Unlike previous years where decisions in significant cases dominated the news, in 2011 it was changes in the law itself that had the biggest impact. Graham Elliott examines them.
Some of these changes were known about before the start of 2011, but we now know for certain in what form they were introduced. Others are developments which should take place in the future, but we know what the issues are and the possible shape of the new rules.
20 per cent rate
Perhaps the most significant change was foreshadowed (and mentioned in this article last year), namely the new 20 per cent standard rate introduced on 4 January. For charities this is a disproportionate increase in the tax burden since charities do not, in general, pay direct taxes, but almost all charities cannot reclaim all of their VAT on costs, so an increase in the tax burden on costs goes straight to the bottom line.
There has been no specific action taken to compensate charities for this. Some charities which are dependent on government grants may have been able to squeeze more money out of the funding pot owing to the increased costs by reference to VAT, but others will have simply suffered a compounding effect from an increase in costs combined with a general reduction in resource.
In particular, the increased VAT rate has an impact on those charities using the old (now obsolete) Lennartz method of accounting for non-business use (see more below) because the deemed supplies must be based on the current VAT rate, not the rate that applied when the capital item was purchased. This means that any increase in the VAT rate must make Lennartz less attractive than it might have seemed at the time it was originally deployed.
Academies VAT regime
All of the above fuelled further calls for a scheme for reimbursement of charity purchase VAT. For years that fell on deaf ears, but the present government has hinted that there might be an exception for charities carrying out work no longer fulfilled by local authorities, since local authorities can reclaim all VAT incurred in regard to their nonbusiness activities, and this suggests that the charities which take on their functions ought also to be able to. As yet nothing general has come of this hint, but something specific has, in the form of the academy schools VAT regime.
Academies have been given the ability to reclaim VAT with effect from April 2011, to the extent that the costs are used for their free education provision. This specifically covers the same areas that are covered by local authorities for community schools, where local authorities have been able to reclaim VAT for many years. It is a moot point as to whether there is any advantage in this for academies, since prior to April their grants included an element for irrecoverable VAT. It must depend on minutiae of budgeting as to whether they will be better or worse off, but nonetheless it makes sense as a general principle. Many charities in comparable positions but offering the local community something different will wonder whether they too can be given this benefit where currently their grant funding probably does not include a specific slice for irrecoverable VAT. We wait to see how far the principle can be pushed in the future.
It is worth pointing out that the rules for academies are more complex than this overview suggests, and academies will need to take professional advice to make a success of their VAT accounting.
Partial exemption combined method
Another foreshadowed change was the introduction, effective from January 2011, of the combined non-business and partial exemption method. This development is an important deregulatory measure for charities which carry out all three kinds of activity, namely taxable, exempt, and non-business.
For tax periods wholly falling after January 2011 a fully-combined special method can be requested which covers both the non-business and exempt use of costs. This can allow for a different apportionment metric for non-business as compared with exempt, in which case a two-stage apportionment will need to be made, but can also use the same metric (if suitable) such that the two stages can be fused into one. This means that a charity need not even distinguish between non-business and exempt activities. They will simply be non-taxable activities. This is a significant improvement for charities which often cannot tell funding agreements which are exempt contracts from those which are grants and thus outside the scope.
On a point of detail, it remains possible to ask for a pure special partial exemption method and deal with non-business on the old-fashioned “fair and reasonable” basis, but you are not allowed to ask for a special non-business method and leave the partial exemption under the standard method (unless a standard-type method is effectively written into a special method).
Capital goods scheme (CGS)
The same reforms saw a significant change to the way of dealing with capital expenditure for charities. Prior to 22 January 2010 charities were able to use Lennartz in cases where the asset was to be used for both non-business and taxable purposes. Lennartz allowed all the VAT to be reclaimed, but then deemed supplies would be made to reflect non-business use over the next ten years. Between then and 2011 such expenditure had to be apportioned in a one-off assessment of likely use over the asset’s lifetime.
But from January expenditure of sufficient scale to qualify for the capital goods scheme now falls into that scheme from the point of view of non-business use as well as partly exempt use (but only if there was an intended business use at the outset). So, for all expenditure with a date of 1 January 2011 onwards, the periodic adjustments under the CGS must reflect any movement there may be in the non-business as well as taxable/exempt use. The only exception relates to an option to declare ‘Armbrecht’ in respect of certain expenditure, but since the positive aspects of this are, to be polite, elusive, I will say no more about it and suggest you mention it to your adviser if you wish to learn more.
Another aspect of CGS that now has a bearing on charities is its interaction with the charity deemed supply in cases where a building that has enjoyed zero-rate relief incurs a usage change charge under schedule 10 VATA. Most charities hope to avoid this potentially catastrophic charge, but if they do not avoid it, it is useful to know that the VAT incurred on that deemed supply falls into the CGS as long as the value is of sufficient scale to warrant it, and the building is less than seven years of age. The selfsupply is, of course, tapered for the period within ten years that the building was used for qualifying purposes (see later). This is reflected in the CGS rule which allows the VAT to be adjusted only over the number of periods which the building is deemed to have been used other than for qualifying purposes. So, in crude terms, if your building suffered a 40 per cent clawback as a result of having been used six years for qualifying purposes before suffering a change of use, then the VAT arising only remains in CGS for four years, not for a whole ten years.
CGS has also been changed to include aircraft and floating structures, and there have been various more minor changes, such as to the length for adjustments in the case of very short property leases, and dealing with part-disposal.
Charity building change of use
As mentioned above, this rule now interacts with CGS, but it also happens to have been changed in itself.
This is the situation where a building that was purchased or built on a zero-rated basis suffers a change of use giving rise to a clawback. For buildings constructed before 1 March 2011, there are two ways this can arise, with two different taxation treatments.
First, a charity may itself use the building differently such that it triggers a clawback. In this case the original VAT avoided is deemed to be repayable by the charity. However, for every full year the charity used the property in a qualifying way, 10 per cent is knocked off that VAT bill. The VAT arising is then treated as input tax of the charity as well as output tax, but will only be recoverable to the extent that the charity uses the building from that point for taxable purposes.
Second, if the charity rents or sells the building (or a part) then that supply is standard-rated at whatever the standard rate is at that time. That does not apply if the letting is to a charity that will use the building for qualifying purposes.
For buildings completed on or after 1 March 2011 that second rule is removed entirely. Only the first rule applies. But it then applies also in cases where the building is sold or leased (except to a qualifying charity). It also adopts a finer grading of taper, based on complete months rather than complete years.
While it would have been helpful if the new single approach could apply to all changes in use, including those which related to a building completed before March, it was not possible to change the effect of a law that people had understood would apply at the time the building was built. The need for certainty under the law has meant that the two approaches need to subsist until March 2021. That said, the circumstances triggering clawback are rare enough that in practice this is not a substantial problem.
Supplies of temporary staff
The most interesting tribunal decision of the year must have been Reed Employment Limited which concerned supplies relating to temporary staff by employment businesses. Ostensibly, this related solely to old contracts pre-dating HMRC’s change of policy in 2009. That change of policy came as a result of the change in employment bureau regulations. The net result of those changes was that any bureau which runs the payroll for a temporary worker is deemed to employ them and that might mean that they supply the staff as principal, and VAT needs to be charged on the full value of the service. Prior to 2009 VAT was only charged on the 'commission'.
Reed Employment challenges that analysis because the tribunal looked beyond both the contracts and the regulations and decided that, in real terms, the bureau could only make a supply of introduction and management, and not the full supply as made by the temporary worker. This meant that VAT applied only to the commission after all.
At first sight this appeared to relate to a situation pertaining only prior to the change in 2009, but the issues raised by the tribunal clearly had the power to challenge the current position.
HMRC responded with Brief 32/11 in which it commented that the case relates to a period prior to 2009, and that it was in any case not a binding decision (being only a tribunal decision) and thus they were minded to ignore it. This therefore has the hallmarks of an issue that will be re-engaged between HMRC and taxpayers, perhaps some time in 2012. The issue is potentially very important for certain charities, but is complex to unravel because it involves the agencies as suppliers as well as charities as consumers.
We now move from measures that have been introduced, and cases decided, to measures that are merely promised.
The cost-sharing exemption has the potential to be very useful to charities, or, potentially, of somewhat limited use. The following gives a potted history of the issue and what may come of it.
For several decades the VAT Directive (and its predecessors) have required member states of the EU to provide for an exemption covering services shared between members of a cost-sharing group where the services are used only to assist the members in making exempt supplies or carrying out non-business activities, and where the charge made for those services merely recoups the cost of provision. Despite the mandatory nature of this exemption the UK has not thus far ever implemented it. When asked to do so in the past, particularly by the charity sector for which the notion of sharing costs with no profit motive is a natural “fit”, the question has been received by HMRC, and the last government, with no more than a Gallic shrug, and there began to be talk of a case being brought against HMRC on the basis of the direct effect of the provision in the Directive. Then the government changed, which seemed, coincidentally, to come at the same time that the EU Commission started taking more interest in forcing states to implement it. The new government offered a review of the position. So, a consultation document was issued in the spring of 2011, with a closing date of 30 September for responses.
The consultation paper contained a good deal of information as to how HMRC saw the provision applying, and some of it made disappointing reading.
It is generally agreed that the phraseology in the Directive, article 132(1)(f), is difficult and obscure. It seems to suggest that the supplier of these exempt “shared” services must itself be a separate legal person from its members. However, the provision also does not read in a manner that grammatically makes that possible. It appears quite literally to have no discernible meaning, which may be one reason why several member states never implemented it. However, HMRC is convinced that groups of charities (and, for that matter banks, health providers, and so on) have to set up a new company or similar entity and buy services from that in order to obtain the exemption. But, this is not sharing at all. If a charity which already has a resource needs to sell it to the cost-sharing entity to start with, and there is no exemption for that particular sale, then VAT has to be accounted for on the supply to the new entity, and there is no ability for that to be reclaimed. The net result is the same as if the charity had sold the services to another charity without the benefit of the exemption.
The only way such a situation could be of benefit is where the new company was able to employ staff and obtain other resources directly and then sell them to its “members”. But the setting up of that is a burden which in many cases will nullify the benefit. It is an approach which reduces the efficacy of the measure by several factors, particularly for small or medium charities. This can only be regarded as a major disappointment. In an attempt to sweeten the pill, HMRC announced in early December that it would allow the cost-sharing entity to be controlled by one of the members, rather than having to be under equal effective ownership by all. Presumably this would assist in putting the necessary resources into that entity, and may even allow that entity to be VAT-grouped with the controller so that supplies can be made at least by that party to the cost-sharing entity without a VAT charge arising. But at the time of writing, the actual regulations have not been published, so there is still a measure of uncertainty around this. The thing that is certain is that the need for all of these arrangements creates a barrier to the provision being used.
There have also been concerns over which services might be regarded as being sufficiently “directly necessary” for the exempt or non-business purposes of the member, so as to qualify for the condition of exemption relating to pertinence of the services to the activities. This is another example of where the original drafting of article 132(1)(f) presents issues of interpretation. There was no need for it to specify that the shared services must be directly necessary, since it would have been sufficient merely that the services were used to produce the exempt or non-business activity. The fact that this rule exists has caused a possible view that services relating to back-office aspects such as IT and HR ought to be excluded from the exemption as being insufficiently “directly” connected with the final exempt or non-business service. But these are just the kinds of services that charities most need to be able to share; and they cannot seriously be regarded as being “indirectly unnecessary”. The announcement in December 2011 did not expressly restrict the services, but, again, the regulations may have something more to say on that. It looks as if the test of sufficient linkage will be essentially based on the partial exemption rules and that a small “de minimis” for taxable use of such costs will be allowed as well.
The new legislation is set to be introduced at Royal Assent, which should be in July 2012. There is a limited degree of retrospection possible but this is almost irrelevant in practical terms, because the cost-sharing structures will not have been set up prior to these rule changes.
Commission Green Paper
Even greater degrees of crystal ball-gazing are involved in the European Commission’s Green Paper of early 2011 which suggested, among other things, that there were far too many exemptions from VAT in the EU legislation and that several of these should be replaced by lower rates of VAT, or else VAT at one rate should apply to everything, thus enabling member states to reduce the standard rate by a few percentage points. Since charities generally make exempt supplies this is an aspect which is of great interest to us.
On the one hand the whole issue of non-recovery of VAT on costs could be wished away by such a development. On the other, if the VAT rate replacing the exemption on income is too high the overall fiscal burden will increase. In such situations there are bound to be winners and losers. The losers may lose a great deal as well. Charities would be very exposed to increased costs.
It must be conceded that simplification of the exemptions is long overdue. We should perhaps welcome a thorough review of them. But one cannot help thinking that this issue is heading straight into the too-difficult tray. There are major issues of sovereignty here, and all of this is being raised at a time when political appetite for initiatives deriving from the EU is meagre, certainly so where they do not deliver on a subsidiary agenda.
Such a fundamental change seems a very long way off, and it would be a rash person who would predict any such change within the next ten years. But then again, stranger things have happened.