Comments of the CIOT on the April 2003 HM Customs consultation Making input tax recovery fairer: The recovery of VAT incurred before VAT registration or in connection with property subject to an 'option to tax', sent to Government on 29 August 2003. This consultation document sets out proposals for changing the current rules relating to:
- VAT incurred prior to registration;
- A change to the intended use of goods and services; and
- VAT incurred prior to making an election to waive exemption.
We agree that some of the present rules are unfair, obscure and burdensome, and that the piecemeal approach adopted in the past has given rise to its own problems. We welcome the decision to look at the three selected topics in the round and, in general, consider that the proposed changes go a long way towards providing practical and pragmatic solutions to technical complexity.
The Chartered Institute of Taxation welcomes the opportunity to contribute to this consultation. Our answers to the specific questions posed are set out in the Appendix.
References to “regs” in the Appendix are references to the VAT Regulations, SI 1995/2518.
The Chartered Institute of Taxation
29 August 2003
ANSWERS TO SPECIFIC QUESTIONS
RECOVERY OF VAT INCURRED PRIOR TO REGISTRATION
Q1: What is your view of the proposed changes?
Section 3 of the consultation document puts forward two proposals:
- Extend the time limit for expenditure on services incurred prior to registration from six months to three years; and
- Amend the rules for recovery of pre-registration VAT so that recovery is allowed insofar as the goods and services are used for the purposes of taxable supplies made after registration.
In general, we support common time limits. The first proposal aligns the time limit for services with the time limit for goods, and this common time limit (three years) is broadly in line with the time limit for recovery of input tax. We welcome this proposal.
The fact that VAT is, or is treated as, input tax does not give rise to an automatic entitlement to deduction. Thus, for example, the goods or services must be attributable to (inter alia) taxable supplies (s26(1), (2)). We therefore consider that the substance of the second proposal is appropriate and that it does little more than make explicit something that is currently implied.
The second proposal gives rise to the need for a practical method of determining whether goods or services are used for the purposes of supplies made before or after registration.
The test in reg 111(2)(a)(ii) is whether goods or services have been “consumed”.
The concept of “consumption” gives rise to conceptual difficulties that are left unresolved by the sparse guidance given in Notice No 700 paras 11.2 and 11.3.
We consider that the concept of “consumption” is apt to be misleading. The proper test is whether goods or services are a “cost component” of one or more supplies made by the taxpayer. In our view, goods or services can be a cost component regardless of whether or not they have been consumed. For example, if pre-registration rent, electricity and repairs are regarded as being consumed immediately, they are nevertheless a cost component of one or more post-registration supplies if the relevant building is wholly used to develop a new product to be put on the market following registration.
The fact that goods and services form a cost component of a post-registration supply will not necessarily give rise to relief under the second proposal. It is necessary to make two adjustments:
- If the goods and services are partly used for making pre-registration supplies and partly to be used for making post-registration supplies, only a proportion of pre-registration VAT is relieved under reg 111. Relief is confined to the proportion attributable to post-registration supplies. Our response to Q2(a) deals with the manner in which this proportion should be calculated.
- The post-registration supplies must be taxable supplies. This does not present any computational problem. As the VAT relieved under reg 111 is treated as input tax (reg 111(1)) and claimed on the taxpayer’s first VAT return (reg 111(3)), it is logical that it should be treated in the same manner as input tax incurred during the taxpayer’s first prescribed accounting period. In other words, it should form part of his partial exemption computation for that period.
We make one general observation about reg 111(1). This provides that “the Commissioners may authorise a taxable person to treat [certain pre-registration VAT] as if it were input tax”. We see no reason why Customs and Excise should have any discretion in the matter. As a matter of EU law, pre-registration VAT is input tax. This arises from the fact that it is incurred in carrying on an economic activity or in the preparatory stage to setting up an economic activity. Taxable persons are therefore entitled to deduct this tax provided they comply with the conditions in force at the relevant time.
The proposal discussed in Q10 indicates that VAT on property-related services will cease to be relieved under reg 111. Relief will arise, if at all, under the proposals discussed in Q7 and Q10. It follows that the administrative arrangement in Notice No 742A para 9.4 will be spent. We disapprove of concessions, whether described as “administrative” or “extra-statutory”. We consider that entitlements should be conferred by legislation. Thus, if either or both of the proposals in Q7 or Q10 are abandoned, we consider that the position of property-related expenses should be specifically dealt with in reg 111.
Any discussion of pre-registration VAT must necessarily consider the Lennartz principle. As a matter of EU law, taxpayers have a right of option to include all, part or none of a capital asset in their VAT accounts. The UK legislation does not expressly confer a right of option. Moreover, the UK provisions dealing with apportionment of input tax and deemed supplies of goods and services in connection with private or non-business applications are not directly relevant to a pre-registration context. We consider that this matter should be considered before the new regime is finalised.
Q2(a): Do you consider the apportionment methods described at Annex A to be fair and easy to use?
In our response to Q1 we indicated that pre-registration VAT should be relieved under reg 111 if the goods and services are a cost component of post-registration supplies, and that partial relief is appropriate if the goods and services are used for the purpose of making both pre-registration and post-registration supplies. We also indicated that any restriction on relief arising from the fact that some or all of the post-registration supplies are exempt could be dealt with in the partial exemption computation for the taxpayer’s first prescribed accounting period.
We consider that a calculation based on whether or not goods and services are a cost component of a post-registration supply is relatively straightforward because the issues can be decided as a matter of principle. We consider that the relevant principles are as follows:
- The consultation document states that “VAT incurred on trading stock on hand at registration will remain fully recoverable”. These goods are clearly cost components of post-registration supplies. No apportionment is necessary.
- Assets (eg machinery, furniture and patent rights) purchased before registration are cost components of post-registration supplies if they are held at the date of registration. An apportionment is necessary if the goods and services are used for the purpose of making both pre-registration and post-registration supplies.
- Some services are clearly a cost-component of one or more post-registration supplies. For example, services billed by a sub-contractor will normally form part of work-in-progress, and therefore be a cost component of a post-registration supply, if the taxpayer finishes the job after the date of registration. The situation may be different if the taxpayer rendered an interim bill to the customer before registration. Much will depend upon the costs billed. Thus, an apportionment may or may not be necessary.
- Other services are cost-components of both pre-registration and post-registration supplies. This will be so in relation to overheads such as rent, cleaning and telephone charges. An apportionment is necessary.
We consider that the five methods illustrated provide a reasonable approach to the question of apportionment. We agree that taxpayers should have freedom to choose any method of calculation that suits their particular circumstances. We also agree that the guiding “fair and reasonable” test is a proper one.
Q2(b): Do you wish to suggest an alternative method?
There is little point in seeking professional advice on which method to adopt, and how to apply it, if trivial sums are at issue. Any relief will be eaten up by the costs involved. Thus, there is a need for a quick and easy method that can be understood by anyone. The fact that it may produce only a rough-and-ready answer is not a material factor if a de minimis limit is imposed.
We consider that the current rules provide the basis for the simplification scheme we propose. Relief would be given on the basis of:
- VAT incurred on goods held in stock at the date of registration;
- VAT incurred on goods and services held as assets at the date of registration;
- VAT on services purchased during a prescribed period ending on the date of registration. The current period is six months. A longer or shorter period may be more appropriate. We have no particular view on what it should be. The fact that services may have been used to make pre-registration supplies is a relevant factor in fixing the period concerned.
We observe that the current six-month time limit for services appears to have been originally introduced as a means of giving rough-and-ready relief for:
(1) overheads attributable to stock-in-trade held at the date of registration, and
2) work-in-progress at the date of registration, which is likely to comprise a mixture of bought-in services and overheads.
Q3: Will this proposal impact on any particular business sector? If so, in what way?
We make no observation on this question.
ENTITLEMENT TO RECOVER VAT FOLLOWING A CHANGE OF INTENTION
Q4: What is your view of this proposal?
Section 4 of the consultation document proposes that taxpayers should recover input tax under the “payback” provisions of reg 109 by simply making an adjustment on their next VAT return.
We welcome this proposal. It has the following beneficial consequences:
- It avoids the need for the taxpayer to make a claim to his local VAT Business Centre. As VAT is a self-assessed tax, it is logical that taxpayers should make accounting adjustments without prior permission unless there is some overriding need for permission;
- It is likely to reduce the delay in receiving the benefit of the adjustment;
- It corrects a long-standing anomaly that, while the legislation requires Customs and Excise to “pay” the sum claimed to the taxpayer, in practice he is required to include the sum concerned on his VAT return for the period in which the claim is accepted (see Notice No 706 para 9.2.2); and
- It provides a common system for dealing with adjustments arising from a change of intention under regs 108 and 109.
AUTOMATIC PERMISSION TO OPT FOR TAX
Q5: What is your view of the proposed automatic permission conditions?
Section 5 of the consultation document proposes a revision to the criteria governing the right to make an election to waive exemption without prior permission. The new criteria are set out in Annex C to the consultation document.
We support any move to improve the existing set of automatic permissions to opt to tax as most, if not all, of the current conditions are ineffectual for most businesses.
We comment as follows:
- We agree with the first condition;
- We regret that the second condition does not include mixed residential and commercial properties;
- We accept the third condition. We assume that “claims under the new scheme of VAT” is a reference to Options A and B described in para 5.12 of the consultation document. This should be reflected in the final text of this condition; and
- We understand the reasons for the fourth and fifth conditions.
Q6: Are there any other conditions you would like to be considered?
INPUT TAX RELATING TO BUILDINGS WHICH REGISTERED BUSINESSES OPT TO TAX
Q7: Which of the two options do you prefer, and why?
Section 5 of the consultation document proposes that a proportion of pre-election input tax should be recovered when an election to waive exemption is made in respect of a building that is not a capital item for the purposes of the capital goods scheme. Two options are set out in para 5.12.
Option A involves an extension of the capital goods scheme. We see no particular advantage in this option. In particular:
- It will not confer any relief if the expenditure incurred is less than £50,000. However, this disadvantage would disappear if no threshold were applied. We deal with thresholds in our response to Q9; and
- Adjustments under the capital goods scheme involve an administrative burden.
Option B involves the creation of a new scheme. This scheme will make provision for a “once and for all” recovery with no requirement for further adjustment. By contrast, Option A involves repayment by annual instalments and the cessation of instalments if, for example, a further change of use involves using the building for carrying on a business making exempt supplies.
We prefer Option B. As most taxpayers eligible for relief are likely to be small businesses, we consider that their preferences should carry most weight. We consider that most small business are likely to prefer this option because of its cash flow advantages, its simplicity, the absence of any on-going administrative burdens and the fact that they are free to make a further change of use without incurring a financial penalty.
Q8: Do you have an alternative method that you would like to be considered?
We offer no alternatives at this stage.
Q9: In option 'A', is £50k the right threshold?
The problem with a threshold is that X will benefit because his expenditure is £50,001 and Y will not because his expenditure is £49,999. Y will feel aggrieved. That said, there must clearly be a threshold because capital expenditure of any kind must have some substance. Trivial expenditure is not regarded as capital expenditure however durable the asset may be.
It may be that £50,000 is an appropriate threshold in most circumstances as the consultation document suggests. We note, however, that small businesses do not need to spend a fortune in order to (say) enlarge their premises. Significantly less than £50,000 can buy a lot when the building at issue is a small workshop.
The interests of small business must always be borne in mind. We therefore consider that a lower threshold is preferable to a higher one. We have no particular figure in mind. It may be that somewhere in region of £10,000 is appropriate. However, the capital goods scheme is an over-complex solution to the question of relief where the sums at stake cannot exceed £175 per annum. We conclude that any consensus in favour of a very low threshold is really an argument for Option B.
TIME LIMITS FOR THE RECOVERY OF VAT INCURRED ON BUILDINGS
Q10: What is your view of the proposals to change the rules governing the recovery of input tax on property-related costs?
Section 5 and Annex C of the consultation document make two proposals:
- To align the rules for recovering pre-registration VAT on property-related costs with the capital goods scheme rules; and
- To provide that the capital goods scheme period of adjustment starts when a building is first used.
The purpose of these proposals is to eliminate the date of registration as a factor governing the tax consequences of the capital goods scheme. Suppose that X and Y both construct a building on 1 January 2005 and incur VAT of £100,000. X registers on that date and Y registers three years later. Suppose also that neither X nor Y makes exempt supplies during their ownership of the building.
Under current legislation, X has a period of adjustment comprising 1 January 2005 – 31 December 2014. Y has a period of adjustment comprising 1 January 2008 – 31 December 2017. Logic suggests that the same period of adjustment should apply to both. Thus, in principle, we accept the logic of this proposal.
Unfortunately, the consultation document is less than clear about the consequences of harmonising the period of adjustment. Three points emerge from the consultation document:
- The fact that Y “enjoy[s] ten years recovery of VAT without having to account for the non-taxable use of the building prior to VAT registration” is seen as a distortion in need of correction (para 5.23);
- The proposal will allow Y to “apply the CGS for the remainder of the ten-year adjustment period following its notional commencement at first use of a building” (para 5.25). This implies that Y will make CGS adjustments for the period 1 January 2008 – 31 December 2014, i.e. for seven intervals; and
- The proposal involves “amendment of Regulation 111 to remove property-related costs from within its provisions” (Annex C). Thus, pre-registration expenditure will not be treated as input tax.
The consequences flowing from this situation are as follows:
- Y will not count his pre-registration VAT as input tax. Thus, while X recovers input tax of £100,000, Y recovers nothing; and
- Y will recover £70,000 in seven annual instalments under the capital goods scheme. X does not make any capital goods scheme adjustments.
This situation creates new distortions between X and Y:
- X recovers £100,000 whereas Y recovers only £70,000. This restriction is justified if Y has used the building to make pre-registration supplies. However, he may not do so. If not, X and Y are treated differently although the building wholly comprises a cost component of post-registration taxable supplies in both cases; and
- X recovers his £100,000 in one sum at the end of his first prescribed accounting period whereas Y recovers his £70,000 in seven annual instalments after he has registered. Y thus incurs a cash flow disadvantage in comparison to X.
We conclude that the proposal removes one anomaly at the expense of creating two others. While we believe that some change needs to be made, we consider that further work needs to be carried out on these proposals to ensure that all permutations have been identified, and the consequences considered, before the legislation is changed. We suggest that a Land & Property Liaison Group working party is set up to look at this issue in more detail.
Q11: What are the advantages/disadvantages of these proposals to you?
The fiscal and cash flow disadvantages of the proposals are explained and illustrated in our response to Q10.
Q12: Are there any other rules governing the recovery of VAT in the three areas described in this paper that you think should be reviewed?
020 7235 9381