INSIGHT: U.K. Supreme Court Ruling on $1.2 Million VAT Refund

A recent unanimous decision of the Law Lords in the U.K. Supreme Court found in favor of a Scottish farming business and secured a refund for it of value-added tax (VAT) in excess of 1 million pounds ($1.2 million) incurred on expenditure. This followed a lengthy and litigious VAT dispute with the U.K. tax authority, HM Revenue & Customs (HMRC), which lost its case at the First-tier Tribunal, the Upper Tribunal and Inner House of the Court of Session.

The Case

The case involved Frank A Smart & Son Ltd (FASL), a Scottish company which carries on a farming business in Aberdeenshire, Scotland. FASL is wholly owned by Mr Frank Smart, FASL’s sole director. The VAT in question was incurred by FASL in purchasing units of single farm payments entitlement (SFPE), to receive, in turn, the single farm payments (SFPs) to which the SFPE units entitled it. FASL’s intention was to use the SFP monies to fund its current and future business activities. FASL is for VAT purposes a fully taxable business.

This decision may open the door for businesses and other VAT-registered organizations across the U.K. to revisit decisions on the recovery of VAT incurred on fundraising activities. While this point has been tested through the courts several times in the past, and indeed most recently as evidenced in the decision of the Court of Justice of the European Union (CJEU) in The Chancellor, Masters and Scholars of the University of Cambridge (C-316/18), the Supreme Court’s recent ruling marks an important inflection point in a very complex area of VAT.

Many VAT-registered businesses take VAT recovery for granted; the logic being that if VAT is due on sales then there is an entitlement to recover all the VAT paid on costs. As you would imagine, HMRC is quite zealous in ensuring that there are appropriate restrictions on VAT recovery where, in its view, the costs do not relate to an onward taxable business activity.

This care in the management of the tax prompted HMRC to challenge FASL’s recovery of around 1 million pounds’ VAT as input tax incurred on the purchase of SFPEs. While there is no doubt that any farming businesses that find themselves precisely in FASL’s position will be celebrating this success, this decision could have far-reaching consequences for many other types of VAT-registered organization. This unanimous Supreme Court ruling will deliver a significant blow to HMRC’s efforts to limit VAT recovery in these circumstances.

Why Did the Dispute Arise?

FASL runs a farming business and its income ordinarily carries a right to recover in full VAT incurred on costs associated with running the business. For instance, this means that if the business pays VAT on purchasing a tractor that will be used on the farm, this VAT can be reclaimed in full on that purchase. Of course, the usual restrictions apply to VAT recovery. FASL is not entitled to reclaim incurred VAT as input tax on items that are not related to its taxable business activities.

Following the EU’s reform of its Common Agricultural Policy, a fundamental change to farmers’ subsidies was enacted. While the SFPEs were allocated to farmers for no consideration or free of charge, farmers benefiting from the SFPEs could sell the rights to receive their allocation. As a result, a secondary market in buying and selling the SFPEs was formed.

FASL not only received its appropriate allocation of SFPEs in line with this change in policy, it decided to enter the secondary market and purchase the right to receive SFPEs initially allocated to other farmers, along with leasing additional land to qualify for the receipt of the SFPEs. There was no dispute between the parties that the payment for the purchase of the right to receive the SFPEs was subject to VAT at the standard rate.

FASL borrowed money to allow it to spend over 7 million pounds purchasing the rights to receive the SFPEs. As a result of these purchases the company’s SFP income resulting from its ownership of the SFPE units between 2010 and 2013 “dwarfed its income from cattle sales.”

When FASL attempted to reclaim the VAT it paid to purchase the SFPEs, totaling just over 1 million pounds, HMRC refused the recovery, arguing that the VAT FASL had paid was not recoverable as input tax.

What Were the Arguments?

The central question in the appeal is whether the receipt of the SFPs, which were transactions outside the scope of VAT, prevented FASL from deducting the VAT which was paid on the purchase of the SFPE units.

HMRC argued that FASL acquired the SFPE units to generate receipt of SFPs or cash, which was a form of investment income. Such income falls to be treated as outside the scope of VAT, with, correspondingly, no entitlement to recovery of VAT as input tax on underlying costs—in FASL’s case an amount of VAT of circa 1 million pounds. HMRC was relying in the first instance on the judgment of the CJEU in BLP Group plc (Case C-4/94).

In contrast, FASL’s argument was relatively straightforward; the subsidies would be used to support and grow the farm’s business in the future, and as a result the VAT incurred must be related to those activities and so was recoverable in full as input tax.

There were several factual points that appear critical to this analysis. First, while the income from the SFPs formed most of FASL’s income, the Supreme Court was quick to confirm that Mr Smart had not withdrawn the income from the business for his personal benefit. Second, the Judges were satisfied, based on the evidence, that the income from SFPs had been used for the benefit of the farm’s fully taxable business activities.

These factual points proved critical to the Supreme Court’s decision-making process. In these circumstances the burden of proof lies with the taxpayer; it must be able to evidence how the organization has used the monies raised to benefit its taxable business.

While the point appears to be relatively straightforward, during the somewhat lengthy litigation process through the courts reference was made to a raft of case law on this point, including Abbey National plc (Case C-408/98), Kretztechnik AG (Case C-465/03) and Sveda UAB (Case C-126/14). Perhaps unsurprisingly, with so much case law on this point it remains a contentious area that is highly sensitive to the facts.

However, this decision does mark an important point of principle from the U.K.’s most senior court of law. Specifically, if VAT is incurred on costs related to the financing of an organization should those costs be attributed to that organization’s taxable income from its business activities and recovered in full (as FASL successfully argued), or blocked on the grounds that you cannot “look through” the funding’s purpose to determine the right to VAT recovery?

The mere fact that an organization’s taxable income is less than the monies received from the fundraising does not prevent those subsidies from supporting the taxable activity.

Planning Points

There are several issues that organizations should be mindful of as a result of this case:

• if HMRC has refused your organization’s right to VAT recovery on similar costs during the last four years now is the time to revisit the matter to see whether this case may unlock a reclaim opportunity. There is a time limit to such claims and so acting now could increase the VAT that may be reclaimed;
• do not assume that HMRC will permit VAT recovery on fundraising costs; there is every chance that HMRC officers will continue to take the view that the VAT incurred on these costs will be blocked. The key determining factor is to retain evidence proving the intended, and actual, use of the monies which are raised as result of the fund-raising activity;
• the VAT treatment of costs that are commonly related to fundraising is a very complex area. In many cases, these costs may not be subject to VAT at all and so it is worth checking this point with your professional advisers before settling any fees that bear VAT. Even if HMRC can be convinced that a VAT incurred cost would be reclaimable, if the VAT was charged incorrectly HMRC will still refuse the right to recover this VAT as input tax and may levy financial penalties for the incorrect recovery of VAT as input tax, where that VAT was not properly chargeable in the first instance; and
• sometimes during the course of these transactions the organization receiving the funding agrees to pay the costs incurred by their counterparties (say via tri-partite or cost sharing agreement). VAT cannot be reclaimed as input tax on costs proper to another organization and so care should be taken to avoid inadvertently reclaiming VAT as input tax in the wrong circumstances.

Philip Munn and Jim Burberry are VAT Partners at RSM.

The authors may be contacted at: philip.munn@rsmuk.com; jim.burberry@rsmuk.com

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.