One of the founding principles of the VAT system is that VAT incurred on costs can be reclaimed, provided it can be linked to a transaction which affords a right to VAT recovery. But how strong does this link have to be? The Court of Justice of the European Union (CJEU) decision in Kretztechnik appeared to have clarified the matter, however two recent cases, University of Cambridge and Frank Smart, have thrown this into doubt and for many the answer is now no clearer.
What are the key decisions?
Kretztechnik was a fully taxable trading company that issued shares for public subscription and sought to recover the input tax on the listing and other related costs. The CJEU concluded that the issue of shares was not a supply for VAT purposes and that the associated costs were a general overhead of the business. The company was entitled to recover the input tax on the related costs to the extent that its business activities generated taxable supplies.
This case followed the principles established in Kretztechnik and held that VAT incurred on costs associated with generating donations is not necessarily directly attributable to non-business activities; instead, the charity can attribute the cost to the activities that the donations will support. If these are generally supporting the overall work of the charity this means the VAT incurred can be partially recoverable. This would not apply where the donations are restricted for charitable non-business use.
In the case of Frank Smart, the Supreme Court with knowledge of the UOC decision decided that costs relating to outside the scope income (Single Farm Payments) were deductible. Frank Smart was able to demonstrate that the professional costs relating to the purchase of the right to receive Farm Payments related to both the immediate out of scope fundraising and the downstream intended taxable farming activity. They were therefore a general overhead of a fully taxable business.
The UOC claimed a VAT deduction in accordance with its VAT recovery method on costs relating to the management of investment funds. It was claimed these costs were a general expense of the University and a partial deduction was appropriate. HMRC contended that they related solely to the non-business investment management activities and that there was no right to deduction.
On referral from the UK courts the CJEU decided that objectively viewed the costs on which deduction is sought must be incorporated into an immediate or subsequent output (a downstream economic activity).
The court determined that whilst the funds raised by the University from its investments were used to support future downstream economic activity because the funds raised subsidised the cost of the University's educational activities when supplied to students etc, the investment management costs could not be said to have been incorporated into and be a cost component of an economic activity so no right of a deduction arose.
What are the takeaways?
So what does this mean for charities in respect of VAT on costs associated with their investment portfolio or costs consumed in undertaking fundraising activities?
A charity’s objectives may be to raise funds to support its charitable activities, this of itself is not enough to demonstrate that investment management and fundraising costs are a general overhead cost of the organisation. The charity will need to demonstrate, on the basis of evidence, that the raising of funds by donations or investments will be used in part to generate new economic activity or to stimulate / grow existing economic activity. The costs must be components of current / future business activity. This may well conflict with their charitable objectives.
If the funds raised are used to subsidise / reduce the price of economic activities in any way then there will be no right to recover any of the associated VAT.
We expect that HMRC will begin to challenge charities on their right to recover some or all of the VAT incurred on fundraising and investment management costs in the future. Documenting the purpose of the fundraising will be important, as will the ability of charities to demonstrate that the income from such activities does not subsidise the cost of economic activities when provided to third party consumers. It should also be noted that even if the new economic activity does not take place for several years, the costs will still be a general overhead.
How can RSM help?
We can help charity clients to assess the impact of the recent cases and confirm whether adjustments need to be made as to how fundraising and investment management costs are coded for VAT purposes within the charity’s financial accounts. We can also advise on how the charity should engage with HMRC in relation to this matter in order to mitigate any potential retrospective adjustments etc.
Where HMRC directly challenge charity clients we can review and ensure that the basis of the assessment is correct, for example we believe that some charities will be able to differentiate the position from the UOC case and some deduction of VAT on investment management costs may still be possible. It will depend on how that investment income is used.
We can also support Boards in gaining a better understanding of the VAT recovery rules and associated case law so that they together with the executive management team can make informed decisions as to how investment and fund-raising income should be used, and how the cost of delivering economic activities should be calculated.