Newmafruit Farms Ltd ploughed its cash into property development but ultimately had to sue its development partner to try and recover the investment. The first tier tribunal has now ruled that the company was not entitled to input tax recovery on the legal costs.
Neil Warren considers the Newmafruit case and wonders if the partial exemption de minimis limits might have helped the company.
Here’s a VAT poser: if you invest some of the surplus profits from your business in a company where you will receive dividends, is this any different for input tax purposes compared to the situation where you lend a company money and receive interest instead?
When I say ‘input tax purposes’, I am referring to the VAT on any costs that directly relate to the investments.
Your initial answer is likely to be that it makes no difference because neither source of income is linked to ‘taxable supplies’ made by the company, so input tax claims are blocked in both cases. This is correct. However, there is a subtle difference to consider:
- Dividend income is outside the scope of VAT. There is no supply of goods or services, therefore any VAT on costs is disallowed as non-business ie it cannot be claimed under any circumstances (VAT Finance Manual VATFIN4250).
- Interest income is exempt from VAT (VAT Notice 701/49, para 4.1), and therefore the input tax is relevant to partial exemption calculations. And here is the potential VAT saver: if the total exempt input tax of a business falls within certain limits in a VAT period and subsequently a partial exemption tax year (ending on 31 March, 30 April or 31 May) then it can be claimed under the partial exemption de minimis rules (VAT Notice 706, section 11). The main test is that exempt input tax must be less than £625 on average and also less than 50% of total input tax.
Note: dividend income is excluded from Box 6 (outputs) of a VAT return but loan interest is included (VAT Notice 700/12, para 3.7).
Smith Accountants Ltd invested £100,000 in a company in order to earn annual interest of 10% and the loan is now a bad debt, so it has incurred legal fees of £10,000 plus VAT to recover the capital. This is the only cost linked to the loan and the company has no other exempt activities.
The input tax of £2,000 means that the company will be partly exempt in the VAT quarter when the invoice is received (£2,000 is greater than £625 x 3 months) but de minimis when the annual adjustment is carried out (£2,000 is less than £625 x 12).
In the case Newmafruit Ltd (TC7254), the company’s investment related to a property development project to a third party in return for interest. However, following the discovery of financial irregularities, it had to take legal action to recover its money.
The company claimed input tax on legal fees on the basis that the fees related to the protection of the company’s assets ie an overhead cost linked to its taxable activities. HMRC claimed that the cost directly related to the exempt activity of making loans in return for interest and there was no link to taxable supplies.
The taxpayer’s appeal was dismissed, with the tribunal commenting that “a lender’s costs of bringing legal proceedings against a borrower for breach of a loan agreement is a cost component of the supply of the loan itself.”
There was a direct and immediate link between the legal fees and an exempt supply, so input tax could not be claimed.
The first challenge with any input tax claim is to consider the purpose of the expense: which source of income does it relate to? Or is it a business overhead (such as accountancy fees)?
If it is clearly relevant to non-business or exempt income, then it cannot be claimed, unless it is linked to an exempt activity where the partial exemption de minimis rules might save the day.
The Newmafruit tribunal report was silent about the amount of input tax involved, so I assume it exceeded the de minimis thresholds, which is a shame for the taxpayer.
About Neil Warren
Neil Warren is an independent VAT consultant and author who worked for Customs and Excise for 14 years until 1997.