VAT: Management charges and partial exemption
HMRC often asserts that management charges are not genuine costs, which can impact on the partial exemption calculation as illustrated in Computational Structural Mechanics Ltd (TC07033).
The companies in this case: Computational Structural Mechanics Ltd (CS) and Linear & Non-linear Structural Dynamics Ltd (LD) are both owned by the same director and shareholder, so they are associated companies.
This is a fascinating case as it posed the question: why would HMRC want to block a charge for standard-rated services made by one limited company to another? When the supplier has properly paid output tax, and the recipient claimed the same amount as input tax, there is no loss of tax to HMRC. So what was going on to prompt HMRC to intervene? Perhaps it was all about the partial exemption de-minimis rules, which can be worth up to £7,500 each year.
The two companies were involved in different activities: CS provided engineering consultancy services and LD tested software. Both companies are VAT-registered and fully taxable in their main activities.
The charges related to work carried out by LD on CS projects, for which a charge of £60,000 plus VAT was made on 1 January 2016. However, CS also owned two buy-to-let residential properties and incurred £6,638 of input tax on property-related building costs. This input tax relates to exempt rental income, so it is blocked under the rules of partial exemption. Or is it?
Partial exemption de minimis limits
There are three different de minimis tests for partial exemption. If a business passes one of those tests, input tax can then be claimed on costs relevant to the exempt activity – ie the property costs in the case of CS.
The main de minimis test is as follows:
- exempt input tax must be less than £625 on average, ie less than £7,500 in a partial exemption tax year; and
- exempt input tax must also be less than 50% of total input tax.
The figure for exempt input tax also includes a proportion of the VAT not claimed on mixed costs (those costs relevant to both taxable and exempt activities) and general overheads (telephone bills, accountancy fees etc). This split is usually worked out by using the partial exemption standard method, based on the proportions of taxable and exempt income in a VAT period.
A partial exemption tax year runs to 31 March, 30 April or 31 May depending on the VAT periods of the business in question. All partly exempt businesses must make an annual calculation to see how much input tax can be claimed in a 12-month period and this outcome supersedes the quarterly calculations.
The key challenge, therefore, is to confirm that exempt input tax is less than £7,500 in a tax year.
HMRC argued that the £60,000 management charge from LD to CS was not relevant to a genuine supply of services. It said that the supply related to the director working for CS, rather than LD providing services to CS, because the same director owned both companies.
If £12,000 of taxable input tax was removed from the CS VAT return, the company failed the 50% de-minimis partial test outlined above, meaning that the company could not claim the £6,638 of input tax on the property costs. If VAT of £12,000 is included as taxable input tax, the 50% test is easily achieved.
I was personally surprised by the decision but the tribunal accepted that CS and LD both had different activities and skills, even though the same director was running both companies. It agreed that LD was entitled to charge CS for services, despite the absence of any written contract or timesheets.
The very high partial exemption de minimis threshold in the UK can produce an annual tax windfall of up to £7,500 a year by claiming input tax on costs that relate to exempt activities.
If you have clients who have a main trading business and buy-to-let properties in the same legal entity, there is scope to reclaim VAT on the property costs.
For example, a husband and wife hairdressing business may own buy-to-let property in their joint names. Don’t forget that jointly owned property is always classed as a partnership for VAT purposes (VAT Notice 742A, para 7.3), but not necessarily for income tax purposes.