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TaxationWeb by Steve Allen

Steve Allen, Director of VAT Solutions (UK) Ltd, discusses VAT recovery on pre-registration costs and a rather strange case that has clarified the position regarding the VAT recovery on service received pre-registration.Businesses registering for VAT are entitled to reclaim some of the VAT on goods and services they incur prior to registering for VAT. I have always considered the rules to be relatively simple and easy to understand, but have recently been proved wrong by HM Customs & Excise's policy branch, which clearly doesn't have a clue how the rules work. Quite worrying, really.

Basic rules

The basic rules are that you can reclaim the input VAT on goods you have purchased in the three years prior to registering for VAT, provided you still have them on hand at the time of registration. You can also recover the VAT on services incurred up to six months prior to registering for VAT, provided you have not supplied them on or they have not been applied to goods that you have sold (e.g. processing services). In both cases, you have to retain the original purchase invoice as proof of entitlement to deduct input tax. The legislation is contained within Regulation 111 of SI 1995/2518, and clearly states the limited number of exceptions to these basic rules.

The sort of costs you are likely to incur before registration are legal and accountancy costs, purchase of machinery, capital items, and stock. In all, a considerable amount of VAT can be incurred before a business starts to trade.

A corporate body can recover VAT incurred before incorporation on its first VAT return, provided the person to whom the supply was made, or who paid for the supply, became a member (shareholder), officer, or employee of the corporate body, and was reimbursed for the whole cost of the goods or services. They must also have been acquired for the purposes of the business.

You are supposed to claim back any pre-registration VAT on your first VAT return. However, HM Customs & Excise may allow the claim to be made on a later return, up to three years after the date the first return was due. You could, therefore, reclaim the VAT on costs up to six years after they were incurred.

Customs' view

This all seems fairly straight forward to me, but the first warning signs that HM Customs & Excise didn't understand their own rules surfaced in the 2003 Budget, when they published a consultation document about pre-registration input tax which stated:

"The first of the proposed changes relates to the recovery of pre-registration VAT. The current rules are:

- VAT on goods incurred more than three years before the taxpayer became registered is excluded from being treated as input tax.

- VAT on services incurred more than six months before the taxpayer became registered is also excluded.

- VAT on goods and services, which have been wholly consumed before the taxpayer becomes registered, is also excluded from being treated as input tax.

The problem is with the third bullet point. Nowhere in the legislation, or the published or Internal Guidance, is there the slightest reference to the VAT on services 'consumed' prior to registration being irrecoverable. However, the legislation specifically refers to the restriction for goods.

A case for the Tribunal

This basic misunderstanding of their own rules came to the forefront recently, when a client of mine had to take a case all the way to Tribunal to prove the point. Hearing HM Customs & Excise argue their case before the Tribunal was most amusing, but also very worrying, as it exposed their complete lack of knowledge of the basic principles of VAT.

The case was Denise Jerzynek T/A Dale Interiors (MAN/03/0452), and involved a small furniture retailer who had claimed the VAT back on her shop rental for a four month period prior to registering for VAT. During a routine VAT inspection, the Customs Officer queried this, but the business's accountant was present and printed off the relevant section of Notice 700 from HM Customs & Excise's own website, which clearly showed that she was entitled to reclaim the VAT and showed it to the Inspector. Still not convinced, he went away to consult his superiors.

Amazingly, the superiors concurred with his view, and an assessment for £1,288 duly followed. On reconsideration, the matter was referred to the Headquarters Policy Unit responsible for this area (and the inaccurate consultation document), and they also upheld the assessment.

Undeterred by the fact that the legislation was quite clear on the point (as was Public Notice 700, paragraph 11, and Internal Guidance Manual V1-13, Chapter 2, Section 7.4), HM Customs & Excise enthusiastically took the case to Tribunal, where they argued that the relevant legislation (Regulation 111 of SI 1995/2518) only applied where the input VAT claimed related to supplies on which VAT is actually payable, and referred to the case of Schemepanel Trading Ltd [1996] STC 871, even though this case related to the recovery of input tax on goods.

The Commissioners' argument then proceeded to say that the business had not made taxable supplies because no VAT was actually chargeable on the supplies made by her during this period (i.e. she was not a taxable person). The Commissioners' argument was that taxable supplies can only be made by taxable persons. This is, of course, clearly nonsense, as it would mean that nobody would ever have to register for VAT. Based on this argument, if you were not registered for VAT, you could not charge VAT, and could not make any taxable supplies. Consequently, you would never exceed the registration threshold for making taxable supplies in excess of £58,000 per annum, because you never have made any taxable supplies in the first place. Clearly, the Commissioners had not thought this through very well!

The Commissioners went on to argue that the primary legislation in section 24 of the VAT Act 1994 took precedence over Regulation 111, even though s.24 specifically referred to the Regulations as giving details of what additional input tax could be claimed. It is somewhat worrying that a Barrister should not understand the basic construction of the law.

The Commissioners' final argument was that even if they where wrong in their interpretation, Regulation 111 stated that the Commissioners "may" allow, rather than "shall" allow, so they were entitled to disallow the input tax on a whim.

Tribunal decision

Not surprisingly, the Tribunal Chairman found in favour of Mrs Jerzynek, and was quite scathing of the case presented by the Commissioners. Costs were awarded to my client, which, taking account of HM Customs & Excise's own costs, will be about ten time the VAT at issue.

The first thing to note is that if HM Customs & Excise had been successful at Tribunal, they would have succeeded in depriving a business of input tax that it was legally entitled to reclaim. They would also have redefined the definition of taxable supplies, and nobody would ever need to register for VAT in the future. I find it quite astonishing that the specialist Headquarters Branch dealing with pre-registration input tax could have such a staggeringly small knowledge of their subject, or that HM Customs & Excise Solicitor's Office could not have spotted the obvious flaws in the case, and allowed it to proceed to Tribunal in the first case.

However, on the bright side, the decision does clarify the position regarding the recovery of input tax on pre-registration services, and can be used to counter any other misguided attempts by HM Customs & Excise to disallow input tax recovery in similar circumstances.

October 2004
Steve Allen
Director, VAT Solutions (UK) Ltd
Email: andrewneedham@vatsolutions-uk.com

VAT Solutions (UK) Ltd
11 Winmarleigh Street,
Warrington,
WA1 1NB

(T) 01925 242497
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VAT Solutions (UK) Limited is an established independent firm of Chartered Tax Advisers, formed by Andrew Needham and Steve Allen. The company has a cross-section of clients from multi-national companies through to medium-sized and numerous smaller regional firms of accountants and solicitors. They produce a regular publication 'VAT Voice', which can be downloaded directly from the Internet via the following address: www.vatsolutions-uk.com/newsletter.doc