Business Brief
Partial exemption

Customs has issued a Business Brief (12/2001). It describes a revised policy concerning partial exemption in relation to the making of supplies overseas, in the wake of the House of Lords' decision in the Liverpool Institute of Performing Arts case (LIPA).

This policy change affects all businesses that make supplies of services that, although outside the scope of UK VAT (being exported services), do give the right to the recovery of input tax. These services are dealt with under reg 103, under which any VAT to be deducted in relation to those services has to be determined on 'use' of the cost in the making of those supplies, rather than automatically being swept up into the taxpayer's partial exemption method.

The standard method is enshrined in reg 101. The points out that a calculation for the recovery of VAT in relation to exported services (under reg 103) has to be carried out before applying the usual partial exemption method dealt with under reg 101. Furthermore, any special method negotiated with Customs that does not explicitly mention the kind of supplies that are included under reg 103, has also to be subject to an initial reg 103 calculation prior to applying the special method. Those special methods that include a reference to the outside scope supplies can be applied without any further consideration of reg 103.

In practical terms, the difference between the standard method and a 'use' method of apportionment is that the standard method could produce a distortion where VAT is incurred on expenditure with only a very tangential relationship to the making of international service supplies, but where those supplies have a high value and therefore weigh heavily in the standard method of calculation. The mischief the regulation is designed to address is where the value of such supplies allows a disproportionate amount of VAT to be recovered on expenditure that has a passing relationship with the supplies made. However, despite the evident logic of this, there is no guidance in the law or the as to how one is to determine the 'use' of a basket of costs in relation to making such supplies.

In simple terms, there is no actual method that has to be applied or is given as guidance. All the says is that any method is satisfactory as long as the result it produces is 'fair and reasonable'. If Customs deems it not to be, it will issue an assessment. Therefore, this aspect of partial exemption is not governed in the way that partial exemption is usually governed, by the application of a standard method in the absence of any negotiated special method. Instead, it is left as a potentially undetermined aspect of the VAT accounting regime - like business/non-business apportionment, which also is not covered by partial exemption regulations.

This introduces a large measure of uncertainty into taxpayers' affairs. However, they can mitigate this uncertainty by specifically entering into an agreement with Customs as to how their reg 103 supplies are to be dealt with.

The corollary must be that any business that makes or may make such supplies, and that either has a special method that does not specifically mention those supplies or uses the standard method, should now write to their VAT office to enter into a specific agreement for the treatment of reg 103 supplies.

They need not do this, but not to do so would involve them in a high degree of uncertainty. As to whether Customs is staffed to an appropriate level to consider and approve these methods (most of which, one supposes, will actually simply be templated on a standard method or an existing special method, and therefore will not treat reg 103 supplies as different from their normal supplies), remains to be seen.

One absolutely bizarre aspect of the is that while it indicates that Customs will assess where it feels that the taxpayer has not arrived at a fair and reasonable 'use' of the costs in question, it confirms that it does not have power to direct the taxpayer to apply a special method. This seems to suggest (almost unbelievably) that Customs would simply have to assess each and every time it felt that the unfairness was going on, and could do nothing to tie the taxpayer to rectify the unperceived unfairness for the future.

It is difficult to imagine a less streamlined approach to this issue. No doubt Customs did perceive a mischief arising in the case, but the majority of businesses that from time to time carry out such supplies would not be distorting the amount of VAT they recovered if those supplies were simply wrapped up into a normal partial exemption method. But now they will have to apply a two-stage method even if their involvement in such supplies is fairly slight. They will have to be seen to be doing so, and they run the risk of Customs disagreeing with the approach they have taken unless they have their partial exemption method renegotiated. Instead of targeting the regulation at the presumably narrow range of organisations that would otherwise enjoy a disproportionate advantage, it has contrived an approach that creates complexity for both VAT officers and many businesses, and all for what is probably a very minor revenue risk indeed.

Incontinence products

Following market research, Customs has finally realised that there is some sensitivity involved when people suffering from incontinence actually buy incontinence products. The particular difficulty was that the zero rate for such products available to eligible people involved their informing the retailer by means of a written declaration that they were eligible for the relief. Not only was it established that various people suffering from incontinence did not know the relief was available (and did not therefore provide the paperwork), but even those who did know about it were loth to provide the retailer with the paperwork.

Customs has decided that incontinence products are extremely unlikely to be purchased by anyone who is not suffering from the condition, or buying on behalf of a sufferer. On this basis, it has decided that, with effect from 1 October 2001, the products will be zero-rated on the shelf, and thus zero-rated to all purchasers. The zero-rate cannot apply to institutional purchasers, but it will apply to all small consignment retail purchases.

Customs able to put its eggs in two baskets

It often happens that, where Customs loses its argument in a VAT tribunal, one can see that it took the wrong argument and might well have been successful had it chosen an alternative approach. That is not merely to say that it did not argue its legal position correctly, but it literally raised an assessment on the wrong basis. It has often been observed that input tax has been disallowed on the basis that there was no business activity, whereas the tribunal has taken the view that a business activity has occurred. The corollary of such a decision is often that there should have been output tax on that business activity (by virtue of a barter transaction, for example), but by that time it was too late for Customs to substitute an assessment for output tax where it had actually assessed for a disallowance of input tax. The question that then arises is whether Customs might have the power to raise two assessments, perhaps with different figures involved, on the basis that one was the preferred assessment and the other an alternative back-stop.

This issue has now been decided in what could turn out to be a significant case. It involves University Court of the University of Glasgow (17372), which had evidently become involved in a VAT avoidance scheme concerning capital expenditure. That scheme was not discussed in great depth, but probably had similar aspects to the well-known Halifax scenario. Customs decided that it did not want to put all its eggs in one basket. If it argued the Halifax principle, whereby the avoidance scheme was contrived and should be ruled as failing to be effective, then that decision was prone to being turned over on appeal if the Halifax decision itself was successfully appealed. So, in order to protect its position, it put forward an alternative argument, based on a direct examination the partial exemption rules, that there was an amount of input tax to be disallowed because of its use in connection with exempt supplies.

The present hearing did not seek to substantiate either of those two arguments, but simply whether Customs was within its rights to issue two assessments in respect of one set of transactions, with different figures involved, in order to protect its position. The tribunal held that Customs was within its rights to do so. There was nothing in the statute that stops two equally plausible views of the law being represented in two different assessments. Nor can it be regarded as double taxation, since only one of the assessments could ever be paid, and that represented only single taxation.

The decision was emphatic, and it certainly seemed like common sense. But it would be unsatisfactory if anything other than a small minority of assessments were issued on this 'in the alternative' basis. That would be too confusing for the taxpayer and too costly to litigate.

However, it has to be noted that the taxpayer has the opportunity, in dealing with a single assessment, of putting forward more than one potential argument, even though those arguments might be mutually exclusive. Although taxpayers use this technique sparingly, since it can seem to cast doubt on their favoured argument, it is a resort that is available to them. On that basis, it seems perfectly reasonable that Customs should be in a position to do something similar with regard to assessments in contentious situations.

Obligation to produce tax invoices

The Chancery Division has heard an interesting case that does not involve Customs, but two companies, and in which the question was whether the supplier company was obliged to provide tax invoices to the customer company even though there was no possibility of those invoices being paid.

The case is that of . Europhone entered into an arrangement with Frontier for services in a situation where the VAT would be due on the earlier of Frontier being paid its fees, and it issuing a tax invoice for the fees. It quickly emerged that Europhone was a slow payer, but Frontier continued to provide services even though payments on its invoices were in arrears. Frontier protected itself in a minimal fashion by ceasing to issue invoices at the time prescribed in the contract, in order to delay setting a tax point for VAT on these services before its customer had the wherewithal to make payment. In due course Europhone went into administrative receivership. The administrators looked for ways of increasing its assets and duly lighted on the fact that Frontier had not rendered invoices in accordance with the contractual agreement. This meant that Europhone was unable to reclaim input tax on the services that had been consumed. Europhone had no intention of paying for those services, but tax invoices would have allowed it to recover the VAT.

Frontier refused to issue these invoices because it knew it would not receive payment, and so the legal proceedings began. The court decided in Frontier's favour. Although there was an agreement in contractual terms that the supplier would issue invoices periodically, it was not a term that the customer could enforce against the supplier. The contractual arrangements were not written in anticipation of administrative receivership, nor an arcane point of VAT legislation that might give the purchaser some form of advantage. The contractual terms were there to protect the supplier's reasonable interests, not to give such an advantage to the purchaser. Accordingly, the case was decided against the purchaser and in favour of the supplier.

This is an interesting point, since VAT legislation does prescribe that invoices must be issued within 30 days of a supply's completion, where the customer is a taxable person. But these were continuous supplies of services, and in theory there was no point at which an invoice was mandatory. Customs could consider that the supply Frontier made clearly exceeded the level of its invoicing, and VAT should be due (although Customs of course was not party to this particular dispute). That would be a debatable point, since even though a contract may set out the value of such supplies, and the terms on which that value should be paid, it is ultimately a matter between the contracting parties as to what value the services should carry, and that does not merely depend on the value of the services but also, to some extent, on such things as how easy it is for a customer to pay. What is certain is that, if such invoices had been issued, it would not be possible to undo that event by issuing credit notes. The correct procedure would have been to await bad debt relief.

Customs probably views this particular decision as being in its favour, since it thwarted an attempt to reclaim VAT in order to finance the payment to the company's debenture holders, at Customs' own expense.

Residential homes - Customs to appeal

Following the decision in Kingscroft Associates, Customs has issued Business Brief 10/2001. This says that Customs will appeal the decision, while reviewing the VAT legislation to seek to maintain the exemption on private residential home fees. It also confirms that Customs will continue to apply the exemption, and makes no offer to entertain the treatment of such services as standard-rated.

Opticians' equipment

A somewhat curious case has come up in front of the tribunal concerning VAT recovery status on ophthalmic diagnostic equipment.

In the case of (17298), it was the appellant's contention that part of the VAT incurred on equipment for testing eyes was recoverable because it partially contributed to the sale of contact lenses and spectacles. The supply of eye testing is in itself exempt from VAT, so Customs took the view that all of the VAT on eye-testing equipment was irrecoverable as relating exclusively to exempt supplies.

The tribunal accepted Customs' view. It confirmed that it agreed with a previous case ( Leightons), where opticians were making two distinctly separate supplies, namely an exempt medical supply and a standard-rated supply of spectacles and contact lenses. That in itself is potentially very embarrassing to Customs, since it has only recently announced its intention to tell opticians that all of their supplies are standard-rated after the Card Protection Plan.

The Vision Aid Centre tribunal was heard in May, by which time Customs had already announced its intention to change that aspect of its policy on 1 June 2001. Yet there is no mention in its submission to that tribunal of the Card Protection Plan decision. Nor was the tribunal case rescinded on the basis that it no longer confirmed Customs' policy concerning composite supplies in relation to opticians. It is difficult to avoid the deduction that Customs simply had no clear policy direction in taking this case to tribunal.

Leaving that point aside, the decision is also a curious one in any case. There is no mention of Wiggett Construction, where it was found that the VAT incurred in respect of the purchase of bare land was apportionable because, although an exempt sale of that land took place later, it was also contingent on the possibility that the vendor would provide taxable construction services. Nor did it refer to the Scottish Homes decision, where VAT was regarded as being apportionable where there was no more than a possibility that the home might be sold on a zero-rated basis to one of its occupants, but where most supplies were straightforward exempt rental.

Common sense does dictate that equipment a business uses to ascertain whether or not the person requires a change in contact lenses or spectacles must be regarded as having some degree of nexus with the standard-rated sale of those products. That might be a small nexus compared to the exempt medical use, but such a point can be dealt with through the partial exemption method.

In summary, the opticians' lobby will probably be delighted that the VAT tribunal has reasserted the view that opticians make mixed rather than composite supplies. They will also probably have good grounds to consider whether this particular appellant should take the immediate case to appeal, on the basis that the tribunal did not consider enough case precedent.

Compiled by Graham Elliott of haysmacintyre

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