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HMRC internal manual

VAT Partial Exemption Guidance

Partial Exemption principles: fair and reasonable

Partial exemption special methods should be “Fair and reasonable”. “Fair and reasonable” is an umbrella term covering a number of different requirements.

Special methods should

  • Reflect the “use” of the VAT bearing goods and services
  • Be able to react to future business changes
  • Be relatively simple to operate and audit
  • Be consistent with respect to sectorisation
  • Guarantee a more accurate calculation than that obtained using the standard methodology

Reflect the “use” of the VAT bearing goods and services

A method produces a fair and reasonable attribution of input tax to taxable supplies if it satisfies the principle of use. The principle of use means that input tax is attributed in accordance with the ‘use or intended use’ of input tax bearing costs in making taxable supplies. The principle of use comes from European legislation supported by a wide body of European and domestic case law.

In simple terms, the principle of use means examining the main categories of business expenditure and determining how they relate to business supplies. In many ways this is no more than an exercise in cost accounting.

The trick is to identify ‘what drives the cost’ and then to use that ‘cost driver’ to attribute the input tax between the taxable and exempt supplies. For example, a business that buys an expensive computer system in order to handle its high volume of transactions, may judge that a transaction count is a fair basis for attribution whereas a sales value for the different transactions may not be.

Most businesses, especially the largest and most complex, focus carefully on costs and understand the importance of reliable ‘cost drivers’. These businesses prepare management accounts to manage costs, plan investments and forecast profits. A robust system of management reporting that is logical, objective and transparent is invariably an ideal basis for a fair and reasonable method.

Be able to react to future business changes

A fair and reasonable method should take account of risks or potential events that might otherwise undermine its effectiveness. For example, if a business occasionally acquires new businesses then it could structure its method to deal with this possibility. One easy way to do this is to include within the method a ‘catch-all’ sector which stipulates that input tax on the costs of the newly acquired businesses is to be attributed in accordance with the principle of use, but does not specify how that is to be achieved. The actual basis for attribution can be determined after the event without risk of under or over-recovery. Accordingly, the relevant input tax will be dealt with in a similar manner to the way input tax on foreign and specified supplies is attributed under regulation 103.

Very large businesses typically include a ‘use based’ sector to deal with board-level projects that cannot be disclosed in advance. Then, if the project becomes a permanent feature, the business can amend its method and there is no risk to input tax recovery either way.

Be relatively simple to operate and audit

Few methods need to be complex and the vast majority of fair and reasonable methods are straightforward and typically comprise a single sector with a single basis of apportionment. Very large businesses or those with diverse activities and rapidly changing cost structures will need more complexity. As a rule of thumb, the complexity of a fair and reasonable method will mirror that of the cost accounting systems that are relied upon for decision-making purposes.

Be consistent with respect to sectorisation

Some businesses choose methods that hive-off some categories of cost to boost recovery rates. However, a method will not be fair unless it treats all categories of significant cost in a consistent manner, so if ‘high recovery’ costs are hived-off then so too must the ‘low recovery’ ones. This can quickly result in complexity without materially affecting the tax result. When considering whether a method is fair and reasonable HMRC will consider whether any demonstrated greater accuracy is offset by an inappropriate increase in the complexity of the calculations. As a rule of thumb, the larger the business and the more VAT is under consideration the greater the level of calculation complexity that is justified.

Guarantee a more accurate calculation than that obtained using the standard methodology

Businesses seeking to use an alternative proxy to turnover need to demonstrate that using an alternative proxy produces a more accurate result. This necessity was confirmed in the ECJ case of Baumarkt C511/10.

Partial exemption methods are not intended to give an exact calculation of the taxable use of each and every cost incurred by a business; it is accepted that some costs will be used in a different proportion to that suggested by the proxy. However it is intended that methods offer a comparatively simple calculation which gives a reasonably accurate overall apportionment of all relevant costs.

Demonstration that an alternative proxy provides a more accurate apportionment than the one given by a turnover-based method will require a comparison of the turnover proxy and the alternative to a precise allocation of costs.

HMRC would normally accept that the allocation in audited accounts represents a precise allocation, although other evidence of the precise use may be acceptable.

Where a precise allocation of costs between the taxable and exempt activities is not maintained and it is not possible, or will not in the future be possible, to confirm that the proposed proxy is more accurate than turnover, the proposed proxy is unlikely to be considered fair and reasonable. However, it may be accepted that one proxy is more accurate than another if it can be demonstrated that with respect to the business’s activities one of the proxies gives an economically credible result and the other does not. Similarly HMRC do not consider that businesses would need to demonstrate greater accuracy when it is clear that turnover methods do not produce a fair and reasonable result, for example where a Standard Method Override would regularly apply, or in sectors such as finance or insurance where the value of the turnover is difficult to ascertain.

Fair and reasonable does not mean that there is only one acceptable method for a business, rather there are likely to be a number of fair and reasonable methods that are equally acceptable. They may give different tax results, although variances are unlikely to be large. The business can choose between them and will probably do so with regard to complexity and compliance cost, as well as tax result.

If a business has doubts over whether its proposed method is fair and reasonable, it should tell HMRC who can explain how the principles work and highlight relevant guidance and Revenue and Customs Brief articles.