VAT partial exemption: input tax attribution and three different answers: which one is correct?

Contributed by Neil Warren CTA (Fellow), ATT

I had a recent query from the owner of a partially exempt business that trades as an estate agent. Its exempt income is earned from mortgage commissions and the VATable income relates to commission received on house sales. So far, so good, it’s an easy business model.

The question she asked related to ten new computers being purchased for her staff:

‘Six work in the estate agency section; three in the mortgage department and one is the office manager, so she has a link to both. Shall we claim 65% of the input tax on the computers when we get the invoice?’

What do you think? To be blunt, there’s a lot more meat to the bone with this question than you might realise. Read on, and all will be revealed.

Principles of partial exemption

Input tax for a partially exempt business must be separated into three different categories:

• Taxable input tax (T) – input tax wholly relates to the taxable activities of the business and can be fully claimed, subject to the usual rules about tax invoices, deductibility, etc. Don’t forget that zero-rated sales are still taxable.
• Exempt input tax (E) – the expense wholly relates to the exempt activities of the business so no input tax can be claimed.
• Residual input tax (R) – sometimes referred to as ‘the pot’ or ‘non-attributable input tax.’ The expense is either relevant to business overheads – such as rent or telephone bills – or is a mixed cost with a direct link to both exempt and taxable activities. A proportion of R can be reclaimed, usually based on the standard method of calculation:

Note – The percentage of R to claim is rounded up to the nearest whole percentage as long as the total amount of residual input tax is less than £400,000 per month on average. If this limit is exceeded, the calculation is made to two decimal places.

What about the computers?

Have you worked out where her suggestion of claiming 65% of the input tax on the computers came from? Basically, she concluded that six out of ten of the computers would be only used by staff working in the taxable estate agency business (T) and the office manager’s computer would be a business overhead (R), so claim 50% of the VAT on this machine. Six claims of 100% and half on the seventh equals 65%. Job done. Or is it?

To add an extra snippet, 80% of the business income is VATable and 20% is exempt. So, as variation two of our input tax challenge, should we claim 80% input tax on the office manager’s computer – as it is classed as residual input tax – and then all input tax on the computers for the estate agency staff. I have a happy client because her proposed 65% has increased to 68%. We are doing well.

HMRC interpretation of the law

Here is the big question: has her business made a single purchase of ten computers – all itemised on a single purchase invoice – or ten separate purchases of one computer each? In other words, a third possible outcome is that the VAT on the deal is wholly classed as residual input tax (R) and – good news – her business can claim 80%, based on its percentage of taxable income with the standard method.

Your initial reaction might be to shout ‘no way will HMRC allow that’ because it gives an unfair result to the business – 65% or 68% is much fairer. But who said that VAT – or tax – is always fair? It is all about the legislation and how it is interpreted.

To quote from HMRC’s manual on partial exemption at policy note  PE21000 :

‘We attribute supplies received rather than purchase invoices. It should be borne in mind that several supplies can be included in one invoice or a single supply can be split over several invoices.’

My client’s business has clearly received a ‘supply of ten computers’ and not purchased ‘ten single computers’. Even if the supplier was asked to issue ten separate sales invoices, this would not move the goalposts if they were purchased at the same time and as part of the same deal. As we all know, VAT is all about who is supplying what and to whom.

Three alternatives

So, to summarise the three calculations – and also give a mention to another bit of the partial exemption legislation about standard method overrides – here is my final answer.

• Method 1 – claim 65% – in suggesting a claim of half of the input tax on the office manager’s computer, my client has invented her own ‘special method’ of calculation, i.e. ignoring the fact that the default position is always the ‘standard method’ based on turnover. She could apply to HMRC for a special method based on staff numbers, as long as it is fair and reasonable in terms of input tax recovery.
• Method 2 – claim 68% – based on the principle that ten single computers are being purchased, six will be wholly used for taxable activities, and one for both activities, with the latter apportioned according to the standard method, i.e. 60% + 8% = 68%
• Method 3 – claim 80% – there is a single purchase of goods, and the goods will be used for both taxable and exempt activities of the business, so all of the input tax is categorised as residual input tax and 80% is therefore claimed with the standard method.

Method 3 is – in my view – correct, but perhaps unfair to HMRC. It’s a bit like refereeing decisions in the Premier League – some go in favour of your team and some go against them.

The legislation recognises that quirky outcomes can happen with partial exemption and the ‘standard method override’ becomes relevant in some cases, i.e. where a ‘use based calculation’ is adopted to calculate how much residual input tax can be claimed rather than the standard method based on turnover. To continue the football theme, the override legislation is the VAR of the VAT world: a review system designed to achieve fair play. However, it is only relevant when very large amounts of input tax are involved, so only applies on rare occasions. See  Notice 706, section 5 .

VAT quirks

Partial exemption; international services; land and property. These are the three big topics in the world of the nation’s favourite tax where there are more twists and turns with the legislation than you get with an Agatha Christie crime novel. I have shared a quirk about partial exemption and input tax attribution but there are many more. I’ll share a land and property quirk with the option to tax rules in my next Tax Weekly article and one about international services thereafter. I’m giving three for the price of one, so to speak.

Links to commentary, legislation and other resources concerning partial exemption can be accessed via this Quick link.