Simplification of Partial Exemption & Capital Goods Scheme

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Simplification of Partial Exemption &

Capital Goods Scheme

Call for evidence

Publication date: 18 July 2019

Closing date for comments: 26 September 2019

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Contents

1. Introduction .................................................................................................................................................... 3

2. Partial Exemption ............................................................................................................................................ 5

3. De Minimis ...................................................................................................................................................... 8

4. The Capital Goods Scheme ........................................................................................................................... 11

5. Other possible areas to review ..................................................................................................................... 15

6. Summary of call for evidence questions ....................................................................................................... 16

7. The consultation process .............................................................................................................................. 18

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1. Introduction

1.1 At Spring Statement 2019, the government announced that it would launch a call

for evidence exploring ways to improve the operation of Partial Exemption (PE)

and the Capital Goods Scheme (CGS), following the findings of the 2017 Office of

Tax Simplification (OTS) VAT review.

1.2 The government wants UK businesses to operate in the best possible environment

to ensure that they remain both productive and competitive. The government also

wants the tax system to be efficient and effective.

1.3 While it is important businesses comply with their tax obligations, the government

recognises that the tax system should not inhibit productivity or prevent fair

competition.

1.4 This call for evidence focusses on PE and the CGS. These are two areas of VAT

which can involve a significant amount of administration for businesses, with

complex calculations often being required for some businesses to determine the

amount of input tax that they are entitled to recover.

What the OTS have said on simplification

1.5 In November 2017, the Office of Tax Simplification (OTS) published its report,

‘Value Added Tax: Routes to Simplification’ which made recommendations on the

operation of various aspects of VAT, including PE and the CGS.

1.6 The OTS highlighted that the processes involved for PE and the CGS are not as

efficient as they could be. It suggested that HMRC should consider reforms to the

PE regime with the aim of simplifying its application. The OTS also identified

issues with the current CGS regime, highlighting that the time and administration

required can sometimes be significant only to result in a relatively small

adjustment.

1.7 The government is taking the opportunity to review the PE and the CGS regimes,

focussing on potential simplifications whilst ensuring that VAT continues to be

collected in an efficient way. VAT raises a significant amount of revenue and plays

an important part in funding the government's public spending priorities. Therefore

when considering any changes the government will also need to factor in any

impacts on revenue.

1.8 This call for evidence is an opportunity for business to share their views on PE and

CGS and potential simplification.

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1.9 The call for evidence is split into three sections:

 The first section looks at the process for applying PE Special Methods (PESMs)

and the possible ways in which this might be improved to reduce burdens for

taxpayers and HMRC alike

 The second section explores how the current PE de minimis limit could be

changed to aid simplification

 The third section considers possible policy solutions to issues caused by the CGS.

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2. Partial Exemption

2.2. VAT registered businesses must charge VAT on all the taxable goods and

services that they supply (output tax). They may also recover the VAT that has

been incurred on the goods and services they have purchased (input tax) in the

course of making those supplies.

2.3. Businesses making exempt supplies do not have to charge any VAT on the

supplies they make, but cannot recover any of the VAT incurred.

2.4. Some businesses make both taxable and exempt supplies (‘partial exemption’)

and incur input tax that cannot be attributed directly to either taxable or exempt

supplies. This input tax is called residual input tax and a calculation must be

performed to determine how much of this is recoverable.

2.5. There are various goods and services which are VAT exempt, such as financial

services, healthcare, gambling, education and insurance, but businesses making

such supplies will very often also make taxable supplies. One example of such a

‘partly exempt’ business would be a casino supplying exempt gambling services

that also has an on-site restaurant that makes standard-rated supplies of food.

2.6. The OTS noted in its VAT review that the many, often complex issues of PE

usually revolve around one basic question: what ‘fair and reasonable method’ can

be used to establish how much of the residual input tax can be recovered?

2.7. There are two types of methods that are available to carry out this calculation. The

default position is to use the standard method which uses turnover to calculate the

recoverable input tax. However, if this does not give a fair and reasonable result a

PESM can be proposed. There are several scenarios where the standard method

could fail: for example, if different supplies use the same costs but in different

ways or if high value supplies are made but with only a slight use of residual

inputs. A PESM will reflect the specific activities of the business and in some

cases can be very complex. Whatever method is used, it must be fair and

reasonable.

2.8. At present where a business requires a PESM, it must submit a proposal with a

signed declaration that the proposal is, in its view, fair and reasonable. This

proposal will be reviewed by HMRC and approval given for its use following

checks on the proposed method. In some cases the review of the proposed

method can take years before approval is given. This approval process can be

burdensome for both HMRC and customers. The government is launching this call

for evidence to gather evidence on how the current administration of PESMs

impacts businesses and to seek ways in which it can be simplified and improved.

The government welcomes suggestions not limited to what is discussed in the

following section.

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Partial Exemption Special Methods

2.9 Removing the requirement for taxpayers to negotiate and obtain approval from

HMRC to use a PESM could be an effective VAT simplification.

2.10. This could simplify and speed up the process of applying a PESM as the need for

time consuming negotiations would no longer be there. A declaration would still

be required that the business believed the PESM to be fair and reasonable.

2.11. At present, a business is required to take reasonable care in arriving at the

proposed PESM, before submitting it with the declaration. By removing the

approval process, the declaration would hold greater importance. HMRC could

review the PESM at any time and bring its operation to an end and potentially

apply penalties for misuse if appropriate. This is because any VAT error is subject

to a review under the current penalties regime and can result in the issue of a

penalty if certain criteria are met.

2.12. Removing the requirement to seek prior approval before applying a PESM is likely

to significantly reduce the burden both on businesses and HMRC in terms of time

and resource, particularly in relation to the negotiation of a final agreed PESM.

However, this lack of approval could also create uncertainty. For example, it could

lead to businesses hiring potentially expensive advisors or spending a

disproportionate amount of time on trying to ensure the PESM is robust.

2.13. The ability to apply a PESM without agreeing it with HMRC could be particularly

beneficial for growing businesses who can readily update their method and reduce

the need to recalculate the amount of VAT that they can recover. It would also

remove the “contractual” nature of PESMs which would give businesses the

flexibility to make changes in real time.

2.14. On the other hand, removing this requirement could restrict transparency between

HMRC and the customer – it might be harder to assess whether a method in place

is fair and reasonable. Without HMRC insight into the process, it may increase the

potential for methods to be used which are not fair and reasonable, resulting in a

situation where HMRC assess liabilities and potentially issue penalties. However,

the greater use, and more detailed application, of sectoral frameworks (which

provide a good basis for particular sectors to establish a method) could go some

way to alleviating this concern. Frameworks are additional guidance for specific

sectors of the UK economy and have been put together with the involvement of

the sector’s representative bodies. The purpose of these is for a business to be

able to submit a PESM that is fair and consistent that can be approved with

minimum discussion.

2.15. The government recognises that reforming the operation of PESMs is an area that

will attract a lot of interest. As such, we are keen to hear any other ways that this

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regime could be simplified and will be interested to learn the experiences of

business in getting PESMs approved, in terms of what works well and what

doesn’t.

Questions

1. Does your business use a PESM? If so, what was your experience in getting the

PESM approved?

2. How long did the approval process take?

3. Do you find the administration involved with PESMs challenging?

4. Would allowing businesses to apply PESMs without seeking approval improve the

system? Please give reasons for your answer.

5. Would there be issues created by removing the requirement to seek approval of a

PESM?

6. Would an increased focus on the use of sectoral frameworks be of benefit, particularly

if approvals were removed?

7. Do you have other suggestions to improve or simplify the application of the PE

regime?

8. Do you have other suggestions on how the way in which HMRC interacts with partly

exempt businesses could be improved?

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3. De Minimis

3.1 In the OTS report on simplifying VAT, it noted that businesses with input tax

attributable to exempt supplies cannot generally reclaim it. However, EU legislation

allows member states to ignore insignificant amounts of input tax relating to exempt

supplies.

3.2 In the UK we apply this simplification. Where exempt input tax incurred by a business

is insignificant it can treat that exempt tax as if it were taxable input tax and recover it

in full if its total value is less than a prescribed amount. An amount that is insignificant

is known as ‘de minimis’ and is set out in law for PE purposes.

3.3 Businesses that engaged with the OTS review welcomed simplification of this regime

as it would benefit small businesses that have to carry out this calculation and, due to

the current de minimis limit, would otherwise have to use a PESM.

3.4 A business can be treated as fully taxable in any VAT period (this is not always the

standard three months) if the total value of its exempt input tax is not more than:

 £625 per month on average; and

 Half of its total input tax in the relevant period.

3.5 For some businesses, every time a VAT return is due, this calculation must be carried

out to determine whether the exempt input tax is recoverable.

3.6 In 2010 the PE de minimis was simplified by introducing two new tests that did not

rely on the businesses performing a PE calculation. Businesses could instead use

readily available accounting information to quickly assess whether they qualified as

de minimis under Test 1 or, if they failed Test 1, under Test 2. Only those businesses

that failed Test 1 and Test 2 would be required to perform a full partial exemption

calculation.

3.7 Test 1: Total input tax incurred is no more than £625 per month on average and the

value of exempt supplies is no more than 50% of the value of all supplies.

3.8 Test 2: Total input tax incurred less input tax directly attributable to taxable supplies is

no more than £625 per month on average and the value of exempt supplies is no

more than 50% of the value of all supplies. However, in practice it seems that most

businesses are not making use of this simplification.

3.9 This call for evidence outlines two other possible options for reforming the de minimis

test: increasing the threshold and removing the de minimis test entirely. However, the

government would welcome other ideas on how the current operation of the PE de

minimis test could be improved.

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Increasing the de minimis limit

3.10 The current PE de minimis limit of £625 has not been increased since its introduction

in 1994. It was suggested in the OTS report that the government should consider

increasing the de minimis limit as well as exploring alternative ways of simplifying the

processes for businesses incurring insignificant amounts of input tax.

3.11 An increase to the de minimis limit could mean that more small businesses fall under

the de minimis limit. These businesses would be able to treat a higher amount of

input tax relating to exempt supplies as insignificant and therefore recover their total

input tax in full.

3.12 However, an increased de minimis limit would not remove the obligation for

businesses to carry out this calculation so may not be a simplification.

Questions

9. What is your experience of carrying out the de minimis test?

10. What would the advantages and disadvantages of increasing the de minimis threshold

be to business?

11. Are you aware of the existing simplification, and do you make use of it?

Removal of the de minimis limit

3.10 Some VAT jurisdictions, such as Germany, do not have a de minimis limit. As a

result, input tax relating to exempt supplies is disallowed in full, regardless of whether

it counts as insignificant. While the de minimis test requires a calculation to be made,

taking up time and resources for businesses, it does allow for full recovery of input tax

when the taxpayer qualifies. The question here is whether the opportunity cost of

spending the time on the calculation is worth the benefit.

3.11 The main benefit to the removal of the de minimis limit is that it would ensure a single

calculation for all businesses, rather than requiring two stages for some because of

the need to establish whether a business is de minimis. However, it would mean that

many small businesses would not be able to benefit from the option to treat

themselves as fully taxable for the VAT period.

3.12 It is worth noting that those businesses whose activities mean they are clearly above

the de minimis threshold are not required to complete the de minimis test. Similarly,

those businesses whose activities may qualify as fully taxable as a result of the de

minimis test, but determine the test is too burdensome, are not required to complete

the de minimis test. In both cases, such businesses will only need to apply the full PE

calculation.

3.13 The de minimis test as well as the simplified tests introduced in 2010 all rely on a

monetary limit (within a two-part test) for determining ‘insignificant’ tax. The

government would be interested in businesses’ views on other ways of determining

‘insignificant’.

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Questions

12. What would be the advantages and disadvantages of removing the de minimis test?

13. Do you have other suggestions to improve or simplify the application of the de minimis

regime?

14. Do you have any suggestions on how to determine what can be considered as

‘insignificant’ that would be different to the current de minimis tests?

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4. The Capital Goods Scheme

4.1 The CGS provides for adjustments to be made over time to the initial VAT

recovery relating to purchases of certain capital items, recognising the longer

working life such assets have. The recovery of the VAT incurred on such assets

is only made once – in the year of purchase. If, during the life of the CGS, there is

any change in the proportion of taxable use then businesses must make an

adjustment to their input tax recovery to take account of this.

4.2 A business can reclaim more if the proportion of its taxable supplies increases,

but it will have to repay some if it decreases. The CGS reflects the proportion of

taxable use against exempt and non-business use, whereas PE only considers

taxable and exempt use.

4.3 The CGS applies to specific assets over a certain value. These are:

VAT exclusive value of:

Land, buildings and civil engineering

work

Alterations, extensions, annexes and

refurbishments.

£250,000 or more

Computers and computer equipment

£50,000 or more

Aircraft, ships, boats or other vessels

£50,000 or more

4.4 An adjustment period is the time over which a business reviews the extent to

which a capital item is used in making taxable supplies. The adjustment period is

known as an interval. There are 5 intervals for computers, ships and aircrafts and

for all other capital items there are 10. An interval is normally a year and is

aligned with the business’ PE tax year.

4.5 The government recognises that administering the CGS can sometimes be

burdensome. It is also likely that businesses will sometimes employ external

advisors to oversee the CGS adjustments.

4.6 Several options have been identified that may simplify the application of the CGS

and ease the administrative burden on CGS users. For example, this call for

evidence considers the benefits of raising the current threshold for land and

property and changing the duration of CGS intervals. Another option could be to

remove computers from the CGS, as you are unlikely to encounter a single

computer costing £50,000 or more given recent technological advances.

4.7 However, this call for evidence is not limited in scope to these options for reform.

If there are any other areas of the CGS that could be improved, the government

would be interested in hearing how this could be achieved.

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CGS Thresholds

4.8 The current threshold for land and buildings is £250,000 and has not been

changed since the CGS was introduced in 1990. Since this threshold was

introduced, the value of commercial property has increased. As such, there has

been a significant increase in the number of businesses who must comply with

the scheme. Increasing the threshold is likely to remove many businesses from

the CGS, although currently we cannot quantify the number. This would simplify

VAT administration for these businesses, as it would remove the need for the

complex and time-consuming calculations for land and building assets that may

be smaller in nature. However, it could disproportionately impact smaller

businesses who wish to be able to use the CGS to adjust for input tax over the

life of the capital item.

4.9 Another factor to consider is regional variation in property prices. For example,

businesses with property assets in London and the South East are much more

likely to be caught by the CGS than in other areas. An increase to the land and

property threshold may therefore not be equally distributed throughout the UK.

4.10 Alterations, extensions, annexes and refurbishments to land and property and

civil engineering works currently have the same threshold of £250,000. If the

threshold is raised for land and property itself another consideration is whether

the threshold for these capital items should also be raised or remain the same.

4.11 One point worth considering is that the CGS prevents a business from recovering

their input tax in full in year 1 and then using the asset for non-business or

exempt activity soon after. This key function of the CGS helps to ensure a fair,

competitive environment for UK businesses to operate in.

Questions

15. What is your experience of the CGS?

16. How much time and resource do you allocate to carrying out CGS calculations? Does

this have an impact on your business?

17. To what extent does the CGS help to prevent cases of tax avoidance and unfair

competition?

18. What would be the advantages and disadvantages of increasing the threshold for land

and property for businesses?

19. Would there be any other issues involved with increasing the land and property

threshold?

20. If the threshold for land and property is increased, do you think we should consider

having a different threshold for alterations, extensions, annexes and refurbishments,

(i.e. retain the current threshold) or would this increase complexity?

21. Are there other ways in which the CGS can be improved?

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