Partial Exemption methods: simplifcations to the standard method: use-based option for new partly exempt businesses
A new partly exempt business may recover its input tax on the basis of use in the following situations:
- During its ‘registration period’; this is the period running from the date a business is first registered for VAT to the day before the start of its first tax year (normally, 31 March, 30 April or 31 May depending on the periods covered by the VAT returns).
- During its first tax year (normally the first period of 12 months commencing on 1 April, 1 May or 1 June following the end of the registration period), provided it did not incur input tax relating to exempt supplies during its registration period.
- During any tax year, provided it did not incur input tax relating to exempt supplies in its previous tax year.
What is meant by a recovery on the basis of use?
A recovery on the basis of use (or 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 EU legislation and is supported by a wide body of European and domestic case law.
HMRC’s published partial exemption guidance provides an in-depth discussion on how the principle of use applies in practice. The guidance refers to the concepts of ‘cost components’ and ‘direct and immediate link’. In simple terms, it requires a business to examine its main categories of expenditure and determine the extent to which they relate to taxable supplies. Most businesses that embark upon a new activity (exempt activity in this case) will have carefully considered how costs will be used, in accordance with cost accounting principles, when preparing its business plan. Provided this is logical, objective and transparent it will invariably form an ideal basis for a fair recovery of input tax.
How do I calculate my annual adjustment?
Where a business adopts this change and calculates its recovery of input tax on the basis of use, it is also required to calculate its annual adjustment on the basis of use to ensure consistency. Also, where a business does not recover input tax on the basis of use but would nevertheless have been entitled to do so, it may still calculate a use-based annual adjustment. This gives new partly exempt businesses maximum flexibility to help ensure they recover a fair amount of input tax. There is no need to notify HMRC.
Example: A business is registered for VAT on 15 July 2009 and its first tax year begins on 1 April 2010. Its registration period is therefore 15 July 2009 to 31 March 2010. To secure funding it drew up a three-year business plan which projects taxable and total income as follows:
|Year ending||Estimated value of taxable supplies (a)||Estimated value of total supplies (b)||Recovery percentage = (a) x 100/(b)|
|31 March 2010||4,000||20,000||20%|
|31 March 2011||70,000||100,000||70%|
|31 March 2012||150,000||200,000||75%|
It incurs total residual input tax on start-up costs of £50,000 during the registration period.
The business is satisfied that overall it uses the start-up costs in proportion to the value of taxable and exempt supplies that it makes and intends to make over the three year period. However, if it operated the normal standard method calculation using the values of supplies made during the registration period, it would only be able to recover 20 per cent of its input tax (£10,000) which does not reflect its intended use of costs.
This change allows the business to recover the input tax on costs incurred in each VAT return within the registration period in accordance with the principle of use. Therefore, the business can select its own calculation for recovering the input tax provided it is fair and reasonable. In this case, as the business intends the start-up costs to be used in proportion to the values of supplies made over the three year period, it can provisionally recover a total of 70 per cent of the residual input tax (£35,000) in the VAT returns that fall within the registration period. It would also be required to perform its first annual adjustment on the basis of use to finalise the calculation. However, this will only affect its input tax recovery if its use or intended use of costs have changed by that time. For simplicity, if we assume that in this example there are no significant changes, the finalised amount of recoverable input tax would be £35,000 and so the annual adjustment would be nil.
For its first tax year that runs from 1 April 2010 to 31 March 2011, the business reverts to the normal values-based calculation. Change 1 means that the business can provisionally recover its input tax during its first tax year by reference to the recovery percentage determined for the registration period (70 per cent in this example), although this would be finalised by way of an annual adjustment at year-end on the basis of values.
The business is therefore able to recover its input tax on the basis of use for almost two years, after which it reverts to the normal values-based calculation. It is only if the business anticipates that a values-based calculation would be unsuitable that it would need to consider applying for a special method.
What happens when the conditions are no longer met?
Once the conditions above cease to apply, residual input tax must be recovered by reference to the normal values-based calculation. Input tax relating to certain financial supplies and supplies from establishments located outside the UK is always recovered on the basis of use (see section 5) and is unaffected by this option.
Is recovery on the basis of use compulsory?
No, it is optional for a business to recover input tax on the basis of use in the circumstances described above. A business can still recover input tax using the values-based calculation or it can seek approval of a special method from HMRC.
What do I need to consider before deciding whether to recover input tax on the basis of use?
A use-based recovery ensures a fair recovery of input tax by definition. However, occasionally HMRC and a business might not agree on what is a use-based recovery of input tax. In these circumstances, it is possible that HMRC will raise an assessment to correct a use-based recovery in order to ensure a fair recovery of input tax and this could attract interest and penalties.
How will HMRC keep track?
HMRC will know that a business has opted to recover on the basis of use if it departs from the normal values-based calculation. If a business recovers input tax using the normal calculation, HMRC will assume it has not opted to recover on the basis of use and, subject to the standard method override, will not disturb those calculations.
What were the old rules?
Under the old rules (prior to 1 April 2009), a new partly exempt business was required to calculate the proportion of recoverable input tax using the standard method values-based calculation. If this did not produce a fair recovery of input tax it would either have to wait until the year-end to calculate a standard method override adjustment or seek approval of a special method. This was despite the fact that once it was up and running (normally after a year or so) the standard method values-based calculation would often be suitable.