Partial exemption disputes are almost never about whether a supply is exempt. They are about attribution and about method, and a small change in method applied across several years produces a very large number. The capital goods scheme then adds a liability nobody recorded.
On this page
Why Partial Exemption Produces So Many Disputes
A business that makes only taxable supplies recovers all its input tax. A business that makes only exempt supplies recovers none. A business that makes both is partly exempt, and has to apportion, and apportionment is a matter of method, judgment and negotiation rather than arithmetic.
The businesses affected are not exotic. Property investors and developers, financial services and insurance intermediaries, education providers, healthcare, charities, care providers, betting and gaming, and any business with a mixture of activities all fall into it.
The Mechanics
Three categories of input tax
- Directly attributable to taxable supplies: fully recoverable.
- Directly attributable to exempt supplies, not recoverable.
- Residual (or non-attributable): overheads and mixed-use costs, recoverable in the proportion given by the method.
Most disputes are about the boundary between the first two and the third. HMRC will argue that a cost is directly attributable to exempt supplies; the business will argue it is residual and therefore partly recoverable, or directly attributable to taxable supplies.
The standard method
The default apportionment is by reference to the value of taxable supplies as a proportion of total supplies, expressed as a percentage and rounded in accordance with the rules. It is applied provisionally in each period and then subject to an annual adjustment.
The de minimis limits
Where exempt input tax falls within the de minimis limits, it can be recovered in full. The tests are mechanical, and there are simplified tests designed to reduce the compliance burden. Businesses close to the limits should model the position before the year end rather than discovering it afterwards.
Special methods
Where the standard method does not produce a fair and reasonable result, a business may apply to HMRC for a partial exemption special method, for example based on floor space, headcount, transaction counts or sectorised calculations. A special method requires HMRC’s approval and a declaration that it is fair and reasonable.
Where the standard method produces a substantially distorted result, a standard method override may be required, obliging the business to adjust to a fair and reasonable recovery even without a special method.
The Capital Goods Scheme
The capital goods scheme adjusts recovery on certain high-value capital items over an extended period, to reflect changes in the extent of taxable use. It applies to specified categories, including land and buildings above a value threshold and certain computer and other equipment, with adjustment periods running over a number of intervals.
The recurring problems are:
- Items nobody identified as CGS items at the time, so no adjustments have ever been made.
- Changes of use, a building moving between taxable and exempt use, which trigger adjustments that are missed.
- Disposals during the adjustment period, which produce a final adjustment.
- Transfers of a going concern, where the transferee inherits the transferor’s CGS obligations, frequently without realising it. See our guide to TOGCs.
Where HMRC Challenges
- Attribution of professional fees on a transaction, particularly acquisition, disposal and financing costs, where the link to taxable or exempt supplies is contested.
- Holding company costs and whether there is an economic activity at all: see our guide to economic activity and Wakefield College.
- Special method operation, where the method as approved is not the method actually applied.
- Sectorisation, where the business has allocated costs between sectors in a way HMRC regards as distortive.
- Failure to apply the override where the standard method result is substantially distorted.
- Missed annual adjustments.
Assessments and Appeals
- Time limits. A VAT assessment must be made within the statutory periods, and the extended period requires the relevant conduct. Check every period in the schedule.
- Best judgment. Where HMRC has assessed on an estimated basis, the principles in Van Boeckel and Pegasus Birds apply, and the tribunal’s task is to find the correct amount, with the burden on the appellant.
- Pay or deposit. Section 84(3) VATA 1994 requires the disputed VAT to be paid or deposited before the tribunal will hear the appeal, subject to hardship: see Totel.
- Behaviour. A method dispute is a difference of technical view, not a deliberate inaccuracy. Resist any suggestion otherwise on the basis of HMRC v Tooth.
- Retrospection. Where a special method is agreed, be clear whether it applies retrospectively and from when.
Practitioner Application
- Maintain a CGS register. Every capital item, its cost, the intervals, the initial recovery percentage and each adjustment. This single document prevents the largest exposure in the area.
- Document attribution decisions at the time. Why a particular cost was treated as directly attributable or residual, with the reasoning. Reconstructing it during an assurance visit is far weaker.
- Review the method when the business changes. A method that was fair and reasonable when approved may be distortive after an acquisition, a new activity or a property transaction.
- Model the de minimis position before the year end, not after it.
- Apply for a special method prospectively where the standard method is unfair, rather than arguing about it retrospectively.
- On a property transaction, check the CGS position on both sides and deal with it in the contract.
Frequently Asked Questions
What is partial exemption?
The apportionment required where a business makes both taxable and exempt supplies. Input tax directly attributable to taxable supplies is fully recoverable, input tax directly attributable to exempt supplies is not, and residual overheads are recovered in the proportion given by the method. Most disputes are about attribution and about the method, not about whether a supply is exempt.
When should I apply for a special method?
When the standard method does not produce a fair and reasonable result, for example where the value of supplies bears no relation to the use of overheads. Apply prospectively, with HMRC’s approval and the required declaration, rather than arguing about it retrospectively after an assessment. Note also that where the standard method produces a substantially distorted result, an override may be required even without a special method.
What is the biggest capital goods scheme risk?
An item nobody identified as a CGS item at the time. A business buys or refurbishes a building, recovers VAT on the basis of taxable use, the use later changes, and no adjustments are ever made. Years afterwards an assurance visit identifies it and adjusts every interval at once. A CGS register prevents it, and almost nothing else does.
Does a TOGC affect the capital goods scheme?
Yes, and it is frequently missed. On a transfer of a going concern the transferee inherits the transferor’s CGS obligations for the remaining intervals. Buyers routinely acquire an unrecognised adjustment liability along with the property. The position should be checked on both sides and dealt with expressly in the contract.
Can HMRC charge a penalty on a partial exemption error?
It can, but a method or attribution dispute is a difference of technical view rather than a deliberate inaccuracy. Under HMRC v Tooth a deliberate inaccuracy requires knowledge of the error and an intention that HMRC rely on it. Where the business documented its attribution reasoning at the time, even a careless finding should be resisted.