Case No: CH/2006/PTA/024

Neutral Citation Number: [2006] EWHC 3306 (Ch)
IN THE HIGH COURT OF JUSTICE
CHANCERY DIVISION
ON APPEAL FROM THE VAT & DUTIES TRIBUNAL

Royal Courts of Justice
Strand, London, WC2A 2LL

20th December 2006 

Before :

MR JUSTICE WARREN
- - - - - - - - - - - - - - - - - - - - -
Between :

	ST HELEN'S SCHOOL NORTHWOOD LIMITED	Appellant	
	- and -		
	THE COMMISSIONERS FOR HER MAJESTY’S REVENUE & CUSTOMS	Respondent	

- - - - - - - - - - - - - - - - - - - - -
- - - - - - - - - - - - - - - - - - - - -

 Mr Roger Thomas (instructed by Messrs Gregory Rowcliffe Milners) for the Appellant
Ms Jessica Simor (instructed by The Solicitor for HM Revenue & Customs) the Respondent

Hearing dates: 2nd and 3rd November 2006
- - - - - - - - - - - - - - - - - - - - -
Judgment

Mr Justice Warren : 
Introduction
1.	This is an appeal from the decision dated 7 February 2006 (“the Decision”) of the VAT & Duties Tribunal (Stephen Oliver QC and Catherine Farquharson ACA) (“the Tribunal”). The case concerns a claim by St Helen’s School Northwood Ltd (“the School”) to deduct 54% of the VAT payable on the cost of construction of a sports complex, the construction cost of which was £2,635,013 including a VAT element of £454,921.  The School applied to use a “partial exemption special method” which produced that result; that application was rejected by HMRC (“Customs”) in a letter dated 3 February 2005.  Following a voluntary disclosure, to which a separate decision referred to below was given, the VAT was reduced by a small amount.  The School then applied to use a “standard method override”.  By a separate decision letter dated 22 November 2005, that application was rejected by Customs.

The Facts

2.	The Tribunal’s summary of the facts is set out in paragraphs 4 to 22 of the Decision.  For completeness, I set out that summary in the Appendix to this Judgment.  I would make these additional observations:

a.	As long ago as 29 January 2002, the School’s architect wrote to the local planning authority (London Borough of Hillingdon) saying this:

“The school have close links with the existing community as demonstrated in the attached paper.  They wish to make the new facilities available under a strict club regime to friends of the school.”

b.	Draft 2 (dated 29 November 2002) of the outline business plan contained the following among other matters:

•	A suggestion that the following overall aim could be adopted “To provide a fully flexible and accessible Sports Centre which will, primarily, accommodate a wide range of activities as part of the School’s curriculum and extra-curriculum programme but would also provide opportunities for appropriate out-of-school use by pupils, parents and “friends” of the School, all at the lowest appropriate capital and revenue cost”.

•	A number of short-term objectives were identified (see paragraph 4.7 of the draft) which in summary were: ensuring the design would met present and foreseeable School needs; providing a programme of activities to meet the needs of the target market (ie non-School use); developing management arrangements to enable utilisation of the facilities within and outside School time and setting up an operating regime to ensure out-of-school use contributed positively to the overall running costs.

•	A number of longer term objectives were also identified (see paragraph 4.8 of the draft), including ensuring “primacy of use for the School and its pupils whilst acknowledging the value of out-of-school use to the School”.

•	Under the heading “Financial Objectives”, a fundamental choice was identified as needing to be made regarding the extent to which the School was seeking to obtain income from out-of-school use.  A number of options were identified, the business plan itself saying that it had been determined that “the most appropriate level at which to pitch the financial aspirations is to ensure that costs of out-of-school use are covered, to seek to cover all the School’s own costs and, if possible, generate sufficient income to fund future developments of the complex”.   In other words, as a minimum, the costs of running the sports centre for school and out-of-school use would be covered so that, as the plan puts it, the School has “use of the new facilities for free in revenue terms”.

•	Paragraph 5.2c. of the draft business plan states “school boarders would be able to use the sports facilities at all times they are open to members (at no charge….)”.

•	The financial projections showed an operating surplus in relation to provision, for a money consideration, of facilities to members and others of £18,000 in year 1 to over £95,000 in year 5.  

c.	Mary Morris, the deputy head of the School, gave evidence.  The Notes of her evidence taken by the Chairman, Mr Oliver, include a reference to boarding pupils at the School.  In relation to out-of-school use, Ms Morris stated that these boarders had to be members of the club with annual renewal.

The legislation

3.	The UK legislation to which I come in a moment implements the provisions of the First Council Directive (67/227/EC) of 11 April 1967 and the Sixth Council Directive (77/388/EC) of 17 May 1977 and must be construed in the light of those Directives.  

4.	As the First Directive, Article 2 includes the following:

“On each transaction, value added tax……shall be chargeable after deduction of the amount of value added tax borne directly by the various cost components.” 

5.	As to the Sixth Directive, Article 2, so far as relevant, subjects to value added tax “the supply of goods or services effected for a consideration….by a taxable person acting as such.”  Under Article 4(1), a taxable person is a person who independently carries out any economic activity within Article 4(2) whatever the purpose or results of that activity.  The economic activities referred to comprise, under Article 4, all activities of producers, traders and service providers.  

6.	Deduction is dealt with under Article 17: Article 17(2) allows deduction in respect of inputs “used for the purpose of his taxable transactions”; and under Article 17(5), there is to be an apportionment in the case of mixed use both for transactions in respect of which VAT is deductible (ie taxable transactions) and transactions in respect of which VAT is not deductible.  It then provides that “such proportion….shall be deductible as is attributable to the [taxable] transactions”. 

7.	The default method of attribution is found in Article 19(1).  It is in effect the fraction A/B where 

a.	A is the total amount exclusive of VAT of turnover per year attributable to  transactions in respect of which VAT is deductible under Article 17(2) and (3) (although (3) is not relevant for present purposes) and

b.	B is the total amount exclusive of VAT of turnover per year attributable to transactions included in A and to transactions in respect of which VAT is not deductible (ie exempt transactions).

8.	However, Article 17(5) also provides that Member States may make certain other specified provisions as set out in paragraphs (a) to (e): paragraph (c) provides that a Member State may authorise or compel a taxable person to make the deduction on the basis of the use (a term which is not defined) of all or part of the goods or services.  

9.	The relevant domestic legislation is found principally in sections 24, 25 and 26 Value Added Tax Act 1994 (“VATA”) and in Regulations 101 and 102 of the Value Added Tax Regulations 1995 (SI 1995 No 2518) (“the Regulations”).  Reference will also need to be made to section 83 VATA and to some of the later Regulations.

10.	Section 24 VATA defines input tax as tax on the supply to a taxable person of goods or services used for the purposes of a business carried on or to be carried on by him.  Thus, tax on supplies to a taxable person of goods or services which are not used for the purposes of a business is not input tax as defined.  Section 24(5) provides for apportionment in cases of mixed use for business and non-business purposes; only so much as is referable to business purposes counts as input tax.  The section uses the concept of business whereas the provisions of the Sixth Directive which I have referred to focus on economic activities but they come to the same thing.

11.	Section 25 provides that a taxable person is entitled, at the end of each accounting period, to credit for so much of his input tax as is allowable under section 26.  Section 26 contains the provisions which describe the input tax allowable under section 25 and, so far as relevant to this appeal, makes it clear that the only input tax allowable is that which is attributable to taxable supplies made by the trader in the furtherance of his business and not to exempt supplies.  Section 26(3) provides in effect that, where a taxable person makes both taxable and exempt supplies, the Commissioners shall make regulations for securing a fair and reasonable attribution of input tax to taxable supplies.  They have done so in the form of the Regulations.  

12.	Regulation 101 provides that the amount of input tax which a taxable person is entitled to deduct is the amount attributable to taxable supplies.  This is calculated by attributing to taxable supplies by the trader the whole of the input tax on supplies to the trader used or to be used exclusively in making taxable supplies; by providing that no part of the input tax on supplies used or to be used by the trader exclusively in making exempt supplies by him is attributable to taxable supplies by him; and by providing that, where supplies to the trader are used or to be used by the trader in making both taxable and exempt supplies by him, the amount of the input tax attributable to taxable supplies by him is the proportion of the input tax on supplies to him used to make both taxable and exempt supplies which the value of the taxable supplies bears to the total value of taxable and exempt supplies.  Input tax on supplies to the trader used to make both taxable and exempt supplies by him is called residual input tax.  This method of apportioning residual input tax between taxable and exempt supplies is known as the standard method.

13.	Regulation 102 provides for the use of methods of attribution other than the standard method.  Customs may either approve or direct the use of such an alternative method which, in accordance with the statutory objective under section 26(3), is directed at achieving a fair and reasonable attribution when the standard method does not do so, or at least a fairer and more reasonable attribution than the standard method.

14.	I should mention Regulations 102A and 102B.  Regulation 102A applies where a special method is in operation but does not fairly and reasonably represent “the extent to which good or services are used” by the taxable person “in making taxable supplies”.  Regulation 102B then requires the taxable person to calculate the difference between the attribution made according to the special method in force and an attribution which “represents the extent to which the goods or services are used” by the taxable person “in making taxable supplies”.  So one sees in both Regulations the same wording referring to “use” of goods and services in “making taxable supplies”.  

15.	Regulations 107A to 107E provide for an override of the standard method in certain circumstances.  Regulations 107A and 107B apply, using similar words to Regulations 102A and 102B, where the standard method results in an attribution which “differs substantially from one which represents the extent to which the goods or services used” by the taxable person “in making taxable supplies”.  

16.	What one can conclude from this is that the UK legislation envisages the “fair and reasonable” attribution of input tax on goods and services to taxable supplies to reflect the extent of the use of those goods and services in making taxable supplies, an approach which is consistent with the Sixth Directive.  The standard method can be viewed in one way as a proxy for an apportionment according to the relative uses (whatever that word may mean) in making exempt and taxable supplies.  

17.	The jurisprudence of the ECJ establishes that there must be a “direct and immediate link” between the goods in question (ie those in respect of which input tax, or some of it, is sought to be deducted) and the taxable outputs of the taxable person: see for instance BLP Group plc v C&E Comrs [1996] 1 WLR 174 and Midland Bank plc v C&E Comrs [2000] STC 501.  This aspect is also connected with the “cost component” concept articulated in Article 2 of the First Directive.  Thus, in Midland Bank, the ECJ said this:

"29. It should be borne in mind that, according to the fundamental principle which underlies the VAT system, and which follows from art 2 of the First and Sixth Directives, VAT applies to each transaction by way of production or distribution after deduction of the VAT directly borne by the various cost components
30. It follows from that principle as well as from the rule enshrined in the judgment of [BLP] para 19, according to which, in order to give rise to the right to deduct, the goods or services acquired must have a direct and immediate link with the taxable transactions, that the right to deduct the VAT charged on such goods or services presupposes that the expenditure incurred in obtaining them was part of the cost components of the taxable transactions. Such expenditure must therefore be part of the costs of the output transactions which utilise the goods and services required. That is why those cost components must generally have arisen before the taxable person carried out the taxable transactions to which they relate.”
18.	As it is put by Jonathan Parker LJ in Dial-a-Phone v C&E Comrs [2004] STC 987, at paragraph [28]

“…..in applying the ‘used for’ test prescribed by art 17(2) of the Sixth Directive the relevant inquiry is whether there is a ’direct and immediate link’ between the input cost in question and the supply or supplies in question; alternatively whether the input cost is a ‘cost component’ of that supply or those supplies. [Underline emphasis supplied]  It is clear from the judgments of the ECJ in BLP and Midland Bank, as I read them, that there is no material difference between these alternative ways of expressing the basic test.”

19.	Thus there are two separate tests but each is reflective of the other and they come to the same thing: the one seeks a direct and immediate link between the goods or services acquired and the output transactions giving rise to the right to deduct; the other seeks to identify the cost of acquiring those assets as a cost component of the output transaction.  

20.	At paragraph [71] Jonathan Parker LJ deals with attribution in this way:

“The word ‘attributable’ and ‘attributed’ in reg 101 fall to be interpreted by reference to art 2 of the First Directive and art 17 of the Sixth Directive, and in accordance with the principles enunciated by the ECJ in BLP and Midland Bank.  Those authorities establish that the appropriate test of attributability in this context is the ‘direct and immediate link’/’cost component’ test referred to in [28] above……Moreover, as the ECJ made clear,,,,,, it is for the national courts to apply [that] test to the facts of the case, ‘and to take account of all the circumstances surrounding the transaction at issue’.” 

21.	Then, at paragraph [74] he observed that “the quest is not for the closest link, but for a sufficient link”, referring to paragraph 35 the opinion of the Advocate General (Jacobs) in Abbey National plc v C&E Comrs [2001] 1 WLR 769 set out at paragraph [29] of his  Judgment.  

22.	It should also be mentioned for completeness, that overhead costs of a business which cannot be attributed to any particular supplies (whether exempt or taxable) are nonetheless cost components of supplies and thus deductible in whole or in part: see Midland Bank, Abbey National and also the decision in Kretztechnik AG v Finanzamt Linz Case C-465/03 [2005] STC 1118.  Since they are cost components of the supplies, there is the necessary direct and immediate link.

23.	Mr Thomas, who appears for the School, referred me to European Commission v France Case C-50/87 [1988] ECR 4797.  That decision of the ECJ shows that the right to recovery of input tax cannot be restricted by national legislation so that if there is the necessary direct and immediate link between an input and a taxable output is established, it is not admissible, by reference to other criteria, to restrict the right to recover the input tax.  In that case the ECJ held invalid a provision of French law which restricted the amount of input tax on the acquisition of land which was recoverable in respect of letting the land when the annual rent was less than a specified proportion of the vale of the land.

24.	I was referred also to C&E Comrs v Southern Primary Housing Association Ltd [2004] STC 209 (“Southern Primary”).  Adopting the summary of this case found in the judgment of Hart J in The Mayflower Theatre Trust Ltd v HMRC [2006] EWHC 766 (31 March 2006), input tax had been incurred by the taxpayer on its acquisition of certain land. It had then sold the land (an exempt supply) to a housing association and, simultaneously, entered into a development contract with the housing association under which it made taxable supplies. The question was whether the inputs were sufficiently connected to the taxable outputs to enable them to be deducted in their totality. Hart J observed that no question seems to have arisen as to the possibility of treating the inputs as overheads and thus apportionable. Both the Tribunal and, on first appeal, the High Court held that there was a sufficient link, essentially because the sale of the land and the entering into the development contract were part of one overall commercial transaction. On appeal to the Court of Appeal, Customs argued that the decisions below had wrongly: 

"(a) focused on the taxpayer's overall commercial aim; (b) treated the two separate supplies as if they were one; (c) asserted that the question whether two supplies are commercially linked is the same as the question whether inputs are attributable to either or both supplies; (d) applied a test of attribution for which there is no authority—namely whether the input enabled the taxpayer to make a taxable supply; (e) failed to appreciate that the taxpayer's use of the land was exhausted on its sale and the land could not thereafter be attributed to construction works carried out thereafter.”  

25.	Jacob LJ (with whom Mantell LJ and Lord Phillips MR agreed) rejected point (a), but concluded: 

"[32] But there is substance in Mrs Hall's [counsel for Customs] remaining points which, by and large, are different ways of looking at the same question. I particularly consider that point (d) is right. The land purchase transaction was commercially necessary to make its performance commercially possible, but it was not a cost component of the contract itself in the same way as the costs of materials used. There is a link with the contract but the link was not direct and immediate. The development contract would not have been made but for the associated land purchase and sale. But 'but for' is not the test and does not equate to the 'direct and immediate link' and 'cost component' test.

[33] One can look at it another way. There is nothing about the development contract as such which makes the land purchase and sale essential. If the housing association had already owned the land or had bought it from some third party, the inputs of the development contract would have been just the costs of carrying it out. The fact that there were commercially linked land transactions does not mean that those transactions are directly linked to the costs of the development contract. One would not say that the cost of buying the land was a cost of the development contract itself. It follows that the input tax on that cost is not a cost of the contract.

[34]  Other guidance from the ECJ supports that conclusion. Thus in BLP para. 26 the Court reaffirmed the principle of neutrality – namely that "all economic activities, whatever their purpose or results, are taxed in a wholly neutral way". That principle would be violated if this development contract were taxed differently from an exactly similar "freestanding" contract. 

[35]  Again if one applies the "fundamental principle" that "VAT applies to each transaction by way of production or distribution of deduction of the VAT directly borne by the various cost components" (Midland para 29) one is driven to ask whether the land purchase price is a cost component of the development contract – which to my mind it is obviously not. And, if one adapts Midland para.30 to the case the test is whether the expenditure on the land purchase was part of the costs of the development contract which used the land acquired. It did not. The carrying out of the development was on the land acquired, but did not utilise the land, whose ownership was irrelevant. My common sense differs in this respect from Sir Donald Rattee's. 

[36] Midland para. 31 is also in point – there the Court said that lawyers' fees were not "generally part of the costs of the output transaction" and "therefore" did not have any direct and immediate link with the output transaction." Again the Court is focussing on the objective, transaction-by-transaction nature of VAT law. The price of a land purchase is not "generally" part of the costs of a development contract and therefore does not have any direct and immediate link with it. 

[37] Turning back to the tribunal, it concluded that there was a direct and immediate link between the land purchase and both the land sale and development contract, with both an exempt and a non-exempt transaction. VAT law does not work in such a generalised way. You have to look at transactions individually, component transaction by component transaction. They may be linked in the sense that one would not have happened without the other, but they remain distinct transactions nonetheless. Only if one transaction is merely ancillary to the main transaction can one disregard the distinct nature of each transaction (see Card Protection Plan Ltd v Customs and Excise Comrs (Case C-349/96) [1999] STC 270, [1999] 2 AC 601, para 29). If that were not so, the principle of neutrality would be violated. Moreover there would be intractable problems as to which input was being attributed to which part of the 'overall transaction'. You may find, as here taxable and exempt transactions all mixed up in the same 'overall' transaction—which is illegitimate."

The Appellate Jurisdiction

26.	The decision of Customs refusing to approve a proposed partial exemption special method or to apply a standard method override can be appealed to a tribunal under section 83 VATA (see paragraph (e) of that section).  The nature of such an appeal was considered by Etherton J in Banbury Visionplus Ltd v Revenue and Customs Commissioners [2006] STC 1568.  He concluded that an appeal was not “limited” in the sense identified by him (ie an appeal where the tribunal is confined to considering whether Custom’s decision was reasonable, in the sense that they did not take into account any irrelevant matters, they took into account all relevant matters and made no error of law and reached a decision which they could properly have reached); instead, the appeal was “full” in the sense that, “even if the disputed decision was a reasonable one, the tribunal should itself decide whether it secured a fair and reasonable attribution of input tax within the meaning of [section 26 VATA]”.  In other words, the tribunal can substitute its own view of what is fair and reasonable, in the context of the question before it, for that of Customs notwithstanding that Customs decision was within the range of decisions which a body properly directing itself could reach.  I propose to follow that approach without any further discussion.

27.	This is not to say that the tribunal is able to put forward its own version of a more reasonable special method (if there is one).  It cannot do so, as the Tribunal recognised in paragraph 43 of the Decision.  Accordingly, a tribunal can substitute its own view for that of Customs in deciding whether a proposed special method is fair and reasonable.  If on an appeal by a taxable person from a refusal of Customs to allow a proposed special method the tribunal decides that the method is fair and reasonable and also that it is more fair and reasonable than the method in operation (be it the standard method or some other special method), the appeal should be allowed.  But if the tribunal thinks that both the existing method and the proposed method are unfair or unreasonable, it could not allow the appeal even if it considers that the proposed special method is less unfair and unreasonable than the existing method.

Correspondence

28.	I should mention some of the correspondence between the School and Customs since it is relied on by Mr Thomas.  It is in that correspondence that the School’s proposed special method is set out and contains Customs’ reasons for rejecting it.  The correspondence was before the Tribunal and its contents are clear. 

29.	Customs were informed that a contract was about to be entered into for the construction of the sports complex by a letter dated 31 January 2003 from the School’s accountants.  Customs were told that the School’s planning permission allowed the use of the facilities between 6.00 am 11.00 pm.  The School would use the complex for its own exempt educational purposes during school hours and the facilities would be available for third party use outside those hours.  There was no reference to the planning restriction which restricted use to purposes ancillary to school use.  It was explained that use outside school hours would be through SHEL which would be granted a licence to occupy.  The licence fee would be subject to VAT because the School would opt to tax the building.  Any profit of SHEL would be gift-aided to the School and the corporate structure would protect the School from third party claims (eg personal injury claims by users of the facilities).  Since there would be mixed use (exempt educational supplies and taxable use in relation to the licence to SHEL) the School sought approval of a special method of partial exemption.  The proposal at that stage was for a percentage recovery of VAT that is to say A/B x 100% where A = Number of hours let to SHEL and B = Total number of hours of use by School and let to SHEL.  This would be subject to annual adjustment over a period of 10 years since the building is an item to which the Capital Goods Scheme applies.

30.	Customs responded on 10 April 2003, following a meeting with the School.  The relevant officer, Miss Miller, agreed with the view that any special method would need to be based on intended use (the contrast, I think being between intended use and actual use since, as Miss Miller stated, the input tax was being incurred long before any supplies were likely to be made).   She expressed reservations about the School’s suggested formula and made observations about an alternative formula (albeit one also based on physical use) which she considered to be more realistic.  And she sought a considerable amount of further information.

31.	Mr Moore, the senior VAT manager at the School’s accountants, wrote again on 23 May 2003: he took issue with this response and sought to persuade Miss Miller of the fairness of the School’s approach.  She responded to that on 9 June 2003, pointing out that, although she had said at the meeting with the School that the proposals appeared to be fair and reasonable to her, she had also said that she was inexperienced in this type of application and would need to seek further advice.  I mention this to dispel any suggestion that Customs, in taking the stance which it now does, is in any way going back on what it had, in principle, agreed early on.

32.	On 18 July 2003, Mr Moore wrote a long letter to Miss Miller putting, eloquently, the School’s case.  Whilst maintaining that the School’s original proposal was fair and reasonable he put forward in his letter, in order to achieve finality, an alternative partial exemption method.  The proportion of VAT recoverable in respect of the construction costs would be calculated on the basis of “actual” use of the facility by SHEL (which at that stage would have been a projection, subject to adjustment) as a proportion of the total hours of use.  The details of the method were fleshed out in an Appendix to the letter.  I would note only that actual use was to be calculated, in the first year, as hours of licence x 76%, that percentage being the projected percentage of capacity which would be utilised during that first year.

33.	The correspondence with Ms Miller continued but Mr Moore was not satisfied with the outcome and the matter was referred to a higher level.  On 28 May 2004, Mr Gaskell, a senior officer at Regional Business Services, wrote to Mr Moore.  He recognised that the standard method had its limitations in the present case and agreed that a special method would be preferable, suggesting that a head-count would be more reflective of actual use than hours used by SHEL.  He then wrote this:

“Ideally I would prefer to agree a realistic method with you and, although a headcount appears suitable, I would be prepared to consider any other proposals which measure actual use.  Failing that, we cannot approve your existing proposal.  Although it is certainly not ideal, the standard method applies unless and until an alternative special method is approved and has the potential to adjust its outcome by means of the override…………”

The School might detect a slightly hollow ring in that last observation given that Customs have subsequently refused to apply the override which the School suggests and have not themselves implemented any other adjustment.

34.	Following further exchanges, Customs, acting through Mr Rowe, another officer at Regional Business Services, formally refused the School’s request to adopt its special method in a letter dated 3 February 2005.  After describing the proposed special method based on hours of use by SHEL and the School, he gave his analysis of the position, leading to the conclusion that the proposed partial exemption method would not give a fair and reasonable recovery of “residual” input tax and that the proposal would not therefore be one which he considered prudent to authorise.  Since Mr Thomas is highly critical of the reasons given for reaching that conclusion, I should look at Mr Rowe’s reasoning.

35.	On the second to fourth pages of his letter, Mr Rowe sets out those reasons which I summarise as follows:

a.	He expresses the opinion that, to determine whether the proposed special method gives a fair and reasonable result, it would appear that the primary purpose of the construction of the sports complex is a major factor in reaching a decision. 

b.	The primary purpose of the facilities is for the School’s own use, reliance being placed by him on the restriction in the planning permission and paragraph 4.8 of the business plan.

c.	The facilities were financed entirely out of the School’s budget the provision of which will have been mainly for educational purposes and not primarily for commercial use.

d.	The charge for the licence had yet to be fixed but would result in full recovery of the VAT paid by SHEL as its input tax.

e.	SHEL had made taxable supplies of £10,000 in the first 5 months to December 2004 and its ability to contribute an open market licence fee at the level suggested by the proposal (ie the proposed special method) is questionable. [Mr Rowe comments that this might be academic “in that it is arguable that ideally what is required is some way of identifying the value of the facilities to the School, and comparing this with the value received under the licence…”]

f.	Not only does the School have exclusive use during the school day, pupils who board have the unrestricted right to use the facilities during non-school hours and non-term time.  In that context, Mr Rowe relies on paragraph 5.2c. of the draft business plan.

g.	There is a fundamental difference in regarding the desirable incidental additional income which can be derived from the sports facilities as allowing some (minor) level of input tax recovery, and seeking to represent this as the main reasons for the construction of the facilities and therefore allowing a substantial majority of input tax recovery.

h.	The terms and conditions of membership confirm that to become a member of the club the applicant has to meet the eligibility criteria which establish that the individual is part of the “school’s recognised community”.

i.	There is a question as to whether the licence is truly to an independent third party: not only is SHEL a wholly owned subsidiary but it gift-aids profits to the School.  It also finances its activity by third-party hire income and partly from the School’s own resources by billing the cost of staff to the School.  

[Mr Rowe stated expressly, however, that he places no weight on consideration of the mechanism by which the tax recovery is sought or to the reality (for VAT purposes) of the setting up of the licence or whether it is indicative of tax planning.]

j.	There is “no consideration at the outset that the capital costs of the project can be recovered by the out of hours use so that it would appear unreasonable to allow any recovery of the capital cost under the suggested method”.

k.	The actual hours of operation detailed in the business plan are inconsistent with those in the proposed special method; in Mr Rowe’s opinion, that method gives an illogical result when compared with the financial aim of third party letting.

36.	On 31 October 2005, Mr Warner, a partner in the School’s accountants, wrote to Mr Rowe arguing that the standard method was not reasonable.  He referred to the standard method override in Regulations 107A-E; he asked that the letter be treated as a voluntary disclosure for the repayment of over £245,000 of VAT.  His letter was replied to by Mr Rowe on 22 November 2005, in which the voluntary disclosure was formally rejected.  Customs declined to accept that the length of time of use in the present case was a reflection of how the assets are used, or could ever be used, or could form the basis for a fair proxy of use (as that word is used in the legislation).

The Tribunal’s decision

37.	The case was presented to the Tribunal in a very different way from the way it was presented to me.  They accordingly expressed their conclusions in a way which may not deal fully with the way in which the case is now put.  Further the Tribunal in fact adopted the “limited” approach to an appeal since discussed by Etherton J in Banbury Visionplus Ltd (and held by him to be an incorrect approach): see paragraph 29 of the Decision.  

38.	The reasons why the Tribunal found that the Commissioners had acted lawfully in refusing to accept the special method proposed by the School are to be found in paragraphs 29-37 of the Decision.  Mr Thomas suggests that, in essence, the Tribunal gave two reasons for rejecting the School’s argument which may be seen as different aspects of a single reason:

a.	That the statutory provisions in VATA, the Regulations and in Article 17 of the Sixth Directive require one to focus on the use by the taxable person of the goods or services for the purposes of his taxable transactions.  Accordingly, a method that brings into account the use of the goods and services by a third party ‘goes beyond what is authorised’; and that was what the proposed special method sought to do: paragraphs 32 and 33.

b.	The costs of construction of the premises were directly and immediately linked to the grant of the licence by the School to SHEL; but not to the use made by SHEL of the complex in the course of its business.  The use made by SHEL of the benefits of the licence was not what the School supplied.  So the proposal (which looked to use made of the premises by SHEL) went beyond the permitted limits for a use-based method: paragraph 37.

39.	Mr Thomas’ description of the first reason seems to me to be correct.  But his description of the second reason gives a slightly unfair impression because it is a somewhat curtailed description.  What the Tribunal say in paragraph 37 is this:

a.	The licence would never have been granted “but for” the fact that the School had built the complex (the Tribunal having expressly recognised in the preceding paragraph, when addressing Southern Primary, that the “but for” test is not the test and does not equate to the ‘direct and immediate link’ and ‘cost component’ tests).  

b.	The School’s expenditure (its outlay of the costs of the construction works) resulted in the sports complex being created for the School. 
 
c.	That expenditure provided the School with the means by which to make its supplies of education and the licence.

d.	But the licence was the limit of the School’s standard rated supply and the licence fee was the limit of the consideration obtained for that supply. 

e.	The use SHEL chose to make of the benefits of the licence is not what the School supplied by granting the licence.  

f.	The corollary is that the costs of construction are directly and immediately linked to the grant of the licence.  

[I would remark here that the “direct and immediate link” which the cases discuss is between (i) the goods acquired by the taxable person, not the cost of such goods and (ii) the goods or services he provides.  But I think the sense of what the Tribunal is saying is clear.  I would also add that another way of putting this is that the costs of construction were not reflected in the cost of providing the licence which might be thought to be the same as saying, in the language of the ECJ, that the cost of the construction work is not a cost component of the taxable supply, that is to say the licence.]

g.	But they are not so linked to the use made by SHEL of the sports complex in the course of its business.

h.	On that basis, the School’s proposed special method goes beyond the permitted limits.

40.	Paragraphs a to c are, I think, entirely correct.  Paragraphs d and e also appear to me to be correct: the School did not supply to any end user, an individual, the use of a sports facility.  What it did supply was a licence to SHEL for SHEL to supply to an end user the use of a sports facility.  Those are different things.  Paragraph e would also appear to me to me correct; and, indeed, the licence may be the closest direct and immediate link with the building which is “the goods” of the School.  

41.	The case was, I think, presented to the Tribunal on the basis that there was a direct and immediate link between the construction of the sports complex and the use made by SHEL of the complex, almost as though the supply by the School was a supply to end users rather than to SHEL; alternatively, there was to be a “look through”, SHEL’s use being the School’s use.  It was on that basis that the Tribunal expressed the views which they did as I have set them out in paragraphs g and h.  I think that, on the basis on which the case was put to them, they reached the right conclusion. 

42.	However, Mr Thomas now puts the argument for the School in a different way as will appear (essentially that the use by SHEL is simply a proxy for use by the School and provides a basis for a fair and reasonable special method). 

The School’s case on the proposed special method

43.	Mr Thomas’ starting point is the alleged unfairness of the standard method.  He says that it is quite clear that the standard method does not produce a fair result.  Thus parents of the pupils are not paying the School £7 million or £8 million a year to have swimming lessons.  Indeed, before the Tribunal, the School calculated that 1.2% of the total annual school fees related to swimming lessons and training for pupils, or some £87,600 for the relevant year: see paragraph 26 (ii) of the Decision. There is no finding about that but, whatever the correct percentage, the point can be made that no reasonable apportionment of fees would produce a large attribution to the physical use made by the School of the sports complex in the education of its pupils.  Mr Thomas also says that it is equally clear that no part of the costs of constructing the sports complex is properly attributable to a number of distinct aspects of the School’s activities such as the boarding fees or school meal charges.  And yet, he says, the standard method attribution incorporates the whole of the fee income in its denominator whilst including only the taxable income from the use of the complex in its numerator.

44.	On the one hand, that real-world analysis has much, superficially, to commend it.  On the other hand, also in the real world, notional allocation of part of the fees paid by parents to swimming and sports activities in the complex may be of little relevance.  One can well imagine that the School has a commercial imperative in providing these facilities in order to retain its reputation and remain competitive in the education market.  Indeed, the actual costs were met out of the School’s assets or out of fund-raising activities or the School’s foundation.  The application of these monies must have been in furtherance of the School’s charitable educational objectives notwithstanding that, as part of a business plan, the School would raise some money through out-of-hours use.  And, as the business plan indicated, the financial objective was to make the complex self-sufficient in terms of its day to day running costs, but there was never any suggestion that the out-or-hours activities would support any significant part of the capital funding of the project.

45.	Mr Thomas points out that the Tribunal recognised that ‘from an early stage in the planning exercise’ the School had in mind a commercial use for the sports complex: Decision paragraph 34.  It therefore accepted, he submits, that the costs of constructing the complex were (in VAT terms) ‘cost components’ of both the taxable supplies which the School would make by licensing the complex to SHEL and of the exempt supplies of education it made to its pupils.  That may be true, but, as I have just pointed out, the commercial use was never going to support the real, overall, economic costs of the complex including its construction even though it was hoped that the commercial use would support the annual running costs.

46.	Reverting to the two reasons given by the Tribunal for rejecting the School’s argument before it (see paragraph 38 above) Mr Thomas remarks that it will immediately be seen that the Tribunal adopted none of the reasons given by Mr Rowe for rejecting the proposed method.  This, he says, is manifest from the last sentence of paragraph 33 of the Tribunal’s decision: “This is the reason why we are against the School”.  The only reason found by the Tribunal for rejecting the School’s appeal against the first decision was, he says, this apparent anomaly – that the use on which the method focussed was the use by SHEL and not by the School.  

47.	What he says is correct, I consider, in relation to the first reason given.  But given the way that the argument was presented, this is not entirely surprising since it was not, as I understand it, argued that the actual physical/time use by SHEL was a proxy for the use, for VAT purposes, by the School.  Instead, it was argued that the apparent imbalance between the input tax deduction sought and the output tax to be paid on licence fee income was explained by looking through the licence to taxable supplies that SHEL would in due course make.  It was that argument which the Tribunal held to be illegitimate (unsurprisingly in the light of the way the arguments were put).

48.	But in relation to the second reason, I think that the position is slightly more complex.  The second reason depends on the absence of a direct and immediate link between the building and the use made of it by SHEL.  However, what Mr Thomas submits in relation to the first reason applies equally to the second reason.  It is that the Tribunal fell into error in failing to appreciate that the use made of the premises by SHEL was a valid and reasonable proxy for the use made of the premises by the School.   

49.	Under the School’s proposed special method, the projected “actual use” by SHEL is to be taken as a proxy for the use (for VAT purposes) of the building in granting the licence.  In this context, the “actual use” is established on the basis set out in the letter dated 18 July 2003 (ie hours of licence x 76%).  That “actual use” is of no help in ascertaining the attribution of input tax unless it is taken as a proportion of some larger use.  Under the proposed special method, that larger use is the total of SHEL’s “actual use” (as just described) and the School’s own “actual use”: that, in turn, is to be ascertained under the proposed special method by reference to availability of the complex to the School between certain hours on weekdays during term time and certain Saturdays throughout the year.  This too, must, I think, be regarded simply as a proxy for the School’s use of the building in the provision by it of educational services.  

50.	I see no reason why an attribution method along the lines proposed is to be ruled out of consideration in limine as an alternative method for the purposes of Regulation 102.  It may be that, on the facts of a particular case, the physical use of a building or a chattel by a third party may be a very good proxy for the use, for VAT purposes, of the taxable person.  I therefore agree with Mr Thomas that the Tribunal’s first reason for rejecting the School’s proposed special partial exemption method cannot be supported.

51.	The Tribunal’s second reason for rejecting the School’s proposed special method was that the costs of construction were not directly and immediately linked to the use made by SHEL of the sports complex in the course of its business.  However, if it is accepted that the use by SHEL of the complex is simply a proxy for the use by the School of the complex in making its taxable supply by granting the licence, it can be seen that this reason is not an objection at all.  

52.	Mr Thomas submits that there can be no doubt that when dealing with the apportionment of residual input tax one is always seeking a reasonable proxy for the use made by the taxable person of the goods and services in question.   This is most clearly the case with the standard method which looks at values of outputs and not at the use of the goods and services on which the input tax has been incurred: the values are a proxy for the use and nothing more.  But the test sanctioned by section 24 seeks to establish to what extent the taxable person is using the goods and services, in respect of which the claim to recover input tax is made, in making taxable supplies.  I agree with that submission subject to this: that there may be cases where actual use for VAT purposes can be clearly identified and there is no need for a proxy of any sort.

53.	Mr Thomas says this in his skeleton argument:  

“To be fair and reasonable, any partial exemption method used in this case must offer an effective means of comparing the use of the premises in making taxable supplies with their use in making exempt supplies.  There may be circumstances in other cases in which an overhead will be more intensively used in making one kind of supply than another and where this is reflected in the price of each supply (or ‘output’).”  

54.	This, I think, is the first time one sees any suggestion on behalf of the School that the construction costs might be regarded as overheads.  The question of expenditure on overheads usually arises in cases where the supply of goods or services to a taxable person cannot be seen to be reflected in an output (as, for instance, in Kretztechnic).  However, where a cost is incurred which for the benefit of the business as a whole, then it is an overhead and is therefore, according to the case, a cost component of the supplies and the necessary direct and immediate link is established.  Where a taxable person makes both taxable and exempt supplies, that overhead cost has to be apportioned between them.  In the present case, it does not seem to matter whether it is correct to describe the construction costs as overheads.  The point is that the whole of the VAT on those costs is input tax of the School and the question is how that input tax is to be allocated between exempt and taxable supplies.  The answer cannot depend on the label attached to the expenditure since, whichever way one looks at it, the expenditure is a cost component of the taxable and exempt supplies between them.

55.	Mr Thomas then makes the point that an apportionment of overheads by reference to the value of outputs may be sensible in a case such as he identifies in paragraph 53 above.  He says that that is not the present case where the onward supply does not exhaust or even diminish the value of the asset which is being used in the supply ie the sports complex.  In other words, the use for VAT purposes of the sports complex does not consume it.  In such a case Mr Thomas submits that there is no reason to compare the value of the outputs generated from making exempt supplies with the sports complex with the value of the outputs generated from making taxable supplies with the sports complex.  

56.	As he puts it:

“Neither contains a greater element of the costs of construction than the other. If one takes the straightforward approach that a capital item, such as the swimming pool complex, depreciates at a uniform rate over its life, one hour’s use in making taxable supplies may be seen to expend precisely the same amount of the input tax incurred on the capital cost of the premises as one hour’s use in making exempt supplies with the premises.  There is, in other words, precisely the same value of input expenditure in each hour’s use, whatever the value of the outputs from the hour’s use may be.

It follows that it is fair and reasonable when dealing with the attribution of input tax on a capital item which does not significantly diminish in value to apportion the expenditure in the period in which it is incurred between the taxable and exempt use to be made of the item by comparing the time it is to be put to each use.”

57.	Mr Thomas then says that although it is strictly true that the proxy put forward by the School did have reference to use made of the premises by a third party, SHEL that is not to say that such use cannot also stand as a reasonable proxy for use by the School:

“It inevitably follows from the fact that SHEL can only use the premises during hours for which it is licensed to do so by the School that the hours in which SHEL uses the premises are a sub-set of the hours in which the School uses the premises by licensing them to SHEL.   Thus the hours of use by SHEL are an adequate proxy for the use of the premises by the School for taxable purposes.”

58.	It is, according to Mr Thomas, in this respect that the Tribunal erred in law.  They should have appreciated that the use by SHEL was a sound proxy for taxable use by the School.  However, it seems to me that Mr Thomas is missing out a step in the argument.

59.	Having done so, it should have concluded that, there being no other reason it had been able to identify which made the School’s proposal unfair and unreasonable, it was wrong of the Commissioners to reject the School’s special method.  The Appellant’s appeal against the Commissioners’ first decision should therefore have been allowed.

60.	For completeness, Mr Thomas dealt with the reasons (as he listed them and I show them in italics as he did – in a way slightly different from that which I have set out above) actually given by Customs for denying the School the right to use its proposed special method, none of which, he said, had any substance:

a.	The fact that the primary purpose of the facilities was for the School’s own use is, Mr Thomas submits, an irrelevance.  He says, quite correctly, that entitlement to deduct input tax is not determined by motivation or purpose relying on in Dial-a-Phone Ltd [2004] STC 987 and the decisions of the ECJ Abbey National and BLP.  One sees this objective approach being adopted in many other cases including the decision of the ECJ in Halifax plc v Customs & Excise Commissioners (Case C-255/02) which shows that the meaning of the term “activities” in the Sixth Directive is very wide and is objective in character in the sense that the activity is considered per se without regard to its purpose or results.  I would also mention the decision of Patten J Customs & Excise Commissioners v Yarburgh Children’s Trust [2002] STC 207 albeit that it was not cited to me.  Patten J clearly holds that the motive of a person in making a supply is not relevant to and cannot dictate the correct tax treatment of a transaction.  This is perhaps another way of saying what the ECJ said in Halifax. But, as the judge says, the exclusion of motive or purpose does not allow the tribunal to disregard the observable terms and features of the transaction and the wider context in which it came to be carried out.  Although what the judge said was in the context of deciding whether a transaction was an economic activity or not, similar remarks can, I think, be made in relation to establishing the use (for VAT purposes) to which an item of property is put and in determining what is or is not a valid proxy for that use in determining whether a proposed special method is fair and reasonable.  I do not, therefore, consider that the establishment of the primary purpose of the construction of the facilities is to be excluded from consideration. 

b.	The source of the funding for the construction of the premises is, Mr Thomas submits, equally irrelevant.  The question is not how the premises were paid for; but whether the premises were used in making taxable supplies.  The Tribunal, as he says, found to be the case: they accepted (see paragraph 37 of the Decision) that there was a direct and immediate between the costs of construction and the grant of the licence (but not to the use made by SHEL of the sports complex).  However, it does not follow from that the source of the funding is irrelevant in considering whether a proposed special method produces and fair and reasonable attribution.  This is a matter to which I will need to return when considering the submissions of Mss Simor on behalf of Customs.

c.	That the (value of the?) taxable supplies made by SHEL had been small in the first months of opening: this was, Mr Thomas submits, on any analysis irrelevant and contains the alleged error of considering use by a third party as use by the School – but without the saving grace that it constituted an adequate proxy for the use by the School.  That is, I think, an unfair criticism since the italicised words are Mr Thomas’ précis of what I have set out more fully at paragraph 35(e) above and are not quite accurate.  Indeed, Mr Rowe did go on to say that this point was probably academic as mentioned in that paragraph.

d.	That the charge to be made by the School to SHEL had yet to be fixed; but would be recoverable in full as input tax by SHEL.  Mr Thomas remarks that it is unclear why it mattered when determining whether a proposed special method was fair and reasonable that output tax charged by the School would be recovered by SHEL.  This simply reflected the fact that SHEL itself was a taxable person making taxable supplies.  I agree and do not understand the relevance of this factor. 

e.	That the licence was to be to a subsidiary of the School who was not a ‘truly independent third party’.  Mr Thomas says that to assert this is to fall into the error of treating separate taxable persons as a single person for VAT purposes.  Authority that this is impermissible may be found in cases such as the decision of the Court of Justice in Staatssecretaris van Financiën v Heerma (Case C-23/98) [2001] STC 1437 paragraph [22] and of the Court of Appeal in Telewest Communications Plc v Customs and Excise Commissioners [2005] STC 481, per Arden LJ at paragraph [88].  I do not think, however, that Mr Rowe was falling into that error; in any case, he attached no weight to this point (see paragraph 35(i) above).

f.	That the capital costs of the project had not been considered to be recoverable out of the out of hours use.  Mr Thomas says the issue is not, again, whether the costs are recovered out of the use; but whether the goods and services are used to make the supplies.  That is clearly correct. 

g.	The School had potentially access at all hours through its boarders.   Mr Thomas’ riposte to that is that, if the boarders were using the swimming pool out of hours, they did so not because the School was educating them but because they were on the premises.  This use by individuals did not constitute the provision of exempt education by the School or use by the School.  I would add that the evidence was, in any case, that boarders had to be members of the Club and thus enjoyed out-of-hours use through the licence to SHEL not by virtue of the supply of education.  

h.	The membership of the club run by SHEL would be restricted to persons connected with the School community.  Mr Thomas observes that this may have been so; but it did not mean, he says, that the taxable supplies to SHEL were sham or that this was in some way the indirect provision of exempt education by the School.  I agree with that.  It is, however, part and parcel of the context in which the “use” for VAT purposes of the sports complex has to be ascertained.

i.	That the hours referred to in the School’s business plan for the project were inconsistent with those used or to be used in the apportionment fraction. Mr Thomas says that this could only have been relevant to a computation of the apportionment fraction and not to the question whether the apportionment method was fair and reasonable.  I agree with that.

61.	According to Mr Thomas, therefore, each of the reasons relied on by Mr Rowe was irrelevant to the question which he had to ask: namely, whether the method proposed by the School was fair and reasonable.  Furthermore, in many instances, the reason was not simply irrelevant but was, he says, wrong in law.  As appears from the comments I have made in considering his criticisms, I do not entirely agree with him on all his criticisms.  Moreover he does not list and deal separately with one other factor relied on by Mr Rowe as set out in paragraph 35(g) above, an aspect which, again, I shall return to in the course of considering Miss Simor’s submissions to which I now turn.

Custom’s case on the proposed special method
62.	Miss Simor says that a special method would not produce a fair and reasonable result if its effect was to allow the supplier to recover tax on inputs that did not form “true cost components” of the taxable supply. To allow such a method would be to allow for over-recovery and would be contrary to the fundamental principle of neutrality which emerges from the cases before the ECJ to which I have already referred.   Like Mr Thomas, who uses the word “actual”, Miss Simor attaches an epithet to “cost component” as though to distinguish cost components which are “true” from something else.  I do not find this added word helpful.  Either something (or its cost) is, for VAT purposes, a cost component of a supply or it is not.  Where an item is a cost component of two supplies, one taxable and one exempt, a process of attribution has to be found.  The search for an appropriate method (if the standard method is unsuitable) will, if successful, result in a fair and reasonable attribution.  One can then say that the part of the item (or its cost) apportioned to the taxable supply is a cost component of that supply, or if you like, a true costs component of it.  But adding the epithet “true” does not assist one in the task of identifying a fair and reasonable method of attribution.

63.	Miss Simor acknowledges that a fair and reasonable attribution to a taxable supply has to reflect the use of a relevant asset in making that supply.  She refers to the use which is to be identified for VAT purposes as the economic use.  She accepts that physical use may reflect economic use but says that it does not necessarily do so; and she submits that any allocation or special method must give a credible result in economic terms.

64.	Her submissions, in a nutshell, are as follows:

a.	The Tribunal were correct in finding that the only relevant supply for the purposes of determining deductible input tax was the supply by the School to SHEL and that supplies or physical use by SHEL were not an appropriate proxy for ‘use’ by the Appellant.

[As to that, the Tribunal did not use the word “proxy” in the Decision.  It is not at all clear to me that it had in mind, and rejected, the approach which Mr Thomas now advocates.  Indeed, the Tribunal seem to have rejected looking at the use made by SHEL of the complex as a matter of principle which, as I have already said, I do not think is correct.]

b.	The cost of constructing the sports complex did not form a cost component of the supply of the licence to any significant extent, albeit that no licence for the use of the complex could have been granted without the existence of a complex.

c.	Accordingly, the ‘special method’ proposed, whereby the hours during which the School could not use the sports complex (and which hypothetically could be used by SHEL) were used as a proxy for the percentage of VAT on inputs (in particular, construction costs) that the school was entitled to deduct, was not reasonable or legitimate.

65.	As to “use” in Article 17 of the Sixth Directive and section 25 VATA, Miss Simor refers to the need for a “direct and immediate link”.  She puts it as link between the cost and the supply or between the input and the output.  It must be remembered that is all shorthand for what the courts have actually said, namely that there has to be a direct and immediate link between the goods or services acquired and the output transactions giving rise to the right to deduct or to put it another way, the cost of the goods or services acquired is part of the cost components of the output transaction which utilises the goods and services acquired..  

66.	In the present case, Miss Simor says that the direct and immediate link between the cost of the sports complex and the licence supplied to SHEL is very limited in nature:

a.	The complex was constructed wholly for the purposes of an exempt supply namely, education.  VAT paid in respect of its construction is therefore a cost that is almost entirely directly attributable to an exempt supply.  It is therefore not recoverable, save for any minor amount.

b.	The only taxable supply made by the School was the grant of the licence, which contains no specific fee but which appears to give rise to an annual fee of around £18,600 per annum.  Only input tax that is attributable to the grant of that licence can be reclaimed.  

c.	The costs of construction were incurred for the purposes of educational supplies not in relation to the taxable supply of the licence.  Put another way, those costs cannot be said to be a cost component of supplying the licence to any significant degree.

67.	The first of those is contentious.  The Tribunal in fact recognised that the School had in mind a commercial purpose for an early stage in the planning process; and it has in fact, consistently with that concept, made taxable supplies in respect of the sports complex.

68.	Similarly, the last of those statements is controversial notwithstanding that Customs say it has never been disputed.  Even if it is true, as Miss Simor says, that the School paid for the complex using its charitable funds (although Mr Thomas says it was funded out of donations and a foundation with no borrowings required), that there was never any intention that SHEL contribute to those costs and that the licence, being for only £18,600 p.a. could not in any event, commercially contribute to those costs, it does not necessarily follow that construction costs are not a cost to any significant degree of providing the licence. 

69.	Miss Simor seeks to make good factual assertion (that SHEL would not contribute to the construction costs commercially) by an analysis of the figures which she puts in her skeleton argument:

a.	The taxable rentals are £1530 per month (as at 31 March 2005) or £18,360 per year.

b.	The VAT bearing cost of the asset was £2,635,013.12

£2,635,013.12 x 54% = £1,422,906 [54% being the proportion attributable to the licence under the School’s proposed special method]

c.	The taxable rental required to meet 54% of the capital expenditure would run for a period of 77.5 years (£18,360 x 77.5 (years) = £1,422,906).

d.	This is said to be a conservative figure since it assumes that there are no capital financing costs, and that all of the funds are used to repay capital and that there are no other contingencies that need to be covered by these funds.  But the licence is for 10 years and there is nothing to suggest that it would continue after that period.  Assuming that SHEL was wound up after 10 years and assuming all rental fees were used to cover the capital costs of the building, only £180,360.00 would be recovered.  Put in terms of VAT this means that the Appellant would recover £245,657.46 VAT but would only contribute £31,563.00 VAT. 

70.	The criticism of the method proposed by the School is that it wrongly assumes that physical use of an asset is the same as economic use (or, as I would put it, use for the purposes of VAT).  On Custom’s approach, the question is not how long or how much SHEL might physically use the sports complex but rather the extent to which the construction costs and running costs of the complex are  economic costs or cost components of the supply of the licence to SHEL for its physical use of the complex by its members.  

71.	Reliance is then placed on Southern Primary, in particular paragraphs 32 and 35 set out at paragraph 25 above in support of the proposition that, although the construction of the complex may have been necessary to make the grant of the licence possible, it does not follow that the costs of construction were a cost component of granting the licence.  

72.	If that is correct, then it follows that no part of the VAT on the construction costs is allowable as input tax in relation to the grant of licence.  Consistently, however, Customs have taken the position that some of the input tax is attributable to the grant of the licence otherwise even the standard method would not be applicable.  I think that that they are correct to have done so and that this was not simply a matter of concession.  The present case is distinguishable from Southern Primary.  One distinction is that, in that case, the taxpayer’s use of the land was effectively exhausted on the sale of land to the housing association: this was Mrs Hall’s point (e) which like all of other points (apart from point (a) – commercial aim) the Court accepted had substance whereas in the present case, the grant of the licence is actually a supply of the building.  Another distinction is that, in that case, the Court held that the carrying out of the development was on the land but did not utilise the land whose ownership was irrelevant, whereas in the present case the whole purpose of the licence is to grant the enjoyment of the land to SHEL during the periods of its licence.  To my mind, particularly bearing in mind that commercial use of the sports complex was contemplated from an early stage, the construction of the sports complex does have a direct and immediate link with the grant of the licence to SHEL.  The School’s case is not to be defeated on the basis that there is no such link and that the costs of construction are not capable of being costs components of the licence.  That unfortunately does not help resolve the question of what is a fair and reasonable attribution of those costs between taxable and exempt supplies.

73.	Then it is said that to allow the special method proposed by the Appellant would be to allow a net VAT reclaim to be made by an exempt supplier in respect of elements of cost (construction cost and in the future other costs) that did not form a cost component of its taxable supply (the licence).  The School would be a net beneficiary in VAT terms of a very substantial sum, with no possibility of that VAT ever being repaid.  The method is in any event not a proper measure of use.  Under the proposed method SHEL could be charged any licence fee and could have one member or no members; the recovery rate would be the same.  Hours of opening do not even reflect ‘physical’ use, let alone economic use.

74.	Taking the proposed special method to its logical conclusion, it is submitted that if the local planning authority amended its planning permission to allow all night opening, SHEL’s licence could be extended to cover all night and, whether the facility was open or not, the Appellant could claim an even higher percentage of VAT recovery.  Indeed SHEL would never have actually physically to use the facilities at all, merely paying some small consideration for the exclusive right to use them being sufficient.  That may be true, but it is not a fair criticism of the proposed special method.  That special method is put forward in the context of the facts as they are in accordance with which, on the School’s case, the formula based on hours of use takes into account only hours during which, realistically, the sports complex can be expected to be used and which, in any case, allows for only 76% capacity in year 1.  If the local planning authority were to change the scope of the permission, and if the licence to SHEL was altered in the way suggested, the proposed special method might then be inappropriate: but those are not the facts against which the proposal has to be judged. 

Discussion

75.	I agree with Mr Thomas that the search in the present case is for a fair and reasonable proxy for the “use” of the sports complex in making the exempt and taxable supplies made by the School.  However, I also agree with Miss Simor that the physical use of the complex is not necessarily a fair and reasonable proxy for that use.  I consider that her use of the phrase “economic use” is a helpful approach to establishing what the search is for.  

76.	In that context, it is instructive, I consider, to look at the position had the School not granted the licence at all and had not allowed any out-of-hours use.  In those circumstances, there would have been no taxable supply at all.  In consequence, none of the input tax would fall to be attributed to taxable supplies as a result of Regulations 101(2)(b) and (c), Regulation 101(2)(d) not applying. However, the sports complex is used for the purposes of the School’s (exempt) business.  It is so used not because there is a supply to parents of the physical use (by their daughters) of the sports complex to their children, but because the availability of the complex is part of the package of benefits which is acquired by parents for the fees they pay and which constitutes the exempt supply by the School.  The use made by the School, for VAT purposes, of the sports complex is its use in providing that package of services, a single supply.  There is, of course, no need to identify a proxy for use when there is only an exempt supply since questions of allocation under Regulation 101(2)(d) do not then arise.  Nonetheless, one can see that the “use” referred in Regulation 101 (as elsewhere) is not physical use but some special VAT use.  It is, I think, the same as what Miss Simor terms “economic use”.

77.	On the facts of the present case, it seems to me that the overwhelming economic use of the sports complex by the School is in relation to the provision of educational services.  In that context, I agree with Miss Simor that the source of funds and the purpose of constructing the sports complex are relevant considerations.  To regard those factors as relevant is not, in my judgment, to fall into the error, as Mr Thomas would say it is, of categorising the nature of a supply by reference to the purpose or motive in making it.  There is no doubt that in the present case, the supplies are distinct and readily identifiable, that is to say the taxable supply of the licence to SHEL and the exempt supply of education.  Nor, in my judgment, is there any question, in taking those factors into account of treating a taxable supply as an exempt supply or vice versa.  The question is what “use” is being made of the inputs in producing the outputs.  It seems to me that the purpose of the School, objectively ascertained, in constructing the sports complex is a highly relevant factor in attributing cost components between the relevant outputs and is an entirely different issue from identifying the nature of the output by reference to purpose or motive (which is inadmissible), the issue addressed by Patten J in Yarburgh Children’s Trust. 

78.	On the evidence, it is clear that, objectively assessed, the principal purpose of the School in building the sports complex was the furtherance of its educational activities and was carried out in connection with its business of making exempt supplies of education.  That conclusion is clear from the way the matter was put in the first draft of the business plan and the approach of the School to the generation of funds by out-of-school use which was designed to meet the running costs of the complex and, if possible, something over and above that.  Further, the capital cost of the complex was met out of funds which were either charitable funds or derived from a fund-raising exercise and which were clearly dedicated to the educational purposes of the School.  The generation of income by out-of-school use was essentially a secondary consideration, albeit that the benefit thereby produced was an aspect of the whole project from the beginning.  

79.	Moreover, it is also clear, I consider, that the income generated by the licence to SHEL was never intended or expected to meet a share of the capital cost proportionate to the physical use of the sports complex by SHEL.  The relevance of this is that it is supportive of the view that the principal, objective, purpose of the expenditure on the sports complex was in furtherance of the School’s main function of providing education to its pupils and that the license to SHEL was secondary, simply putting to productive use that which has been acquired for a different main purpose.  In terms of VAT, the provision of an exempt supply of education was the principal use of the sports complex and the taxable supply of the licence to SHEL was a secondary use.  

80.	Any method of allocation between the exempt and taxable supplies made by the School must, in my judgment, reflect that use.  Given the approach of Etherton J in Banbury Visionplus Ltd, the questions for me are whether the standard method and the School’s proposed special method each produce a fair and reasonable attribution and if so whether the School’s method is more fair and reasonable than the standard method.  In my judgment, the standard method, whatever its shortcomings, does produce a fair and reasonable apportionment which does reflect the economic use which is made by the School of the sports complex.  Further, without saying that the School’s proposed special method is not a fair and reasonable method, the standard method produces, in my judgment, an allocation which is more fair and reasonable than the schools proposed special method.  

81.	Accordingly, the School’s appeal against Custom’s rejection of the proposed special method fails.

Standard Method Override

82.	The School then says that a standard method override should be applied under Regulation 107B.  The Regulation applies where the attribution which is being applied produces a result which “differs substantially” from one which represents the extent to which the goods or services are used by the taxable person in making taxable supplies.  In other words, the override will apply in the present case if the standard method results in an allocation under the standard method which differs substantially from one which represents the extent to which the sports complex is used by the School in granting the licence to SHEL.

83.	For the same reasons as I have given in deciding that the School’s proposed special method is not to be preferred to the standard method, I do not consider that the standard method, whatever its shortcomings, can be said to produce a result which differs substantially from the one which represents the extent of the School’s economic use of the sports complex in granting the licence.  Certainly, the way in which the School seeks to calculate that difference does not, in my judgment, represent a proper calculation of any such difference and is to be rejected.

84.	Accordingly, the School’s appeal from the rejection by Customs of their rejection of the override also fails.

Conclusion

85.	The School’s appeals from the Decision and from the consequent order of the Tribunal are dismissed.

Appendix: the Tribunal’s summary of the facts
[Paragraph numbers are those of the Decision]

Planning permission
4.	On 27 January 2002 the School applied for planning permission to build a new swimming pool and sports hall ("the sports complex") in the School's grounds. Planning permission was granted on 10 July 2002; the consent is conditional on the sports complex being "used only for purposes ancillary to the use of the premises as a school" and that the hours of opening be restricted to between 0600 and 2300 hours. The School was permitted to allow access to the groups listed in the "community links" document attached to the planning permission; a proviso stated that any proposal to increase the number of organizations using the sports complex or to make it available for use by the general public or on a fee-paying basis required further permission.

The first business plan
5.	On 29 November 2002 a business plan was commissioned from consultants by the School's governors. The governors had in mind the possibility of exploiting the sports complex commercially and wished to know whether it would be viable to have what Mary Morris described as "a dual purpose pool".

Special method - application and rejection
6.	The School registered for VAT from 1 January 2003. Recovery of the VAT incurred on the building of the sports complex was the reason the School became registered. On 31 January 2003 the School proposed a special method. This sought as recoverable input tax the proportion of the total input tax incurred on the sports complex construction works based on a number of hours for which the complex was let to "SHEL" (which was incorporated in 2003 and has at all material times been wholly owned by the School and whose full name is St Helen's Enterprises Ltd) as a proportion of the number of hours the sports complex was used by the School plus the hours for which it was let to SHEL. This was not accepted by the Customs.

7.	A revised application proposing a special method was submitted by the School on 18 July 2003. This was based on the hours of actual use of the sports complex. The recoverable input tax by this method was a proportion of the input tax incurred on building the sports complex being the proportion that the total hours of actual use by SHEL bore to the total hours of actual use by the School and by SHEL. Correspondence followed between the School's advisers and the Customs. This concluded with the Customs' decision, by letter of 3 February 2005, to reject the School's proposed special method. The standard method applied as a result.

Construction work on the sports complex
8.	Construction work on the sports complex started in the middle of the summer of 2003. The School engaged the architect and the building contractor. The planned works contained certain features reflecting the potential requirements of a commercial user for use outside school hours. For example, a space for a reception desk and filing was provided.

Letter agreement to grant licence to SHEL
9.	By letter of 4 October 2003 from the School to SHEL the School offered, and SHEL agreed to take, a licence to occupy the sports complex (then under construction) on the following terms:

•	The period of the licence was expressed to be for ten years from practical completion (expected to be June 2004) subject to earlier determination on 6 months notice by either side at any time after 18 months from practical completion.

•	The licence to SHEL was subject to the School's right to exclusive use of the sports complex "between the hours of 8.00am and 6.00pm five days a week during term-time (comprising 34.4 weeks per annum) plus occasional Sunday mornings. 

•	Rates and utility charges were to be split 70% SHEL and 30% the School.

•	Costs of maintenance and insurance were to be the School's responsibility and 70% of these were to be "recharged" to SHEL. 

•	SHEL was to provide lifeguards while the sports complex was being used by the School and the cost of these was to be recharged to the School.

•	The School was to provide SHEL with administrative services including payroll, book-keeping and accountancy.The letter agreement did not specify any licence fee.

The Athis draft business plan
10.	Athis, consultants, were commissioned to provide a business plan. The draft produced on 4 December 2003 recited that where currently the sports complex was seen in isolation, it might become an element of a larger commercial organization and that the "broad objectives" included allowing greater involvement between the School and local community. Anticipating that a trading company would be involved the "strategic objective" specified an arms length relationship between the trading company and the School and that any surpluses would be gifted by the trading company to the School.

SHEL's and the School's responses to the business plan
11.	A meeting of the board of SHEL on 11 February 2004 noted that the business plan envisaged the generation of "incremental income" and that there were VAT implications. According to the minutes the School's governors had not by then taken the decision to run the sports complex "as a commercial entity". A further meeting of SHEL held on 27 February 2004 considered in more detail the practicalities of the project.

12.	The School's governors met on 22 March 2004 and on the agenda was a report on the sports complex project. Financial projections were supplied by Athis. As regards VAT, the governors were told that "in order to achieve any recovery on the constructions costs of the sports complex, the School would need to enter into a commercial arrangement". "Variables" in the arrangement were explained to the governors. The governors agreed –

"In principle the commercial letting of the sports complex outside School hours be approved".

Further consideration of the business plan and the financial arrangements took place at a meeting of SHEL's board on 26 April 2004. The board agreed to open the sports complex to commercial use.

Option to tax
13.	On 7 January 2004 the School and SHEL jointly notified the Customs of the decision to opt to tax for the sports complex.

Construction completed and opening of sports complex
14.	On 8 July 2004 the construction works were complete. The pool was opened for school use in September 2004. The pool was opened to "members" of the St Helen's Swimming and Fitness Club and others for use out of School hours on 25 October 2004.

The licence commences
15.	We were shown no documentation but it was not in dispute that a licence in favour of SHEL started to run from 8 July 2004. We infer that its terms were, as already set out, for ten years terminable on 6 months notice after 18 months from commencement. The licence fee has not been specified in any documentation but it appears from relevant invoices to have been £18,600 per year.

Financing the sports complex: the School's contributions and receipts
16.	The School and St Helen's Centenary Foundation Trust provided the funds for the construction works of the sports complex. The total VAT inclusive cost was £2,635,013. (The VAT element was £454,921.)

17.	The School lent SHEL some £240,000 at interest to enable SHEL to buy equipment and to pay salaries until it started its operation of the sports complex.

18.	The School receives the £18,600 licence fee from SHEL. This is consideration for a taxable supply made by the School.

19.	The School pays some £124,000 to SHEL to cover the School's share (calculated by reference to its and SHEL's times of use of the sports complex) of personnel working in the complex, i.e. the centre manager, the swimming teacher, lifeguards, fitness assistance and cleaning staff.

20.	The School carries the whole cost of utilities and certain other expenses such as insurance and cross charges 70% of these to SHEL: see the licence and a letter of 23 December 2004.

SHEL's payments to and receipts from the School  
21.	SHEL receives, as taxable consideration, the School's annual contribution of £124,000 to staffing costs. That amount will, we infer, be consideration for SHEL's taxable supply of staff services to the School. SHEL pays the licence fee to the School and recovers input VAT on the VAT element.

SHEL’s other supplies

22.	SHEL and the School are not in the same VAT group. SHEL provides services to the members of the St Helen’s Swimming and Fitness Club all of whom are related to the School in some way, to other users such as local clubs and associations and to parents for birthday parties of pupils etc. As well as its supplies to the School (see paragraph 19). The outputs of SHEL’S business include subscriptions from members and other payments for the use of the sports complex during non school hours.