PE41000 - Consideration of Partial Exemption (PE) special methods: when a special method is appropriate

The use of a special method is appropriate when the standard method does not give a ‘fair and reasonable’ recovery of input tax (see- PE24000 - Partial Exemption methods: Fair and reasonable) and where the alternative guarantee a more accurate result. More accurate is by reference to the precise use of the costs.

What is the precise allocation?

By precise allocation HMRC mean the extent that each good or service is used to make deductible supplies. The decision in the case of St Helen’s School said that use

”is not physical use but some special VAT use. It is I think the same as what [HMRC counsel] terms ‘economic use’ ”.

HMRC consider that the economic use is the measure of the extent that goods and services form cost components of the price of the various supplies.

Precise attribution of each and every cost and how it is reflected in the various outputs of the business involves a detailed and onerous calculation, one very few businesses will undertake. Nevertheless a precise allocation remains at the theoretical core of partial exemption.

What alternatives to the precise allocation are acceptable?

A precise allocation is highly unlikely to be maintained. In the absence of a precise allocation, HMRC would normally accept that the allocation in the company accounts reflects a fairly precise use of costs.

Management accounts are not subject to the same regulations as audited accounts. Businesses will design their management accounts to best help them run their business. It is perfectly legitimate for businesses to have different sets of management accounts for different business purposes. These different accounts may allocate costs in different ways. It follows that not all management accounts will be acceptable. Whether they can be accepted is something that needs to be decided on a case by case basis considering amongst other issues the transparency of the allocation method and the historical consistency of the accounting system.

In many cases company accounts will either not allocate costs to the different income streams or will only allocate some costs. Any accepted precision of accounting allocation will only be to the extent the relevant costs are actually allocated.

Where a business does not consider it appropriate to allocate costs to activities for the purpose of its statutory accounting or management purposes it is unlikely that an allocation method other than the default will be appropriate. However it is possible that some businesses will retain alternative information detailing how costs relate to supplies for example pricing information or planned expenditure forecasts. These may be accepted as representing a precise allocation.

The expectation is that any measure of precise use will be maintained by the business to allow the accuracy of the proxy to be assessed. One off exercises are unlikely to be acceptable as demonstrations of precise use. Businesses tend to evolve over time and part of those changes will include the use of costs. Alternatives proxies to ones based on turnover will be allowed where they guarantee a more accurate calculation. HMRC consider that ‘guarantee’ involves maintaining evidence which allows the greater accuracy provided by the non turnover proxy to be confirmed in subsequent periods.

Uneconomic allocations

In some cases it will be clear that the standard proxy calculation is not reflecting the use of costs by a business but no record of the precise use is available. For example in cases where the standard proxy allocates costs in an uneconomic way.

In these circumstances HMRC consider that an allocation which gives an economically credible result is more accurate, and nearer to the precise allocation than one which does not.

The CoA in London Clubs [2011] EWCA Civ 1323 pointed out that “Business is carried on with a view to a profit”

HMRC normally expect that when costs are allocated to activities they will not exceed the turnover generated, meaning the business makes a profit. Of course, there may be perfectly normal business reasons why a business does not always achieve the profit it hopes to make. These include frustrated sales and reduced prices to sell time limited products. With start up businesses and activities it may be that early losses are anticipated. The expectation being that future profits will, in time, recoups initial losses. In those and similar cases an excess of costs over turnover is part of normal trading. By contrast, a situation where costs exceed turnover on a planned and continuing basis is not normal business practice and the credibility of the economics of the cost allocation will need to be justified.

It should be noted that in businesses where healthy profits are made, there could be a wide range of cost allocations between taxable and exempt supplies which give an economically credible result. In those cases HMRC would expect the accuracy of the proxy picked to be demonstrated by reference to the precise use.

As an example consider a business which supplies £100 of taxable Good A and £100 of the independently exempt service B incurring £125 of shared costs to do so.

A proxy which allocates £120 of the shared costs to Good A and £5 to service B does not appear, at face value, to be economically credible as the business loses £20 for every Good A it makes and sells.

Conversely a proxy which allocates the same costs £100 to good A and £25 to service B does give an economically credible result as neither supply loses money for the business. Similarly allocating the costs, £25 to Good A and £100 to service B is also economically credible.

The last two examples allocate either 20% or 80% of the costs to supplies A and B. Obviously any allocation percentage between those figures would also give a result which is economically credible. This is a wide range and HMRC would expect the proxy used to be justified by reference to something other than the mere fact that it is economically credible.

Does the precise allocation method have to be used for the proxy for use?

No. While businesses could use the precise calculation HMRC appreciate that it could be burden using the precise allocation method to allocate the VAT bearing costs. This will especially be the case if the precise allocation is not part of the VAT accounting system. As such the precise allocation may not be fair and reasonable for a business to use.

HMRC are therefore prepared to accept alternative proxies for that precise use providing that they are more accurate than the standard turnover calculation. Turnover is the standard proxy. Where turnover does not provide a fair calculation the reason should be established as this will give an indication as to suitable alternatives. The simplest alternative would be to adjust the turnover calculation. This could be suitable in cases where there are distortive values. In other cases a different proxy would be required. HMRC would however normally expect the proxy used to be one featuring predominantly in the precise cost allocation.

How can businesses demonstrate a calculation is more accurate?

HMRC consider that accuracy is an objective assessment by reference to real data and calculations as opposed to being a subjective opinion or a hypothetical argument. Put simply the alternative calculation gives a recovery rate nearer to the precise rate than an income based calculation does.

There will always be costs within a business whose use differs from that suggested by a proxy calculation. Identifying such costs does not necessarily mean that overall the allocation given by the proxy is not appropriate. Variations are excepted when proxies are chosen and do not cause concern unless the overall recovery does not reflect the use in making deductible supplies.

This is perhaps best explained by an example

Two companies A Co. & B Co. are in a VAT Group. A Co’s supplies are 99% taxable supplies. B Co’s supplies are 99% exempt. Each company has a similar turnover and the recovery under the standard method would be 50%. If the audited accounts show that A Co incurs 80% of the group’s residual VAT bearing costs, HMRC would accept that a taxable use of 80% reflects a precise allocation and using a proxy which allocates a taxable proportion nearer 80% than 50% is more accurate.

Of course being more accurate is only one part in deciding whether a method is fair and reasonable. A method also needs to reflect use. In the above example 100% is more accurate than 50% however given the precise use is 80% neither method is likely to be considered appropriate.