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.
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.
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.
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.