20780

VALUE ADDED TAX – Company providing investment management and advice – taxable and exempt supplies – deduction of residual input tax – whether Standard Method and/or proposed Special Method “fair and reasonable” – VATA Section 26 – Regulations 101 and 102 of VAT Regulations 1995 – Appeal Refused.

EDINBURGH TRIBUNAL CENTRE

	MCINROY & WOOD LIMITED	Appellant

	- and -

	THE COMMISSIONERS FOR 
	HER MAJESTY’S REVENUE & CUSTOMS	       Respondents

			Tribunal:	 (Chairman):  Mr Kenneth Mure, QC
					 (Member):     Ian M P Condie, CA

Sitting in Edinburgh on Monday 14 and Tuesday 15 July 2008

for the Appellant		Colin Tyre, QC

for the Respondents	Julian Ghosh, QC

© CROWN COPYRIGHT 2008.
DECISION

Introduction
The Appellant (“MW”) is in business providing investment management and advice.  A wholly owned subsidiary, McInroy & Wood Portfolios Limited (“P”) manages and administers 5 (formerly 6) unit trusts.  MW makes both taxable and exempt supplies and insofar as it incurs residual input tax on expenditure not referable to either category of supply, the method of apportioning this arises.  Recently this became of significance in relation to VAT incurred on costs of building new premises for MW’s operations.  While MW’s clients pay an annual 1% charge on shareholdings owned directly by them, that charge does not extend to unit holdings of clients.  There a 1½% per annum management charge is made, deducted by the Trustees of the particular unit trust.  A “recharge” is paid annually by P to MW of varying amount.  In the year to April 2007 this was for £1.5 million (tab 37).  Much of the argument during the Hearing related to the nature and significance of the “recharge” payment.

The Law
In relation to the VAT treatment of management of inter alia unit trusts as exempt supplies we were referred to Article 135(1) (g) of the recast VAT Directive 2006/112 as implemented by VATA 1994, Schedule 9, Group 5, item 9.  Reference was also made to Abbey National Plc v C&E [2006] STC 1136 at p1164 paras 62-63.

On the matter of the Standard or a Special Method as being appropriate in apportioning residual input tax we were referred to – 

VAT Regulations 1995, Regulations 99-102
Banbury Visionplus v HMRC [2006] STC 1568
St Helen’s School Northwood Ltd v HMRC [2007] STC 633
DCM (Optical Holdings) Ltd v HMRC (2007) SLT 705
Merchant Navy Officers’ Pension Fund Trustees Ltd v C&E (ref no 14262)

The Facts
We heard evidence from Mr Victor Wood, a Director and major shareholder of MW and from Mr John McAulay CA, its Finance Director and Company Secretary, who spoke to the business operations conducted by the companies.  To an extent their evidence was not controversial.  However there were certain areas which were more opinionative in nature.  We had regard also to the documentation produced.

The Respondents lodged a Witness Statement for Mr James Warham, one of their officers.  The Appellant’s counsel made no objection to its being referred to.

On the basis of the evidence led and produced we make the following:-

FINDINGS-IN-FACT
1.	MW is a Limited Company providing investment management services.  It is an independent concern and gives “long-term” advice.  It carries on business at Easter Alderston, Haddington.  It has a staff of about 30.  
2.	In about 1989 for the purpose of holding clients’ shareholdings via the mechanism of unit trusts MW set up a wholly owned subsidiary company, P, to administer these.  A separate company was then necessary to satisfy FSA requirements.  P has no employees of its own.  It did not require additional resources when it was set up.  P’s work is carried out by MW’s employees.  Currently there are 5 such unit trusts distinguished by different objectives such as capital and income growth, smaller companies, and emerging markets.  
3.	MW has about 350 clients.  About 50 have portfolios with only direct shareholdings.  About 200 hold investments only in P’s unit trusts.  The remaining 100 or so hold both units in the trusts and direct shareholdings.
4.	MW is the representative company of a VAT group consisting of itself and P.
5.	The standard client agreement (tab 25) grants MW full discretion over the management of client’s funds.  There is an annual charge 1%, levied quarterly, on the value of shareholdings.  That charge does not extend to units in the unit trusts, which are subject to an annual administration charge of 1½% out of trust assets.
6.	MW has introduced its clients to the unit trust investment vehicle as offering advantages of Capital Gains Tax deferral and of savings in administrative costs.  In recent years the value of clients’ unit trust holdings has increased substantially and the value of clients’ direct shareholdings has diminished correspondingly.  This has not had an impact on investment activity.  However, exempt income of the group has increased vis-à-vis taxable income.
7.	MW produces preferred lists of investments which it has researched and reviewed.  These are categorised according to the broad investment objectives noted supra.  The investments in direct shareholdings made for clients and by the unit trusts are determined by these lists.  The shareholdings held by the unit trusts would broadly correspond proportionately in selection and amount with those recommended for individuals’ directly held portfolios where the investment objectives of the unit trust and the individual were the same.  In its reports to clients MW seeks to identify the underlying shareholdings of the units held (tab 40).
8.	The investment advice used by the unit trusts is that provided by MW’s lists.  As the volume of unit trust investment has increased the Group’s exempt income has increased and its taxable income has reduced.  The management charge of 1½% per annum deducted from the capital of each unit trust is paid over to P.  P provides the services of arranging periodic valuations and reports for investors.  A “recharge” is made annually by P to MW to compensate it for advice in selecting the unit trusts’ assets.  If it were not made, MW would not be profitable, which would affect its viability for financial services’ regulation.  MW’s Profit & Loss account (tab 35/20) is produced.  The largest expense is for staff salaries, reflecting the business’s staff-intensive nature.  A summary of the Group’s Profit & Loss accounts, showing the relative fee income and amounts of the “recharges” for the last 9 years is produced (tab 37).
9.	Since in recent years the proportion of Group income derived from the unit trusts has increased, the Standard Method produces a lower recoverable fraction of residual input tax – of only about 20% in recent years (tab 37).
10.	There have been extended negotiations between the Appellant’s representatives and the Respondents about a Special Method of apportioning residual input tax.  While aspects of that have been changed essentially a Special Method formulated by reference to the proportions of attributable expenditure has been proposed.  That would produce a recoverable fraction of about 76% (tab 42) or 57% if ignoring the building costs.  (This latter figure was adopted by the Appellant’s counsel in submissions).
11.	The Respondents have rejected the various Special Methods proposed.

Parties’ Submissions
Both Parties prepared Skeleton Arguments which were adopted by their Counsel in closing submissions.  These are produced.  

On behalf of the Appellant Mr Tyre referred us first to the authorities in UK and Community VAT provisions defining as exempt unit trust management.  He then noted the special provisions governing the deduction of VAT on residual inputs which cannot be attributed directly to either standard rated or exempt supplies.  He summarised the case-law relating to the operation of the Standard Method of apportionment of such residual input tax and when it can be displaced in favour of a Special Method in order to achieve a “fair and reasonable” result.  This all seemed to be non-contentious.

He then considered the nature of the “recharge” and referred us to para 15 of his Skeleton Argument.  The Standard Method did not, Mr Tyre argued, produce a “fair and reasonable” result here as there was no relationship between the resources applied and income received.  He argued that each unit trust was simply one other client.  There were many more individual clients than unit trusts and they should be viewed equally.  The scale of each unit trust’s investments was irrelevant, he argued.  The trusts required a disproportionately small amount of the staff’s work.

On the other hand the Special Method proposed did in Mr Tyre’s view produce a “fair and reasonable” result.  The business involved intellectual effort by its staff.  The nature of the activities were the same:  both taxable and exempt activities were discretionary fund management.  Surely overheads were consumed in the same way?  These would surely follow the pattern of staff activities?  If staff spend more time on non unit trust investors, expenditure on overheads should reasonably be similarly attributed to taxable rather than exempt activities.  

The measurement for this apportionment should be by reference to the audited accounts, Mr Tyre submitted.  He referred us to tab 42/1, which shows a breakdown of attributable and non-attributable expenditure.  Overheads, he argued should follow this.  The overall consequence of this was an attributable figure of 76% to taxable activities, but perhaps more appropriately 57% ignoring the peculiar factor of building costs.  This, Mr Tyre submitted, was the reasonable proxy for use and on any view more “fair and reasonable” than the Standard Method.

In his submissions in reply Mr Ghosh laid emphasis on the nature of the re-charge.  While MW charged a 1% fee on clients’ discretionary share portfolios, that fee was waived for unit trust investments.  The responsibility for payment of the 1½% charge in respect of units falls on the trustees.  P, which receives the 1½%, does not generate outputs to clients investing in units.  In fact it is MW which gives advice on the underlying investments of the unit trusts.  While MW is not paid to the extent that clients invest in units, that is compensated for by the re-charge.  That, Mr Ghosh argued, represents a transfer-price exercise.  It becomes part of MW’s accounting profit.  If there were no re-charge MW would make a loss, which would be attributable to its generating money for P.  Mr Ghosh criticised the analysis of MW’s clientele as being a relatively large number of clients with discretionary portfolios and a small number, presently 5, of unit trusts and, further, that MW was more engaged with the large number of discretionary portfolio clients.  Rather, Mr Ghosh submitted, MW carried out the same process of work for all its investors.  The low-risk profile was the same for all.  MW carried out the same work “across the board” rather than disproportionately more work for the portfolio clients and much less for the unit trusts.

The Standard Method provided, in Mr Ghosh’s view, an appropriate proxy for use.  The proposed Special Method did not.  It assumed that the use of the overheads “tracked” the other expenditure.  There was no reasonable basis to support this.

The allocation of residual input tax between exempt and taxable supplies must primarily reflect use.  In nature that use, argued Mr Ghosh, is “economic” use under reference to the decision in St Helen’s School (paras 63 and 80).  The making of the re-charge by P to MW tended to confirm economic use.

The proposed Special Method did not provide a satisfactory proxy for use, Mr Ghosh concluded.  It did not take sufficient account of the re-charge and the context in which that was made.  There was nothing unfair about the Standard Method in the present case.  The proposed Special Method was unfair.  On any view it was not more fair than the Standard Method.  Accordingly the Tribunal should refuse the Appeal.  

Decision
The legal aspects in the Appeal seem largely uncontroversial.  We agree that the administration and asset management activities relating to the unit trusts are exempt within the structure of VAT.  We agree that to displace the Standard Method of apportionment of residual input tax it must be demonstrated not simply that it is unfair and unreasonable but also that the proposed Special Method is both “fair and reasonable”.  It is not enough simply to show that it is less unfair and unreasonable.  We accept that these concepts involve the criteria of ease of operation and implementation by the taxpayer and ease of verification by the tax authorities.  Finally, of course, as a general proposition inputs must be related to taxable outputs before input tax can be deducted.  (Sections 24-26 VATA 1994).

The factual issues for us to determine relate to the assessment of the Standard Method and Proposed Special Method as appropriate to this particular case.  The Standard Method (presently) apportions residual input tax by reference to turnover.  It is income or earnings-based.  The fees charged by the Appellant are a fixed percentage of funds under management rather than one fixed figure.  The fee charged to the individual client depends on the value of his portfolio.  The work done by the Appellant is the researching and appraisal of various investment opportunities and the preparation of a list of investments (or lists for particular objectives) which does not relate to any particular client or trust but for the clientele as a whole and so is used “across the board”.  The position of the unit trusts is somewhat peculiar.  We noted in particular Mr McAulay’s evidence in re-examination to the effect that – while P did not provide investment expertise, it had an arrangement with MW to act as investment advisor to the trusts; there was no formal arrangement; and selection of investments was determined by MW’s preferred list.  In our view regard must be paid to the “re-charge”.  In amount it is substantial and has been made in consecutive business years to date (tab 37).  MW would have been loss-making otherwise which would have had serious consequences for financial regulatory purposes.

While MW and P are members of a VAT group they are separate entities for Corporation Tax purposes.  We understand that the “re-charge” is acknowledged as being a share of income which on sound accounting principles belongs to MW.  Essentially it is in our view a quid pro quo for the provision of investment expertise.  Although there was no formal provision for the “re-charge” it was the expectation and established practice within the Group.

Mr Tyre stressed in argument that in his view resources expended had no correlation with income received.  He viewed the unit trusts as five clients as against, say, fifty individuals as clients.  Any extra unit trust was only one additional client irrespective of the size of its capital, using the same services, and so not increasing overheads (the expense producing in this case the residual input tax).

We do not find this interpretation of the facts persuasive or realistic.  Given that the Appellant’s chosen charging mechanism is by way of a fixed percentage, remaining constant whatever the value of the client’s portfolio, and moreover that the “re-charge” has increased broadly in line with the level of income generated by P, it appears to us that an apportionment of overhead costs by reference to turnover is eminently appropriate as “fair and reasonable”.  The charging structure selected by the Appellant depends on the value of assets.  The income and turnover of the Appellant depends on the value of all its clients’ assets, not the number of clients, and increases or decreases in proportion to that overall value.  The responsibilities and consequences for the advice must vary with the size of the particular client’s investments. 

Moreover the Standard Method is easy to operate and verify.  For all of these reasons it fulfils the requirements of being “fair and reasonable”.

However, standing the decision in St Helen’s School (especially at paras 13 and 27 of Warren J’s opinion) we must consider whether the Proposed Special Method produces a result which is more fair and reasonable.  In doing so we would agree with Mr Tyre that we can give a decision in principle in favour of such a Special Method with a proviso that some refinement or detailed adjustment to its terms may be necessary (see DCM (Optical Holdings) Ltd para [16]).

An expenditure-based method has been under discussion between the Parties for some time, with certain variations actively considered.  Essentially it depends on the respective totals of attributable expenditure on the taxable and exempt activities.  Is that ratio appropriate as the proxy for use to be applied to the non-attributable expenditure?  Certainly as a formula it would seem that it can be operated reasonably readily and confirmed by reference to tax records.

However, we have serious reservations about such a method in principle as producing a “fair and reasonable” result.  The nature of the residual expenditure is listed in the Appendix to Mr Ghosh’s Skeleton Argument, viz gas and electricity, equipment leasing, stationery, IT costs and training, shredding etc.  These would appear to be general overheads.  At tab 42/1 and 1A the 2 classes of attributable expenditure are listed.  That attributed to taxable supplies is much greater than that attributed to exempt supplies.  However, included in the total for taxable supplies there are 2 very substantial sums for “Adam & Company – private clients depository bank and admin system”.  These represent a very substantial portion of the total attributed to taxable expenditure and relate to an outsourced matter.  That, we fear, must tend to distort a fair allocation of un-attributed expenditure.

Further, we have concerns about the effect of the operation of such a formula on un-attributable expenditure in the event of a change in the structure of the clientele of MW – say as the number of investors with direct portfolios diminishes.  There appeared to be a divergence here between the view of Mr McAulay in evidence and the submission made by Mr Tyre.

The calculations at tab 42/1 and 1A do not include staff salaries which, of course, do not bear VAT but are by far the major item of expenditure of MW.  Contrary to Mr Tyre’s submission we take the view that they cannot be allocated on the basis of client numbers, including each of the 5 unit trusts as one client irrespective of the amount of its funds.  Our view is that salaries should be apportioned rateably in relation to the value of funds under management which, of course, reflects the Appellant’s charging structure.

The expenditure which prompts this Appeal, we were told, is that relating to the construction of new business premises.  We are not satisfied that an appropriate proxy for use applicable to VAT on this expenditure can be derived from the formula proposed.

In conclusion we do not consider that the proposed expenditure-based proxy for use provides a “fair and reasonable” formula.  Certainly it does not in our view produce a more “fair and reasonable” result than the Standard Method.  The turnover formula of the Standard Method seems to us eminently appropriate for the Appellant’s type of business even although the result is less favourable.  The structure of MW is staff intensive.  It produces intellectual effort which is applied in drawing up a list of selected share investments (or different lists with distinctive objectives).  That is its core activity.  The list is used “across the board” for all investors whether individuals or the unit trusts.  In turn remuneration is paid by reference to a fixed percentage to value, not on a sliding scale according to the individual investor’s capital, or involving a fixed charge per investor.

We consider that the Respondents were justified in rejecting the proposed Special Method and accordingly we dismiss this Appeal.

Costs
In view of our decision it is appropriate that costs be awarded to the Respondents and subject to taxation, if necessary, in terms of Rule 29(3) of the VAT Tribunal Rules 1986.

Finally we have to express our appreciation of the excellent and detailed arguments presented by Mr Tyre and Mr Ghosh and their colleagues.

MR KENNETH MURE, QC

CHAIRMAN

RELEASE:      21  AUGUST 2008

EDN/07/130