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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: allocation

 
 
 
 
 
 
 
 
 

Introduction

Allocation refers to dividing residual input tax between sectors in a sectorised method (see also PE22000 - Partial Exemption principles: Sectorisation). This section deals with commonly used allocation methods for special methods. In deciding whether the potential proxies are appropriate you need to consider whether they reflect use would be fair and reasonable Bear in mind in deciding on alternative proxies that you will need to demonstrate that they guarantee a more accurate calculation than that given by income. We would normally expect that that cost allocation methodologies proposed in a PE method are used by the business for other accounting/financial purposes.

Some businesses may use more than one allocation method, applying them to different types of costs. Consider a financial business occupying a building that is half occupied by them and half rented out to another business. A two-sector method seems appropriate, one dealing with the finance supplies, one dealing with the rental supplies. A floor space allocation could be appropriate for the building costs, but it would not be for the computer costs, which are used only to a small extent to make the rental supplies. Equally, a headcount allocation may be appropriate for the computer costs, since all staff have one computer, but would not be for the building costs, since staff are only involved to a small extent in the rental supplies. Accordingly, in such circumstances it may be appropriate to allocate the two types of costs separately to the sectors, using floor space for building costs and headcount for computer costs.

Outputs based allocation

This is allocation to sectors in the same proportion as the value of supplies made. It is the default method of allocation and is appropriate where:

  • sectors use residual input tax bearing costs in the same proportion to the values; and
  • most supplies are made in the same tax year as the related costs are incurred.

Sectorisation will be more likely to give a fair and reasonable result where a significant proportion of the residual input tax can be directly allocated to individual business activities (the potential sectors),

However, where most of a trader’s input tax is residual to the whole business and input tax bearing costs are used in the same proportion as values, sectorisation may not give any extra accuracy. A single values-based calculation will often reflect use, and be easier to operate and check than a sectorised method.

Cost accounting allocation

The method the business uses to allocate its costs for the purpose of operating and managing its business would normally be the most suitable when outputs is not considered appropriate. The purpose of a partial exemption allocation is to fairly share the residual input tax bearing costs between sectors in proportion to their economic use; the purpose of a cost accounting system is to fairly share costs between business sectors.

We would normally accept that the cost accounting system used by the business gives an accurate use calculation for the costs allocated using it.

Accordingly, this method should give a fair and reasonable result where the partial exemption sectors are aligned with the business sectors, where the input tax on those costs can be separately identified and where residual costs are full absorbed into the revenue generating areas.

Even where the input tax on costs cannot be separately identified (often because they are stripped out of the cost allocation system before the costs are allocated), the management cost allocation system may produce a fair and reasonable result.

The advantages of using such a system are that:

  • the business does not have to use a separate allocation system for its’ partial exemption method;
  • the allocation method will tend to follow the changing circumstances of the business without need to amend the method;
  • the cost allocation system will be underpinned by accounting principals, and audited, possibly independently; and
  • the business has other motivations other than VAT to ensure that the allocation method reflects the use of the costs.

Other allocation methods

Good reasons need to be provided if a business is to use a method other than one based on outputs or the method it uses in its normal management of the business.

It may be that the proposal is seeking to create a sector which is not recognised in the normal business accounting. In that case you should first consider whether a separate sector is appropriate; (see PE22000 - Partial Exemption principles: Sectorisation). If the sector is appropriate and there are good reasons why the normal accounting method can not be used alternatives may be considered.

Before an alternative can be agreed it needs to be demonstrated that the proposed proxy is appropriate and more accurate than that given by income. This would normally be by reference to a comparison to an accurate allocation give by an appropriate full cost allocation exercise. Such an exercise will be expected to demonstrate a financial independence of each sector and also will allocate costs to sectors in a proportion. This is required because the proxy to be used;

  • will be an addition to the normal accounting system. Requiring additional work to operate it needs to be shown that the extra complexity leads to a corresponding increase in accuracy.
  • is less likely to follow the changing circumstances of the business as it does not form part of the business management system,
  • is unlikely to be independently checked and audited; and
  • is likely to be measured purely for VAT. There will therefore be no separate motivation ensuring it accurately reflects costs

The most common alternatives are;

Headcount allocation

This is allocation to sectors in the same proportion as the number of staff in each sector. It is often referred to as a head count method and is a common allocation method. It is most appropriate when:

  • the predominant residual costs are staff supporting ones;
  • costs are used in proportion to staff time; and
  • most staff work for one sector or another.

It is important where such a method is adopted the staff numbers are based on full time equivalents, in order to take account of part time staff, and staff whose duties change within the year.

Staff time can also be used instead of staff numbers, but will only be appropriate where a business records this information for other purposes.

Floor space allocation

Another allocation method is allocation to sectors in the same proportion as the amount of floor space taken up by each sector. It is most appropriate when:

  • residual input tax bearing costs are predominately building related (rent, fixtures, fittings);
  • individual sectors exclusively occupy specific floor space; and
  • the costs are used in proportion to that floor space.

Any such method should make clear what floor space is to be treated as occupied by a sector and what space is to be considered as communal. This method is therefore most easy to operate and verify when sectors occupy different rooms and/or floors.

Inputs based allocation

This is allocation to sectors in the same proportion as the amount of inputs (costs) incurred in each sector. It may give a fair and reasonable result when:

  • the main residual costs relate to managing or supporting the sectors;
  • most costs can be directly allocated to one sector or another; and
  • the residual costs are used in proportion to the inputs.

Careful consideration will however need to be given to what inputs are included in the calculation, particularly non VAT bearing elements such as staff costs.

Particular care should be taken where a business has non-VAT grouped associate companies. Buying goods and services and selling them on to the associate can have a very distortive effect. In such circumstances, it is normally appropriate to exclude goods and services sold on in the same state from the calculation.

Rather than inputs, directly attributable input tax may be a more appropriate calculation in some circumstances, though this is unlikely where there are exempt and / or zero-rated supplies received, or where staff costs are included more heavily in one sector than in others.

Transaction based allocation

This is allocation to sectors in the same proportion as the number of transactions made. Effectively the number of supplies, or significant supplies, made by the business is counted, although other things can also be counted if more appropriate.

Although this is not a common allocation method, it may be appropriate where many of the input tax bearing costs can be directly allocated to one business activity or another, and residual costs are used in proportion to the number of transactions.

When approving or directing a transaction based method, it is essential that both parties agree what will or will not be treated as a transaction, and that this is set out unambiguously in the special method letter. There are no simple answers as to what should be considered a transaction and what should not, it will depend on the supplies made, and how costs are used in making them.