New 15 billion VAT refund scheme for NHS and central government could impact net funding

The Treasury has now formally launched its consultation asking for stakeholders’ views on proposals for a major reform of the current VAT refund scheme for public bodies.

Most activities of public bodies, such as government departments and the NHS, are outside the scope of VAT, either because they are non-business in nature and/or provided as a statutory obligation. Under normal VAT rules, this would mean that the public body would not be entitled to recover VAT incurred on these activities. As a result, it was traditionally cheaper for public bodies to undertake services in-house rather than outsource to the private sector with the addition of irrecoverable VAT costs. This irrecoverable VAT was essentially creating a larger civil service as it was cheaper to employ staff.

To overcome this, the ‘Section 41’ VAT scheme was introduced in 1984 to allow listed public bodies to recover VAT paid on specified services contracted out to external providers. The aim was to ensure spending and procurement decisions were not driven by their VAT cost.  However, VAT on goods and services that are not on this list cannot be recovered.

Since the scheme began, the NHS and central government have greatly increased their interactions with the private sector, and it has now become far more complex to determine whether an outsourced service is on the list of those on which VAT can be recovered.  This uncertainty can complicate the tender process for government contracts and make it more difficult for the government to accurately predict VAT costs when making funding decisions. Where HMRC believes that a public body has misinterpreted the rules, it has the power to assess to claw back overclaimed VAT; so, appeals and disputes with HMRC are common.

Estimated to equate to between £10-15 bn per annum, the Treasury now proposes to permit full refunds of the VAT incurred on all goods and services incurred during the course of non-business activities for public bodies who are eligible for the scheme. Full details of the proposals can be found in this consultation document: VAT and the Public Sector: Reform to VAT Refund Rules.

A simpler VAT recovery system for the public sector is in many ways a positive development and, if successful, may encourage the government to consider similar schemes for other sectors such as charities. However, there are many potential ramifications of this plan, not just for the public sector, but also for the contractors or commercial providers of similar NHS services. For example:

• The NHS and listed bodies will have their core funding reduced to balance against the expected increase in VAT recovery from HMRC. This will be actioned on an estimated basis and may distort overall public funding.
• An NHS trust competing to provide commissioned care services may have a better VAT recovery position and therefore a large financial advantage over competing bidders from outside the NHS.
• A new entitlement to recover VAT on goods may mean that the NHS decides to keep some activities in-house instead of completely outsourcing them, increasing the number of public sector staff.
• VAT planning in the sector could increase as suppliers look to take advantage of the new scheme.

So far, no target date has been set for the new scheme to come into effect and the consultation seeks general comments from stakeholders on what it describes as a ‘long term project’. Nevertheless, public bodies and those who supply goods and services to them should review their position and consider submitting a response.