This month’s Chartered Accountants Tax Case Digest looks at a Scottish Court of Session appeal which examined whether a farming company could reclaim VAT on the purchase of single farm payment entitlements (“SFPEs”). The Court rejected HMRC’s appeal and argument that VAT on the purchases was irrecoverable as it did not directly relate to any VATable sales activity.

While the facts of the case were relatively unusual, commentators are lauding the outcome as good news both for taxpayers generally and for the farming sector.

Previously, the view was that no VAT can be claimed on costs which generate non-business income, this now appears restrictive and suggests it is necessary consider looking beyond the cost itself to understand how the income generated is used before reaching a conclusion on input VAT recovery.

In similar recent cases, the Courts have adopted the same ‘look through’ approach – the taxpayer is entitled to look through an outside the scope investment activity and recover VAT according to the actual business undertaken downstream using the funds generated.

Background

The case concerned the rights of a farming company to reclaim VAT on the purchase of SFPEs. HMRC argued that the VAT incurred on the purchase of SFPEs had a direct and immediate link to the subsidies which the taxpayer earned as a result.

The taxpayer had claimed repayment of VAT amounting to £1,054,852.28 which was paid on its purchase of 34,477 units of SPFEs.

Those units are issued by the Scottish Government in accordance with the European Union Single Farm Payment (“SFP”) scheme, a scheme which makes provision for the payment of agricultural subsidies throughout the European Union.

The SFPE units purchased by the taxpayer entitled him, on fulfilling specified conditions, to obtain benefits under the SFP scheme. The units are tradeable.

The critical question in the appeal was whether the SFPE units were services used or to be used for the purposes of the taxpayer’s taxable business supplies, so as to entitle it to repayment of the value added tax charged on them.

Mr Smart’s company invested the income in his taxable farming activities which included the construction of new cattle sheds and the erection of wind turbines to generate electricity for the national grid.

The taxpayer made a claim to such repayment, but this was refused by HMRC. As those subsidies are outside the scope of VAT, HMRC argued that VAT on the purchases was irrecoverable as it did not directly relate to any VATable sales activity.

The taxpayer appealed to the First-tier Tribunal, where its claim to repayment was successful. HMRC appealed to the Upper Tribunal, but the appeal was refused. HMRC appealed to the Scottish Court of Session against the decision of the Upper Tribunal.

Decision

The relevant European Union and UK legislation was set out by the Court in addition to various relevant CJEU cases.

From the various cases, the Court identified five basic principles that govern the recoverability of input tax.

First, at a general level, the deduction of input tax is intended to relieve a trading entity entirely of the VAT that is payable in the course of all of its economic activities; this ensures overall neutrality of taxation in respect of all activities that are subject to VAT.

Secondly, if VAT paid on an input transaction is to be deductible, there must be a direct and immediate link between that input transaction and the output transactions that give rise to a right of deduction.

This is necessary because, if deduction of the input tax is to be permitted, the expenditure on the relevant inputs must be a component in the cost of the output transactions that are charged with the output VAT from which the input VAT is to be deducted.

Thirdly, such a link will be broken if the goods or services obtained through the input transaction are used by the taxpayer for the purposes of an exempt transaction or a transaction that does not fall within the scope of VAT, including activities that are not economic activities in the sense in which that expression is used in dealing with VAT.

Fourthly, the direct and immediate link will not be broken if the goods or services in question form part of the general overheads on the taxpayer’s business, in such a way that they form component parts of the price of the taxpayer’s product.

This represents common sense. When goods or services are supplied to a customer, the costs incurred by the supplier in providing the relevant goods or services will include not only the cost of purchasing or manufacturing the goods or providing the services but also general overheads.

To take a simple example, if the supplier manufactures goods, the cost of providing the goods will include not merely the cost of raw materials but also the cost of plant and equipment. This is a general proposition that has been recognized throughout the case law of the Court of Justice.

Fifthly, if the goods or services in question are used partly as general overheads of the taxpayer’s business and partly for the purposes of exempt or zero-rated transactions, the input tax must be apportioned between those two uses. The reasons for this are obvious and straightforward.

The primary argument for HMRC focused on the existence or otherwise of a direct and immediate link between the relevant input transaction and the taxpayer’s outputs.

Either a direct and immediate link must exist between a particular input transaction and a particular output transaction, or it must be possible to attribute the input tax to the taxable person’s economic activities as a whole by virtue of their being part of the general overheads of the business.

In assessing the existence of a direct and immediate link, the objective character of the transaction must be considered. For this purpose it is not permissible, it was said, to have regard to the intentions of the taxpayer; instead an objectively assessed direct and immediate connection was required. In the present case,

HMRC’s argument was that on an objective analysis the purchase of the SFPEs was directly and immediately linked to the receipt of the SFP income, but that was out with the VAT scheme. The existence of that link, taken together with the proposition that the ultimate intention of the taxpayer was irrelevant, meant that there could not be any direct and immediate link to the general overheads of the taxpayer’s business.

In the Court’s opinion this argument was misconceived. The receipt of the SFP payments is merely a consequence of the acquisition of the SFPEs. It cannot be considered a separate business activity distinct from the taxpayer’s general business.

The SFPEs are rather a form of investment, made by the taxpayer for the purposes of its business, and from which income is derived. There is no business activity beyond providing additional finance for the taxpayer’s existing farming business, the future development of that business and possible future diversification by the taxpayer into a wind farm.

HMRC relied on the fact that the SFPs could not have been claimed if the taxpayer did not perform any taxable transactions within the scope of VAT. That is correct as far as it goes, but the taxpayer did in fact perform taxable transactions on a regular basis, with the result that this possibility is hypothetical.

The Court rejected all of HMRC’s arguments. While all parties agreed that subsidies were outside the scope, the key test was how the income from those subsidies was to be used. The costs should therefore correctly be treated as a general overhead of the business making the input VAT recoverable in full.

The full judgment in this case is available from: - https://www.scotcourts.gov.uk/docs/default-source/cos-general-docs/pdf-docs-for-opinions/2017csih77.pdf?sfvrsn=0