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HMRC internal manual

VAT Partial Exemption Guidance

Partial Exemption principles: use

The term ‘use’ needs to be considered in the context of the tax. It does not take its everyday meaning. In the case of St Helens School [CH2006/0244] the Court said in deciding what “use” means

“One can see that the “use” referred in regulation 101 (as elsewhere) is not physical use but some special VAT use. It is, I think, the same as what [HMRC’s Counsel] termed “economic use.”

HMRC’s opinion, as argued by counsel in that case, is that the economic use of a cost is the extent that the cost does, or is intended to, form a cost component of the price of the supplies made. It is measured by an economic/financial analysis of the supplies made or to be made by the business and how the relevant costs have been reflected in the price charged/to be charged for the goods or services.

As an example in the St Helens case there were construction costs of a sports complex totalling £2.6 million. The business argued that 54% of the constructed asset was to be used for a taxable lease. That is £1.4 million of costs were used for the lease. The expected taxable income over the life of the lease was £183,000. Spending £1.4 million on an activity which would realise £183,000 was not, HMRC argued, a credible result in economic terms. The judge agreed that the allocation made by the business did not reflect the real economics of the transactions.

An indication of how ‘economic use’ could be tested in practice was given by the Court of Appeal in the case of London Clubs Management Ltd 2011 EWCA Civ 1323.

The court said

“in the absence of a realistic expectation that the Respondent’s catering activity could produce a profit in the foreseeable future if overheads were allocated in accordance with the proposed method would, in my view be a critical factor in favour of the existing method and against the proposed PESM.”

The court pointed out that “Business is carried on with a view to profit”. If a particular allocation method suggests that an activity is not profitable then the allocation method is unlikely to be reflecting the economic use. Obvious exceptions exist in cases where profitable supplies were planned but were frustrated.

Note that this is a test which eliminates certain methods as uneconomic. Just because a particular allocation method suggests that all supplies are profitable, or break even, does not mean that the ‘use’ has been accurately reflected.

Consider the case of a business which makes £100,000 taxable supplies and £100,000 exempt supplies incurring no directly attributable costs, but which nevertheless incurs £80,000 of overheads. Whether the entire costs are attributed to the taxable or exempt activities, both supplies would still realise a profit. That does not mean that every potential allocation method will be accepted as reflecting the use.

It follows that the above test is more suitable for identifying methods which are not appropriate rather than methods which are.

The default calculation would in the above example allocate 50% of the costs to each supply. In order to move away from that default a business or HMRC would need to demonstrate that an alternative calculation more accurately reflects the economic use. That would require an identification of the precise use, the extent that the costs have been included as components of the respective prices.

Unless all costs are directly attributable to either taxable or exempt supplies any calculation to identify recoverable and irrecoverable input tax is a best estimate. However, where a business uses separate accounts that fully assign all costs to different income streams, and those accounts are reliable and relied upon for non-taxation purposes, then the costings will usually be acceptable in a PE calculation to determine the economic use of those costs.