HM Revenue and Customs Brief 35/14 - Decision on calculating deductible VAT
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Published 10 October 2014
Purpose of this brief
This brief sets out HM Revenue and Customs’ (HMRC) position
following the decision of the Upper Tribunal (UT) in Lok’nStore Group
The case concerned whether the Partial Exemption Special Method (PESM)
proposed by LnS
produced a more fair and reasonable result for calculating deductible
VAT on overheads than the standard method.
appeal on the grounds that it could not find that that the First Tier
had erred in law in concluding that the PESM
produced a more fair and reasonable result than the standard method.
is not appealing the decision, but does not intend to change its policy
regarding floor space PESMs. HMRC
does not consider that floor space methods are usually appropriate for
the retail sector.
You can read the full text of the decision on the CURIA
provides taxable self-storage facilities in purpose built stores. It
also provides exempt insurance for stored goods to all customers who do
not otherwise have adequate cover. The issue in this case was the
amount of input VAT that could be recovered on general overhead costs,
such as those incurred on the construction, maintenance and operation
of its stores.
proposed a PESM
which involved a floor space allocation resulting in a 99.98% recovery
rate for VAT on overheads. HMRC
rejected this on the grounds that it did not provide for a better
reflection of how the costs were used than the standard method.
Relying on the ‘cost component of the price’ test set out in
AB SKF (C-29/08), the FTT
concluded that the impact of the general overheads on the price of the
insurance ‘must be very small’ and therefore these costs are only used
to a very small extent for the supplies of insurance. It also found
that the Appellant used the storage area of the buildings ‘almost
exclusively’ for taxable storage. Accordingly it found that the
proposed special method was fair and reasonable and better reflected
use than the standard method, so allowed the appeal.
appealed to the UT
on the grounds that the FTT
had erred in law in that they had applied the wrong test, that they
erred in their application of that test by stating that the price of
insurance was set by reference to the market rate rather than the
overhead costs, and that they erred in their approach to assessing
economic use by adopting a method based on physical use.
1.2 The Upper
Although the UT
agreed that the FTT
had indeed erred in law in applying the cost component test, it was not
convinced that this led to an incorrect result.
In respect to the FTT’s
conclusion that the overhead costs were not cost components of the
insurance, the UT
reasoned that there were a number of possible ways to reach that
conclusion and it was therefore impossible to conclude that the FTT had misdirected
In relation to HMRC’s
argument that the FTT
had relied on physical use rather than economic use, the UT said that although
the use of the standard method appeared to be justified, it was unable
to say that it was the only reasonably possible way of looking at the
For the above reasons, the appeal was dismissed.
1.3 HMRC’s view of
The decision makes clear that whether an input cost is a cost
component of an output is highly fact specific.
Despite upholding the FTT
decision, the UT
emphasised by reference to Etherton LJ in London Clubs that close
attention must be paid to the facts of each case in understanding and
assessing the economic or commercial reality underlying the use of the
relevant VAT inputs.
In the LnS
case, the FTT
found that the VAT bearing costs in question were only cost components
of insurance to a very slight extent. Where VAT bearing costs are used
only slightly for exempt supplies, then HMRC agrees that
a method which results in almost full recovery is appropriate.
However, the decision could be interpreted to suggest that a
cost can only be a cost component of an output supply if the price of
that output was set by reference to the cost. HMRC would not
agree with that interpretation.
Even where the price of an output transaction is not set by
reference to particular costs, those costs can still be incorporated
into the price in that they contribute to its value. This was the
conclusion of the Tribunal in TLLC Ltd v Revenue and Customs 
UKFTT 467 (TC).
Accordingly, although we are not challenging the UT decision in LnS, we do not
consider that the decision has any further implications for our policy
on floor space PESMs.
1.4 HMRC’s position
does not consider that floor space PESMs are normally appropriate for
retail businesses. This view has not changed as a result of the LnS decision.
Businesses wishing to apply for a new or amended PESM
similar to that in LnS
will need to demonstrate that the overhead costs are not cost
components of their exempt supplies, and that they do not intend to
recover those costs through their exempt outputs.
About the Author
© Crown Copyright 2014.
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for educational / informational purposes only. Article reproduced by
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Article Published/Sorted/Amended on Scopulus 2014-10-15 09:03:44 in Tax Articles