The above Brief sets out HMRC’s position following the decision of the Upper Tribunal (UT) in Lok’nStore Group PLC (LnS). The case dealt with whether the partial exemption special method (PESM) proposed by LnS produced a more fair and reasonable result for calculating deductible VAT on overheads than the standard method.

The UT dismissed HMRC’s appeal on the grounds that it could not find that that the First Tier Tribunal (FTT) had erred in law in concluding that the PESM produced a more fair and reasonable result than the standard method.

HMRC is not appealing the decision, but does not intend to change its policy regarding floor space PESMs. HMRC does not consider that floor space methods are usually appropriate for the retail sector.

LnS provides taxable self-storage facilities in purpose built stores. It also provides exempt insurance for stored goods to all customers who do not otherwise have adequate cover. The issue in this case was the amount of input VAT that could be recovered on general overhead costs, such as those incurred on the construction, maintenance and operation of its stores.

LnS proposed a PESM which involved a floor space allocation resulting in a 99.98% recovery rate for VAT on overheads. HMRC rejected this on the grounds that it did not provide for a better reflection of how the costs were used than the standard method.

Relying on the ‘cost component of the price’ test set out in the CJEU case AB SKF (C-29/08), the FTT concluded that the impact of the general overheads on the price of the insurance ‘must be very small’ and therefore these costs are only used to a very small extent for the supplies of insurance. It also found that the Appellant used the storage area of the buildings ‘almost exclusively’ for taxable storage. Accordingly it found that the proposed special method was fair and reasonable and better reflected use than the standard method, so allowed the appeal.

HMRC appealed to the UT on the grounds that the FTT had erred in law in that they had applied the wrong test, that they erred in their application of that test by stating that the price of insurance was set by reference to the market rate rather than the overhead costs, and that they erred in their approach to assessing economic use by adopting a method based on physical use.

Although the UT agreed that the FTT had indeed erred in law in applying the cost component test, it was not convinced that this led to an incorrect result. In respect to the FTT’s conclusion that the overhead costs were not cost components of the insurance, the UT reasoned that there were a number of possible ways to reach that conclusion and it was therefore impossible to conclude that the FTT had misdirected itself.

In relation to HMRC’s argument that the FTT had relied on physical use rather than economic use, the UT said that although the use of the standard method appeared to be justified, it was unable to say that it was the only reasonably possible way of looking at the matter. For the above reasons, the appeal was dismissed.

HMRC’s view is that the decision makes clear that whether an input cost is a cost component of an output is highly fact specific. Despite upholding the FTT decision, the UT emphasised that close attention must be paid to the facts of each case in understanding and assessing the economic or commercial reality underlying the use of the relevant VAT inputs.

In the LnS case, the FTT found that the VAT bearing costs in question were only cost components of insurance to a very slight extent. Where VAT bearing costs are used only slightly for exempt supplies, then HMRC agrees that a method which results in almost full recovery is appropriate.

However, the decision could be interpreted to suggest that a cost can only be a cost component of an output supply if the price of that output was set by reference to the cost. HMRC would not agree with that interpretation.

Even where the price of an output transaction is not set by reference to particular costs, those costs can still be incorporated into the price in that they contribute to its value. This was the conclusion of the Tribunal in TLLC Ltd v Revenue and Customs [2013] UKFTT 467 (TC).

Accordingly, although HMRC is not challenging the UT decision in LnS, HMRC do not consider that the decision has any further implications for their policy on floor space PESMs.

HMRC does not consider that floor space PESMs are normally appropriate for retail businesses. This view has not changed as a result of the LnS decision. Businesses wishing to apply for a new or amended PESM similar to that in LnS will need to demonstrate that the overhead costs are not cost components of their exempt supplies, and that they do not intend to recover those costs through their exempt outputs.