VAT Input Tax and Exempt Supplies - Reasonable Proportion

For businesses which make both taxable and exempt supplies for VAT, there is a need to apportion the VAT they pay (input tax) between that relating to their taxable supplies and that relating to their exempt supplies, as the latter cannot be reclaimed as input tax. The publicly stated position of HM Revenue and Customs (HMRC) is that all the input tax will normally be ‘blocked’ (i.e. not recoverable) and it is up to the VAT registered trader to justify that the method for calculating the input tax recovered is ‘fair and reasonable’ given the particular circumstances.

This can be very difficult to do, as deciding whether a particular expense relates to the taxable or non-taxable supplies can be almost impossible. In practice, an apportionment is agreed between the taxpayer and HMRC. There are ‘industry standards’ which can be applied in some cases.

In a recent VAT Tribunal case heard in Scotland, Lombard, a subsidiary of the Royal Bank of Scotland, sought to increase the amount of input tax it could claim from 15 per cent (the industry standard) to 50 per cent. Its argument was based on the point that in a normal leasing transaction it makes two supplies, one of which is taxable and one of which is exempt. Since VAT law, rather than accounting necessity, creates the concept of an exempt transaction, Lombard had no means of arriving at a precise apportionment. HMRC had proposed no alternative basis for performing the calculation.

The Tribunal agreed that in the circumstances, reclaiming 50 per cent of the input VAT was fair. HMRC appealed to the Court of Session, which was swift to order the matter back to the negotiating table. The Tribunal had not explained why it held 50 per cent to be a reasonable proportion, nor had it explained why the method proposed by Lombard was considered to be fair and reasonable.

So, the matter will now have to be negotiated afresh. However, it does raise the issue for partially-exempt traders as to whether they should look again at the basis under which they calculate their recoverable proportion of input tax to see if a larger percentage recovery might be justifiable.