Policy paper

Statement of Practice B1

Published 31 March 1978

Income Tax and Corporation Tax

A person carrying on a business who is not a taxable person for VAT

1. This broadly covers persons whose output is wholly exempt from VAT and those whose taxable output (including that which is zero-rated) does not exceed a certain limit each year. (This limit is increased periodically.)

Such persons will suffer VAT on much of their business expenditure. Where an item of expenditure is allowable as a deduction in computing income for Income or Corporation Tax purposes, the VAT related to that expenditure will also be allowable. If the expenditure qualifies for capital allowances, these allowances will be based on the cost inclusive of the related VAT.

A taxable person for VAT whose output is wholly taxable (whether at the standard rate of VAT or zero-rated)

2. There is no essential difference for this purpose between taxable and zero-rated output. It is expected that in general a VAT account will be kept on the lines recommended in the HM Revenue and Customs (HMRC) Notice No 700 setting VAT on outputs against VAT on inputs and accounting for (or reclaiming) the difference. In computing income for direct tax purposes in these circumstances it would be correct to take into account both income and expenditure exclusive of the related VAT. VAT on inputs is set off whether it relates to capital or revenue expenditure and it would follow that capital allowances would be determined upon the cost exclusive of VAT. There are certain categories of VAT on inputs which are non-deductible - notably that relating to the cost of motor cars and entertaining. This VAT will no doubt be included in the accounts of the business as part of the expenditure to which it relates. So far as the motor cars are concerned capital allowances will be computed on the cost inclusive of the VAT and the entertaining expenditure which is not allowed as a deduction for direct tax purposes will be the expenditure inclusive of VAT. If a trading debt becomes bad it may well include the VAT related to the sale. To the extent that this tax has been accounted for to HMRC and cannot be recovered from them, the full amount of the debt including VAT may be allowed as a trading expense for direct taxation purposes.

Where a trader does not maintain a separate VAT account the adjustments to be made in computing income and capital allowances for direct taxation purposes would be such as to achieve the corresponding result.

A partly exempt person

3. As explained in HMRC Notice No 706, a taxable person whose output is partly exempt and partly taxable may set off only part of his VAT on inputs against his VAT on outputs. In such a case the computation of income for direct tax purposes will follow the general principles set out in 1 and 2 above. The VAT on inputs which cannot be set off may comprise 2 elements:

• (a) that which is non-deductible because it relates to motor cars or to business entertainment
• (b) that which is referable to the exempt output

The treatment for direct tax purposes of non-deductible VAT on inputs under (a) will be the same as for a wholly taxable person, as explained above. VAT on inputs within (b) should be allocated to the categories of expenditure giving rise to it, and its treatment in computing income for direct tax purposes will be the same as the treatment of the expenditure to which it relates.

In many cases the extent to which a partly exempt person ultimately bears VAT on goods and services supplied to him will be determined in accordance with a working arrangement with HMRC (such as the special schemes for retailers set out in Notice No 727). It follows that some approximation may be necessary in allocating the VAT ultimately borne to the various items of expenditure to which it was related. Inspectors of taxes will be prepared to consider any reasonable arrangements for allocation which follow the general principles set out above.

In certain circumstances traders may also decide that the cost of keeping records of some items of VAT on inputs is excessive in relation to the ultimate set-off to be obtained and will not make any claim. Where a trader ultimately bears additional VAT in consequence this may be treated as a part of the relevant expense or capital outlay for direct tax purposes.

Capital Gains Tax

If VAT has been suffered on the purchase of an asset but that VAT is available for set-off in the purchaser’s VAT account, the cost of the asset for Capital Gains Tax purposes will be the cost exclusive of VAT. Where no VAT set-off is available, the cost will be inclusive of the VAT borne. Where an asset is disposed of, any VAT chargeable will be disregarded in computing the capital gain.

Note

First published as a Revenue Press Release date 7 May 1973. For the corresponding practice relating to Capital Gains Tax, see Statement of Practice D7.