Article:

A new approach for partial exemption for COVID affected organisations

08 April 2021

HMRC has released details of a new fast track approach for seeking approval for a temporary change to a partial exemption method. This holds out a potential cash lifeline to organisations whose VAT recovery has been severely reduced by changes to their activities brought about by COVID and the associated government restrictions.

A temporary change in VAT recovery method could significantly increase VAT recovery for many businesses, charities and membership organisations.

VAT recovery for partially exempt organisations

Organisations that make exempt supplies are obliged to allocate the VAT they incur on purchases to exempt and taxable activities. The element relating to taxable supplies can be recovered whereas that relating to exempt ones cannot. In most cases, this allocation requires a calculation to be carried out to apportion the VAT on general costs that support both taxable and exempt activities (known as residual input tax). This calculation is known as the ‘partial exemption method’. An entity has a choice to use the ‘standard method’ based on income that is laid down in legislation or a ‘special method’ of their own design that has previously been agreed with HMRC.

In many cases though this calculation no longer reaches a fair conclusion because the business in the year has fundamentally changed due to COVID-19 restrictions. For example, a Charity may earn most if its taxable income from the operation of retail outlets, which have been closed due to the government restrictions. This will mean that any calculation using income may no longer fairly reflect the use of general assets and overheads. Therefore, an alternative calculation and adjustment would be appropriate - albeit on a temporary basis.

In such cases, the way to achieve a temporary method differs depending on whether they are using the standard or special method.

Standard method

There is an automatic adjustment required for businesses operating the standard method where the result differs from a fair and reasonable ‘use based’ calculation by more than a fixed amount (i.e. the difference is more than £50k or more than 50% of the overall residual input tax and £25k).

Any organisation using the standard method should, therefore, consider if it still leads to a fair result given the changes caused by COVID-19. If it might not do so, they should carry out an alternative ‘use based’ calculation to see if they should make an adjustment using the standard method override to adjust the recovery in the year. As a very basic test for organisations whose activities are otherwise quite stable (other than during the pandemic) would be to compare the recovery in the previous year to this one and see if there is a significant difference.

Special method

An adjustment to the special method generally requires agreement by HMRC. The business brief released by HMRC announced that they will be using an accelerated process to consider COVID-related changes to a special method and indicates that such requests will be dealt with quite swiftly.

Where HMRC are satisfied that the aim of the proposal is to address Coronavirus issues only, in order to facilitate a quick decision, HMRC will restrict its enquiries to how that proposal addresses those issues. Naturally, where there may be significant risk that the remainder of the existing method produces an overall result which is not fair and reasonable (for example, where the special method has been in place for many years without review), HMRC say that further examination of that method will be considered.

Where your supplies made have changed as a result of coronavirus, but are anticipated to move back toward a pre-pandemic position in due course, HMRC say they are likely to accept proposed temporary methods that:

  • Use representative income streams from the previous tax year or potentially an average of the last three years before the pandemic to get a fair and reasonable recovery rate
  • Deal fairly with costs that were incurred in relation to an activity that was planned but has been delayed due to coronavirus – it is likely that projected income from the activity (supported by business plans or similar commercial evidence) may provide an appropriate method of apportionment.

Any changes to methods will need to be for at least a year but you can request for them to be applied for longer, then the previous method will, subject to any other changes, resume. However, if you apply for, say, a year of an alternative special method, you must write to HMRC with reasons for carrying this on into another tax year. HMRC have also confirmed that they may even allow some retrospection.

Sales credits

HMRC have made one very welcome clarification relating to situations where planned supplies have been prevented as a result of COVID-19, for example, where a taxable conference or event has been cancelled. Normally, this would give rise to an adjustment to the VAT recovery for any income based calculation, as the taxable supply did not take place. However, HMRC have confirmed that, in such circumstances, requests not to make an adjustment will be considered sympathetically.

Next steps

We would strongly recommend that all partially exempt organisations consider whether their apportionment methods are appropriate given their operating situation during the COVID-19 pandemic. Where a rethink is appropriate, alternative calculations should be considered and adjustments carried out accordingly.

HMRC’s new approach is likely to be of particular benefit for Charities, Membership organisations, Religious and professional groups or those with significant income from events, provision of accommodation or similar supplies.

Please get in touch your usual BDO contact to discuss your options in more detail.