20743
 INPUT TAX – Partial exemption – decision of the Commissioners to refuse the use of a special method – proposed method still in incomplete form – appeal dismissed 

	
MANCHESTER TRIBUNAL CENTRE 			   

 
 	
	LAURA ANDERSON LTD	Appellants

	- and -

THE COMMISSIONERS FOR
	HER MAJESTY’S REVENUE AND CUSTOMS	Respondents

Tribunal:	LADY MITTING (Chairman)	
		PETER WHITEHEAD (Member)

Sitting in public in Manchester on 17 June 2008

Andrew Brearey, VAT Consultant for the Appellant 

Joanna Vicary, counsel, instructed by the Solicitor for HM Revenue and Customs for the Respondents 

	© CROWN COPYRIGHT 2008
DECISION
1.	The Appellant appeals against two related decisions.  The first decision is that of the Commissioners, notified on 25 May 2007 refusing to agree the use of a partial exemption special method proposed by the Appellant, thereby imposing the use of the standard method.  The Appellant then appeals against the subsequent assessment to tax in the sum of £12,012 plus interest calculated on 5 July 2007.  The quantum of the assessment was not in dispute and it was accepted by both parties that if the appeal should succeed on the first issue then the Appellant should also succeed on the second.  If the Appellant did not succeed on the first issue then the assessment would be upheld.

2.	No oral evidence was called on behalf of the Appellant but the Appellant’s case was put by its VAT advisor, Mr. Andrew Brearey.  For the Commissioners, oral evidence was given by Mrs. Susan Harrison, an officer with specialist status in partial exemption and an unchallenged witness statement was put in by Mrs. Caroline Moss, the case officer.

3.	The issue before the tribunal was whether the partial exemption special method proposed by the Appellant produced a fair and reasonable attribution of input tax.

4.	The Appellant provides a domestic repair and maintenance building service to the public, trading under the name Virgo Home Improvements.  It also provides intermediary financial services to providers of finance to Virgo’s customers.

5.	Virgo uses a number of means of obtaining business.  It advertises on television and newspapers; employs door-to-door canvassers and cold calls by telephone.  All these methods have one objective and that is to secure an entry into a prospective customer’s house by a sales representative.  Some of the advertisements will mention that finance is available but others will not.  A soon as a prospective customer indicates an interest, a sales representative will visit, establish the work which needs to be done, provide a quote and if acceptable procure a signed contract and a deposit.  The representative will outline the financial options available and ask the customer how he wishes to pay.  If by cash, there will be no further discussion of finance but if the customer indicates an interest in the finance option, the salesman will take him through a finance agreement which the customer will complete there and then.  The company will then pass the finance agreement on to one of its providers.  The provider, if it accepts the application, will then enter into correspondence direct with the customer.  Virgo does nothing more with the finance application than have the initial agreement signed and pass it on to one of its providers.  The job itself, whether paid for by cash or by finance, then proceeds in identical fashion with the visit of a surveyor who organises the ordering of materials and sets the job up.  The work is then carried out and in the case of a cash job, the contractor collects payment upon completion.  In the case of a finance job, the contractor merely obtains a signature to certify satisfactory completion and the invoice is passed on to the finance provider who will pay Virgo direct.  The company has very few employees.  In January 2007 it had on its books 132 staff covering management, administration, canvassing, the sales representatives, the surveyors and the fitters who carry out the work.  Of these the vast majority are self-employed.

6.	The company receives commission from the providers of the finance to its customers.  The company believed it suffered no costs in relation to this exempt activity and therefore never carried out any apportionment but merely reclaimed its input tax in full in the belief that the entirety related to its taxable supplies as a provider of building services.  In early 2006, an assurance visit was carried out on behalf of the Commissioners by Mr. J Gavaghan.  He advised that some input tax must have related to the exempt activity and  a partial exemption adjustment should therefore have been made.  He invited Mr. Brearey to put forward a proposal for a special method of apportionment if he wished but went on to advise that in default, the standard method would apply.  We were told by Mr. Brearey that Mr. Gavaghan had himself said that he did not believe the standard method would be appropriate in this case but there was no substantiation of this statement.  Mr. Brearey put forward a head count proposal in May 2006.  This was rejected by the Commissioners and after some further correspondence was abandoned and in March 2007, Mr. Brearey put forward the proposal which is now before the tribunal.

7.	That the standard method was inappropriate was illustrated by Mr. Brearey by reference to sales and purchases set alongside the fees paid by the Appellant for marketing and promotion and professional advice.  In 2004, total income (sales plus commission) totalled £7 million.  By 2007 this had reduced to £5 million, a percentage decrease of 32.29.  The individual components however diverged quite considerably.  The percentage reduction in sales was 29.75 but in commission was 63.19%.  The amount spent by the company in marketing and promotion stood at £424,000 in 2004 down to £197,000 in 2007, a percentage reduction of 74.56.  Against this professional fees had remained reasonably static at £180,000 in 2004 down to £173,000 in 2007, a percentage reduction of 4.19.  The conclusion drawn by Mr. Brearey was that the monies spent on professional fees, marketing and promotion were not reflected in turnover.  In 2006 and 2007, the company had in fact increased its marketing and promotion costs by 33%.  In the same period taxable sales increased by 8% and exempt commission by 2.5%.  Mr. Brearey’s conclusion was that the data showed that the ratio that taxable supplies had to total supplies was not indicative of the use to which input costs were put as, had this have been the case there would be a correlation between changes in value which was not evident from the data.  Mr. Brearey’s submission quite simply was that the exempt income (the commission) was not a product of marketing or professional fees but of external forces such as the state of the UK economy, interest rates and the credit worthiness of the customer.  There was no correlation between exempt income and costs.  Equally the relationship between exempt income and taxable income was out of kilter.  The standard method was therefore unfair because commission levels were not dictated by costs.

8.	It may assist at this stage to put the figures into some sort of context.  For the year ended May 2005, the Appellant company reclaimed input tax in the total sum of £468,395.  The use of the standard method of apportionment would lead to a recovery of £456,380, hence the Commissioners’ assessment in the sum of £12,012.  If the Appellant’s special method were approved, recoverable input tax would be £462,504, a difference between the two methods of some £6,000.  The starting point in Mr. Brearey’s method was the usual starting point of identifying those costs which related exclusively to the making of taxable supplies and were therefore directly attributable.  It was accepted by the Commissioners that the company incurred no costs which related exclusively to the exempt income and the direct attribution was therefore based on the entire cost of purchases as set out in the company accounts.  Input tax was fully recoverable on these.  This left the overheads to be dealt with.  The overheads included the usual fixed costs such as utilities, security and cleaning but were made up in the main of marketing and promotional costs, professional fees and telephone bills.  Mr. Brearey’s second stage was to split the company’s sales between those which were cash sales and those which were supported by finance.  Insofar as cash sales were concerned, Mr. Brearey treated the input tax as fully recoverable.  This however left the sales supported by finance and in relation to those sales an apportionment had to be carried out and the method proposed by Mr. Brearey was a “process” approach.  Mr. Brearey took a standard job starting with a visit of the salesman through the completion of the order, the purchasing of the materials, the carrying out of the work and the final invoicing.  He identified 17 processes to which he applied a weighting on a time basis.  Each process was therefore allotted a number of points which ranged from 5 to 1.  The total number of points was 42.  He then isolated the processes which related purely to finance (7 points) and treated 7/42 as exempt.  The remaining 35 points were attributable to processes covering all jobs and he therefore treated 35/42 as recoverable.  Mr. Brearey readily accepted that the weightings had not been carried out scientifically.  They were estimated based on common sense and experience.  It would, we were told, be a very costly exercise to do a scientific weighting as this would involve a complete survey of the work carried out by the company.  This was not something which the company wished to spend money on unless the scheme has been definitively approved, in which event the detailed analysis would be carried out. 

9.	Mrs. Harrison explained the Commissioners’ objections to this method and why she felt they had not been able to agree it.  Some of these concerns were addressed during the course of the hearing; others were not.  First the Commissioners were unclear whether the method was based on processes or transactions.  It was made clear by Mr. Brearey and accepted by the Commissioners that it was a process based calculation.  Secondly, it assumed that for every sale, every process would be applicable.  This could not be the case because, for example the processes included the completion and processing of credit applications which would not be applicable to a cash sale.  Equally they included the invoicing and collection of payment for a cash sale which would not be applicable to credit sales.  Mrs. Harrison accepted that this objection could be remedied by keeping the weighting but refining the calculation to factor in the apportionment of jobs.  Thirdly, once the initial weighting calculation had been carried out a percentage was arrived at and the proposal was that this percentage would then be applied quarter by quarter.  However this would be a fixed fraction whereas in reality the percentage should vary quarter by quarter according to the ratio of cash and credit sales in any period.  This objection was not really addressed save by Mr. Brearey maintaining that any variation would be minute and a vague suggestion that it could be reviewed from time to time.  Fourth, the second stage of Mr. Brearey’s calculation separated out the cash sales from finance sales.  The cash sales were treated as entitling full input tax deduction.  In effect therefore cash sales had been dealt with and finished and should not be included in any further stage of the calculation.  However cash sales had been included in the list of weightings, thus giving an element of double counting.  Fifth, Mrs. Harrison envisaged a difficulty in the Appellant operating the scheme and the Commissioners verifying it.  It was unclear how easily the information could be produced by the Appellant’s accounting systems and whether or not records were maintained that would enable the Commissioners to check.  In response, Mr. Brearey maintained that although it would be a very expensive exercise, there were sufficient records available to enable the exercise to be carried out accurately and to enable verification by the Commissioners.  Sixth, Mrs. Harrison pointed out that there was no correlation between the number and types of processes used and the advertising, marketing and professional costs which constituted 77% of the company’s overheads.  The thrust of advertising, argued Mrs. Harrison, was to generate more sales for the business.  The greater the number of sales, the greater the profit and the greater the profit, the greater the drawings of the business consultant whom Mrs. Harrison believed to be paid on results.  Mrs. Harrison accepted that certain fixed costs would not and could not correlate but the larger costs she thought should, and indeed would if the standard method were used as this was based on turnover and in her view in the main, professional fees, marketing and promotions would be reflected in turnover not processes.  Mr. Brearey’s response was that it would be unlikely that any method would have a strong correlation with the marketing and promotional costs.  Marketing and promotion expenditure was spent in advance and related to obtaining leads.  A small number of leads would convert to taxable supplies from which an even smaller number would produce exempt income.  The proposed method looked at outcomes and how many of the sales converted to exempt commission and what inputs were used to produce that commission.  Mr. Brearey was able to clarify the position of the business consultant and indeed this would remove one element of the Commissioners’ challenges.  The business consultant was not paid on results but was paid at a fixed rate.

10.	Mr. Brearey’s basic contention was that the use of the standard method allocated too much input tax to exempt supplies.  The standard method did not give a fair attribution, a much fairer one being given by his proposed special method.  Equally it was easily verifiable because the processes were obvious and the time spent could be identified and everything that was needed was within the system.  Mr. Brearey accepted that a number of the Commissioners’ concerns had not really been addressed and equally he accepted that the method put forward needed further work on it but he had wanted the tribunal hearing to be a starting point.

Conclusions

11.	Mrs. Harrison in her evidence said that the aim of a partial exemption calculation was to find a method which accurately reflected the use of the costs.  Mr. Brearey’s submission was that the costs were used to boost taxable sales and this we accept.  The relationship between commission and total income is out of kilter.  It must follow that the relationship between commission based sales and total sales does not run consistently.  As shown by the statistics produced by Mr. Brearey the commission income of the company fell at a considerably greater rate than sales income.  There is no real correlation between overhead costs and finance commission.  The company does not actively market any financial service.  It markets a building service for which a payment by finance is an option.  The company does not influence the number of finance related sales it gets and the number of any such sales will vary.  In effect, the finance income to the company is incidental to its sales income and could be seen as a not insignificant bonus.  It is not costs-related.  We can therefore understand Mr. Brearey’s contention that the standard method results in excessive input tax being allotted to exempt supplies.  The question for the tribunal however is whether or not the proposed special method produces a fair and reasonable result.  A number of challenges have been raised to the method by the Commissioners of varying degrees of importance.  Some are no doubt capable of resolution, some not.  Mr. Brearey denied that there was any element of double counting in the list of processes but we believe there must have been.  The list of processes includes processes common to both cash and credit sales; processes applicable only to cash sales and processes applicable only to finance-backed sales.  It cannot be the case that each job contains every element or every process.  A cash job would not contain the processes of completion and processing of the finance-backed forms and a finance job would not contain the cash based processes.  If we are looking at finance-backed sales, we should only look at those processes relating to finance-backed sales, not those relating to cash sales.  If therefore the cash processes are removed from the list of processes, the points would reduce immediately.  Equally we are slightly unhappy with the description of some of the processes.  They are in very vague terms, for example “completion of order”.  Mr. Brearey’s view is that this is a standard description of a process and relates purely to taxable supplies.  However in his skeleton argument he refers to the “the sales representative will offer the customer repair services and finance options…  If the customer wishes to be introduced to a finance provider, he will complete a finance agreement”.  This indicates to us that the initial process might well include some element of description to the customer of the various finance options available to him before the second process is reached of completing the application.  Again, this is something which could no doubt be ironed out with further refinement of the processes but is only going to add to the complexity.  The main problem which we have with the scheme is that it is at the moment in an incomplete form.  We have referred already to matters that we believe would affect the number of processes and perhaps the weighting given to each.  On a proper scientific analysis, perhaps the description of the processes but almost certainly the weightings are going to vary.  They may increase, they may decrease but put together with the flaws we have pinpointed already, there could be quite a significant variation in the final form of the scheme.  The Commissioners were unable to agree the scheme in the form in which it was put forward and we likewise are not able to sanction it either.  On the basis of the information in front of us, which contained no supporting evidence or documentation as to how the formula had been arrived at, we are unable to find that the proposal gives a fair and reasonable result.  We share the Commissioners’ concern also that once the calculation has been carried out initially a percentage would be arrived at which it would then again prove very costly to review.  If a system of review is factored in which could allow for a variation of the percentage then clearly that objection would be overcome.  The difficulties of operation and verification may or may not exist.  Mr. Brearey merely told us that the systems were there and if that is right then again that problem is overcome but again no evidence was given as to the nature of the records available.

12.	For the reasons given above, we are unable to accept that in its current form, the special method proposed by the Appellant produces a fair and reasonable attribution to the input tax.  The appeal must therefore fail in respect of both decisions and the assessment be upheld.  Miss Vicary made no application for costs and no order is made.

MAN/2007/0952

Lady Mitting
CHAIRMAN
Release Date: 15 July 2008