Introduction

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VAT will only become a major cost to a business if it is unable to recover all or some of the VAT incurred on costs from HMRC. 

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The recoverability of VAT will depend largely on the type of supplies made by a business and whether these are taxable (billed including VAT or Zero Rated) or Exempt where no VAT is applicable on the supply.  The below paragraphs aim to set out the basics of VAT recovery and how a businesses P&L will or can be impacted by decisions made by companies and the associated VAT cost.

 

Fully Recoverable Businesses

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A business that is fully recoverable for VAT means that it only makes taxable supplies to its customers and as such it has the right to full recovery of the VAT incurred on its costs under HMRC rules.  Therefore businesses that can fully recover VAT will have little or no P&L VAT cost.

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Partially Exempt Businesses​

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Partially exempt businesses on the other hand that make a mixture of taxable and exempt supplies will not be able to recover all the VAT incurred on costs as some of the VAT relates to exempt supplies made by the business.  Where a business only makes exempt supplies to UK customers, VAT incurred on costs will in most cases be irrecoverable and become a cost in the P&L. 

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Businesses such as banks will usually be partially exempt as they usually supply a mixture of taxable and exempt financial services.​​

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To ensure partially exempt businesses obtain a fair and reasonable level of VAT recovery, they will need to have a method of VAT recovery which allows them to recover a percentage of the VAT incurred on costs.

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There are two methods for achieving this under HMRC rules, namely the Standard Method or using a Special Method that is negotiated and agreed with HMRC. 

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The Standard Values Method calculation is as follows:

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Taxable Sales (Std rated + Reduced Rate and Zero Rated) = VAT Recovery %​

Total Sales (Taxable as above + Exempt Sales) ​

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The more taxable sales a business generates, the higher the VAT recovery rate will be.  The VAT recovery rates will be multiplied but the pools of input VAT incurred in or allocated to a business area to arrive at the amount of VAT recoverable from HMRC. VAT recovery then becomes a credit to the P&L at either a single line level or at a profit centre / business segment level. 

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Special Methods - are normally required where the business in question has a complex operational structure including VAT grouping, multiple product offerings, operates in different market segments, has service companies etc and as such the standard method may not provide a fair and reasonable VAT recovery outcome based on where VAT is consumed in the business.  For example, a business making an equal amount of taxable and exempt supplies may not be consuming an equal amount of VAT.  Special methods try to address these imbalances by specifying the basis of how VAT will be allocated fairly among different business areas.​

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Special methods for example can use VAT recovery methods based on transaction counts, floor space, sales credits, industry specific methods etc instead of values, but will all most likely use the same formula as the standard method but with different headings.  For example the number of taxable transactions or the number of taxable sales credits.  

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VAT recovery methods will produce different outcomes in terms of VAT recovery but HMRC's key aim is to ensure the method is fair and reasonable and is based on a business allocating its VAT based on how the associated costs are consumed within the business. 

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How VAT Can Impact Profitability

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VAT Groups - Offer companies a way to simplify their intercompany billing and VAT reporting to HMRC by allowing companies to form VAT groups by bringing a number of entities under a single UK VAT registration and with one entity being the representative member.  This allows members of the group to:

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• File a single consolidated Group VAT Return and eliminating the need to file multiple standalone VAT returns

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• Enables members of the VAT group to buy and sell goods and services without the need to add VAT to their invoices as transactions are deemed to be outside the scope of VAT.​​​

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Note - Failure ​​​to set up a VAT group where entities are partially exempt would introduce and increase the VAT costs in the P&L as not all of the VAT billed on invoices from related entities would be recoverable from HMRC.

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Reverse Charge VAT - UK Companies that purchase services from entities outside the UK will normally have to self account for UK reverse charge VAT at 20% to HMRC. This measure ensures that there is a level playing field for UK suppliers and prevents UK companies from simply sourcing services from outside the UK to reduce costs by not paying UK VAT.  

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For example, a UK VAT registered company that purchases consultancy services from a French company will receive an invoice from the French company which will not include VAT but the UK company will have to add 20% VAT to the value of the invoice and include this VAT on its VAT return to HMRC.  The UK company if it is a fully taxable business, will normally be able to fully recover this VAT from HMRC and in effect will not pay HMRC any VAT as the VAT payable and VAT recoverable will net to zero on their VAT return in box 5. 

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On the other hand if the UK company is a partial exempt entity (as above) such as a bank, it will only be able to recover a percentage of the reverse charge VAT payable to HMRC and as such the irrecoverable portion of the VAT will become a P&L cost.

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Note (a)  Reverse Charge VAT will also be applicable to services purchased and or recharged from overseas subsidiaries that are not members of the UK VAT group by virtue of having a UK branch within the VAT group.  Reverse charge VAT will apply to transfers of intangibles such as branding charges and goodwill.  Also see VAT cases Skandia and Danske on the VAT news page which can have an impact on VAT.

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Note (b)  Reverse Charge VAT of 20 % should always be built in to budgets that contain costs relating to services that will be purchased from overseas.  Failure to do this can lead to nasty surprises and significant cost VAT cost when VAT suddenly has to be accounted for to HMRC. 

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Cost Recharges from the UK to Overseas Subs and Branches - Another area that can be overlooked in terms of VAT cost is where a company incurs or pays for UK costs including VAT and or non UK costs plus reverse charge VAT on behalf  their overseas subs and branches.  Where the underlying services are provided and consumed by the overseas entities, then there is the potential for full VAT recovery on these costs instead of  partial recovery if the UK entity is a partially recoverable business.  (makes a mixture of taxable and exempt supplies (See above).  This area can often be overlooked and as such companies can incur significantly more irrecoverable VAT in the P&L

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Fixed Establishment and VAT Grouping - The term Fixed Establishment from a HMRC point of view refers to a company resident in the UK that has a sufficient degree of structure and permanence in terms of human and technical resources to enable it provide the services that it supplies.

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A company may generally be considered to have a “fixed establishment” in the UK if it has a real trading presence in the UK, that is to say, if:

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• it has a permanent place of business in the UK, and

• that place of business comprises sufficient human and technical resources for it to carry on its business activities

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A company is not considered to have a “fixed establishment” in the UK merely as a result of the fact that:

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• it has a “brass plate” presence in the UK

• it carries on business through a UK agent, or

• it has a UK subsidiary.

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​One of the conditions of a company joining a VAT group is that it has a fixed establishment in the UK.  As such a branch of an overseas entity can be a member of a UK VAT group and as such the overseas parent will also become a member of the UK VAT group by virtue of its branch.  Intercompany recharges between the overseas entity and its branch and other members of the VAT group can therefore be disregarded for VAT  (subject to anti avoidance rules Sec43 (2a) ).  This therefore means that reverse charge VAT as mentioned above will not be applicable to these transactions and as such irrecoverable VAT can be eliminated where members of the VAT group are partially exempt. 

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​Note: - When registering companies as members of a VAT group in the UK, it is imperative that the rules around fixed establishment are water tight otherwise VAT grouping for companies and/or branches can be withdrawn (de-grouping) by HMRC and past supplies then become subject to assessments which can have a major impact on P&L where the VAT is irrecoverable and interest is charged by HMRC.

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