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HMRC internal manual

VAT Partial Exemption Guidance

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HM Revenue & Customs
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Partial Exemption principles: sectorisation

 
 
 
 
 
 

Introduction

Sectorised methods are ones where the residual input tax is divided between different business areas. Normally this is because the recovery of non-attributable input tax by reference to one calculation would not be fair and reasonable. This is because costs are used in each sector in different proportions and the averaging achieved through a single calculation does not give a fair and reasonable result.

The principle of splitting Partial exemption method into Sectors comes from Europe. Article 173(2)a and 173(2)b specifically which respectively allow member states to;

Authorise the taxable person to determine a proportion for each sector of his business provided that separate accounts are kept for each sector and

Require the taxable person to determine a proportion for each sector of his business provided that separate accounts are kept for each sector

Normally a sectorised method will be appropriate because the business recognises that it has different business activities that use costs in different ways and to include all activities in a single sector would be distortive. Sectorised methods are inevitably more complex but ultimately can be more accurate and thus can be more likely to give a result that is fair and reasonable. However fair and reasonable covers a range of methods and recoveries. Because of this sectorised methods are only likely to be appropriate for larger businesses.

When is a sectorised method appropriate?

A sectorised method will only be appropriate when the additional burdens on the business and HMRC arising from a more complicated calculation are offset by the additional accuracy gained. This requires a material difference between the tax recovered by single and sectorised calculations.

Given the vires from Europe the starting point for sectorisation is the nature of the account of the business. If the business does not keep separate accounts for their different activities it is unlikely that a sectorised method will be appropriate. Partial exemption is a balance between simplicity and accuracy. Creating artificial sectors where they do not already exist within a business’s normal accounting creates an additional burden on a business. It also creates a burden on HMRC who will have no independently audited means of checking the allocation of the costs between sectors.

By separate accounts we mean accounts, based on established accounting principals, and operated for purposes independent of VAT, completed on a full absorption costing basis. That is the costs allocated within the accounts contain all the costs appropriate to the sector. No further allocation of overhead or other costs is required. This may involve totally separate accounts for each business sector or a single set of accounts where all costs are clearly allocated.

In general, it is normally appropriate to align a sectorised method with the cost accounting system of a business and the sectors therein. However businesses with sectors which have a similar recovery rate may wish to combine those activities in a single sector in a PE method.

In exceptional circumstances sectorisation may be appropriate where the business does not normally fully separate activities in the accounts or where activities are only partly separated. However in these cases the business should provide HMRC with evidence that the cost allocation basis is fair and reasonable; See PE22500 - Partial Exemption principles: Allocation in special methods.

Example

The following example illustrates how a sectorised method gives a significant difference to a single calculation completed on the same basis.

Sectorised Calculation

Activity A

Taxable income £4,000,000 : Exempt income £1,000,000 : Residual tax £400,000

Income based recovery

£4,000,000 x £400,000 = £320,000
   
£4,000,000 + £1,000,000  

 

Activity B

Taxable income £1,000,000 : Exempt income £4,000,000 : Residual tax £100,000

Income based recovery

£1,000,000 x £100,000 = £20,000
   
£1,000,000 + £4,000,000  

 

 Total recovery £320,000 + £20,000 = £340,000

Single Calculation

Taxable income £5,000,000 : Exempt income £5,000,000 : Residual tax £500,000

Income based recovery

£5,000,000 x £500,000 = £250,000
   
£5,000,000 + £5,000,000  

 

The difference between the two calculations is £70,000 which is significant. Providing income is considered an appropriate proxy for use and the income and cost allocation to the sectors can be confirmed a sectorised method appears appropriate.

When is a sectorised method not appropriate?

Sectorisation is not appropriate unless the accuracy gained offsets the extra administrative burdens on the business and HMRC.

Where there is more than one distorting activity the sectorisation needs to be consistent. If more than one activity distorts the recovery significantly then a sectorised method needs to address all distortions. It is not appropriate to sectorise for one distortion and to ignore another.

Example

The following example gives a situation where the two potential sectors have very different recovery rates yet a sectorised method does not materially differ from a single calculation.

Sectorised Calculation

Activity A

Taxable income £4,500,000 : Exempt income £3,000,000 : Residual tax £400,000

Income based recovery

£4,500,000 x £400,000 = £240,000
   
£4,500,000 + £3,000,000  

 

 Activity B

Taxable income £500,000 : Exempt income £2,000,000 : Residual tax £100,000

Income based recovery

£500,000 x £100,000 = £20,000
   
£500,000 + £2,000,000  

 

Total recovery £240,000 + £20,000 = £260,000

Single Calculation

Taxable income £5,000,000 : Exempt income £5,000,000 : Residual tax £500,000

Income based recovery

£5,000,000 x £500,000 = £250,000
   
£5,000,000 + £5,000,000  

 

The difference between the two calculations is £10,000 which is not significant. Providing income is considered an appropriate proxy for use and the income and costs are not anticipated to change significantly a sectorised method does not appear appropriate.

Sectorisation and VAT groups

With VAT groups, it is important that recovery in a sector reflects the supplies made outside the group, rather than the disregarded supplies made within a group. Consider a computer leasing business that makes supplies both to third parties and to an insurance company within the group. Whilst the only supplies made by the sector that will appear on the VAT return are taxable ones, the input tax bearing costs are significantly used to make the exempt insurance supplies. Any apportionment method for that sector should reflect the fact that the input tax is used to make these supplies.

This can be achieved by including the intra group activities in the denominator of the apportionment and in the numerator to the extent that the receiving sector makes taxable supplies. Alternatively it can be achieved by reallocating an appropriate proportion of the input tax from the supplying sector to the receiving sector. The former is usually appropriate where the receiving sector makes no intra group supplies itself, the latter where it does.

The use of company names should be avoided as descriptions of sectors within special methods. Whilst companies are often used by a business to divide activities into sectors, using the company name as a description has caused problems where reorganisations have resulted in companies changing names, or activities being transferred between companies. Instead, the sector should describe the business activity undertaken by the business area.

Mechanics

It is important that any sectorised method includes a requirement to directly allocate any residual tax incurred relating to the specific sectors in which the costs are used. A method that allocates input tax between all sectors when it is only used by one or two is less likely to produce a fair and reasonable result.

Good practice is to include a sector to deal with any input tax incurred that is not otherwise dealt with by the method. This will usually occur where a new business activity commences or is acquired which is not addressed by the current sectors. The recovery in this sector should be on the basis of the use of the input tax bearing costs, reflecting regulations 102(5), (6) and (7), VAT Regulations 1995. This will ensure that a fair and reasonable amount of that input tax will be recovered and that the business is aware of what to do in such circumstances.