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HMRC internal manual

VAT Partial Exemption Guidance

Consideration of Partial Exemption (PE) special methods: consideration, approval and refusal of a special method


Consideration of a special method

When considering whether a method is fair and reasonable, you should focus on how the costs on which the input tax is incurred are used, rather than the input tax itself:

  • Is it realistic that this proportion of the costs is ascribed to these supplies?
  • Do the accounts of the business treat the costs in the same way as the PE method?
  • Does the partial exemption method imply that the cost of making a supply is greater than its value?

There may be good reasons for all these, but equally it may be that the method does not apportion the costs appropriately.

You should bear in mind that it is possible that some businesses and advisors may approach proposals with an intention to maximise recovery rather than reflect the use of the input tax bearing costs in making taxable supplies.

They may choose the method giving highest recovery (often with the aid of computer modelling software, which may not use the actual figures accounted for by the business in the relevant periods), and present arguments as to why this gives a fair and reasonable result.

It is therefore worth asking whether the business, or their advisors, have considered any other special methods, what the result of those methods would be, and why the method proposed was chosen instead of the alternatives.

Approval of a special method

Decisions on the acceptability, or otherwise, of a special method for a particular business will always be difficult. You need to be satisfied that the proposal reflects the use of the goods and services to make taxable supplies.

Every case needs to be considered on the basis of all the available information; do not assume that a method that has been approved for an apparently similar business will automatically give a fair and reasonable result for your business. There may be small but significant differences between the two businesses’ mix of supplies or the way they operate.

Alternatively the person who approved the method for the other business could have overlooked something relevant. As partial exemption is all about determining how much of a business’s input tax is incurred in making taxable supplies, it follows that you need to identify all the business’s activities. You will also need to consider intended activities to the extent that they are known to the business.

It is expected that a specialist partial exemption resource, such as a PESO or other TAPE team officer will be involved in the preparation of a partial exemption method. This is because partial exemption is a complex area and there are often significant amounts of tax to be addressed.

It is very important, for example, to use terms in the approval letter that are legally certain and to ensure that the method is capable of dealing with possible changes in the way the business operates. Specialist resources will be able to advise on current Departmental policy and best practice along with any relevant case law that may affect your business.

In any case, you should always notify your local TAPE team if you receive an application for a special method. This will enable the details of the method application to be recorded so that they are available for risk and assurance purposes. It also enables the time taken to approve or reject the method to be monitored; which is a measure of our customer service.

All approvals of special methods must now be in writing.

Since partial exemption special method approval letters are among the most important letters that are sent to businesses, it is vital that they are carefully checked before issue for typing errors, ambiguous statements and imprecise definitions. As noted above, the intention and operation of the method may be compromised if statements are capable of being interpreted in different ways or are otherwise unclear as to their meaning.

Refusal of a special method

A special method request should always be refused if:

  • it does not reflect the use of the input tax bearing costs; or
  • it does not guarantee a more accurate result than the standard method or
  • visiting officers cannot readily check its accuracy, this includes audit officers being refused access to the program that will run the method; and
  • it does not deal with all the input tax incurred by the taxpayer.

Any refusal to approve a method may be appealed to the Tribunal under section 83(e) VATA 94, so it is important that full reasons are given to the business as to why approval has not been given. A letter should be sent, setting out in full detail:

  • HMRC’s concerns as to why the method would not give a fair and reasonable result; and
  • confirmation that the proposal has been rejected, but inviting further proposals that address those concerns.

It may also be helpful to set out the Commissioners understanding of the operation of the proposed method, requesting confirmation that it is correct, in case their interpretation is different. Any ambiguities can then be addressed.

Following refusal of a method, businesses will often ask the Officer to come up with a method that is fair and reasonable. This is not the role of HMRC. It is for the business to propose a method, and the Commissioners to approve or reject a method. However, the officer should be as helpful as practical to the business and where possible, should indicate the types of method that would be likely to receive approval.

If a method request is received with a declaration one of three things should happen to that request:

  • The method should be approved;
  • The method should be rejected or
  • A request should be made for the additional information we require in order to make a decision. Where this information is not provided in a reasonable time the method should be rejected on the grounds that the business has not given us sufficient information to enable us to be satisfied that it is fair and reasonable.

Sometimes the request for further information will lead to a meeting with the business and as a result of that meeting a different proposal will emerge. Although we can discuss variations and alternatives to proposed methods, we need to be aware that in respect of special method requests with a declaration we need to formally approve or reject each one. We also need to communicate our decision to the business as soon as it is made. If we reject a proposal we need to give reasons for the rejection.

It follows that when a business proposes a method which is different from the one for which it has submitted a declaration, it needs to formally withdraw the original request or we need to formally reject it. Any subsequent proposal will need a new declaration before it can be approved.

In the above scenario it is important that both declarations are recorded on EF. It is not appropriate to overwrite the original request with the new one or to leave the original declaration unanswered until an approvable method is received.

Tax year in which the method should be approved

Applications not approved

The method given approval is not always the one first applied for. Receipt of the first application therefore doesn’t set the tax year from which a new PESM can have effect. If it did, a business could submit an application which no reasonable body of Commissioners could approve and then test a number of alternative methods over several years before settling on one which they like and which we would probably approve. This benefit of hindsight would give them an unfair advantage over HMRC, who can direct new, or override existing, special methods only from a current or future date (with the exception of ‘declaration’ overrides).

Requirement for a Declaration

Regulation 102(9) specifies that no method can be approved unless the Commissioners have received a Declaration to say that the method is fair and reasonable.

The Declaration helps our risk assessment of an application, but doesn’t mean we approve all applications. Despite a Declaration, we can’t approve something which we can see is neither fair nor reasonable. In these cases we inform the business that we can’t approve their proposal, give the reasons why, and invite new proposals which take account of our concerns. Any new proposal must be accompanied by a new Declaration, quite simply because it is another method in the context of Regulation 102(9).

Timing of Declaration

The regulation does not use the term ‘prior’ so the declaration can be received after the application. However guidance in PE43200 says that we normally expect the Declaration to accompany the proposed method for which approval is sought. It acknowledges that some businesses may want to discuss PE principles before proposing a method. This is popular with many large businesses who wish to obtain broad agreement before making a declaration, although this goes beyond what we intended by ‘discussing principles’.

It is worth making the point that it is the taxable person who declares their belief that the method is fair and reasonable. They should not postpone making a Declaration until they know that we will approve their application.

Effect of the Declaration on the time of receipt of an application

It follows that any discussions prior to making the Declaration must fall short of an application to use a method. If the business is not confident in its understanding of PE in the context of its business, then it is in no position to propose a fair and reasonable method. Accordingly, the tax year in which the approved application was received can be no earlier than that in which the Declaration was received (and is unlikely to be later by the nature and wording of the Declaration).

Retrospection can not be considered until a method is agreed. Once the method is agreed the appropriate declaration can be identified. Where the agreed method differs from that originally proposed a new declaration will be required. The new, as opposed to the original, declaration will set the year, the start of which, a method may be backdated.


Delays in submitting a Declaration will delay the start of the new PESM. Delay could be to the advantage of the business, so must be closely monitored. We should consider a direction or override at an early stage if delays are leading to loss of revenue. Officers must speak with their TAPE team and/or Regional PESO at this early stage.

If the current method is to the disadvantage of the business, they should be encouraged to submit an application for a new method, accompanied by a Declaration.

Businesses who consider that their special method is not fair and reasonable but are not in a position to submit a special method application and declaration should be encouraged to consider serving a Special Method Override Notice which will guarantee a fair and reasonable recovery.


Retrospection is dealt with in detail in PE46500 and PE47000. It should only be agreed in the specific circumstances laid down in guidance, but may be allowed for other exceptional reasons with policy team agreement.

The usual date from which a new PESM will take effect is the start of the tax year in which the declaration for the approved application was received. Absence of a Declaration can mean delay in approving a new method.

We should encourage businesses to consider serving a SMON if there is a risk that a new method may not be agreed before the start of the next tax year.

Core information needed to fully consider a special method proposal

You are likely to need the following core information to enable you to consider fully a new PESM proposal:

  • A brief explanation of why the current method is no longer suitable or the new proposal is better (or, for a new business, why the standard method is not suitable). It may be helpful to consider why a business considered and rejected other options;
  • Details of the business structure. This may include VAT group or division details or separate accounting functions within a single business (e.g. a self-accounting branch). Much of the information may be readily available on EF but you should consider carefully any changes or proposed changes to the information we currently hold on EF;
  • Brief details of all the business activities which the business undertakes or intends to undertake and their approximate values;
  • The VAT liabilities of their main supplies and their place of supply;
  • Details of the main costs they incur which bear input tax and the activities to which those costs relate;
  • A worked example of the proposed method using actual figures. You should only consider proposals which use projected figures where this is not possible, for example a new business or a totally new activity by an existing business;
  • A copy of the most recent annual accounts;
  • Copies of management accounts or other management information where relevant.
  • Where appropriate details of the precise use of costs and a demonstration that the proposed method gives a result wich is closer to the precise use than that given by an income calculation.

In addition, the following information, where relevant, will assist you in making your decision. Each item is covered in more detail below:

  • Details of all non-business activities and other income sources/streams
  • Foreign (‘out of country’) and specified supplies
  • Incidental and distorting income
  • Values-based methods
  • Unused input tax
  • Land and computers subject to the Capital Goods Scheme (CGS)
  • Items subject to ‘Lennartz’ accounting
  • Sectors
  • Cost accounting
  • Group Registrations
  • Corporate Groups with separate VAT registrations
  • Non accounting-based methods

Non-business activities and other income sources/streams

Does the business have any non-business activities (e.g. charitable activities)? If so, it would be helpful to understand how any non-business apportionment will be carried out before the PE method is applied.

Foreign (‘out of country’) and specified supplies

Does the business make any foreign supplies or specified supplies (foreign supplies are sometimes referred to as ‘out of country’ supplies)? If so you will need to establish what they are. (See PE34000 for more information)

Will input tax recovery on those supplies be dealt with outside the PESM or is the business seeking a ‘combined method’ to deal with this input tax? (See PE34500)

Incidental and distorting income

You should identify and quantify all income from financial transactions and real estate transactions which the business considers to be ‘incidental’. You should also confirm you are happy with their status as incidental (see PE32000). You may also wish to consider whether any supplies the business considers not to be incidental actually are.

You will need to identify and quantify any income the business considers will distort its PE calculations. You may also wish to review whether you consider any income not identified by the business to be distortive.

How does the proposed method deal with distorting income (if any) which is not considered to be ‘incidental’? Remember - distorting income may still use some costs which incur residual input tax. Excluding such income completely might not reflect the true use of costs.

Values-based methods

How will the business determine values in the method for supplies made, supplies received and self-supplies (where applicable)?

Unused input tax

Are there likely to be regular instances where costs remain unused at the end of your tax year? If so, does the method deal adequately with these costs?

Land and computers subject to the Capital Goods Scheme (CGS)

You should consider whether the business owns or has plans to own any capital items which fall within the CGS. For each such item, the following points may help you consider the level of risk:

  • Its value at the time it became a capital item
  • The length of time remaining in the CGS
  • The proposed treatment of the item within the method (e.g. a separate capital goods sector or a special CGS method)
  • Evidence that the proposed method will properly reflect the taxable use of the capital item(s)

Option to Tax

You should consider whether the business has or plans to have an interest in any opted properties and whether this will impact on its proposals.

Items subject to ‘Lennartz’ accounting

You should consider whether the business owns or has plans to own any assets to which ‘Lennartz’ accounting* will apply. For each such asset the following points may help you consider the level of risk:

  • The treatment of each item within the proposed method
  • How the Lennartz mechanism interacts with your proposed method
  • The anticipated non-business percentage of use for each Lennartz item (the ‘Lennartz percentage’). It may be helpful to obtain details of the business’s proposed calculation to establish the output tax due on the Lennartz charge
  • Whether separate sectors are proposed for Lennartz items

  • ‘Lennartz’ accounting allows a business to allocate an asset wholly to business purposes, recover all the VAT charged at the time it is incurred (subject to the normal partial exemption rules) then account for VAT on the non-business use on subsequent VAT returns over a fixed period of time. See ‘VAT Information Sheet 14/07’ for more details.


Is the business proposing a sectorised method?

Sectorisation will be the norm for larger and more complex businesses and for VAT groups organised in that way. Sectorisation will normally follow the sectors and method of attribution used by the business itself for its financial and management accounts.

You can approve such methods provided you are satisfied that attribution and allocation of costs is carried out on a robust basis, and that you can properly document the method being used and proposed. However, it may be necessary to create additional sectors for distortive transactions, or to amend attributions where they may not properly reflect use?

  • Sectorising should not attempt to artificially divide a single business.
  • It will need to show that sectors are established on a sound basis which takes into account the appropriateness of the method as a whole. Sectors must be chosen objectively and consistently. It is not acceptable to create sectors which increase recovery while ignoring equally valid sectors which depress recovery; in other words, it is unacceptable to cherry pick.
  • Sectors may improve accuracy but increase complexity. Are all the proposed sectors really necessary or is it possible to achieve a fair and reasonable result with fewer sectors?
  • Confirm that the costs allocated to each particular sector / sub-sector relate exclusively to the supplies made in that sector.
  • Clearly establish the proposed basis for allocating residual input tax among sectors.
  • Confirm that the accounting system is capable of dealing with the level of allocation that the method requires.
  • Confirm that the sectors are supported by accounts

Remember - it is good practice to include a sector which deals with any input tax incurred that is not otherwise dealt with by the method. Normally this will be for new business activities that arise after the approval of the method. The recovery in this sector should be on the basis of the use of the input tax bearing costs, thereby ensuring a fair recovery of input tax

Cost accounting

If the business uses a cost-accounting mechanism and intends to use this mechanism as a basis for its PESM you should:

  • Establish details of the cost accounting mechanism including the procedures, e.g. costs centres/drivers etc…
  • Understand fully the method(s) it uses to allocate costs
  • Understand how each category of supply uses VAT-bearing costs
  • If the proposed method allocates any costs in a different way from its normal business accounting mechanism, establish the differences and the reasons for them

Even where the input tax on costs cannot be separately identified (perhaps because it is stripped out of the cost allocation system before the costs are allocated) the management cost allocation system may produce a fair and reasonable result.

The advantages of using such a system are that:

  • The business does not have to use a separate allocation system for its partial exemption method.
  • The allocation method will tend to follow the changing circumstances of the business without need to amend the partial exemption method.
  • The cost allocation system will be underpinned by sound accounting principles and audited, possibly independently.
  • The business has motivations other than VAT to ensure that the allocation method reflects the use of the costs.

Even where the business does not wish to follow their normal cost accounting in their PESM, knowledge of their cost accounting system treatment of costs may assist you in evaluating the method proposed.

Group Registrations

You will need to establish:

  • Full details of the VAT group structure, the activities of each member and the main costs incurred by them.
  • Details of any intended additions to or removals from the current VAT group within the foreseeable future.
  • Details of intra-group trading.
  • Details of how the method will deal with dormant group members.
  • Details of re-charges of costs by any holding company to group companies.
  • How the method will deal with new or unforeseen activities.
  • Details of any movement of capital items between group companies.

Corporate Groups with separate VAT registrations for group members

You will need to establish:

  • Details of management charges/recharges made between corporate group members.
  • The basis of these charges (e.g. staff costs, input tax bearing costs, charges at cost, charges with a mark up etc.)
  • Details of how these recharges/management charges actually use residual input tax.
  • Whether you consider such charges to be distorting within the method.
  • Details of any known plans or proposals to acquire or dispose of companies or to change business activities within the foreseeable future.

Non accounting-based methods

If the proposed method relies on calculations made outside the accounting system, you will need to establish how these will be made and how they can be audited by HMRC. This should include full details of any weighting used. For example:

  • Transaction count - Confirm the exact definition of a transaction and how the number of transactions will be ascertained.
  • Floor-space - Any method based on floor-space should be accompanied by a schedule of the areas and plans together with details of the intended attribution within the method.
  • Staff numbers or staff time allocated to activities, business streams, sectors etc…. You will need to establish exactly how the business intends to work this in practice and how the underlying data can be verified (e.g. internal time sheets). You will also need to establish details of any staff or time to be excluded from the calculations and how the method will reflect any part-time staff. A worked example based on current staff data should be provided. For example, how will time spent be defined - e.g. hours, half-day units, one-day units etc?

Please note this list is not exhaustive.

Further information that will help you to process an application effectively

  • When does the business want the method to start (e.g. the start of the current tax year, the next VAT accounting period)?
  • Does the business want a non-standard tax year?
  • Does the business use non-standard tax periods (i.e. VAT periods aligned to its own accounting periods rather than to exact calendar months)? If so, consideration will need to be given to the definition of their tax year.
  • Has the business clearly defined any terms in its proposal which are non-standard, non-legal or specific to your business?
  • Are there any known plans or proposals to change the business activities within the foreseeable future?


Have you received (where applicable):

  • The ‘declaration’ that the proposed method is fair and reasonable. (Please see PE43000 for more details).
  • Working papers showing calculations which demonstrate how the method will operate.
  • Details of the precise use along with a demonstration that the proposed calculation gives a more accurate result than the standard method.
  • A copy of the most recent annual accounts.
  • Copies of relevant parts of management accounts or information (if applicable).
  • Copies of costings or business plans (if applicable).
  • Any other relevant documentation if applicable (e.g. floor plans).