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HMRC internal manual

VAT Partial Exemption Guidance

Partial Exemption methods: exclusions from the standard method and incidental supplies

Exclusions from the standard method
Incidental supplies
Distortive supplies
Applying the principles
Examples where a supply would be seen as incidental
Incidental financial supplies

Exclusions from the standard method

There are certain supplies that must always be excluded from the calculation. These are set out in Regulation 101(3) of the VAT Regulations 1995.

Types of supplies Description
Capital goods used by the business. Any sum received from the sale of capital goods (this is not restricted to items that fall into the capital goods scheme) that have been used by the business.

This is to ensure that a one-off supply, such as the sale of machinery or redundant premises, does not distort the calculation.

The meaning of capital goods is covered in PE67000 - The Capital Goods Scheme.    
  Incidental supplies Any sum received in respect of certain financial or real estate transactions* which are incidental to one or more business activities.

The standard method apportions residual input tax by reference to the value of supplies. The inclusion of incidental supplies would distort that calculation.

Below gives more information about incidental supplies.

(* Real estate transactions include any grant, assignment, surrender or reverse surrender of any interest in, right over or licence to occupy land.)    
  Self-supplies (including reverse charges) This includes the value of any supply that a taxable person makes to himself (i.e. a self-supply), for example the value of a supply that a business accounts for under the reverse charge procedure.



Any input tax incurred on supplies to be excluded from the standard method should be dealt with in the normal way. It should be either directly attributed to that supply or included as residual tax as appropriate.


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Incidental supplies

Incidental supplies are not defined in either EU or UK law, and so reference needs to be made to case law, which is explained below.

An incidental supply must be a supply of either finance or real estate and can be any liability. It arises merely as a minor consequence of normal business activity. When considering whether a supply is incidental, it is necessary to identify all the business activities of the entity. It must then be established whether the supply in question is incidental to any of these business activities or if it is a separate supply in its own right. In addition, the courts have said that an activity which is the direct, permanent and necessary extension of another main activity is not an incidental activity. If the business makes no other supplies apart from the supply in question, it cannot be incidental as there are no main activities for the supply to be incidental to.

The term ‘incidental’ was considered by the VAT Tribunal in the case of C H Beazer (Holdings) PLC, and by the ECJ in Regie Dauphinoise (C-306/94), EDM (C-77/01), and Floridienne and Berginvest SA (C-142/99).

C H Beazer (Holdings) Plc

Beazer was a partly exempt holding company. It reclaimed input tax incurred on the disposal of existing shares and ignored the sale for the purposes of its PE calculation, treating it as incidental. The Tribunal confirmed that this was correct, and in doing so it decided that incidental meant ‘occurring or liable to occur in fortuitous or subordinate conjunction with’. Although the conclusion has been superseded (see next paragraph), the Tribunal’s definition of incidental is still helpful.

In the subsequent case of AB SKF (Case C- 29/08), the court of justice decided that a disposal of shares in a subsidiary by a holding company that had previously provided taxable management services to it was the direct, permanent and necessary extension of that management business. It therefore followed that the disposal was not an incidental financial transaction.

Regie Dauphinoise

Regie was a property management company. It held monies received on behalf of clients in its own bank account, until they were due to be paid over, and was allowed to retain the interest earned. No separate resources were employed on this activity. The ECJ ruled that the exempt supplies were not incidental because the receipt of the interest was a ‘direct, permanent and necessary extension of the taxable activity of property management’. Accordingly, the amount of interest received should be included in the denominator of the fraction used to calculate the deductible proportion.

This case is important because the court of justice explained that a direct permanent and necessary extension of an economic activity could not be incidental to it.


EDM was a holding company owning shares in mining subsidiaries. It made loans to the subsidiaries and received interest from them and it also carried on various treasury activities. The question was whether those activities were incidental.

The court of justice said that the level of the respective turnover of the activities may be an indicator that one of them was incidental but was not a determinative factor. In the case of a mining concern that was prospecting you had to look at taxable activities in the medium term because there may be few taxable supplies in the initial stages. The exempt activities could be incidental insofar as they involved only very limited use of taxed costs. It left it to the national court to decide what this meant in practice in individual cases.

The tests in Régie and EDM were confirmed in NCC Construction (Case C-174/08).


Floridienne and Berginvest SA [C-142/99] were holding companies involved in the management of their subsidiaries, for which they received a fee. They also received dividends and interest on loans made to their subsidiaries. The ECJ considered whether or not interest received from loans to their subsidiaries should be excluded from the denominator of the fraction used to calculate the deductible proportion. In doing so the Court provided some helpful pointers on whether or not these loans were incidental.

Floridienne claimed that interest received from the loans was potentially income from credit transactions arising merely as a result of the main activity (namely the holding of shares) and was therefore incidental and outside the scope of VAT. The Belgian government argued that the income from the loans to the subsidiaries constituted the direct, permanent and necessary extension of a taxable activity comprising the supply of services to their subsidiaries (the terminology used in Regie), so was not incidental to the management services.

The Court of Justice said that loan transactions, such as those made by Floridienne, are subject to VAT only if they constitute either an economic activity of the operator in themselves, or the direct, permanent and necessary extension of a taxable activity, without, however, being incidental to that activity.

The Court held that when a holding company makes capital available to its subsidiaries, then that may be considered an economic activity provided that it was not carried out merely on occasional basis, but with a commercial purpose in order to maximise returns on capital invested. That was not the case in Floridienne and the loans were outside the scope of VAT.

By contrast with Regie, the activity of making capital available to subsidiaries was seen as a quite separate activity from the provision of taxable management services to those subsidiaries and so could not be incidental to those services. It followed therefore that there was a restriction of VAT on related taxed inputs.

In conclusion, if loans are made on an occasional basis, they will not be an economic activity and cannot then be a supply, incidental or otherwise. On the other hand, if a loan is made with a view to obtaining income by way of interest on a continuing basis (and not confined to managing an investment portfolio in the same way as a private investor), then it can be a supply.

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Distortive supplies

EDM emphasised the distortive nature of incidental supplies due to the insignificant amount of residual input tax normally used in making such transactions. However, although a business may make supplies that distort its partial exemption recovery, it does not necessarily follow that those supplies are incidental. This was a point that was made by the Tribunal in Capital One Bank (Europe) Plc (Decision No: 19238).

For example, an insurance business might buy and sell securities, such as shares, as one of its normal activities. The inclusion of the value of those supplies in a partial exemption calculation is likely to be distortive, because the values are so high it would overstate the amount of residual inputs used to make that supply compared with their other activities. The supply of shares will not be incidental though as they are part of a principal business activity and cannot be excluded from the partial exemption calculations under VAT regulations 101(3)(b) (for the standard method) or 102(2) (for outputs based special methods). The investment of premiums is a direct, necessary and permanent extension of running an insurance business. Therefore an alternative proxy for the use of costs in share dealing must be found (e.g. separate sectors) to reflect the amount of residual input tax used and a partial exemption special method needs to be put in place (guidance on special methods can be found at PE40000 onwards).

On the other hand, if a retail business sells some shares in a subsidiary to raise capital the supply will be incidental as it is not part of its normal business activities. As an incidental supply, it should not be reflected in any partial exemption calculation because the use of overhead costs would be so slight that to include the supply would understate the extent to which those residual costs are used by this business. The value of the supply must be excluded therefore from any output values based partial exemption calculations under the VAT regulations. It is likely that direct costs, such as legal fees, will be substantial though. If supplies have been made outside the EU, an apportionment calculation may be necessary under regulation. Regulation 103 apportionments must be carried out before PE calculations unless there is an approved combined special method.

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Applying the principles

To help determine whether a supply is incidental, the transaction should be examined to see how it compares against the tests arising from Regie Dauphinoise and EDM.

  • Is the transaction part of the normal activity of the business?
  • Does the transaction use only slight amounts of residual inputs?

The table below will help in doing this, although this list is not exhaustive, nor should it be taken that more ‘ticks’ in the ‘incidental’ column automatically points to an incidental supply, or vice versa.

Indicators that a supply might be incidental: Indicators that a supply might not be incidental:
* The transaction is related to the business’s normal activities, but not part of one. * It is a necessary activity in order to carry out one or more of the business’s normal activities.
  * It is a permanent extension of one of the business’s normal activities.
  * It is a separate activity in its own right.
* Income received results from ‘passive’ action e.g. deposit interest on a bank account. * Income received results from specific actions e.g. finance commission received by a retailer for supplying goods on credit.
* Costs are picked-up by a wider business area. * Related costs are identified and budgets are set for them e.g. by charging to a specific cost centre.
* The supplies are made as and when as part of a wider business area without monitoring. * The business monitors progress in making the supplies e.g. targets are set, performance queried, objectives outlined, strategies prepared, high-level decisions taken.
* Auditors (internal or external) do not report on the supplies * Auditors (internal or external) report on the supplies.
* Written guidance advises staff to minimise risks to revenue. * Written guidance advises staff to maximise income e.g. staff are permitted to do speculative investments.
* Only a few staff are engaged in actions relating to the supply compared with total staff. * Several staff are permanently and actively engaged in maximising income.
* The duties involved in such activities are only a small part of the total person’s duties.  
* When the values are included in the partial exemption calculation the result implies that the supply uses more inputs than would any normal economic analysis. * When the values are included in the partial exemption calculation it results in a fair and reasonable apportionment of the input tax.

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Examples where a supply would be seen as incidental

Example 1

A Treasury department of a large non-financial multi-national company carries out the following activities:

It undertakes forex and derivative transactions to hedge against risks in respect of its purchase of goods needed to operate its business and to hedge against currency risks in respect of sale of its services. It does not make transactions in order to make a spread, nor have control over the selling price. Written guidance instructs staff not to make speculative transactions.

It also invests surplus money on overnight deposit with half a dozen banks to earn best rate of interest.

With the surplus funds, it makes occasional loans to companies outside the VAT group but within the corporate group, and receives interest.

For streamlining purposes, the business has set up a separate company within the VAT group to deal with these activities. Only a few staff are involved in these activities and they sit in a small room in the Head Office building. The majority of their time is spent in providing financial information, reports etc. to the Board and others within the corporate group. Few direct costs are incurred in respect of this Treasury activity apart from access to Reuters information systems but these systems are also used to provide reports and other information to senior management.

Applying the principles:

a) Is it a minor or subordinate activity that is not a direct, necessary and permanent extension, i.e. a part, of the normal activity of the business? Yes.

The forex and derivative transactions are non-supplies as per the Willis principles (see Business Brief 21/05). Whilst the other activities are supplies, they are undertaken to support the business’s normal activities, but are not a part of them, neither can they be said to be separate services in their own right.

The loans made to companies outside the VAT group are occasional ones, and again, not part of the business’s normal activities.

b) Does it make only slight use of residual input tax? Yes

Only a few staff work in the Treasury department compared with the total number of staff. The interest earned on the investment of surplus funds is income earned passively i.e. the depositing of funds use barely any resource.

Again, on balance, the answer to both tests is yes, therefore the treasury activities are incidental. If in the future the business decided to extend the treasury department activities, e.g. to speculate on the money market, make loans on a regular basis outside the corporate group, or provide treasury services for a fee, the decision would have to be reviewed .

Example 2

ManufactureCo needs some land in order to expand its manufacturing business. It purchases a plot of land but does not need it in its entirety so it sells part of it to another business. ManufactureCo has never used the area of land it has sold.

Applying the principles:

a) Is it a minor or subordinate activity that is not a direct, necessary and permanent extension, i.e. a part, of the normal activity of the business? Yes.

ManufactureCo is not in the business of selling land. It has done so as a one off supply in order to capitalise on excess real estate. Therefore it is not part of its normal business activities.

b) Does it make only slight use of residual input tax? Yes

Whilst the supply may incur significant direct costs, the overhead costs will be negligible.

Examples where a supply would not be seen as incidental

Example 3

GolfclubCo charges an annual fee to its members. If the member cannot pay in full at the beginning of the year, they are allowed to pay 25% deposit and the club lends them the remaining 75%. The member then pays the ‘loan’ back to the club in three instalments, plus interest. Approximately 5% of the membership choose to pay their fees this way.

Applying the principles:

a) Is the receipt of exempt interest a minor or subordinate activity that is not a direct, necessary and permanent extension, i.e. a part, of the normal activity of the business? No.

It is clear that this company is in the business of providing golf club membership and facilities, rather than providing loans. However, this is not a one-off transaction, it is a direct and permanent extension of the main activity. If they wish to maximise membership then allowing potential members time to pay the fees is necessary. The income is deliberately sought, i.e. it is not passively earned by chance.

b) Does it make only slight use of overheads?

Since the supply is an integral part of the main activity, and therefore cannot be incidental, there is no need to apply the second test.

Example 4

HoldingCo is a holding company VAT grouped with several taxable trading subsidiaries. It does not make any management charges. It makes supplies of loans to companies within the corporate group outside the EU and receives interest.

Applying the principles:

a) Is the receipt of interest a minor or subordinate activity that is not a direct, necessary and permanent extension, i.e. a part, of the normal activity of the business? No.

HoldingCo does not have any other business activity but the supply of loans. There are no business activities that the supply can be incidental to. It is therefore its main business activity and is not an incidental supply.

b) Does it make only slight use of residual inputs?

Since we have established that it is the main business activity, there is no need to apply the second tests.

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Incidental financial supplies

Issues of shares by trading companies used to be regarded as incidental financial transactions. However, the ECJ overturned that policy in the case of Kretztechnik (Case C-465/03) in May 2005. This means that the costs of the issue will now be treated as a general overhead of the trading company and the VAT incurred on such costs will be treated as residual input tax. New issues of shares and other types of securities such as bonds (and whether equity or debt) will now not normally be regarded as supplies by the issuer, although in the case of loan security, there will be a supply in the reverse direction.

Transfers and sales of existing shares and securities for a consideration, for example a sale of a subsidiary, will continue to be exempt supplies provided they are made in the course of business activity.

The right to deduct is dependent upon where the counter party to the transaction belongs. Treatment of input tax incurred on incidental financial supplies made outside the EU is covered in PE35000 - Regulation 103B.