St Helen’s School Northwood Ltd v Revenue and Customs [2006] UKVAT V19449 (07 February 2006)

19449

INPUT TAX – Partial exemption – Special method – School constructed sports complex and granted licence for use out of school hours to trading company – Whether Customs acted unreasonably in rejecting a special method proposed by School that apportioned input tax on construction costs by reference to hours of use by School and company – No – Whether “standard method override” producing similar result reasonable – No – VAT  Act 1994 s.26(1) – VAT Gen Regs, regs 102 and 107B – Appeals dismissed

LONDON TRIBUNAL CENTRE

	ST HELEN’S SCHOOL NORTHWOOD LTD	           Appellant

-	and –

	THE COMMISSIONERS FOR HER MAJESTY’S REVENUE & CUSTOMS 	 Respondents

				Tribunal:	STEPHEN OLIVER QC (Chairman)
						CATHERINE FARQUHARSON ACA

Sitting in public in London on 5, 6 and 8 December 2005

Keith Warner of Horwath Clark Whitehill LLP, for the Appellant 

Jessica Simor, instructed by the General Counsel and Acting Solicitor for the Commissioners of HMRC, for the Respondents

© CROWN COPYRIGHT 2006

DECISION

1.	St Helen’s School Northwood Ltd (“the School”) appeals against a refusal of the Commissioners (“the Customs”) to permit the School, a provider of education, to deduct 54% of the VAT payable on the cost of construction of a sports complex.  The cost was £2,635,013.  The VAT incurred was £454,921.  Applying a 54% recovery rate, the VAT reclaimed is £245,657.  The School’s application to use a “partial exemption special method” that produced that result was rejected by letter of 3 February 2005. Following a voluntary disclosure, to which a separate decision referred to below was given, the VAT reclaimed was reduced by a small amount.    The separate decision in a letter of 22 November 2005 rejected the School’s application to use a “standard method override”.  Both decisions have been appealed.

2.	The School is a registered charity whose primary purpose is to provide education for girls between 3 and 18 years.  It has an annual fee income of some £6.7m consisting wholly of exempt supplies.  

3.	Evidence for the School was given by Mary Morris, the Head.  Evidence for the Customs was given by Anthony Rowe an officer with the Customs whose role is that of “Partial Exemption Liaison Officer”.  

Summary of the facts

Planning permission

4.	On 27 January 2002 the School applied for planning permission to build a new swimming pool and sports hall (“the sports complex”) in the School’s grounds.  Planning permission was granted on 10 July 2002; the consent is conditional on the sports complex being “used only for purposes ancillary to the use of the premises as a school” and that the hours of opening be restricted to between 0600 and 2300 hours.  The School was permitted to allow access to the groups listed in the “community links” document attached to the planning permission; a proviso stated that any proposal to increase the number of organizations using the sports complex or to make it available for use by the general public or on a fee-paying basis required further permission.

The first business plan

5.	On 29 November 2002 a business plan was commissioned from consultants by the School’s governors.  The governors had in mind the possibility of exploiting the sports complex commercially and wished to know whether it would be viable to have what Mary Morris described as “a dual purpose pool”.  

Special method – application and rejection

6.	The School registered for VAT from 1 January 2003.  Recovery of the VAT incurred on the building of the sports complex was the reason the School became registered.  On 31 January 2003 the School proposed a special method.  This sought as recoverable input tax the proportion of the total input tax incurred on the sports complex construction works based on a number of hours for which the complex was let to “SHEL” (which was incorporated in 2003 and has at all material times been wholly owned by the School and whose full name is St Helen’s Enterprises Ltd) as a proportion of the number of hours the sports complex was used by the School plus the hours for which it was let to SHEL.  This was not accepted by the Customs.  

7.	A revised application proposing a special method was submitted by the School on 18 July 2003.  This was based on the hours of actual use of the sports complex.  The recoverable input tax by this method was a proportion of the input tax incurred on building the sports complex being the proportion that the total hours of actual use by SHEL bore to the total hours of actual use by the School and by SHEL.  Correspondence followed between the School’s advisers and the Customs.  This concluded with the Customs’ decision, by letter of 3 February 2005, to reject the School’s proposed special method.  The standard method applied as a result.  

Construction work on the sports complex

8.	Construction work on the sports complex started in the middle of the summer of 2003. The School engaged the architect and the building contractor. The planned works contained certain features reflecting the potential requirements of a commercial user for use outside school hours.  For example, a space for a reception desk and filing was provided.  

Letter agreement to grant licence to SHEL

9.	By letter of 4 October 2003 from the School to SHEL the School offered, and SHEL agreed to take, a licence to occupy the sports complex (then under construction) on the following terms:

•	The period of the licence was expressed to be for ten years from practical completion (expected to be June 2004) subject to earlier determination on 6 months notice by either side at any time after 18 months from practical completion.

•	The licence to SHEL was subject to the School’s right to exclusive use of the sports complex “between the hours of 8.00am and 6.00pm five days a week during term-time (comprising 34.4 weeks per annum) plus occasional Sunday mornings.

•	Rates and utility charges were to be split 70% SHEL and 30% the School.  

•	Costs of maintenance and insurance were to be the School’s responsibility and 70% of these were to be “recharged” to SHEL.

•	SHEL was to provide lifeguards while the sports complex was being used by the School and the cost of these was to be recharged to the School.

•	The School was to provide SHEL with administrative services including payroll, book-keeping and accountancy.

The letter agreement did not specify any licence fee.  

The Athis draft business plan

10.	Athis, consultants, were commissioned to provide a business plan. The draft produced on 4 December 2003 recited that where currently the sports complex was seen in isolation, it might become an element of a larger commercial organization and that the “broad objectives” included allowing greater involvement between the School and local community.  Anticipating that a trading company would be involved the “strategic objective” specified an arms length relationship between the trading company and the School and that any surpluses would be gifted by the trading company to the School.

SHEL’s and the School’s responses to the business plan  

11.	A meeting of the board of SHEL on 11 February 2004 noted that the business plan envisaged the generation of  “incremental income” and that there were VAT implications.  According to the minutes the School’s governors had not by then taken the decision to run the sports complex “as a commercial entity”.  A further meeting of SHEL held on 27 February 2004 considered in more detail the practicalities of  the project.  

12.	The School’s governors met on 22 March 2004 and on the agenda was a report on the sports complex project.  Financial projections were supplied by Athis.  As regards VAT, the governors were told that “in order to achieve any recovery on the constructions costs of the sports complex, the School would need to enter into a commercial arrangement”.  “Variables” in the arrangement were explained to the governors.  The governors agreed  -

“In principle the commercial letting of the sports complex outside School hours be approved”.

Further consideration of the business plan and the financial arrangements took place at a meeting of SHEL’s board on 26 April 2004.  The board agreed to open the sports complex to commercial use.

Option to tax

13.	On 7 January 2004 the School and SHEL jointly notified the Customs of the decision to opt to tax for the sports complex.

Construction completed and opening of sports complex

14.	On 8 July 2004 the construction works were complete.  The pool was opened for school use in September 2004.  The pool was opened to “members” of the St Helen’s Swimming and Fitness Club and others for use out of School hours on 25 October 2004.  

The licence commences

15.	We were shown no documentation but it was not in dispute that a licence in favour of SHEL started to run from 8 July 2004.  We infer that its terms were, as already set out, for ten years terminable on 6 months notice after 18 months from commencement.  The licence fee has not been specified in any documentation but it appears from relevant invoices to have been £18,600 per year.

Financing the sports complex : the School’s contributions and receipts

16.	The School and St Helen’s Centenary Foundation Trust provided the funds for the construction works of the sports complex.  The total VAT inclusive cost was £2,635,013.  (The VAT element was £454,921.)

17.	The School lent SHEL some £240,000 at interest to enable SHEL to buy equipment and to pay salaries until it started its operation of the sports complex.

18.	The School receives the £18,600 licence fee from SHEL. This is consideration for a taxable supply made by the School.

19.	The School pays some £124,000 to SHEL to cover the School’s share (calculated by reference to its and SHEL’s times of use of the sports complex) of personnel working in the complex, i.e. the centre manager, the swimming teacher, lifeguards, fitness assistance and cleaning staff.  

20.	The School carries the whole cost of utilities and certain other expenses such as insurance and cross charges 70% of these to SHEL: see the licence and a letter of 23 December 2004.  

SHEL’s payments to and receipts from the School

21.	SHEL receives, as taxable consideration, the School’s annual contribution of £124,000 to staffing costs.  That amount will, we infer, be consideration for SHEL’s taxable supply of staff services to the School.  SHEL pays the licence fee to the School and recovers input VAT on the VAT element.

SHEL’s other supplies

22.	SHEL and the School are not in the same VAT group. SHEL provides services to the members of the St Helen’s Swimming and Fitness Club all of whom are related to the School in some way, to other users such as local clubs and associations and to parents for birthday parties of pupils etc. As well as its supplies to the School (see paragraph 19). The outputs of SHEL’s business include subscriptions from members and other payments for the use of the sports complex during non-School hours.  

The School’s input tax recovery applying the standard method

23.	The input tax of £454,921 incurred by the School on the construction of the sports complex relates to “goods or services … used or to be used in making both taxable and exempt supplies”.  Regulation 101(2)(d) of the VAT General Regulations requires the attribution of  “such proportion of the input tax on such goods or services … as bears the same ratio to the total of such input tax as the value of taxable supplies made by him [the School] bears to the value of all supplies made by him [the School] in the period”.  Its effect therefore is to attribute to the School’s taxable supplies of £18,600 (i.e. consideration for the licence) the proportion that £18,600 bears to the School’s total supplies (i.e. £18,600 plus £6,700,000).  On this basis the recoverable amount is 1% of £454,921, i.e. £4,549.  It is common ground that that is the correct result from applying regulation 101(2)(d).  

The School’s proposed special method

24.	The School relies on regulation 102 which provides, under the heading “Use of other methods”, that:

“(1)	… the Commissioners may approve or direct the use by a taxable person of a method other than that specified in regulation 101 …”.

The School has proposed an apportionment of the total cost incurred by it (£454,921) between the part attributable to SHEL’s actual use of the sports complex (as a proportion of the total hours of actual use of the complex) and the part so attributable to the School’s actual use.  This can be expressed in numbers as an A/A+B fraction where A is 3,365 hours of SHEL’s use (for the first year) and A+B is 5,055 hours of total use in the same period.  On that basis the School will be allowed to recover 66% of the input tax.  

The School’s justification for their proposed special method

25.	The School take the view that (to quote from their skeleton argument) “the standard method was grossly distortive and therefore unfair and unreasonable.  This was because although it was intended to market and exploit the sports complex extensively out of school hours and during the holidays, a standard method would only permit in the region of a 1% recovery of input tax”.  Later it is said – “… the intended use of the sports complex is estimated to be in the region of 66% of the time the complex is used”.  On the basis that the costs of  construction are borne, say, 50:50 but the value of the supply is 99% exempt and 1% taxable the result produced by the standard method cannot, it is argued for the School, be fair and a special method based on use should apply.  The arrangement for using SHEL to carry on the trade of providing services to outsiders through its own workforce and technical resources was, so the School’s skeleton argument runs, driven by the risk of challenge by the Charity Commissioners and the exposure to direct tax were the School to do the trading itself; the direct tax advantage was, apparently, that direct tax could be avoided by the expedient of SHEL gift-aiding up its surplus each year to the School and thereby eliminating any profit otherwise chargeable to corporation tax.  For those reasons the application of a use-based special method is said to be fair and reasonable. 

26.	The School put forward two further features in justification of their proposal:

(i)	the financial predictions show that SHEL will, over the 20 year life of the sports complex, have paid £140,000 of VAT and the School will have paid VAT of £63,000 (in respect of the licence fees). Output tax in excess of £200,000 will therefore have been paid over to the Customs throughout the likely life of the complex.  The VAT incurred on the cost ingredient of those services should therefore be recoverable when incurred;

(ii)	if 1.2% of the total annual school fees relate (as the School calculates) to swimming lessons and training for pupils, i.e. to exempt education supplies, this comes to only £87,600 which is a significantly lower income than SHEL is generating.  The apportionment of input tax should reflect that.

The response of the Customs

27.	The Customs say that the sports complex was constructed by the School with its own funds for the purpose of education in pursuance of a business plan commissioned by it and of planning permission granted to it for it to use the sports complex for education purposes with other uses being only “ancillary”.  Membership of the club run by SHEL is confined to those with connections to the School.  The licence to SHEL supplies a relatively small interest in the land for a relatively small consideration.  Those factors show that the cost of construction and the VAT payable in respect of that construction are very largely attributable to the exempt supply of education.  Moreover, the Customs’ skeleton runs:

“Allowing a deduction would in this case amount to partial zero-rating for a taxable supply; something that is not permitted”.

28.	The Customs go on to say that the construction costs are only to a very limited degree a cost ingredient of  the standard-rated licence granted by the School; those costs could never have been covered by the licence income.  The Customs recognized that the construction of the sports complex had to happen to make possible the grant of  the licence to SHEL.  It did not, in the light of the decision of the Court of Appeal in Customs and Excise Commissioners v Southern Primary Ltd [2003] STC 525, follow that the proportion of costs produced by the School’s proposed special method were a cost component of granting the licence.  

Conclusions

29.	Regarding the first decision of 3 February 2005, the question for us is whether the Customs acted lawfully in refusing to accept the special method proposed by the School. This requires us to decide whether the Customs properly exercised their discretion under regulation 102(1) which provides that they “may approve or direct the use by a taxable person of  the method other than that specified in regulation 101”.  We need to ask, therefore, whether the Customs acted in a way in which no reasonable panel of Commissioners could have acted or whether they took into account some irrelevant matter or disregarded something to which they should have given weight.  The statutory provision governing standard and special methods is in VAT Act 1994 section 26.  This provides for “Input tax allowable under section 25.”  It reads:

“(1)	The amount of input tax for which a taxable person is entitled to credit at the end of any period shall be so much of the input tax for the period (that is input tax on supplies, acquisitions and importations in the period) as is allowable by or under regulations as being attributable to supplies within subsection (2) below.  

(2)	The supplies within this subsection are the following supplies made or to be made by the taxable person in the course or furtherance of his business –

(a)	taxable supplies;
…

(3)	The Commissioners shall make regulations for securing a fair and reasonable attribution of input tax to supplies within subsection (2) above, and any such regulations may provide for –

…”

The School is the taxable person. The supplies to which the School’s input tax may be attributed are taxable supplies made by it in the course or furtherance of its business. The only taxable supply by the School, following the election of 7 June 2004, is the grant of the licence. (It will be noted in this connection that the School and SHEL have not chosen to be part of the same VAT group.)

30.	In terms of Article 17.2 of the Sixth VAT Directive (77/388) the School, as taxable person, is entitled to deduct the VAT on the construction costs “from the VAT which [it] is liable to pay” only insofar as the construction costs “are used for the purposes of [its] taxable transactions”. Also relevant is Article 2 of the First Directive (67/227) which provides:

“On each transaction, value added tax … shall be chargeable after deduction of the amount of value added tax borne directly by the various cost components.”

There must therefore be a direct and immediate link between the cost and the supply or, put in VAT terms, between the input and the output. See for example Midland Bank Plc v Customs and Excise Commissioners (Case C-98/98) [2000] STC 5001 and Southern Primary (Supra).

31.	The provisions referred to above are, as we read them, relevant in two ways to the question of whether the proposed special method is reasonable. 

32.	In the first place those provisions concern the requirement in the primary statutory provisions, both in the Sixth Directive and in the VAT Act, that supplies to the taxable person claiming to deduct the VAT charged on them be used by that taxable person for the purposes of his taxable transactions: see the words of article 17.2.  And see section 26(1) and (2) which give credit for the input tax on the supplies in question where those supplies are attributable to onward supplies made by the taxable person in the course or furtherance of his business.  Section 26(3) authorizes the making of regulations covering apportionment.

33.	A method that brings the use by a third party trader for the purposes of that third party’s taxable business into the apportionment calculation will, as we read the enabling provisions, go beyond what is authorized.  That is what the proposed special method (summarized in paragraph 7 above) seeks to do and that is the reason why we are against the School.

34.	We recognize that the School had in mind a commercial use for the sports complex from an early stage in the planning exercise.  As construction progressed, the role of SHEL became more clearly defined.  The hours of use to be allocated to SHEL and the formal arrangements were all in place by the time the works were completed.  But SHEL’s use has always been SHEL’s business.  SHEL is a separately registered trader and as such uses its rights under the licence to make its own supplies.  The VAT Act and the Sixth Directive do not, however, contemplate that SHEL’s use should be brought into the apportionment reckoning required to determine how much of the School’s inputs be attributed to the School’s taxable supply of the licence and to its exempt supply of education.  The proposed special method seeks to do that and in doing so goes beyond the statutory limits.

35.	The second point is this.  The “direct and immediate link” requirement, explained and applied in “Southern Primary”, serves to identify what cost components qualify for relief for input tax and where the limits lie.  Relevant to the present issue is the question of how far the School’s inputs, in the form of costs of construction of the sports complex, may be attributed to its standard rated supply of the licence.  

36.	Southern Primary failed the test.  It had incurred input tax on the purchase of land (a taxable transaction) which it sold on by a non-taxable supply to a housing association as part of an arrangement under which Southern Primary was to build houses on that land for the housing association.  Was the input tax incurred on the purchase of the land to be relieved against the VAT for which Southern Primary was accountable on its house-building supplies?  The Court of Appeal recognized that “but for” the land purchase in the first place Southern Primary would not have been in a position to make the house-building supplies. Unlike the building materials purchased by Southern Primary, there was nothing in the house-building contract that made the land purchase and sale essential to it.  “But for”, observed the Court in paragraph 32, “is not the test and does not equate to the ‘direct and immediate link’ and ‘cost component’ tests”.

37.	So here, the licence would never have been granted to SHEL and SHEL could not have used the sports complex in non-school hours to make its supplies “but for” the fact that the School had built the sports complex.  The School’s outlay of the costs of construction works resulted in the sports complex being created for the School.  The expenditure provided the School with the means by which to make its supplies of education and of the licence.  But the licence was the limit of the School’s standard rated supply and the license fee was the limit of the consideration obtained for that supply.  The use SHEL chose to make of the benefits of the licence is not what the School supplied by granting the licence. The corollary is that the costs of construction are directly and immediately linked to the grant of the licence but not to the use made by SHEL of the sports complex in the course of its business.  On that basis too the School’s proposal of a use-based special method goes beyond the permitted limits. The Customs, in our opinion, acted reasonably in refusing to accept it.

38.	Turning now to the second decision, taken on 22 November 2005, the Commissioners, by letter of that date, rejected the School’s claim calculated under the “standard method override” under Regulation 107B and submitted by way of voluntary declaration on 31 October 2005.

39.	Regulation 107B reads:

“(1)	This regulation applies where a taxable person has made an attribution under regulation 107(1)(a) according to the method specified in regulation 101 and that attribution differs substantially from one which represents the extent to which the goods or services are used by him or are to be used by him, or a successor of his, in making taxable supplies. 

(2)	Where this regulation applies the taxable person shall

(a)	calculate the difference, and
(b)	in addition to any amount required to be included under regulation 107(1)(c), account for the amounts so calculated on the return for the first prescribed accounting period next following the longer period, except where the Commissioners allow another return to be used for this purpose.”

Regulation 107(1), referred to in regulation 107B above, provides:

“(1)	Where a taxable person to whom a longer period is applicable has provisionally attributed an amount of input tax to taxable supplies in accordance with the method, and where all his exempt input tax in that longer period cannot be treated as attributable to taxable supplies under regulation … 106, and saves the Commissioners may dispense with the following requirement to adjust, he shall –

(a)	determine for the longer period the amount of input tax which is attributable to taxable supplies according to the method used in the prescribed accounting periods, …”.

40.	By their letter of 31 October 2004 the School submitted a voluntary declaration for input tax under-recovered.  This invoked the standard method override.  The letter put forward a use-based attribution method on similar lines to the method that had been the subject of the first decision, taken on  3 February 2005.  

41.	The Customs rejected the School’s application for substantially the same reasons as they rejected the special method.  The letter of 22 November 2005 from the Customs went on (and this is not disputed) to say that the standard method override did not in any event apply to two of the tax periods, i.e. the pre-registration period from 25 September 2002 until 31 December 2002 and the residual input tax for the period from 1 January 2003 to 31 May 2003.  

42.	The issue for us as regards the decision of 22 November 2005 is whether the calculation put forward by the School in applying a method which is, for all practical purposes, identical with the special method is reasonable.  In this case it appears, the School is using the special method that was proposed under regulation 102 as the basis for calculating the standard method override under regulation 107B.  For the reasons that we have given dismissing the School’s appeal in relation to the first decision of 3 February 2005, we reject the School’s application to use the standard method override in accordance with their application of 31 October 2005.

43.	In conclusion, we have one general point to make.  Our authority is limited to deciding whether the Customs acted reasonably in refusing to accept the proposed special method and whether the standard method override is acceptable.  We have no authority to put forward our own version of a more reasonable special method (if there is one).  But it may still be open to the School to do so if it chooses.

44.	For all those reasons we dismiss the appeals.

STEPHEN OLIVER QC
CHAIRMAN

RELEASED: 7 February 2006

LON/05/197