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Tolley's Practical Tax by Barry Stocks and Irit Herzenshtein

Barry Stocks and Irit Herzenshtein review VAT developments involving Charities.There have been a number of VAT developments over the last 18 months that are important to charities. On the positive side, these developments include new opportunities to recover VAT where HMRC had previously held that there was no recovery, while on the negative side there is the likelihood of additional VAT costs being incurred in the future. In this article, we will look at these opportunities and consider the possible costs arising from the changes.

VAT recovery is a key concern for many charities as it affects their cash flow and costs. It is obvious that to continue the good work that charities do, costs need to be kept to a minimum and, without doubt, VAT is a significant cost to them. The Charities Tax Reform Group (CTRG) has been campaigning for many years to minimise the VAT burden. It estimates that charities pay approximately £500 million of irrecoverable VAT per year. This almost negates the £586 million that charities receive in Gift Aid - a scenario where the Government is giving with one hand but taking away with the other. While there are a number of specific VAT reliefs for charities, these are narrowly drawn and recent additions have amounted to no more than minor tinkering as opposed to the major changes wanted by the CTRG.

The Government has always maintained that its hands are tied because VAT is centred on European legislation and the UK is thus restricted in what it can do. While this is true, the way the legislation has been interpreted by the authorities has not always been to the benefit of charities. However, a number of recent decisions have overturned some of the long-held negative views maintained by HMRC. Leading cases Church of England Children's Society, Charles-Tijmens, and Lennartz have provided new opportunities for charities to improve their VAT recovery and make reclaims for past overpayments of VAT. While these cases were widely reported when they were published, now is a good time to reflect on the impact they have had.

Church of England Children's Society

Going back to basics: to recover VAT on expenditure, a charity must first consider which of its activities are business and which are non-business and then determine to which of these the expenditure relates. The general rule is that VAT on costs relating to non-business activities cannot be recovered. The decision of the High Court in Church of England Children's Society ('Children's Society') overturned HMRC's views regarding what charities can treat as input tax and when it is recoverable. Following the case, charities with both business and non-business activities are entitled to greater VAT recovery on the costs of their fundraising activities than was previously allowed.

The Children's Society employed a professional fundraising organisation (PFO) which charged an agency fee to find new donors. The donors received a newsletter and the Children's Society argued that this was a zero-rated supply to which all of the VAT on the agency's fee could be attributed and, therefore, reclaimable in full. HMRC did not accept this and refused the claim on the grounds that the payments were donations and not consideration for a supply of a newsletter. HMRC maintained that the costs of producing the newsletter (including the PFO's fees) were not related to the Society's business activities and, consequently, there were no grounds for any VAT recovery. However, the High Court agreed with the Society that fundraising should not be seen as an end in itself but as a means of raising income to support the charity's wider activities. To the extent that these included business activities, VAT recovery should be allowed.

Following the decision, HMRC issued Business Brief 19/05 in October of last year. In the Business Brief, HMRC made a statement to advise on the way forward on fundraising costs:

'Where funds are raised solely for a restricted charitable purpose involving wholly non-business activities, the VAT incurred on raising those funds is not input tax and is not recoverable.

'Conversely, where the funds raised are used wholly to support the making of business supplies, all of the VAT incurred on fundraising costs can be treated as input tax. The recovery of this input tax will depend upon whether these business supplies are taxable or exempt. Where fundraising input tax is wholly attributable to the making of taxable supplies by the charity, it can be recovered in full, subject to the normal rules. On the other hand, where fundraising input tax is wholly attributable to the making of exempt supplies by the charity, none of it will be recoverable, subject to the partial exemption de-minimis limits.

'So where a charity which has non-business and business activities incurs VAT on fundraising costs and the funds raised support various activities of the charity, the VAT incurred can only be recoverable input tax to the extent that the funds raised will support taxable business supplies. In practice this means that VAT incurred on fundraising costs must first be subject to an initial business/non-business apportionment to determine how much of the VAT incurred may be treated as input tax. Then, in circumstances where the charity has exempt business activities, this input tax is further subject to the partial exemption rules.

'In some cases, a charity's existing business /non-business apportionment method and partial exemption method will produce a fair and reasonable basis by which input tax can be recovered. However, where this is not the case, HMRC will consider proposals for alternative methods. If exceptional circumstances exist, HMRC may allow alternative methods to be applied retrospectively, provided it is fair and reasonable for the charity as a whole.'

We would take issue with one of the points raised in HMRC's statement. Unlike partial exemption methods, no business/non-business method is laid down in law, so HMRC approval is not strictly needed to decide what method should be used. Provided the method is fair and reasonable, it should be allowed and HMRC should not disallow a retrospective method that meets this criterion. In practice, negotiation is normally required but the ultimate arbiter of what is fair and reasonable is not HMRC but the Tribunal and the courts.

The end result is that HMRC now finally accept that VAT can be partially recovered on non-business activities supporting business activities. In our experience, many charities are still to review their methods and expenditure to take account of this decision. The relevant types of expenditure will differ from one charity to another but the costs that should be reviewed to Other committed fundraising costs.

Lennartz

Another area where charities can review VAT recovery is based on an historic 1991 European Court of Justice case - Lennartz. Very broadly, the ECJ decided that, where VAT on expenditure is incurred for business and non-business purposes, the taxpayer can take full recovery up front and repay the VAT relating to non-business use over the life of the asset.

The Lennartz mechanism is potentially a powerful tool in minimising VAT costs for charities, particularly in situations where substantial expenditure has been incurred on acquiring, refurbishing or extending buildings for mixed use. The mechanism is not, of course, limited to real estate but can be used for any asset. In many cases, this can produce significant cash flow benefits and overall savings by accounting for private use at acquisition.

Charles-Tijmens

Some time after the Lennartzdecision, HMRC tried to limit the application of the Lennartz mechanism. In 2003 the UK legislation was amended so that, although the Lennartz mechanism could be applied to goods such as computers that are used for both taxable business and non-business purposes, it could not be applied to purchases of high value land and property where the VAT had to be apportioned at the time of the purchase.

The ECJ decision on Charles-Tijmens forced HMRC to change this policy. In August 2005 HMRC issued Business Brief 15/05 which sets out its revised policy. HMRC now accepts that businesses which purchase land or buildings, or construct buildings for both business and non-business use can (subject to the partial exemption rules) reclaim VAT in full at the time of the purchase and then account for output tax on the non-business use of the asset over its economic life. HMRC has taken the view that this should be a maximum of 20 years for land and property and five years for other assets. As a result, businesses and, in particular, charities are able to make significant VAT cash flow savings.

There is, however, a question mark over the time period set by HMRC. In equity, why should a 20 year period be used when the freehold of a building has been acquired and the anticipated useful life of the building far exceeds 20 years? Surely a longer period should be applied and the cash-flow benefit further improved. Unfortunately, it does not seem that this will be the case. In an opinion issued in June this year (C-72/05 Household of Jorg and Stefanie Wollny), the Advocate General suggested that the period of ten years should be used which will be in line with the Capital Goods Scheme. HMRC is known to be following this case with interest. If the ECJ follows the AG's opinion, we can expect to see HMRC's policy reviewed again, and a ten year period replacing the current policy of 20 years. This would inevitably reduce the cash-flow benefit but, despite this, the principle would still be worth applying in most cases.

Clearly, HMRC (and tax authorities in other member states) are not happy with the current state of play as regards the Lennartz mechanism. However, the AG's opinion in Household of Jorg and Stefanie Wollny does give a damage limitation opportunity to the department - so charities thinking of applying the Lennartz mechanism on assets for a period of over ten years should submit their claims as soon as possible.

Partial exemption

Certain supplies made by charities such as those that fall within VATA 1994 Schedule 9, Group 13 - the 'cultural exemption' - are exempt. The recent High Court decision in The Mayflower Theatre Trust could be good news for such charities that are partially exempt. This case is significant as it has looked at the allocation of input tax on production costs and whether a direct and immediate link can be made to taxable supplies for VAT recovery.

The issue in Mayflower is whether the input tax paid by the Theatre Trust on the supplies made to it by production companies could be deducted. HMRC argued that these costs were wholly attributable to the exempt supply of the theatrical performance, whereas the Trust argued that the costs were also attributable to taxable supplies such as taxable promotional tickets and merchandise sales. The High Court agreed with the Trust and decided Mayflower was able to recover some of the VAT on its production costs. Following the decision, HMRC announced that it intended to appeal against the decision to the Court of Appeal.

HMRC's view is that the High Court decision only affects theatres making supplies of admission which fall within the cultural exemption and taxable corporate sponsorship packages that include a ticket entitlement. It states that the case has no wider application. This is perhaps questionable. As a result, charities should consider the apportionment of their VAT costs as there may be an opportunity to recover additional VAT. The court did decide that HMRC's cost component approach was too narrow and the Tribunal was wrong to relate the production costs exclusively to exempt supplies. The production fee was related, to some extent, to Mayflower's taxable supplies of programmes, catering and souvenirs etc .

The 2006 Budget proposed two key changes to the partial exemption regime. The first is that businesses must make a declaration that their method is 'fair and reasonable' before HMRC will approve it. The second is an option for special methods to include provisions dealing with 'out of country' supplies. The declaration could potentially have an impact on charities. Considering that over 60 per cent of partially exempt charities use a special method, it was surprising that there was no mention of charities in the proposal. In July, the CTRG responded to the proposals making the following representations:

• There should be a de-minimis amount whereby retrospection will not apply on grounds of immateriality

• The term 'fair and reasonable' is ambiguous and open to differing interpretations

• Guidance should be given to charities as to what circumstances could trigger retrospection

• Clarification is needed regarding the interaction with business/non-business methods.

The proposals result in potential complications for many charities. It is to be hoped that the special position of charities is recognised by HMRC and appropriate guidance notes issued to officers.

Cultural Exemption

Many charities benefit from the cultural services exemption which allows eligible bodies to supply cultural services free of VAT. However, HMRC is taking an ever- increasing interest in not-for-profit organisations that claim the cultural exemption which, in turn, has led to a number of cases over the years. Perhaps the leading case is the ECJ decision in the Zoological Society of London (C-267/00), which established that it was the administration of the body that needed to be provided on an essentially voluntary basis rather than the facilities provided by the charity to secure VAT exemption.

The cultural exemption was more recently considered by the High Court in the case of Longborough Festival Opera. The case illustrated the kind of financial arrangements permitted between sponsors which allowed the VAT exemption to be retained. In overturning the VAT Tribunal decision, the court held that supplies made by the Opera, which were musical performances of a cultural nature, were exempt from VAT despite financial guarantees being given by trustees. It was noted that the guarantees given by the trustees did not create a financial interest in Longborough Festival Opera that would result in forfeiting the cultural exemption. The Court of Appeal subsequently refused HMRC leave to appeal.

The case adds weight to an earlier Tribunal decision - The Zoological Society of Wales - where it was held that nominal payments to the Chairman of the Society did not deprive the charity of exemption.

Any charity providing cultural services should consider these decisions and review the liability of their cultural services, particularly if HMRC has previously held them to be taxable.

Alternatively, not all charities will want exemption to apply. For example, if they are incurring a large capital spend and require VAT recovery, they will need to adopt a structure to make the supplies taxable. This could be achieved by having a remunerated board member (see the High Court decision of Bournemouth Symphony Orchestra).

Three year cap

Businesses and charities have moved a step closer to benefiting from Michael Fleming t/a Bodycraft and Conde Nast Publications Ltd following their victory in the Court of Appeal. The cases applied the principles established in the ECJ decision of Marks & Spencer (C-62/00) which challenged the legality of the introduction of the 'three year cap' restricting VAT repayments from HMRC to three years. The decision has been followed by a number of VAT Tribunals, for example in the case of Church of Scientology Religious Education Inc.

Consequently, HMRC issued Business Brief 13/06 on 24 August 2006 setting out its policy in the light of these decisions. The Business Brief advises that HMRC will meet claims relating to:

• Amounts improperly paid as VAT before 4 December 1996;

• Amounts over-declared as output tax in an accounting period ending before 4 December 1996; or

• Amounts which became deductible as input tax on or before 30 April 1997, and which have not yet been deducted.

The Business Brief sets out a number of conditions for making the claim which would be worthy of an article in their own right. In particular, the claimant must sign an undertaking to repay any repayment received with interest should HMRC be successful in appealing to the House of Lords. The grounds for such an undertaking appear spurious but most claimants will probably go along with it to facilitate the repayment.

Charities considering making claims based on the Lennartz and Children's Society cases discussed earlier should consider those claims in the light of the Business Brief as the amounts of the claims could be significantly increased.

Compound interest

The Business Brief also mentions the repayment of simple interest in addition to the input tax claim. However, charities and businesses that have made retrospective VAT claims resulting from HMRC's misinterpretation or misapplication of VAT law should consider if they are entitled to compound interest on the repayments.

Currently, the law provides that such repayments should include simple interest. This is intended to compensate the taxpayer for loss suffered as a result of not being able to reclaim VAT to which it was entitled, or having to pay VAT that was not due.

Following the High Court case of BT and taking into account Sempra Metals, the European Court of Justice has been asked to consider whether the taxpayer is entitled to interest at a compound interest rate instead of a simple rate. The ECJ's response could completely overhaul the compensation by interest system we know at present.

A date has not yet been set for when the questions will be heard. However, in anticipation, charities and businesses that have submitted claims for overpaid output tax or under-recovered input tax following misdirection by HMRC are recommended to submit protective claims in order for true restitution to be restored.

With the legality of the three year cap in doubt, claims could go back over 30 years and potential reclaims could be significant.

Postal Services

Not all the developments have brought good news. The European Commission has raised concerns on the VAT liability of supplies of postal services in the UK. If this leads to the loss of the exemption for postal services, there would be a significant cost impact for charities that rely on mailing for fund raising activities. Although this possibility is some way off, charities should start thinking about how the imposition of VAT on postage would increase their costs.

Similarly, the consultation period on the staff hire concession was completed on 31 August 2006. The results of the consultation have not been released yet but the potential withdrawal of this concession could result in further VAT costs for charities.

More good than bad

Overall, the developments over the last 18 months appear to have been more good than bad. Charities should review their position in the light of the opportunities that have arisen as the window of opportunity to make claims based on the current interpretation of Lennartz, for instance, could be limited.

Barry Stocks and Irit Herzenshtein
August 2006

Barry Stocks is a VAT Senior Manager and Irit Herzenshtein is a VAT Partner at PKF Accountants and business advisers. They specialise in the taxation of charities. Barry can be contacted at barry.stocks@uk.pkf.com and Irit can be contacted at irit.herzenshtein@uk.pkf.com

The above article was first published in Tolley's Practical VAT on 1 September 2006, and is reproduced with the kind permission of LexisNexis UK.