DCM (Optical Holdings) Ltd v Revenue & Customs [2006] UKVAT V19549 (18 April 2006)

                                                                                    19549
VALUE ADDED TAX – deduction of input tax – taxpayer providing both taxable and exempt supplies – refusal by Respondents to approve Partial Exemption Special Method – whether refusal reasonable – whether Tribunal has a more extensive right to review – Appeal dismissed – VATA 1994 Sections 25-26; VAT Regulations (1995/2518) 101 and 102.

EDINBURGH TRIBUNAL CENTRE

	DCM (OPTICAL HOLDINGS) LTD	Appellant

	- and -

	THE COMMISSIONERS FOR 
	HER MAJESTY’S REVENUE & CUSTOMS	       Respondents

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

Sitting in Edinburgh on Monday 13, Tuesday 14, Wednesday 15 and Thursday16 February 2006

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

for the Respondents	Mr Andrew Young, Advocate

© CROWN COPYRIGHT 2006.

DECISION

Introduction
This is an Appeal in terms of Section 83(e) VATA 1994 in relation to the proportion of input tax which should be allowable under Section 26 of the Act.  Subsection (3) thereof enables the Commissioners to make regulations “for securing a fair and reasonable attribution” of input tax between taxable and exempt supplies.

Here, the Appellant is a retail optician.  It makes both taxable and exempt supplies.  Certain of its inputs bear input tax; others do not (particularly staff wages, which are substantial in the case of professional optometrists and opticians).  While VAT on inputs applied in producing taxable supplies is recoverable, VAT on inputs applied in producing exempt supplies is not recoverable.  Where inputs are attributable to both taxable and exempt outputs, the tax thereon is considered “residual input tax”.  

Regulation 101 of SI 1995/2815 provides for the apportionment of residual input tax between taxable and exempt supplies in proportion to their respective values.  This is described as the “standard method”.  In terms of Regulation 102 the Respondents may approve an alternative method of apportioning residual input tax.

The Appellant submitted an alternative method for apportionment in December 2000 (and as further revised in December 2001) but this was refused by the Respondents in November 2002.  Essentially the Appellant proposed that the residual input tax should be apportioned on the basis of usage of the floor area of their premises as between taxable, exempt and “non-attributable” business activities.  (See Documents 15, 23 and 34).  This Appeal is in respect of that refusal.

The Law
As a matter of law it is settled that an optician in providing a customer with spectacles makes two distinct supplies, viz of frames and lenses (or, as appropriate, contact lenses) which is taxable and, also, of professional services in eye-testing and dispensing and prescribing lenses.  These services are exempt from VAT.

Sections 25-26 VATA 1994 provide for the relief of input tax paid by a taxable person by its being credited against the output tax on his taxable supplies.  While input tax on goods and services wholly used in producing taxable supplies is deductible, input tax on goods and services wholly used in producing exempt supplies is not.  The residual input tax relating to both taxable and exempt supplies then falls to be apportioned.  In particular Section 26(3) provides that – 

“The Commissioners shall make regulations for securing a fair and reasonable attribution of input tax to supplies within sub-section (2) above …”

Sub-section (2) indicates that the only input tax for which credit may be given is that attributable to taxable supplies made by the taxable person.

Provision is made for the “fair and reasonable” attribution of input tax to taxable supplies in Regulation 101 of the VAT Regulations (1995/2518).  Essentially that provides for the apportionment of input tax between taxable and exempt supplies on the basis of their proportionate values.  The calculation is based on the businesses’ turnover.  The calculation is called the “standard method”.  

Regulation 102 provides further that the Respondents may approve or direct other methods of apportionment of input tax.  Such other methods are described as “partial exemption special methods” (or PESMs).

In the course of the Hearing reference was made in particular to the following authorities:-

Merchant Navy Officers Pension Fund (LON-14262)
Southport Visionplus Ltd (LON-17502)
Optika Ltd (LON-18627)
Banbury Visionplus Ltd (LON-19266) 
C&E Commissioners v Leightons Ltd [1995] STC 458
John Dee Ltd v C&E Commissioners [1995] STC 941
C&E Commissioners v Southern Primary Housing Association Ltd [2004] STC 209
Associated Provincial Picture Houses Ltd v Wednesbury Corporation [1948] I KB 223
EC Commission v United Kingdom [1998] STC 251

The Evidence
The Appellant led as witnesses Mr Douglas Struth, a Chartered Surveyor, who explained principles of zoning in the context of calculating rents for commercial premises, and Mr David Moulsdale, the Chief Executive of the Appellant.  The Respondents led two HMRC officials, Mrs Irene Parkes, who drafted for her manager’s signature the Refusal complained of (Document 34) and Mr Phillip Mattacks, CTA, a senior policy advisor in the Partial Exemption Team of HMRC.  We noted that Mrs Parkes confirmed that any PESM agreed could be back-dated to when apportionment had been agreed in principle between the parties.  Mr Mattacks spoke to the current practice of the Partial Exemption Team but, perhaps significantly, was not involved in the decision-making process which led to the Refusal in the present case.  Their witness statements are included in the Pleadings Bundle (pages 33, 37, 42 and 51).

A helpful Joint Minute of Admissions was lodged clarifying the particular supplies being made by the Appellant as being taxable or exempt (Pleadings Bundle page 32M).  

Floor plans of several of the Appellant’s premises were lodged showing their layouts.  We understand that these (so far as the physical layout is concerned) are not contentious.  

We understand too that it is accepted that the copies in the Bundle of Documents are true copies of correspondence which passed between the Parties and their representatives.  

On the basis of that we make the following Findings-in-Fact:-

1.	The Appellant is the representative member of a VAT group of companies trading as retail ophthalmic opticians under the name “Optical Express”.  Its Chief Executive is David Moulsdale.
2.	The Appellant group is in business as opticians principally.  90% of its receipts reflect sales of spectacles and contact lenses.  This is apportioned between taxable supplies of spectacles and contact lenses and the exempt dispensing services on a 36:64 basis.  The balance of 10% of its receipts relate to eye tests (which are exempt from VAT) and the sale of sunglasses and optical aids generally.  In addition to providing optical services certain of the Appellants’ branches have recently provided dental and laser treatment.
3.	As at 2001-2002 the Appellant traded from about 130 branches.  Currently its branches total 182.  Dental services are now provided at 40 branches.  Laser treatment is available at 12.  Advice on this is provided at 36 branches.  About half of the Appellant’s premises are situated in traditional High Street premises.  The other half are situated in new, purpose-built shopping centres.  
4.	There is substantial competition in the provision of optical services to the public.  While inevitably the layouts of individual premises differ for inter alia structural reasons, the emphasis in the front area is on retail purposes.  Shop fronts and windows are used to promote all services provided.  Spectacle displays are laid out in the shop fronts and front retail areas.
5.	Typically the front “zone” of the Appellant’s shops is the retail area through which all customers pass.  Displays of spectacle frames are located there with each shop holding several hundred individual frames.  The dispensing area is adjoining or overlapping, with the shop’s reception desk and several dispensing desks being located there, at which customers sit to try on frames initially.  They return there after their spectacles have been completed with the lenses prescribed, and an optical assistant or optician will check that they fit correctly.  Display carousels and mirrors are not used for dispensing purposes.  About 70% of the Appellants’ outlets have their own laboratory facilities.  These mainly are in modern shop units where there can be located in the dispensing area work-benches and lens-generators at which technicians prepare the prescribed lenses.  (This aspect of the shop layout is intended to promote the efficiency of the Appellant’s service).  To the rear the optometrists’ consulting rooms are located.  There they carry out eye-tests and check the medical condition of the eyes generally and prescribe the requisite lens strengths.
6.	The structure and layout of each of the Appellant’s premises remains relatively permanent.  While décor and floor-coverings may be “freshened up”, structural or other major alterations occur only exceptionally.  These would require landlords’ or public authority consents and would involve substantial expenditure such as on heating, ventilation, air conditioning and power supplies.  Accordingly there is not a programme of regular or periodic refurbishment.  Changes even in layout and presentation would not be made at the instance of local staff but rather at Board level.
7.	In negotiating rental levels for retail premises it is general surveying practice to zone the floor areas from front to back at 20 foot intervals (30 foot intervals in Scotland) with 3 zones and thereafter a residual area.  The rental level value is halved from zone to zone.  This technique is subject however to other factors, principally market demand and also the nature of the layout of the premises, with special consideration required for older premises.  One rent level applicable to the whole premises would then be negotiated.
8.	Partial Exemption Special Methods for apportionment of input tax on the basis of usage of floor space have been approved by the Respondents under Regulation 102 for other major optical chains including Boots Group plc and Vision Express (UK) Ltd.  (See Pleadings Bundle page 50J-N).  A Special Method was approved for the Appellant for about a Year from 1997 to 1998.  It was not based on floor space but on inputs.  (Document 6).
9.	The Appellant made application to the Respondents for approval of a PESM by letter dated 13 December 2000 and as revised by letter dated 6 December 2001 (Documents 15 and 23).  This was prepared by reference to floor space.
10.	This PESM was rejected by the Respondents by letter dated 11 November 2002 (Document 34).  This letter was drafted by Mrs Parkes for signature by her manager, Mr Hunter.  This matter had been referred by her earlier to a specialist internal department viz the Partial Exemption Team of the Respondents, and she drafted the letter of refusal on the basis of an E-mail dated 8 November 2002 from a member of the Team, Femi Clagundoye (Documents pages 144/145).  That refusal is the subject of this Appeal.
11.	While the Respondents do not have a policy that a PESM based on floor space will never give a “fair and reasonable” result, they (or their Partial Exemption Team) believe that ordinarily it will not.  They consider as a matter of present policy that the absence of large floor areas with exclusive use complicates the calculation of an appropriate formula.
12.	The amounts of residual input tax paid by the Appellant in the Quarters ending from July 2000 to April 2003 are set out in Document no 38 (see page 86).  The relative items of expenditure are not referable exclusively to either taxable or exempt supplies.  The major item is “rent & service charges”.  The totals are shown in the top section and in the two sections below it is allocated between the shop premises and the business headquarters.  Only about 5.25% of residual input tax is referable to the business headquarters.

Parties’ Submissions
Both Parties helpfully lodged Heads of Submissions and Skeleton Arguments.  Also, there is a record of their oral submissions in the shorthand notes.  In view of that it seems appropriate simply to condense the salient points in their respective arguments.

-	for the Appellant
Mr Cordara addressed us firstly on the nature of our jurisdiction.  

He submitted that this was not limited or restricted.  We could substitute our own decision as appropriate and in any event set out guidelines.  On any view in the present case there were errors of both fact and law in the Respondents’ decision to refuse the partial exemption special method.  Either such error vitiated the decision and accordingly it should be set aside.

Mr Cordara argued that we should consider the special method, the basis for its rejection, and the implications of the standard method.  He referred us to the Tribunal’s decision in Merchant Navy Officers Pension Fund.  In the present case if the special method were preferable to the standard method, the special method should prevail.  In addition to defending the special method proposed he acknowledged that he had to find fault with the standard method.

The “full cost apportionment” method, devised for opticians, which had been considered in the course of negotiations between the Parties (see particularly Document 15, page 28) was not satisfactory here, Mr Cordara continued.  It could be distorted and produce an “unfair” result if, say, a cheap source of inputs for taxable supplies (eg lenses) were found.  That would correspondingly increase the quantum of inputs for exempt supplies but essentially the trading pattern would remain unchanged.  The effect of wages, especially of skilled optometrists providing exempt professional services, would also distort the apportionment.

On the other hand there was a compelling logic in the “floor space” approach which made it preferable as producing a “fair and reasonable” result.  The major element in the “breakdown of partially recoverable VAT” (Document 38 page 86) comprised rent and service charges.  The standard method based on output attribution was wholly inadequate as a proxy for use, he submitted.  The problem of an optician’s business is that there is no proportionate consumption of inputs as between taxable and exempt outputs.  It was facile to suggest, as the Respondents did, that - “The standard method gets it right”.  Other optical chains, including Vision Express, have in use a “floor-based” special method.

Mr Cordara then referred to the letter containing the Respondents’ refusal.  (Document 34).  In paragraph 3 the fact that customers had to “walk through” the retail area to reach the consulting rooms where the exempt professional services were provided, did not make the retail area a cost component of the exempt supply.  The impact of VAT, he argued, should not be affected by shop layout and customers’ ambulatory patterns.  He referred us to the decision in Southern Primary Housing Association in particular in support of his argument that as a matter of law the costs of the front area do not relate to the exempt professional services provided at the back.

Further in paragraph 3 it was wrong in fact to suggest that the mirrors were used as part of the dispensing service.  The evidence was to the effect that this was provided to customers seated at special tables.  Another factual error (paragraph 4) was the reference to changes in use of the floor area.  The evidence indicated that this did not happen regularly or routinely.

These arguments applied in relation to the 95% share of residual input tax relating to expenditure on the stores (described in the notes as “pot 1”).  The remaining 5% of residual input tax (“pot 2”) related to the enterprise’s Head Office at Westfield, Cumbernauld (see Document 38, page 86).  The denominator proposed for the appropriate fraction was revised in the Appellants’ agents’ letter of 6 December 2001, Appendix A (Documents, page 48).  The numerator incorporates the stage 1 calculation and is thus dependent upon its accuracy.  

The point of controversy in respect of stage 2 was very narrow, Mr Cordara submitted, and relates to Mr Mattacks’ complaint that staff salaries were not included.  Their exclusion was justifiable, Mr Cordara continued, because the high level of pay of the professional staff was not indicative of the consumption of taxable rent.  The pay level of an optometrist in the south of England was not indicative of the consumption of inputs at Head Office.  Mr Mattacks had failed to produce any publication indicating that staff salaries could be a good proxy for use.  Further, their omission from the suggested calculation had not been referred to in the Respondents’ letter setting out this decision.  A further reason for excluding wages and salaries was that staff do not charge VAT and do not supply goods and services to their employers.  Mr Cordara reminded us that Mr Mattacks had not been involved in the decision-making process in the present case or visited the Appellants’ premises.

Finally, Mr Cordara addressed us on the aspect of “zoning” floor area.  He commended this to us as simply representing commercial reality.  While one rent level might apply to the whole premises, the reality of the rent profile, reflecting certain areas as more valuable, should be taken into account.  (The “walkways” shown on the plans reflected the argument – not favoured by Mr Cordara – that the front shop area was not purely “retail”).

Mr Cordara urged us to allow the Appeal.

-	for the Respondents
Mr Young set out his reply in 3 stages.  

Firstly, he considered the extent of our jurisdiction and floor-based special methods in principle.  The criterion (Section 26 (3)) seemed to be securing a “fair and reasonable attribution” of input tax.  By reference to the decision of the Court of Appeal in John Dee Ltd v C&E and the Tribunal in Banbury Visionplus and related cases the Tribunal’s jurisdiction, he submitted, was limited.  In other words it may simply quash the Respondents’ decision if it is unreasonable.  The Tribunal may not, he submitted, usurp the Commissioners’ discretion and approve or prescribe the form of an acceptable partial exemption special method.

He then referred to recent decisions on floor-based apportionment methods in the case of opticians’ premises, viz Optika and Banbury Visionplus, supra.  There was no requirement to compare the proposed partial exemption special method with the standard method, he argued.  A complication in the case of an optician’s business is that given that its core business activity involves the making of the mixed supply of dispensed spectacles, it is impossible to divide the retail area into taxable and exempt sections.  That whole area, he submitted, is mixed.  He criticised the zoning of floor space as a means or aid to apportioning inputs.

Secondly, Mr Young summarised his understanding of the factual evidence in relation to the structure of the Appellants’ business and the typical layout of its various premises, and the stages in which a customer was attended to and served by its staff.

Finally, he sought to justify the Commissioners’ stance in rejecting the proposed method.  He urged us to confirm the rejection of the proposals on the basis of several incorrect classifications of certain areas, viz frame stands, shop windows and displays, dispensing areas, and zone A demarcation as shown on the sample shop plans.  (We comment on this further in our Decision infra).  Any one such error in the proposed method, Mr Young submitted, was of such significance that it required us to uphold the Respondents’ refusal.

Mr Young sought to distinguish the issue in Southern Primary from the present case.  That, he argued, dealt with the concept of direct attribution i.e. the immediate link between input and output.  There the issue was attributing input tax to the appropriate supply.  That decision did not deal with the apportionment of residual input tax between taxable and exempt supplies, which was the issue in the present case.

Mr Young founded also on the problem of verification of changes of use of the floor area noted in the refusal.  That, he submitted, was a valid objection and he referred us to para 117 in Banbury Visionplus.  Further, the use of “general overheads” distorted the apportionment between taxable and exempt supplies.  He sought to distinguish the decision in Merchant Navy Officers Pension Fund: that related to the termination of a Special Method, with somewhat distinct considerations arising.

Even if it were valid to compare the effects of the standard method and a proposed special method, there was insufficient information to make a satisfactory comparison in the present case.  He noted that no evidence had been led from the Appellant’s accountants or its financial director.

Finally, Mr Young referred to the matter of zoning.  (It was not referred to in the letter of refusal and presumably had not been considered).  However, he submitted that inevitably it would not have affected the Commissioners’ decision not to approve the proposed special method.  Zoning had been disapproved in Optika and Banbury Visionplus.  There was no official policy in relation to special methods appropriate for opticians and, so far as reference had been made to other such businesses, that was irrelevant to the present case and in any event had not been evidenced in any detail.

Mr Young invited us to refuse the appeal.

Decision
The first matter which arises is the nature of our jurisdiction.  We consider that it is limited in the sense that we should consider whether the Respondents’ refusal proceeds upon a reasonable assessment and is not undermined by any error of fact or law.  However, we cannot substitute our own discretion and we cannot prescribe an acceptable alternative special method or set out guidelines.  We prefer the arguments of Mr Young to those of Mr Cordara on this aspect of the Appeal.  As we read the statutory provisions the criterion of a “fair and reasonable attribution of input tax” is prescribed in Section 26(3) VATA.  The Regulations relative thereto (nos 101 and 102) set out a formula to that end and, further, permit the Commissioners to approve or direct another (i.e. special) method.  There is no reference there or elsewhere to the Tribunal having a comparable or parallel discretion.  Section 83(e) introduces the Tribunal into the process by granting a taxpayer, aggrieved by the proportion of input tax allowable under Section 26, a right of appeal to it.  That in our view enables us to review the Respondents’ refusal in a Wednesbury context (see Associated Provincial Picture Houses Ltd v Wednesbury Corporation [1948] IKB223) as being justified or not, but no further.

On the basis of the authorities cited it seems that we cannot take into account the “fairness” or otherwise of the standard method in reaching our decision.  In any event the evidence before us does not provide a comparison of the full financial consequences of applying the standard and proposed methods.  As Mr Young reminded us, we heard no such evidence from the Appellant’s accountants or financial director on this aspect.

Accordingly we accept and follow the reasoning in Banbury Visionplus Ltd and related cases at paras 94-100 and we note also the observations of Neill LJ in relation to a somewhat comparable provision in John Dee Ltd v C&E [1995] STC 941 at p952.  These indicate that if, say, the proper assessment of material omitted from the decision-making process inevitably would not have altered the decision, we could still uphold the decision as justified.

We now have to consider the basis for the Respondents’ refusal.  We regard that in the context of the proposed partial exemption special method which, it is accepted, is set out in the Appellant’s accountants’ letters of 13 December 2000 and 6 December 2001 (Documents 15 and 23).  The letter of refusal (Document 34) was drafted by Mrs Parkes and signed by her manager.  That falls to be read in conjunction with the E-mail from Mr Clagundoye of the Partial Exemption Team dated 8 November 2002 (Document 58 at page 144-145) upon which it proceeded.

In our view the Respondents’ refusal was reasonable and, therefore, we refuse this Appeal.

We consider that the refusal was reasonable and justifiable on the basis of their criticisms of the Appellant’s categorisation of floor space as “taxable” or “exempt” or “non-attributable” in Appendix “A” to Document 23.  On the other hand we do not consider that the other reasons set out in the refusal (Document 34) have substance.  However, given the significance of the shortcomings of the suggested categorisation of floor space, that in itself in our view justifies the Respondents’ rejection of the proposed partial exemption special method.  Whatever merit there may be in an approach based on the zoning of floor area, the form proposed in Document 23 is in our view undermined in that its categorisations are incorrect.  The dispensing areas should be described as “exempt”, not as “non-attributable”.  The retail area has been classified as “taxable” (by implication of the footnote no 1 at page 47), while it should be “mixed”.  The retail sale of both goods and services takes place there.  Not only are spectacles provided but professional advice is given there too.  The shop windows are not fully “taxable”: the “exempt” services provided are promoted there too.  Finally, the frame-stands are not wholly “taxable”: on the basis of Banbury Visionplus these are “mixed”.  

On the other hand we disagree with certain other objections taken in Document 34.

In the fourth paragraph the Respondents complain that the proposed method does not allow for changes in use of the floor area.  That criticism is not tenable on the evidence.  We accept the evidence of Mr Moulsdale that such changes were rare and exceptional and not part of a “rolling” plan for refurbishment of all the outlets.  While superficial décor and floor coverings might be changed periodically, the layout of the floor area would not.  Ordinarily that would require landlord’s permission, the preparation of plans for approval, and possible local authority permission particularly in relation to any alterations affecting structure.  That process would also require changes in services on the premises eg, power outlets, computer installations, ventilation etc.  All this discouraged a pattern of radical alteration.

That criticism makes reference also to an “unreasonable burden” resulting for the Respondents.  While the decision in Merchant Navy Officers Pension Fund acknowledges that where a special method imposes an “unreasonable burden” or strain on resources on HMRC, say in relation to verification of its consequences, we are not satisfied that that would arise here.  While there are 182 premises, the business has a substantial turnover.  Considering each shop individually does not seem to us an undue burden given particularly that the Appellant offered to provide floor plans of all premises.  (Plans of a sample of 5 or 6 had been submitted earlier).  It seems that the Respondents recently cut short a meeting with the Appellant and its professional representatives, which could have explored this.

In the next paragraph of Document 34 reference is made to “stage 2” of the calculations.  That relates to expenditure relating to head office.  It is minimal in relation to overall costs (about 5%) and should not in our view present an insuperable factor in approving a special method.

However, notwithstanding our reservations about certain aspects of the Respondents’ refusal for the reasons indicated earlier we consider that we cannot overrule it.

Costs
Having reserved their position at the conclusion of the Hearing the Respondents by letter dated 2 March 2006 now seek an award of costs in the event of their success.

We consider that an award of costs to the Respondents is not appropriate in the somewhat exceptional circumstances of this Appeal.  We are sympathetic to the Appellant’s stance in seeking a “floor-based” apportionment of inputs.  That apparently has been approved in the case of other optical chains.  (See Pleadings Bundle, pages 50J-N).  It seems questionable whether the standard method can ever produce a “fair and reasonable” result in the circumstances of the present case.  The allocation of the outputs as between “taxable” and “exempt” bears no relationship to the costs of taxable and exempt inputs.  In particular the substantial costs of salaries paid to professional optical staff distorts this.  The Appellant has, as we have noted, offered to produce plans of all of its premises for this purpose.  Its advisors had hoped thereby for further negotiations for a “floor-based” method at the meeting noted supra with the Respondents shortly before this appeal.  The Appellant’s Chief Executive, Finance Director, solicitors and accountants had all been in attendance.  However, the meeting was terminated abruptly by the Respondents after only a brief discussion.  In our view the Respondents failed to respond adequately to the information provided by the Appellant and its eagerness to continue negotiations.

Accordingly we make no award of costs.

MR KENNETH MURE, QC

CHAIRMAN

RELEASE:  18 APRIL 2006
EDN/02/182