Partially exempt traders can apply for a retrospective special method, if they have been impacted by the pandemic restrictions. Some taxpayers could save thousands of pounds.

R&C Brief 04/21

Revenue and Customs Brief 04/21 concerning VAT and partial exemption is very complicated and verbose. Many readers will have given up the ghost by the end of the first paragraph! But HMRC is actually giving a great opportunity here, which might help many partly exempt businesses whose trading patterns have been badly affected by the coronavirus pandemic.

Here is a practical case study to explain things.

Gym and insurance

Sports Ltd has two activities – it operates a successful gym charging membership fees and also sells sports insurance, earning commission as a broker. Both activities trade from the same rented premises. The company is partly exempt because the insurance commission is VAT-exempt and the gym income is VATable. The insurance commission is 20% of total sales.

Partial exemption and input tax

The company has three major expenses that are subject to VAT:

  • rent on the premises
  • marketing costs for the insurance activity
  • equipment for the gym

The VAT treatment of two of these expenses is simple – the equipment wholly relates to the taxable gym, so input tax can be fully claimed. The marketing costs wholly relate to the exempt insurance activity so no input tax is claimed.

It is the rent that causes the challenge. This is an example of ‘residual input tax’ – a cost that relates to both taxable and exempt activities, and so input tax can be partly claimed.

Standard method

Sports Ltd is likely to use the standard method of calculation for partial exemption, the default position, where the residual input tax claimed each period is based on the following formula:

Input tax to claim = Taxable sales (excluding VAT)

Taxable sales (excluding VAT) + Exempt sales

The percentage is rounded up to the nearest whole number as long as total residual input tax is less than £400,000 per month on average, – 85.1% means you will claim 86%.

Without coronavirus, Sports Ltd would claim 80% of its residual input tax in a typical trading period.

Reduction in taxable sales

The impact of coronavirus has been massive on gyms and many other businesses because of local and national restrictions.

If Sports Ltd continues to sell insurance to customers, but has frozen gym membership subscriptions because of coronavirus lockdowns, its VAT position has changed dramatically. The 80% VATable income percentage is probably now 50% for the last 12 months. If annual rent is £200,000 plus £40,000 VAT, input tax claimed will have reduced from £32,000 to £20,000 with the standard method. This is clearly not fair.

Special method request – retrospective opportunity

HMRC has recognised situations like Sports Ltd and Brief 4/21 gives a business the chance to apply for a temporary special method of calculation without a lot of questions and delay. The method can be applied retrospectively from the time that coronavirus first took its toll.

The application must explain how coronavirus has affected the business trading. A special method is any method of calculation that is not the standard method.

Square footage?

Sports Ltd might consider a temporary special method based on square footage splits: how much of the premises is used for the gym and how much for the insurance activity? An estimate would be that an 80/20 split would probably be accurate.

Alternatively, it could request a method that introduces a notional turnover figure for taxable sales for weeks where the gym is closed because of lockdown, based on past turnover. The logic is that the costs haven’t gone away (landlords still want rent) so income must be included to balance the books.

Fair and reasonable

A taxpayer can propose any method that is fair and reasonable. Special methods must always be approved by HMRC and the taxpayer must certify that it is ‘fair and reasonable’ in terms of input tax recovery. When coronavirus restrictions have ended, taxpayers will revert to their previous method.

Standard method override

For larger partially exempt businesses, there is an extra twist to the tale where a standard method override calculation might be necessary. That is beyond the scope of this article but see VAT Notice 706, section 5. If the override adjustment gives a fair outcome, there will be no need to apply to HMRC for a temporary special method.