DECISION
Introduction
1.
This appeal concerns the method that must be used by the Appellant,
Lok’nStore Group Plc (“LnS”), to determine the amount of VAT on supplies to it
that it is entitled to deduct from VAT which it is liable to pay to the
Respondents (“HMRC”).
2.
A taxable person is entitled to deduct VAT incurred on supplies of goods
and services that are used or to be used for the purposes of making taxable
supplies (ie supplies on which VAT is charged) or which otherwise give a right
to deduct. VAT incurred on goods and services that are used for the purposes
of exempt supplies cannot be deducted. Where a taxable person makes both
taxable and exempt supplies (ie is partly exempt), VAT incurred on supplies of
goods and services is only deductible in so far as those goods and services are
used for the purposes of the taxable supplies. In such cases, an apportionment
must be made. The default method of apportionment is called, in the UK, the standard method and is described more fully below. The standard method must be
used by all partly exempt taxable persons unless HMRC have agreed or directed
the use of a different method, called a partial exemption special method
(“PESM”).
3.
LnS is a taxable person. LnS supplies taxable self-storage services
and, to a lesser extent, other goods and services. It also makes exempt
supplies of insurance. LnS considered that the standard method did not provide
a fair and reasonable attribution of VAT incurred on overhead costs to its
taxable supplies. LnS proposed four PESMs to HMRC which, in LnS's view,
achieved a fairer and more reasonable attribution. In a letter dated 10 June
2009, HMRC:
(1)
rejected the four PESMs proposed by LnS; and
(2)
confirmed an assessment issued to LnS on 6 March 2008 for £140,899 VAT
relating to periods 04/05 to 04/07 which HMRC considered was not recoverable in
those periods on the application of the standard method.
4.
LnS asked for the decisions to be reviewed. In a letter dated 21 August
2009, HMRC upheld the earlier decisions. LnS appeals against that review
decision.
5.
At the hearing, LnS stated that the Tribunal was only now asked to
consider one of the four proposed PESMs: the mix of floor space and values
method originally submitted by LnS on 19 June 2008 and amended by letter dated
15 December. It is described in more detail below. HMRC maintained that
the standard method is the appropriate method for LnS to apportion VAT on its
overheads.
6.
The issues in this appeal are whether the standard method and LnS's
proposed PESM produce a fair and reasonable attribution and, if both do so,
whether LnS's proposed PESM is fairer and more reasonable than the standard
method.
Facts
7. Witness
statements were produced by Mr Raymond Davies on behalf of LnS and Mr Alexander
Sherwood on behalf of HMRC. The witness statements were admitted as evidence
in chief. Both witnesses gave oral evidence and were cross-examined. The
parties also produced bundles of documents. On the basis of the witness
evidence and documents, we find the material facts to be as follows.
8. LnS
operates 21 self-storage facilities or stores in the south-east of England from
which it provides self-storage services to the general public and to
businesses. The stores have been purpose-built by LnS. They are, typically,
large buildings with rather plain exteriors distinguished by panels painted in
the company colour of bright orange. They have a ground floor and, usually,
two or more other floors of storage space, divided into steel windowless rooms
with wire mesh ceilings. On the ground floor of each store is a reception area
where staff deal with existing and potential customers. All stores have CCTV
monitoring and a secure perimeter. This appeal is concerned with the deduction
of VAT on the overhead costs associated with the construction, maintenance and
operation of LnS’s stores.
9.
LnS grants customers licences to store goods in the stores, usually in
lockable steel containers but sometimes in open covered containers and (for
very large items) on pallets in storage areas. Some of the stores have outside
storage. Customers either provide their own padlock to secure the units or
they can buy a padlock and key from the store. With rare exceptions, LnS does
not keep keys to the customers’ units. The units range in size from 25 to
10,000 square feet. LnS staff advise potential customers how much space they
are likely to need and there is also information on this on LnS's website. LnS
charges different amounts per square foot in different stores and ground floor
space is often charged at a higher rate. It was common ground that the
provision of storage by LnS is a supply of services chargeable to VAT at the
standard rate.
10.
LnS also hires vans to its storage customers. The van hire operates at
a loss and is used to encourage people to rent storage space. The vans are
hired out at £10 per day for those moving in, and £40 per day for customers who
have already moved in. It is common ground that the van hire is chargeable to
VAT at the standard rate. LnS also sells products related to storage, such as
bubble-wrap, tape and boxes. These products are sold to anyone who walks into
the store, not just those renting storage space. Any walk-in customers are
asked about their storage needs and encouraged to lease storage space where
appropriate. These supplies of storage-related products are also standard
rated for VAT.
11.
LnS provides some of its customers with insurance for their goods while
they are stored with LnS. It was common ground that the supplies of insurance
are exempt. LnS takes out a block insurance policy with Brit Insurance Ltd for
a fixed premium payment, which entitles LnS to offer a single insurance cover
product, up to a pre-set cover limit, to storage customers. Insurance is only
provided to customers and only covers the goods (not the container or space)
while they are in storage and not while they are in transit or elsewhere.
12.
Insurance is currently supplied at a fixed price of £1 per week per
£1,000 of goods insured, with a minimum of £2,000 worth of insurance. Prior to
November 2008, the price was 75p per week per £1,000 of goods. The price
increase was driven by market forces rather than by any other factor. LnS set
the price of its insurance by reference to the amounts charged by its
competitors for similar insurance.
13.
Customers taking out insurance are required to declare the maximum value
of goods they are storing. There is a fixed excess of £100 and the terms of
the insurance policy are not negotiable. It is a requirement of the
Self-Storage Association, of which LnS is a member, that all customers must
insure their goods. Customers cannot move their goods into storage at an LnS
store until they either show that they already have suitable insurance or buy
it through LnS.
14.
Insurance is discussed with customers when they discuss their storage
requirements and before any documents are signed. It is possible that
insurance may be discussed when a customer is being shown round the storage
units but we find that this was not what usually happened and, in any event,
insurance agreements were always concluded in the reception areas.
15.
Not all customers purchase insurance from LnS. In the Annual Report and
Accounts for the year ended 31 July 2011, the chief executive's review stated
that, during the year, over 86% of new customers took LnS's insurance. The
review also stated that ancillary sales accounted for 9.9% of storage revenues
in the year and were increasingly focused on insurance which increases overall
margin. In each of the last seven years, insurance turnover was between 4.1%
and 6.8% of LnS’s total turnover. The insurance sales contribute significant
profit to LnS but the business would still be profitable and sustainable
without it.
16.
LnS’s management accounts and financial statements do not allocate costs
to insurance or other ancillary sales.
Legislation
17.
Article 168 of Directive 2006/112/EEC (“the VAT Directive”) provides
that a taxable person is entitled to deduct VAT due or paid in respect of
supplies of goods or services to him from the VAT which he is liable to pay in
so far as the goods and services are used for the purposes of the taxed
transactions of the taxable person. There is no right to deduct VAT due or
paid in respect of supplies of goods or services which are used by the taxable
person for the purposes of exempt transactions.
18.
Where goods or services are used by a taxable person both for
transactions in respect of which VAT is deductible (eg taxable transactions)
and for transactions in respect of which VAT is not deductible (eg exempt
transactions), Article 173(1) of the VAT Directive provides that only such
proportion of the VAT as is attributable to the former transactions is deductible.
The deductible proportion is determined in accordance with Articles 174 and 175
which provide a default turnover-based calculation. Article 173(2) allows
Member States to adopt other measures to determine the deductible proportion.
Article 173(2)(c) allows Member States to authorise or require a taxable person
to make the deduction on the basis of the use made of all or part of the goods
and services. The UK PESM regime described below is based upon Article
173(2)(c).
19.
The UK has implemented the provisions of the VAT Directive in the Value
Added Tax Act 1994 (“the VATA”) and regulations made under it. Section 24 of
the VATA defines “input tax” as VAT on the supply of any goods or services to a
taxable person which are used or to be used for the purpose of any business
carried on or to be carried on by the taxable person. Section 25(2) provides
that a taxable person is entitled to deduct input tax allowable under section
26 from output tax due from the person at the end of each prescribed accounting
period. Section 26 states that the amount of input tax for which a taxable
person is entitled to credit is such input tax as is allowable by or under
regulations as attributable to taxable supplies. Section 26(3) provides that
where a taxable person makes both taxable and exempt supplies, HMRC shall make
regulations for securing a fair and reasonable attribution of input tax to
taxable supplies.
20.
The relevant regulations are Regulations 101 and 102 of the Value Added
Tax Regulations 1995 (“the VAT Regulations”). Regulation 101(2) sets out the
default standard method of apportionment:
“…in respect of each
prescribed accounting period—
(a) goods imported or acquired
by and goods or services supplied to, the taxable person in the period shall be
identified,
(b) there shall be attributed
to taxable supplies the whole of the input tax on such of those goods or
services as are used or to be used by him exclusively in making taxable
supplies,
(c) no part of the input tax
on such of those goods or services as are used or to be used by him exclusively
in making exempt supplies, or in carrying on any activity other than the making
of taxable supplies, shall be attributed to taxable supplies,
(d) … there shall be
attributed to taxable supplies such proportion of the residual input tax as
bears the same ratio to the total of such input tax as the value of taxable
supplies made by him bears to the value of all supplies made by him in the
period,
…”.
21.
Regulation 101(10) of the VAT Regulations defines "residual input tax"
as input tax incurred by a taxable person on goods or services which are used
or to be used by him in making both taxable and exempt supplies.
22.
The standard method for apportioning residual input tax in Regulation
101(2)(d) of the VAT Regulations reflects the turnover-based calculation in
Article 174 of the VAT Directive. The proportion of residual input tax
deductible is determined by dividing the value of the taxable supplies made by
a business in each VAT period by the value of the aggregate of both the taxable
and exempt supplies made by it in that same period, and expressing the result
as a percentage. As pointed out by Warren J in St Helen’s School Northwood
Ltd v HMRC [2006] EWHC 3306 (Ch), [2007] STC 633 at [16] the standard method can be viewed as a proxy for an apportionment
according to use.
23.
Regulation 102 of the VAT Regulations provides, so far as is material,
that
“(1) … the Commissioners may
approve or direct the use by a taxable person of a method other than that
specified in regulation 101.
…
(3) A taxable person using a
method as approved or directed to be used by the Commissioners under paragraph
(1) above shall continue to use that method unless the Commissioners approve or
direct the termination of its use.
…
(5) Any approval given or
direction made under this regulation shall only have effect if it is in writing
in the form of a document which identifies itself as being such an approval or
direction.
…
(9) With effect from 1st
April 2007 the Commissioners shall not approve the use of a method under
this regulation unless the taxable person has made a declaration to the effect
that to the best of his knowledge and belief the method fairly and reasonably
represents the extent to which the goods or services are used or to be used by
him in making taxable supplies.
…
(10) The declaration referred
to in regulation (9) above shall –
(a) be in writing,
(b) be signed by the taxable
person or by a person authorised to sign it on his behalf, and
(c) include a statement that
the person signing it has taken reasonable steps to ensure that he is in
possession of all relevant information.”
24.
Regulation 102(1) of the VAT Regulations enables HMRC to approve or
direct the use by a taxable person of a PESM which, as Etherton LJ observed in HMRC
v London Clubs Management Limited [2011] EWCA Civ 1323, [2012] STC 388 at
[29] is directed [by Section 26(3) of the VATA] to achieving a
fair and reasonable attribution when the standard method does not do so, or at
least a fairer and more reasonable attribution than the standard method.
LnS's proposed PESM
25.
The PESM proposed by LnS replaces the standard method’s turnover-based
calculation with a method that uses floor space as the proxy for the use of
VAT-bearing costs together with a turnover element for those parts of the
stores used for taxable and exempt supplies (ie the reception areas). The PESM
was set out in detail in a letter of 15 December 2008 to HMRC.
26.
Under the proposed floor space and values PESM, input tax is directly
attributed to taxable and exempt supplies as far as possible and deducted or
not accordingly. Input tax that is not directly attributable to either taxable
or exempt supplies is attributed to taxable supplies in the proportion which
“taxable floor space” in LnS’s stores bears to “total floor space”. “Taxable
floor space” for this purpose means areas of the stores used for making taxable
supplies of storage space to customers. The PESM states that the only areas
that are used for making both taxable and exempt supplies are the reception
areas. The floor space of the reception area is further reduced to reflect the
area used exclusively for making taxable supplies. The remaining mixed use
floor space of the reception area is apportioned between taxable and exempt use
in accordance with the ratio of the value of LnS’s taxable supplies to the
value of all its supplies.
27.
On this basis, LnS calculated that only 0.02% of its income was
attributable to insurance sold through the reception areas. The result of the
PESM is that LnS would be entitled to deduct 99.98% of VAT incurred on the
construction, maintenance and operation of the stores.
Authorities
28.
The issue of what constitutes a fair and reasonable method of
attribution of input tax has been considered by the courts on many occasions.
We were referred to several authorities by counsel. The general principles to
be applied when considering deduction of input tax where a person makes both
taxable and exempt supplies were set out by Carnwath LJ in Mayflower Theatre
Trust Limited v HMRC [2007] EWCA Civ 116, [2007] STC 880 on page 885 at [9]
as follows:
“i) Input tax is directly
attributable to a given output if it has a "direct and immediate
link" with that output (referred to as "the BLP test" [BLP
Group Plc v HM Customs and Excise [1995] STC 424]).
ii) That test has been
formulated in different ways over the years, for example: whether the input is
a "cost component" of the output; or whether the input is
"essential" to the particular output. Such formulations are the same
in substance as the "direct and immediate link" test.
iii) The application of the BLP
test is a matter of objective analysis as to how particular inputs are used and
is not dependent upon establishing what is the ultimate aim pursued by the
taxable person. It requires more than mere commercial links between
transactions, or a "but for" approach.
iv) The test is not one of
identifying what is the transaction with which the input has the most direct
and immediate link, but whether there is a sufficiently direct and immediate
link with a taxable economic activity.
v) The test is one of mixed
fact and law, and is therefore amenable to review in the higher courts, albeit
the test is fact sensitive.”
29.
In Mayflower Theatre Trust, a theatre, which was a charitable trust,
made exempt supplies of the admission to performances but treated VAT on
payments to production companies for staging the performances as residual input
tax. The Court of Appeal held that the production services were not solely
attributable to supplies of admission but also had a direct and immediate link
to the theatre's taxable supplies of programme sales. The theatre was entitled
to treat the input tax as residual.
30.
We were also referred to HM Customs and Excise v Southern Primary
Housing Association Limited [2003] EWCA Civ 1662, [2004] STC 209. In that case, the issue was whether input tax incurred on land
purchased by the taxpayer was directly and immediately linked to an exempt sale
of the land, or to an overall transaction consisting of the sale of the land
and the taxable supply of construction of residential dwellings. In Southern
Primary, Jacob LJ accepted that the tribunal had been wrong to ask whether
the input enabled the taxpayer to make a supply in determining attribution.
Jacob LJ observed at [32]:
“The land purchase transaction
was commercially necessary to make its performance commercially possible, but
it was not a cost component of the contract itself in the same way as the costs
of materials used. There is a link with the contract but the link was not
direct and immediate. The development contract would not have been made but
for the associated land purchase and sale. But "but for" is not the
test and does not equate to the "direct and immediate link" and "cost
component" test.”
31.
Mr Andrew Hitchmough, who appeared with Mr Thomas Chacko for LnS,
submitted that there was a direct read across from Southern Primary to
LnS. Mr Sarabjit Singh, who appeared for HMRC, submitted that the case cannot
be read across because it was about direct attribution to specific outputs
whereas LnS’s appeal concerned overheads which could not be attributed to
particular outputs. It is correct that Southern Primary did not concern
overheads but, as Skatteverket v AB SKF Case C-29/08 [2010] STC 419 (discussed
further below) shows, the "direct and immediate link" and "cost
component" tests are also relevant when considering overheads. We accept
Mr Hitchmough’s submission that “but for” is not the test for attribution of
VAT on overheads. It follows from Southern Primary that the fact
that LnS would not have made supplies of insurance if it did not have
facilities to store the insured goods is not the correct test.
32.
Mr Hitchmough also relied on similarities between LnS’s situation and
that of the appellant in Camden Motors (Holdings) Limited v HMRC
[2008] UKVAT V20674. In that case, a car dealer introduced customers to
finance houses in return for commission which was an exempt activity. The
issue was how much input tax incurred on the refurbishment of the car showroom
could the car dealer recover. The car dealer applied the standard method which
resulted in 100% deduction of VAT. HMRC objected and said that the car dealer
should apply the standard method override. The tribunal found, at [74] and [75],
that the sale of cars was the economic driver of the business and a far higher
proportion of its costs were used in respect of car sales than sales of finance
because a greater infrastructure was needed to sell and service cars than to
sell financial products. We agree with the approach taken by the Tribunal in Camden
Motors.
33.
Both parties sought to rely on the decision of Warren J in St Helen’s
School as setting out the principles to be applied in determining the
apportionment of residual input tax. The school in that case granted a licence
of a new sports complex to a subsidiary (“SHEL”) in order to facilitate
commercial (i.e. taxable) use of the new complex outside school hours in term
time and during the holidays. The school retained the right to use the complex
for its own, exempt, purposes during school hours in term time. The school
argued that it should be able to recover input tax on construction of the
complex by reference to the physical use made of the new complex by SHEL,
SHEL’s use of the complex being compared to that of the school itself by a
time-based apportionment. Warren J rejected that argument, on the grounds that
it did not accord with the “economic use” of the new complex. At [76]-[79], he
concluded:
“76. In that context, it is
instructive, I consider, to look at the position had the School not granted the
licence at all and had [it] not allowed any out-of-hours use. In those
circumstances, there would have been no taxable supply at all. In consequence,
none of the input tax would fall to be attributed to taxable supplies as a
result of Regulations 101(2)(b) and (c), Regulation 101(2)(d) not applying.
However, the sports complex is used for the purposes of the School's
(exempt) business. It is so used not because there is a supply to parents of
the physical use (by their daughters) of the sports complex to their children,
but because the availability of the complex is part of the package of benefits
which is acquired by parents for the fees they pay and which constitutes the exempt
supply by the School. The use made by the School, for VAT purposes, of the
sports complex is its use in providing that package of services, a single
supply. There is, of course, no need to identify a proxy for use when there is
only an exempt supply since questions of allocation under Regulation 101(2)(d)
do not then arise. Nonetheless, one can see that the "use" referred
in Regulation 101 (as elsewhere) is not physical use but some special VAT use.
It is, I think, the same as what Miss Simor terms "economic use".
77. On the facts of the
present case, it seems to me that the overwhelming economic use of the sports
complex by the School is in relation to the provision of educational services.
In that context, I agree with Miss Simor that the source of funds and the
purpose of constructing the sports complex are relevant considerations. To
regard those factors as relevant is not, in my judgment, to fall into the
error, as Mr Thomas would say it is, of categorising the nature of a supply by
reference to the purpose or motive in making it. There is no doubt that in the
present case, the supplies are distinct and readily identifiable, that is to
say the taxable supply of the licence to SHEL and the exempt supply of
education. Nor, in my judgment, is there any question, in taking those factors
into account of treating a taxable supply as an exempt supply or vice versa.
The question is what "use" is being made of the inputs in producing
the outputs. It seems to me that the purpose of the School, objectively
ascertained, in constructing the sports complex is a highly relevant factor in
attributing cost components between the relevant outputs and is an entirely
different issue from identifying the nature of the output by reference to
purpose or motive (which is inadmissible), the issue addressed by Patten J in Yarburgh
Children's Trust.
78. On the evidence, it is
clear that, objectively assessed, the principal purpose of the School in
building the sports complex was the furtherance of its educational activities
and was carried out in connection with its business of making exempt supplies
of education. That conclusion is clear from the way the matter was put in the
first draft of the business plan and the approach of the School to the
generation of funds by out-of-school use which was designed to meet the running
costs of the complex and, if possible, something over and above that. Further,
the capital cost of the complex was met out of funds which were either
charitable funds or derived from a fund-raising exercise and which were clearly
dedicated to the educational purposes of the School. The generation of income
by out-of-school use was essentially a secondary consideration, albeit that the
benefit thereby produced was an aspect of the whole project from the beginning.
79. Moreover, it is also
clear, I consider, that the income generated by the licence to SHEL was never
intended or expected to meet a share of the capital cost proportionate to the
physical use of the sports complex by SHEL. The relevance of this is that it
is supportive of the view that the principal, objective, purpose of the
expenditure on the sports complex was in furtherance of the School's main
function of providing education to its pupils and that the license to SHEL was
secondary, simply putting to productive use that which has been acquired for a
different main purpose. In terms of VAT, the provision of an exempt supply of
education was the principal use of the sports complex and the taxable supply of
the licence to SHEL was a secondary use.”
34.
St Helen’s School was approved by the Court of Appeal in London
Clubs Management which concerned the appropriate apportionment of input tax
in the case of a casino with a catering operation. A very similar situation
had been considered by the VAT and Duties Tribunal in Aspinall’s Club
Limited v HM Customs and Excise (2002) (VAT Decision 17797). In that
case, a gaming club maintained extensive (standard rated) dining facilities for
gamblers making use of its exempt gaming facilities. The club sought to apply
a PESM based on floor area that attributed large amounts of its
property-related expenditure to taxable catering activity. The tribunal
dismissed the club’s appeal, holding that exempt gaming was clearly the
foundation of the business. The catering was not operated at a profit and its
costs were incurred to support the exempt gaming activity. The Tribunal held
that a floor area based method, which would have allowed deduction of 55% of
input tax on overheads, did not achieve a reasonable attribution of input tax.
35.
In London Clubs Management, the taxpayer operated a number of
casinos with restaurants and bars. The taxpayer proposed a PESM based on floor
space which HMRC refused. The Tribunal held that, although it was not profitable
at the time, the catering was not merely provided to facilitate exempt gambling
but was an activity in its own right. The Tribunal concluded that the floor
space method was more fair and reasonable than the existing method and allowed
the appeal. The Court of Appeal held that, in view of the Tribunal’s finding
of fact that the catering was a business in its own right carried on with a
view to making a profit, the Tribunal’s decision could not be disturbed. In
the Court of Appeal, Etherton LJ, having analysed Aspinall’s, said this
at [41]-[42]:
“That case and the reasoning
of the Tribunal, with which I agree, is illustrative of three points of
principle. First, it shows the importance in these cases of close attention to
the facts in order to understand the economic or commercial reality underlying
the use of the relevant VAT inputs. Secondly, identification of the source or
potential source of profit in a business may be an important feature of a
business throwing light on whether or not the standard method or a PESM is a
more fair, reasonable and accurate method of attribution. It all depends on
the facts of each case: cf. Banbury Visionplus Ltd v Revenue and Customs
Commissioners [2006] STC 1568 at [68]. Thirdly, depending again on the
precise factual situation under consideration, the approach of the Tribunal in Aspinall's
Club (see para 49) may well be appropriate in a case where the taxable
supplies are not, in themselves, a source of profit:
"Those costs are funded
by the gaming. That in itself does not make them cost components of those
exempt supplies. But in this case it is additional proof, if any is needed,
that gaming is the foundation of the business and it is the furtherance of that
gaming which causes and is seen as justifying commercially the decisions to
incur the expenditure."
As both St Helen's School
and Aspinall's Club show, and as was emphasised in Dial-a-Phone v
Customs and Excise Commissioners [2004] STC 987 at [72] by Parker LJ (with
whom the other members of the Court agreed), analysis of attribution for the
purposes of Article 2 of the First Directive, Article 17 of the Sixth Directive
and Regulation 101 is highly fact sensitive.”
36.
It is clear from the passage cited above that the task for the Tribunal
is to determine the use of the supplies on which the VAT is incurred by
reference to economic or commercial reality. We bear in mind that the profit
which is derived from an activity may be relevant in determining whether a
method produces a fair and reasonable attribution but that is not necessarily
the case. As Etherton LJ observed in London Clubs Management at [84],
“profit may be an important factor, but it is not necessarily so, and in some
cases it may be entirely irrelevant”.
Submissions
37.
Mr Hitchmough submitted that the standard method does not work in the
case of LnS because it assumes that exactly the same amount of residual input
tax is used in order to generate £1 of exempt income as to generate £1 of
taxable income. LnS contended that the proposed PESM reflects the true nature
of its business (selling storage space) and the economic use of its overheads.
Mr Hitchmough emphasised that the sale of storage space, not insurance, is the
“driver” of LnS’s business, as education was in St Helen’s School, car
sales were in Camden Motors and gambling was in Aspinall’s, and
the proposed PESM reflects this. The fact that LnS is only able to sell
insurance because it supplies space to store the goods in its stores does not,
of itself, mean that overheads are being used for the purpose of selling
insurance.
38.
Mr Singh submitted that LnS was in error in assuming that physical space
was an accurate reflection of how the overheads were used to make taxable
supplies. The proposed PESM was flawed because it allocates all storage space
exclusively to a taxable use, whereas the reality is that the storage space is
attributable to both taxable and exempt supplies, as the storage space is used
to generate both taxable supplies of storage and exempt supplies of insurance.
It was similar to the error made by the school in St Helen’s School. Mr
Singh said that it was important not to be distracted by physical use of the
stores. HMRC’s view was that the premises were used for the purposes of the
business as a whole, which included making exempt supplies of insurance. LnS
was wrong to say that all the floor space apart from the reception area was
used only to make taxable supplies and that insurance sales take place
physically in reception. HMRC’s case is that the storage space is also used to
generate exempt income which is important part of LnS’s business and a
significant contribution to its profit. The sale of storage and insurance are
negotiated at the same time. The two are inextricably intertwined. Physical
use of space is not an appropriate proxy as it does not reflect economic use.
An important feature of LnS’s business is the sale of insurance as indicated by
the increased focus on sales. The increase in turnover and contribution to
profit show that it is a driver of LnS’s business. The lack of allocation of
costs in the management accounts of the business indicate that the overheads
are used for the purposes of the business as a whole. The standard method is
fair and reasonable because it changes with the levels of turnover for exempt
and taxable supplies which is appropriate when overheads are used to make all
supplies.
Discussion
39.
Input tax is recoverable by a business to the extent that supplies on
which it has incurred VAT are used to make taxable supplies (section 26 VAT Act
1994). Where a supply is used by a business for mixed (ie taxable and exempt)
purposes, some form of apportionment is necessary. The purpose of a method is
to provide a fair and reasonable apportionment of the supplies on which VAT has
been incurred according to use by reference to a proxy. As Etherton LJ
observed in London Clubs Management, at [33],
"The onus
is on the taxpayer to show that the proposed PESM is more fair and reasonable,
that is to say, more accurate ..."
40.
The task for this Tribunal is to determine whether the standard method
and the proposed PESM produce a fair and reasonable attribution of the supplies
on which LnS has incurred VAT to taxable supplies by LnS. That requires us to
form a view on whether the methods are accurate proxies for apportionment
according to use. If we conclude that both do so, then we must determine
whether LnS has established that its proposed PESM is fairer and more
reasonable, ie a more accurate proxy, than the standard method.
41.
The starting point is use. This appeal concerns the deduction of VAT on
the overhead costs associated with the construction, maintenance and operation
of LnS’s stores. We must determine the extent to which the goods and services
supplied to LnS in connection with the construction, maintenance and operation
of its stores are used for transactions in respect of which VAT is deductible
ie taxable supplies.
42.
The meaning of “use” and the way it should be measured for VAT purposes
was discussed by Warren J in St Helen’s School. Warren J observed, at
[75] that "physical use of the complex is not necessarily a fair and
reasonable proxy … [and] … the phrase ‘economic use’ is a helpful approach to
establishing what the search is for.”
43.
The term "economic use" is consistent with the analysis of the
CJEU in the SKF case. SKF was the parent company of an industrial group
which made taxable supplies. SKF proposed to sell shares in two of its
subsidiaries in order to raise funds to finance other activities of the group.
The SKF case concerned the deductibility of VAT incurred on services
relating to the sale of shares. The issue was not simply whether the services
were attributable to the sale of shares but also whether they were attributable
to SKF’s business generally ie were overheads. At [57]-[58], the CJEU said:
“57 According to settled
case-law, the existence of a direct and immediate link between a particular
input transaction and a particular output transaction or transactions giving
rise to entitlement to deduct is, in principle, necessary before the taxable
person is entitled to deduct input VAT and in order to determine the extent of
such entitlement ... The right to deduct VAT charged on the acquisition of
input goods or services presupposes that the expenditure incurred in acquiring
them was a component of the cost of the output transactions that gave rise to
the right to deduct …
58 It is, however, also
accepted that a taxable person has a right to deduct even where there is no
direct and immediate link between a particular input transaction and an output
transaction or transactions giving rise to the right to deduct, where the costs
of the services in question are part of his general costs and are, as such,
components of the price of the goods or services which he supplies. Such costs
do have a direct and immediate link with the taxable person’s economic activity
as a whole …”
44.
There is no dispute in this case that the VAT incurred on construction,
maintenance and operation of LnS’s stores are part of its general costs ie are
overheads. In the passage above, the CJEU makes clear that the "direct
and immediate link" and "cost component" tests are also relevant
when considering overheads. At [60], the CJEU set out how to apply the tests:
"It follows that whether
there is a right to deduct is determined by the nature of the output
transactions to which the input transactions are assigned. Accordingly, there
is a right to deduct when the input transaction subject to VAT has a direct and
immediate link with one or more output transactions giving rise to the right to
deduct. If that is not the case, it is necessary to examine whether the costs
incurred to acquire the input goods or services are part of the general costs
linked to the taxable person’s overall economic activity. In either case,
whether there is a direct and immediate link will depend on whether the cost of
the input services is incorporated either in the cost of particular output
transactions or in the cost of goods or services supplied by the taxable person
as part of his economic activities."
45.
At [62], the CJEU showed the national court how it should approach the
issue:
"In order to establish
whether there is such a direct and immediate link, it is necessary to ascertain
whether the costs incurred are likely to be incorporated in the prices of the
shares which SKF intends to sell or whether they are only among the cost
components of SKF’s products."
46.
Applying the CJEU’s guidance in SKF, in determining what the
goods and services supplied to LnS in connection with the construction,
maintenance and operation of its stores are used for, it is necessary to
ascertain whether and, if so to what extent, the costs of such supplies are
likely to be incorporated in the prices of LnS’s supplies to its customers. In
our view, the actual or likely impact of the costs of overheads on the prices
of LnS’s supplies not only establishes whether there is a direct and immediate
link with those supplies but is also a useful measure of the extent of the
economic use of the overheads.
47.
First, we consider whether and the extent to which the overhead costs
are incorporated in the price of the insurance. The evidence showed that LnS
set the price of its insurance by reference to the amounts charged by its
competitors for insurance rather than in response to any costs (not even the
cost of the block policy). We find that the costs of constructing, maintaining
and operating the stores did not materially affect and were not incorporated in
the price of the insurance. We consider that there is some link between
overheads costs and the sale of insurance simply because the insurance is sold
in the reception areas of the stores and the overheads relate, in some part, to
those areas. We could not determine the impact of such costs on the price of
the insurance from the evidence before us but, for the reasons given above, we
consider that the impact of the cost of general overheads on the price of
insurance must be very small. Accordingly, we conclude that LnS uses the goods
and services supplied to it in connection with the construction, maintenance
and operation of its stores in relation to the exempt supplies of insurance
only to a very small extent.
48.
The link between overhead costs associated with the construction,
maintenance and operation of LnS’s stores and the taxable supplies of storage
is easier to discern. In our view, if LnS opens a new store or enlarges or
refurbishes a store then the overhead costs will increase. Not all customers
purchase insurance from LnS and it follows that, if LnS is to recover them, the
costs of the new or improved space are likely to be incorporated in the prices
of the storage. We consider that costs of constructing, maintaining and
operating the store are linked to the price of the supplies of storage because
expenditure on new stores and valuation of development projects is assessed in
the LnS annual reports in terms of projected space rental levels and levels of
occupancy and not by reference to projected sales of insurance. In our view,
if the overhead costs increased then that would be likely to lead to an
increase in the charges per square foot for storage.
49.
Our conclusion is that LnS uses the goods and services supplied to it in
connection with the construction, maintenance and operation of its stores
almost exclusively for the purpose of making supplies of storage. This
conclusion does not determine the appeal. Next we consider whether the methods
provide a fair and reasonable determination of the amount of the VAT that is
attributable to LnS’s taxable supplies and whether one method is fairer and
more reasonable than the other.
50.
As Etherton LJ stated in London Clubs Management at [34]:
“A fair and reasonable
attribution to a taxable supply must, for the purposes of art 17(2) and (5) of
the Sixth Directive and reg 101(2)(d) of the Regulations, reflect the use of a
relevant asset in making that supply. In assessing that use, and its extent,
consideration is not limited to physical use. The assessment must be of the
real economic use of the asset, that is to say having regard to economic
reality, in the light of the observable terms and features of the taxpayer's
business”
51.
The standard method, found in regulation 101(2)(d) of the VAT
Regulations, involves dividing the value of taxable supplies by the value of
all supplies to arrive at a percentage figure, which is treated as the
percentage of residual input tax that is attributable to taxable supplies. The
application of the standard method in this case would result in 94% to 96% of
LnS’s residual input tax being attributed to taxable supplies. The proposed
PESM produces a level of taxable use of 99.98%.
52.
HMRC contend that the level of taxable income to total income is
generally a good measure of the economic use of goods and services. The greater
the level of taxable income, the greater the economic use of the overhead costs
in making taxable supplies. Equally, the greater the level of exempt income,
the greater the use of the overhead costs in making exempt supplies. In our
view, that proposition only holds good where the relationship between the
overhead costs and the income from the taxable and exempt supplies is, broadly,
the same. If the costs of goods and services used to make exempt supplies are
far greater than the costs of the goods and service used to make taxable
supplies then the use of a turnover method would lead to an over recovery of
VAT on those costs. In such a case, the economic reality is that the use of
goods and services is weighted towards the exempt supplies which cost more to
make and consume more of the VAT-bearing overheads.
53.
Further, we do not consider that the contribution to LnS’s profitability
made by insurance sales and the, understandable, focus on increasing the volume
of such a profitable line of business are relevant in determining the extent to
which supplies relating to the construction, maintenance and operation of its
stores are used by LnS to make supplies of insurance. The fact that a supply
generates a large turnover or profit does not, by itself, indicate that the
activity uses a high level of overheads.
54.
In LnS’s case, we have found that the goods and services on which the
residual VAT is incurred are used almost exclusively for the purpose of making
taxable supplies of storage which is the main focus of its business. We
consider that a fair and reasonable attribution of the residual input tax would
show that the overheads were almost exclusively attributable to taxable
supplies of storage. Although both methods attribute the majority of the overheads
to taxable supplies and both might be considered to be fair and reasonable, the
PESM proposed by LnS better reflects the economic use of the overheads by LnS
and is, accordingly, a more accurate proxy than the standard method.
Decision
55.
For the reasons given above, our decision is that the PESM proposed by
LnS produces an attribution which is fairer and more reasonable than the
attribution that would result from the standard method and, therefore, the
appeal is allowed.
Rights of appeal
56.
This document contains full findings of fact and reasons for the
decision. Any party dissatisfied with the Tribunal’s decision has a right to
apply for permission to appeal against it pursuant to Rule 39 of the Tribunal
Procedure (First-tier Tribunal) (Tax Chamber) Rules 2009. The application must be received by this Tribunal not later than
56 days after this decision is sent to that party. The parties are referred to
“Guidance to accompany a Decision from the First-tier Tribunal (Tax Chamber)”
which accompanies and forms part of this Decision Notice.
GREG SINFIELD
TRIBUNAL JUDGE
RELEASE DATE: 14
September 2012
