Reforms to public sector VAT refund scheme

The Treasury is seeking views on proposals for a major reform of the current VAT refund scheme for public bodies, in order to make it simpler to operate and improve value for money in the delivery of services

Under the current VAT rules, government departments, devolved administrations, the NHS and Highways England are eligible for VAT refunds under Section 41 of the UK VAT Act (1994).

Unlike commercial organisations, many public sector organisations do not carry out business activities and cannot reclaim VAT incurred on the goods and services they buy. VAT is therefore a cost for departments.

As a result, it was traditionally cheaper for public bodies to undertake services in-house rather than outsource to the private sector with the addition of irrecoverable VAT costs.

Section 41 was introduced in 1984 to remove VAT from being a factor in decision making, by allowing public bodies to recover VAT paid on specified services contracted out to external providers, but not on all services.

However, the Treasury says work carried out internally HMRC suggests that ‘Section 41 in its current form is unduly complex, administratively burdensome and a barrier to effective financial planning.’

It now wants to extend the scope of Section 41 to permit full refunds of the VAT incurred on all goods and services during the course of non-business activities for those organisations currently falling within the scope of Section 41, an approach known as the ‘full refund model’.

It suggests departmental irrecoverable VAT costs total £10bn-£15bn, but the Treasury notes these estimates are highly uncertain as data is not currently readily available.

The Treasury says analysis suggests that reforming Section 41 in this way will improve tax neutrality in government procurement, encouraging policy delivery and procurement decisions which represent genuine best value.

It argues this model avoids the risk of reintroducing the artificial disincentive for government departments to pursue activities which are cost effective, that would likely occur if Section 41 were to be scrapped entirely and government departments had to fund their VAT liabilities directly from their budgets.

In addition, the full refund model would significantly reduce extraneous administrative burden on the Treasury, HMRC and central government in the long-term. A simpler set of rules for government VAT refunds also diminishes the pressure on these organisations to seek external advice when engaging with the complexity of the system.

In its analysis of the options, RSM said that while a simpler VAT recovery system for the public sector is a positive development, there are many potential ramifications of the Treasury’s plan, not just for the public sector, but also for the contractors or commercial providers of similar NHS services.

The firm pointed out that the NHS and listed bodies will have their core funding reduced to balance against the expected increase in VAT recovery from HMRC. This will be actioned on an estimated basis and may distort overall public funding.

For example, an NHS trust competing to provide commissioned care services may have a better VAT recovery position and therefore a large financial advantage over competing bidders from outside the NHS.

In addition, a new entitlement to recover VAT on goods may mean that the NHS decides to keep some activities in-house instead of completely outsourcing them, increasing the number of public sector staff.

RSM also warns that VAT planning in the sector could increase as suppliers look to take advantage of the new scheme.

The Treasury’s policy paper states: ‘The government welcomes views from all interested parties on appropriate timing and methodology for implementation. In particular, the government welcomes views on the impact a reform would have on existing accounting systems and contracts with external service providers, and any associated potential costs.’

The deadline for responses is 19 November, and views should be sent to HMTVATandExcisePolicy@hmtreasury.gov.uk.

VAT and the Public Sector: Reform to VAT refund rules

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