[2010 UKFTT 393 (TC)

TC00675

Appeal number:  EDN/02/182

VALUE ADDED TAX – Residual Input Tax – Partial Exemption Special Method (floor-based) – whether “fair and reasonable” – Regulations nos 101 and 102, VAT Regulations 1995 (1995 SI 2518) – Appeal continued, hearing merits in full – Provisional Approval.

FIRST-TIER TRIBUNAL

TAX 

	DCM (OPTICAL HOLDINGS) LTD	Appellant

	- and -

	THE COMMISSIONERS FOR HER MAJESTY’S
	REVENUE AND CUSTOMS (VAT)	Respondents

				TRIBUNAL JUDGE: 	Mr Kenneth Mure, QC
				(Members):		Mr K Pritchard, OBE., BL., WS
							I R Welch, CA, JP

Sitting in public in Edinburgh on Monday 15 to Friday 19 June 2009

Mr Roderick Cordara, QC, SC and Mr Edmond King, Barrister-at-law, for the Appellant

Mr Julian Ghosh QC and Mr Joseph Goldsmith, Barrister-at-law, instructed by the General Counsel and Solicitor to HM Revenue and Customs for the Respondents

© CROWN COPYRIGHT 2009

DECISION

Preliminary

1.	The Appellant, which is in business as an optician, makes both taxable and exempt supplies.  Certain of its taxed inputs are not attributable exclusively to either its taxable or exempt supplies.  In the first instance such “residual expenditure” is by statute apportioned between these two classes of supplies proportionately according to their respective total values.  However, where it is “fair and reasonable”, an alternative basis of apportionment may be allowed.  Such a Partial Exemption Special Method (“PESM”) based on the usage of floor area was proposed to the Respondents who rejected it.  It is against that rejection that this Appeal pursued.
2.	When we heard this Appeal earlier we considered that our jurisdiction was limited in scope, viz that in accordance with Wednesbury principles our review was limited to whether the Respondents’ rejection of the proposed PESM had been reasonable or not.  Following the decisions of the High Court in England in Banbury Visionplus Ltd v HMRC [2006] STC 1568 and St Helen’s School Northwood v HMRC [2007] STC 633 our decision was appealed to the First Division of the Court of Session which has directed that our jurisdiction is a full appellate jurisdiction and, moreover, has set out for us helpful guidelines for exercising this in relation to the details and refinement of the proposed PESM.
3.	The requirement of Regs 101 and 102, VAT Regulations 1995 (1995 SI 2518) is that a proposed PESM should be “fair and reasonable” – and more so than the Standard Method – if it is to supplant the Standard Method.  If the PESM does not meet that criterion, the Standard Method applies – and that even if it is not “fair and reasonable”.  This proposition did not seem to be controversial and we refer again to St Helen’s School Northwood Ltd v HMRC, supra.  
4.	The proposed PESM has been modified somewhat since the original hearing.  These revisals address certain criticisms which we made earlier.  They relate to the re-classification of certain areas of the business premises and, as we see it, bear to be details rather than fundamental to the structure of the PESM.  The original and revised area classifications are set out conveniently in Respondents’ Skeleton Argument at paras 9.3 and 12.3 respectively.  Most significantly the “taxable” areas are now restricted to an area of 1.8 metres immediately in front of the framed display stands and the laboratories in which lenses are manufactured and fitted ie the “retail” areas.  The dispensing desks in the front areas now become “medical” (or VAT exempt) rather than being non-attributable.  “Void” areas (not accessible) and “excluded” areas (stairs and lavatories) are now introduced.  The remaining areas are “mixed”.  We comment on the net effect of this on the PESM calculations in our Decision infra.  The effect of this in reducing the numerator, restricts the percentage of tax recoverable.
Viewing of Premises
5.	The Respondents made a preliminary application (heard on 5 June 2009) that the Tribunal should view three of the Appellant’s premises in Edinburgh, located nearby, viz (i) Shandwick Place; (ii) George Street; (iii) Princes Street.  A note of argument was produced and was adopted by their Counsel.
6.	The Appellant opposed the application as hasty and premature.  Its Counsel argued that evidence should be heard first and the need to view thereafter considered.  Plans of the premises were available.  There was no one representative store.  The nature of the business was of a type likely to be familiar to the Tribunal members, he argued.  
7.	We considered that the opportunity to view the selected premises would be helpful and in the event the visits and the consideration of various points arising have been of considerable advantage to us.  We visited two of the premises in George Street and Shandwick Place before hearing further evidence (following the guidance in McPhail: Sheriff Court Practice ch 16-92/93) and thereafter, before concluding the evidence, we visited the Princes Street premises.  The last is an example of new open plan larger premises while Shandwick Place and George Street are traditional and showed the manner of adaptation of premises for the provision of different services.  
Further Evidence and Findings-in-Fact
8.	In the course of this continued hearing we heard further evidence from Mr T S Mein, a Chartered Accountant, and Financial Director (formerly Financial Controller) of the Appellant for 10 years, then from two experts Professor Steven P Taylor called by the Appellant, an optometrist, and Professor M Jalie, called by the Respondents, a dispensing optician.  It is important at this stage to distinguish the professional expertise and practical experience of both of these expert witnesses.  An optometrist is trained especially to conduct eye-tests, generally checking the health of the eyes, and issuing a prescription for spectacles or contact lenses.  The prescription will provide 3 sets of dimensions for the lens essentially.  A dispensing optician is trained to dispense a pair of spectacles or contact lenses by reference to the prescription and adjust the selected frame to accommodate these and to suit the individual patient.  (An optometrist is qualified to carry out this secondary task too, but, as we understand the economics of the optical business, he will not do so ordinarily as the level of his remuneration and cost of his services are higher than these of a dispensing optician).
9.	Critically both experts differed over the sense of “dispensing” and whether it extends to or affects cosmetic or aesthetic decisions in the selection of frames.  There is no statutory definition of “dispensing” in, for example, the Opticians Act 1989.  Professor Taylor argued that dispensing was essentially ensuring that the spectacle frames held the lenses in the correct position in front of the eyes.  Fashion considerations did not arise, he considered, and given the amount of stock held by the Appellant’s branches only exceptionally would the nature of the lens affect the choice of frame.  (96% of lenses would fit all of the frames currently stocked by the Appellant.  In only some of the remaining 4% would there be a need to select an alternative frame.  About 10 years ago larger spectacle frames were in popular fashion.  Fitting larger and heavier lenses into these was more problematical).  Sometimes, to optimise performance, lenses from special materials are preferable e.g. sportsmen may prefer polycarbonate lenses, but this would not affect frame choice.  Professor Taylor considered that dispensing in the Appellant’s manner of operating took place only at the dispensing desks, not starting until measurements of face and spectacle frame were taken at these desks.
10.	In addition to his academic experience and teaching Professor Taylor works part-time as an optometrist.  He visited one of the Appellant’s outlets in Brighton to view the manner in which they conducted their activities and served their customers.
11.	Professor Jalie differed, taking a wider interpretation of “dispensing” and including the selection of frames on aesthetic grounds.  He is, of course, a dispensing optician, qualified and experienced only in that particular stage of the provision of a pair of spectacles or contact lenses.  (In fact he de-registered as a dispensing optician in 2008 and ceased full-time practice in 1986).  He is, we understand, an expert in the design of optical lenses.
12.	This differing interpretation is significant in determining whether the choosing of a frame, conducted in the 1.8 metres “taxable” area in front of the frame stands, involves “dispensing”.  We preferred on the basis of his broader professional experience and our own assessment of the evidence of the course of providing customers’ spectacles in the Appellant’s establishments, Professor Taylor’s more limited definition of “dispensing”, ie confining it to the dispensing desks and not (unless exceptionally) extending to the “taxable” area in front of the display stands.  In any event this issue may be resolved on legal principle.  Whatever the sense of “dispensing” is, it is not as such the exempt activity for VAT purposes.  The exemption is in respect of “medical services”, infra.  
13.	Mr Mein’s evidence was less controversial.  He spoke to various financial and administrative matters within the Appellant’s organisation.  In particular he considered the various heads of residual and un-attributed expenditure.  (See Bundle B p80, 86).  He was pressed in cross-examination about advertising, service charges, heating and lighting.  As noted in this Decision we accepted his explanations as to the fairness of their apportionment between taxable and exempt supplies in the PESM.  (Evidence was taken about the setting-off of discounts on spectacles against taxable and exempt elements:  ultimately this seems to be an issue distinct from the present appeal).  We found Mr Mein candid and credible on matters within his expertise and knowledge.  He indicated, and we accepted, that he was not best able to speak to patterns of customer behaviour and optical matters.
“Medical Services”
14.	This concept was raised as a fresh legal issue.  Mr Cordara argued that crucially the exemption from VAT in respect of medical services extended to therapeutic care only.  His argument is set out in paras 32 et seq of the Appellant’s Supplementary Heads of Submission by reference to various ECJ decisions.  We note in particular Commission v UK [1988] STC 251, which in the case of spectacles draws the distinction between the supply of goods (taxable) and the provision of a medical service (exempt).  Here, reference might be made to paras 1 and 2 of the Joint Minute of Admissions.  
15.	The essence of an exempt medical service seems to be a therapeutic aim.  Fashion advice and aesthetic considerations fall outside that definition in our view.
16.	This suggests to us that as a matter not simply of fact but also of law the dispensing of spectacles (ie the exempt activity) in the Appellant’s premises takes place substantially if not entirely at the dispensing desks and only exceptionally, if at all, does an aspect of the medical service take place within the 1.8 metre taxable area in front of the frame display stands.
Revisals to Findings-in-Fact
17.	We make three revisals to our original Findings-in-Fact on the basis of the additional evidence led:-
(i)	add to Finding-in-Fact “3” – 
“The Appellant employs about 240 optometrists, and has the services of another 60 or so who are self-employed.  It has over 200 managers and assistant managers.  Its other retail assistants total about 950, 37 of whom have dispensing qualifications.  A similar minority of its managers and assistant managers will have dispensing qualifications.  As the cost of an optometrist’s services is the highest, the financially efficient use of their time is important.  For example, in the case of smaller branches one optometrist will attend part-time, morning or afternoon”
(ii)	substitute for the present Finding-in-Fact “5” the following –
	“Each of the Appellant’s shops will hold several hundred individual spectacle frames.  Each frame will bear its own price tag indicating an inclusive amount for the frame (taxable) and dispensing costs (exempt) in respect of fitting the lenses into the frame.  The receipt given to the customer/patient on payment must disclose separately the cost of the frame and the dispensing cost which make up the displayed cost.  The spectacles are displayed on racks which are commonly on the side-walls at the front of the shop, where mirrors also are located, affording the opportunity for customers to select and try on individual frames.  An area of 1.8 metres immediately in front of the frame racks and mirrors is shown on the plans produced and is classified as “taxable” and is essentially a retail area.  Only exceptionally (if at all) might it be used for dispensing.  Initially a customer (or patient) will consult the optometrist in a consultation room, being within the “medical” areas as shown on the plans.  There the optometrist will conduct the eye-test and issue a prescription.  The optometrist will give final advice as to the health of the eyes, lens strength, any bi-focal or vary-focal requirement, any clinically required tint, and lens material.  He may give guidance in the few cases (about 4%) where thick lenses are required as to suitable frames and, also, where spectacles are required for special purposes.  The optometrist’s work is then completed.  Having obtained his prescription the customer will return to the front of the shop and go to the retail area to select a spectacle frame.  About 96% of lenses prescribed will suit any frame in the Appellant’s shops and provide satisfactory vision.  The dispensing of the optometrist’s prescription is carried out at the dispensing desks located also in the front area.  (The desks are classified as “medical”).  The customer will attend there only after he has had his eyes tested and obtained a prescription for his spectacles.  Having himself selected a frame the customer will consult with a dispensing optician or retail assistant at one of the dispensing desks.  Each desk has its computer screen, on which the patient’s personal information and prescription details will be available.  This consultation will be carried out with both parties sitting and at eye-level which is essential for the proper and accurate fitting of frames.  The frames are measured to fit the customer’s face and to ensure that the lenses are held correctly in front of his eyes.  Thereafter, the spectacles will be made, the lenses being cut and fitted to the frame.  About 70% of the Appellant’s outlets have their own laboratory facilities”.
(iii)	By adding to Finding-in-Fact “12” – 
“An updated record of such non-attributable expenditure and residual input tax paid is produced (Bundle B, p80, 86).  About 10% is now referable to the business headquarters”.

Parties’ Submissions
18.	Parties provided written submissions for the earlier hearing.  Supplementary written submissions are now available and are produced.  Counsel adopted these in their oral submissions and we refer to the arguments presented in our Decision.
Decision
19.	In our earlier Decision, in dealing with Costs, we doubted whether the Standard Method produced a “fair and reasonable” apportionment of residual expenditure in this case.  Having considered this further during this stage of the Appeal we are satisfied and confirm that it does not.  We were shown that the fraction of recoverable input tax on residual expenditure has fallen from 32% in mid-1999 to 8% recently.  (See Bundle G, item SM 1 and 2).  A major factor in producing this result is the high cost to the business of salaries paid to its optometrists and professional staff.  To meet these costs the value of exempt supplies ie medical services, is correspondingly increased.  The recoverable fraction prescribed by the Standard Method depends on the value of taxable supplies as against all (ie both taxable and exempt) supplies.  Thus the denominator is increased by salaries paid to the professional staff.  We do not consider this to be a realistic approach to apportioning in effect the cost of the use of business premises.  We understand that the amount of exempt income has increased somewhat in relation to eye-testing and from the provision of laser services and dentistry.  However, that does not justify the reduction in the recoverable percentage from 32% to 8%.  There is no direct connection between turnover and the consumption of taxable inputs.  In our view a “fair and reasonable” formula must attempt to take into account the nature of the expenditure (that it relates to premises’ costs) and its usage for distinct taxable and exempt supplies.  
20.	The PESM relates to two “pots” of expenditure- that relating to its business outlets (“Pot 1”) and the other relating to its head office (“Pot 2”), now about 10% of residual inputs.
21.	It appears that the Respondents have negotiated floor-based PESM’s with other optical multiples.  (See Finding-in-Fact no 8 in our earlier Decision).  Apportionment of expenditure on premises on the basis of their premises’ use seems to be more appropriate.  On the other hand the standard method here does not produce a satisfactory proxy for use in our view.  As we understand, there is no objection in principle to such a Special Method.  (See Auchterarder Golf Club – Edinburgh Tribunal no 19907 – penultimate paragraph).  It is certainly not inconsistent with being “fair and reasonable”.  
22.	However, in valuing floor area the feature of zoning proposed as a feature of the PESM ie attribution of higher values to certain floor areas in accordance with valuation practice, has been disapproved by other Tribunals.  (See Optika Ltd (London no 18627), Vision Express (Manchester – no 20870) and Banbury Vision Plus [2006] EWHC 1024 (Ch) supra).  The shared line of argument (not challenged in the High Court in Banbury) is that, however calculated, the rental is one amount, not severable or divisible between certain areas.  Moreover, in Vision Express it was stressed that the taxpayer’s business was one entity which could not be sub-divided into different areas.  All activities were inter-related with its core business.  In the present case, of course, the Appellant in its larger outlets provides laser and dental services.  These services were added where there was unused accommodation.  There are no outlets dedicated to these services exclusively.  They are not managed independently of the general core service.  
23.	We share these misgivings in relation to the present case although we observe that commercial competition in the provision of optical services has developed since deregulation of them in the mid-1980’s.  As a result the commercial element and the factor which requires “High Street” premises and a high standard of fitting-out is the marketing of spectacle frames.  Displays are concentrated in the front, at ground level, the relatively expensive “zones”.  (Mr Mein suggested that smaller modest premises would suffice if customers supplied their own frames and consulted the Appellants only for eye-tests and dispensing lenses).  Principles of zoning vary between Scottish and English surveying practice.  However, zoning is an accepted tool for establishing the rent of premises.  The rent so determined is paid as a whole and not in portions in relation to the individual zones.  In the negotiation of commercial rentals zoning may be appropriate in relation to valuing premises for general retail purposes.  However it does not necessarily follow that zoning is of immediate relevance to attributing residual input expenditure as between taxable and exempt supplies of an optician’s business.  The marketing of an optician’s business may be distinguishable in many respects from that of a furnishings or clothing retailer which is more susceptible, perhaps, to impulse buying.  Even if we were minded to approve zoning as an element in the PESM, we think that it could only be applied appropriately to VAT on rent, and not the other residuary expenditure not related to the premises as such.  (We consider these in para 26 infra).
24.	However, we consider that there is merit in other aspects of the proposed PESM.  As we read the terms of the Opinion of the Court of Session we should not reject the PESM if it were found satisfactory subject to limited modification (See Para 16).  The aspect of zoning, it appears to us, is severable from the proposed scheme and could be removed without damaging it in principle, and, indeed, in relation to the outlets a comparative calculation of recoverable input VAT can be made following the proposed method without zoning.  For instance, in respect of the George Street outlet the floor-based PESM without zoning produces a recoverable 21.17% of residual expenditure.  (This contrasts with a percentage of 8.49% in terms of the Standard Method).  A higher percentage of 47.39 results when zoning is incorporated into the PESM.
25.	The PESM without the factor of zoning appears to us to be “fair and reasonable”.  The formula is logical and precise and readily applicable, certainly in the case of the premises which we viewed.  The critical demarcation line is that defining the “taxable” (or retail or non-medical) area ie the area of 1.8 metres in front of the frame displays.  This formula must surely be easily applicable throughout the Appellant’s stores.  Within that 1.8 metre margin we are satisfied, as our Findings-in-Fact record, dispensing in the sense of a medical service does not take place – except, perhaps, exceptionally and in minor respects, so trifling that the logic of this is not undermined.  As a matter of fact and law these are non-medical retail areas.  The selection of frames is not a therapeutic service, and we agree with Mr Cordara that this is of the essence in determining the VAT exemption.  The other areas too are well-defined, viz “exempt” (or medical) areas, being the dispensing desks, consulting rooms, and reception; “void” (not accessible) areas; “excluded” areas (stairs and lavatories); and the remaining “mixed” areas.  Again this formula is readily applicable to any premises.
26.	The categories of residual expenditure are set out in Bundle B, p86.  Substantially these are rent, maintenance, and service charges (62%).  Most obviously a floor-based apportionment seems appropriate for such outlays.  The same reasoning would apply to telephone, heating and lighting costs (possibly a disproportionate amount of heat and light might be consumed in the retail areas at the front of the stores where display stands and entrances are located).  “Assets” would most likely be computers for general use, not attributable to particular outputs.  Evidence was led from Mr Mein in relation to advertising costs which could not be attributed to particular outputs e.g. dental and laser advertising would be attributed to exempt medical services.  For the residual general advertising and promotion costs an allocation reflecting the floor-based apportionment of the premises seems prima facia acceptable and reasonable.  No contrary evidence or, indeed, argument was led.  
27.	In the revised form of the PESM floor area is now divided between medical (exempt), non-medical (taxable), mixed, void and excluded areas.  Excluded areas (stairs and lavatories) are omitted in the calculations.  Formerly, the categories were taxable, exempt and non-attributable.
28.	Critically, we consider that the nature of the fraction of the floor area to be applied has been devised on a conservative basis, indeed adverse to the Appellant’s interest where there might be scope for variation.  The numerator in the revised form of the PESM is the non-medical (taxable) area and an appropriate portion of the mixed area.  The preliminary calculation of that portion, arguably, might have been made by taking the ratio of simply the non-medical and medical areas.  However, a much smaller portion is taken by increasing the denominator to include not only non-medical and medical but also mixed and void areas.  (See diagram in Bundle H4 p8).
29.	Further, in the fraction (as finalised) to be applied to apportion the residual expenditure, the denominator has been maximised, so serving to reduce the percentage of VAT recoverable by introducing void areas into the denominator.
30.	Finally, the dispensing desks where the dispensing opticians or retail assistants dispense spectacles have now been designated as medical (or exempt) areas rather than, say, mixed, so excluding the albeit marginal benefit of any retail element.  
31.	The recoverable fraction of residual input tax relating to the Appellant’s head office and general overhead expenditure is treated separately in the PESM (“Pot 2”).  That also is set out in Messrs Pricewaterhouse Cooper’s letter of 6 December 2001 to Mrs Parkes of HMRC (Bundle B, item 23) and it has not been revised.  Earlier only 5% of the total residual input tax related to the head office and overheads but, we were informed, it has now increased to about 10% (cf Final sentence, now added to our Finding-in-Fact 12).  Both parties treated this as a secondary issue given that the Appellant’s argument on Pot 1 must succeed before Pot 2 could be considered (also the amount at stake is smaller).  Mr Cordara presented his argument in support of this in his earlier oral submissions and it is further noted in the Written Arguments.  The apportionment of VAT on residual expenses relating to head office is done by reference to a ratio of input tax figures.  The denominator is the total input tax.  The numerator includes all the input tax recoverable attributable to the retail outlets.  Thus the formula for Pot 2 inter-relates with the formula for Pot 1, the retail outlets.  
32.	The main criticism levelled here was that no account is taken of wages and salaries in the fraction.  (That, however, is not noted in the Respondents’ letter of rejection).  We share the Appellant’s view that this could only be distortive.  The cost of wages and salaries includes the high cost of professional salaries, in particular of the optometrists.  That factor, we agree, is not apt to apportion residual input tax relating to head office expenditure.  The optometrists’ work is not conducted there.  We consider that the percentage calculation, by reference to ratios of input tax, seems “fair and reasonable” in respect of the central administration of the business.  
Further Procedure
33.	Subject to removing the factor of zoning we consider that the PESM as now revised is both “fair and reasonable”.  We consider that it is appropriate for us to give this tentative approval of the scheme in view of the terms of the Court of Session’s directions to us.  However this suggested modification has not been canvassed with parties for their views.  In fairness before giving our concluded decision we think it appropriate that parties should have the opportunity (if they wish) of addressing us on the particular point viz is zoning severable from the PESM?  Accordingly we invite them to do so and we should be happy to entertain either oral or, if parties consider it preferable, written submissions, on this limited aspect.

Costs
34.	We shall deal with costs relating to this hearing and to the preliminary application to view the three outlets in our final decision.

MR KENNETH MURE, QC
TRIBUNAL JUDGE

RELEASE DATE:  28 SEPTEMBER 2009