpaid VAT, completely overturning the decision of the Court of Appeal which had found in favour of Littlewoods on all counts.

The Court has ruled that the statutory interest received by Littlewoods under the VAT Act was an adequate remedy for the loss of use of the money.  In reaching this decision, the Court has determined, firstly that Littlewoods common law claim was excluded by s78 as to allow a common law remedy as Littlewoods claimed, ran counter to the clear intention of parliament in placing limitations on interest paid under s78.

The Court acknowledged that it must also consider Littlewoods’ rights under EU law to reimbursement both of overpaid tax and all sums directly relating to that tax including the costs of being deprived of the use of the money. Littlewoods had measured that cost by reference to the benefit to the UK Government of having the use of Littlewoods’ overpaid tax over the period since 1973 using the cost of Government borrowing compounded. The European Court had previously ruled that any remedy must give “adequate indemnity” to the taxpayer – but contrary to the Court of Appeal, the Supreme Court considered that the statutory remedy met that test and did not require “full reimbursement” as Littlewoods contended and that the UK statutory simple interest provisions were consistent with the remedies offered in many other EU member states.

In reaching this conclusion the Court seemed influenced by a number of factors:

  • that Littlewoods had already received statutory interest of 125% of the overpaid tax;
  • that the circumstances giving rise to a claim for overpaid tax over such a long period (the Fleming decision and the extended transitional period) were very unusual.

The Court seems to have chosen to ignore the fact that, when very long time periods are involved compounding has a very significant impact, as the size of Littlewoods’ claim demonstrated.

This decision is another nail in the coffin for taxpayers seeking remedies under common law in cases where they argue that the statutory remedy is inadequate. We have already seen the Supreme Court rule that a customer who has borne the burden of incorrectly charged tax has no common law claim against HMRC and must instead claim against the suppliers who would in turn be bound by the  limitation periods in the VAT Act which were compatible with EU law and there for the protection of the public finances ( (Investment Trust Companies in liquidation).

The judgement can be found here. https://www.supremecourt.uk/cases/uksc-2015-0177.htm

Business or non business?


This is a Bulgarian case referred to the CJEU. Briefly, a property developer sought to recover VAT on the reconstruction of a waste water plant owned by the local council. The developer needed the waste water plant, so that it could develop a nearby holiday village. The issue was simply whether it could recover input tax in circumstances where the council also benefited from a free of charge improvement to its waste water facility. Answer, yes.

Not a long judgment and the court clearly felt that the cost incurred had a direct and immediate link with the property developer’s business. The Court held that a restriction of input tax should only arise if the developer carried out reconstruction works, which weren’t necessary for the operation of the holiday village.

A helpful decision, as HMRC can seek to restrict input tax recovery in circumstances where the asset is not owned by the business in question.

HMRC do have taxing powers under the Supply of Services Order 1993, but they would have to show non business use. This decision would rule that out in my view. https://lnkd.in/e2Sq3sM

Deduction of VAT following business transfer


This decision involves NT Advisors, but on this occasion in relation to its own tax affairs, rather than the tax avoidance schemes it promoted to its clients.

The case concerns the recovery of input tax on barristers fees in the defence of tax schemes being litigated in UK courts. The contentious issues in this case resulted from the transfer of the appellants business before the input tax was incurred.

The appellant did not apply to retain the transferors VAT number, leaving behind approximately £1m in unpaid VAT. HMRC also claimed there was little chance that the tax schemes would succeed.

For NT to lose, the judge by his own admission would have applied a ‘hyper-literal’ interpretation of the laws on VAT deduction. This could have unfairly disadvantaged other taxpayers in the future. It’s good to see that NT’s chequered history did not produce a bad result in this case.

In brief, the judge held that the input tax would have been deductible by the transferor; that the business purchase agreement transferred the entitlement to future income and that the costs of running that business should be deductible by the transferee. This would clearly include the barristers fees.

https://lnkd.in/d-RDBMt

Direct attribution to taxable supplies


A First-Tier Tribunal decision in a case involving Queens Club (QC), the tennis club that hosts the pre Wimbledon tennis tournament.

QC incurred input tax on the design and refurbishment of its bars and cafe, to create a more attractive offering for use by its members and members’ guests. The dispute concerned whether this input tax was fully recoverable or whether, as HMRC argued, it was partly referable to the exempt sporting activities.

These were the key findings which assisted the judge in finding for QC:

  1. There was no contractual obligation to provide members with the facilities;
  2. Most members do not use them;
  3. The judge distinguished similar decisions involving sporting clubs with more modest facilities on the grounds that the member would necessarily acquire a right of access to a single clubhouse. In this case, the bar and restaurant occupied one part of one of the four buildings available to members;
  4. HMRC failed to show that people joined the club or sought to renew their membership as a direct result of the refurbishment of the social space.

A case that is very influenced by the nature of Queens Club, compared to more traditional members sporting clubs.

Nevertheless, will be useful (or not) in other cases involving input tax recovery.

https://lnkd.in/efCvfAK

Hall or annex?


Litton & Thorner’s Community Hall. A First-Tier decision on whether building work amounted to an annex which qualified for zero-rating under Notes (16) and (17) to Group 5, Schedule 8 to the VAT Act and/or whether the work could be zero-rated on the basis that it was completion of the previously constructed village hall.

Briefly, a ‘lean to’ was built to act as a storage facility for the village hall, as the pre-existing storage was inadequate and inconvenient to use. The lean to had both internal and external access through two sets of double doors.

Highlights of the decision:

  1. The lean to qualified as an annex. It was capable of independent operation and this was not undermined by the internal access nor because it was only used as storage for the village hall. 
  2. If that failed, it should be viewed as the completion of the building despite the passage of time and the lack of planning permission for the lean to when the village hall was built.

Although this is great news for the charity concerned, I am surprised by this decision, as it contradicts a number of previous authorities.

I think it’s a great lesson in not giving up, because you might find a sympathetic judge.

https://lnkd.in/eCMCM-M

Has the court rewritten the rules for independent providers of higher education?


The attached article was written following the Court of Appeal judgement in SAE Education. This judgment concerned the VAT liability of education provided by an independent provider of higher education. A crucial question for the independent sector.

The court has modified its approach to the qualifying criteria for a college of a university, but the outcome may not be markedly different. Please read the article below for further details.

http://wonkhe.com/blogs/has-the-court-of-appeal-rewritten-the-vat-rules-for-independent-colleges/