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HMRC internal manual

VAT Partial Exemption Guidance

Consideration of Partial Exemption (PE) special methods: when income goes wrong

In certain circumstances an income based proxy such as that in the Standard method will not secure a fair and reasonable attribution of input tax to taxable supplies. Some of the following ‘faults’ will be found at many businesses but the extent of any distortion is not significant enough to prevent the method being fair and reasonable. Simple identification of a fault or potential fault is therefore not sufficient to merit moving from an income based calculation. It needs to be demonstrated that the fault is significant and that an alternative method which guarantees a more accurate result is available.

Broadly speaking there are three reasons why income may not be fair and reasonable:

  1. Distortion due to output values;
  2. Timing differences between inputs and outputs;
  3. Interdependence between supplies of differing liabilities.

However, these can be broken down into more specific reasons:

Distortion due to output values

High value supplies with only slight use of residual inputs

The Problem: Very high value supplies, which are generated using negligible resources, although the same issue could also happen with high numbers of lower value supplies which, when considered as a whole, use negligible resources. The most common examples are one-off or occasional supplies.

Supplies made using an agent may cause the same issue and lead to a situation where, whilst there are costs directly attributable to the supply, the use of residual costs is limited to instructing and monitoring of the agent.

Examples/case law: Occasional sales of securities or bullion; rental conducted through an agent; disposal of buildings or land by business not usually involved in that activity; bank deposits. EDM, Regie Dauphinoise, NCC Construction, Rightacres Ltd, Beazer (Holdings)

Solution: Exclusion of value from calculation. Many examples are excluded automatically by the effect of regulation 101(3) and 102(2), though this will not always be the case, particularly in a sectorised method when a distortive supply may be incidental to the sector, but not the business as a whole.

Supplies which are of high value in comparison to their use of resources but where that use is not negligible

The Problem: A business may make supplies which due to their value, either individually or collectively, suggest a much greater use of costs than is the case. Never-the-less, those supplies still make a significant enough use of costs that their complete exclusion from an output values calculation would mean that the calculation would not be fair and reasonable.

Examples/case law: High value, low margin supplies are the most common examples of this issue; regular dealing in commodities, securities or other financial instruments alongside other business activities.

Solution: Sectorise so that the high value supplies are dealt with separately where possible. Transaction counts can also provide a solution. Alternatively some form of weighting can be applied to either the value of supplies or transactions, although it is often difficult to identify how such a weighting can be arrived at.

Not all costs are used to make all supplies or the same mix of supplies

The Problem: Costs may be residual, yet not used for all the supplies of the business. However the effect of the standard method is to attribute to all of those supplies, whether or not the cost on which the input tax is incurred is a cost component of them all. For example, consider a business whose core activity is the dispensing of spectacles, both a taxable supply of goods and an exempt supply of services. The business also makes supplies renting out land which are agreed not to be incidental. It is likely that the majority of the residual costs will only relate to the core activity, with only a few having a direct and immediate link to the rental supplies. By including the value of the rental supplies in the calculation to determine the recoverable proportion of the residual input tax, you will skew it either towards taxable, if the land is opted, or exempt, if it is not.

The position can become more complicated if there are different streams of business, each with taxable and exempt supplies, but which use different costs, or at least partly different costs. That said, in such cases the various distortions can often end up balancing each other out.

Examples/case law: Mayflower Theatre

Solution: Sectorise by cost, so that only supplies which for which the cost is a cost component are used to apportion it. In the Mayflower Theatre example, the input tax on production costs could be apportioned by ticket sales plus programme sales whilst input tax on other costs could be apportioned by all costs.

Different supplies use the same costs, but in different ways

The Problem: Where different supplies are made via different business units, those units can consume costs differently, even though the costs that are being consumed are the same. For instance, if a retailer owns a building, with the ground floor occupied by its retail activity, but the higher floors rented out, all supplies will consume the same residual cost base of rent, heat and lighting. However, the use of the spaces supported by those costs will be very different, and is likely to lead to distortion. The supplies made from the upper floors will be swamped by those on the lower floors.

Examples/case law: This was an issue in NPI, Lincoln, and McInroy and Wood, but in each case those were found not to be an example where distortion occurred.

Solution: Sectorise into different business units.

The output values are identified differently

The Problem:

  1. When a business incurs taxable costs to be used in making supplies both at full value and on a commission basis and one is taxable and the other is exempt. The standard method would then favour the full value supply which would either give an over or under recovery of input tax.
  2. Outputs for VAT purposes are not equivalent to turnover as recorded by the business

Examples/case law:

  1. Travel agents: They incur costs that are used to supply holidays (taxable) and insurance (exempt). Often the holidays will be at full value and the insurance received on a commission basis although in some cases, holidays can be sold both as principle and as agent.
  2. Trading e.g. securities, where net gains are valued as turnover as opposed to each sale transaction

Solution: To gross up the value of the commission income so that the values are treated like for like.

Timing differences

Capitalised costs and costs relating to start up businesses.

The Problem: Input tax on costs, particularly capital costs, may relate to supplies in later longer periods. The standard method can give no, or a much distorted, result, since the attribution will be based only on the supplies in the current year.

Examples/case law: Any new business venture that will make taxed and exempt supplies.

Faxworld & Rompelman confirm the right to a fair deduction.

Solution: A calculation based on, or including, business projections for the supplies to be made. Changes to CGS to deal with capitalised costs.

Failed intentions or losses

The Problem: When a business incurs input tax on a project that is expected to produce large amounts of income but the project fails and the expected income is not realised. The standard method would allocate the residual input tax in a ratio that may not reflect the intended value of supplies.

Examples/case law: Ghent Coal, Examples with insurers and failed websites

Solution: A calculation including the anticipated income for the failed venture based on business projections. It is often likely to be appropriate to use a separate sector for such distinct ventures.

Winding down costs

The Problem: Trading has ceased or is much reduced but costs related back to earlier trading are still coming in. If current trading gives an answer at all it is unlikely to be a fair one.

Examples/case law: Run off insurance companies. Fini confirms that input tax deduction is still available.

Solution: Refer back to recovery rates when trading was in full swing.


Transactions not at arms length

The Problem:

  1. A supply is made between connected parties and the supplier is able to inflate or diminish the value of that supply so that its true value is not reflected in the selling price. Where there are interdependent taxable and exempt supplies the supplier is able to shift the value between each supply to suit the overall tax position of both parties.
  2. A supplier makes two supplies that are inextricably intertwined and are interdependent, such that the customer’s focus is on the overall price. The taxable and exempt proportion can accordingly be varied to suit the customer, the supplier or both. The taxable and exempt supplies may accordingly be sold at values which do not represent a normal commercial offering when viewed independently, but do together. This may skew the values to be included within the standard method.

Examples/case law:

  1. Rent / Service Charge
  2. Hire Purchase


  1. Use open market value
  2. Exclude the value of the supplies sold with no mark up.

Supply specific subsidies

The Problem: A taxable person receives a subsidy in respect of one of its activities. Actual turnover does not therefore reflect the true income received in respect of that activity. As such, the supply is under-valued in an outputs based calculation and insufficient input tax is attributed to it.

Examples/case law: HEI’s receive grants and subsidies to provide education in addition to fees charged to students. The Standard Method only accounts for the fees and therefore under-values the supply of education meaning that an outputs calculation over-attributes input tax to taxable supplies.

Solution: Include the value of grants or subsidies within the calculation.