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N2. Special methods
HMRC POWERS​
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HMRC power to approve or direct
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"(1) Subject to paragraphs (2) and (9) below and regulations 103, 103A, 103B, 105A and 106ZA, the Commissioners may approve or direct the use by a taxable person of a method other than that specified in regulation 101." (SI 1995/2518, r.102)
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(1) In the case of goods or services used by a taxable person both for transactions in respect of which VAT is deductible pursuant to Articles 168, 169 and 170, and for transactions in respect of which VAT is not deductible, only such proportion of the VAT as is attributable to the former transactions shall be deductible.
The deductible proportion shall be determined, in accordance with Articles 174 and 175, for all the transactions carried out by the taxable person.
(2) Member States may take the following measures:
(a) authorise the taxable person to determine a proportion for each sector of his business, provided that separate accounts are kept for each sector;
(b) require the taxable person to determine a proportion for each sector of his business and to keep separate accounts for each sector;
(c) authorise or require the taxable person to make the deduction on the basis of the use made of all or part of the goods and services;
(d) authorise or require the taxable person to make the deduction in accordance with the rule laid down in the first subparagraph of paragraph 1, in respect of all goods and services used for all transactions referred to therein;
(e) provide that, where the VAT which is not deductible by the taxable person is insignificant, it is to be treated as nil." (PVD, Article 173)
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- Direction takes effect prospectively only
"(4) Any direction under paragraph (1) or (3) above shall take effect from the date upon which the Commissioners give such direction or from such later date as they may specify." (SI 1995/2518, r.102)
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- Approval may take effect retrospectively
"(16) In this regulation “the effective date of the method” is the date when the method to which the declaration relates first takes effect and may predate the date when the declaration was made." (SI 1995/2518, r.102)
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- Retrospective approval may be given for persons who had no PESM
"Whilst retrospective changes of method will only be approved in exceptional circumstances, the retrospective approval of a method may be granted where a partly exempt business has failed to adopt any method to apportion input tax. This usually occurs where the taxpayer did not realise that he was partly exempt. By default, the business must use the standard method (as adjusted by the override if appropriate) and the assurance officer should calculate any over recovery of input tax, subject to the relevant time limits, de minimis rules, and the override; and may assess.
However, if the standard method does not give a fair and reasonable result and the business proposes a special method that does, the officer may approve such a method as the basis of the calculation of exempt input tax. If this happens the Commissioners are retrospectively approving the use of a special method. This policy has been adopted in acknowledgement of the fact that the business was not in a position to propose an alternative method at an earlier point in time, since they were unaware that such a calculation should have been undertaken.
Backdated approval may also be granted where a business has been unknowingly operating an unapproved special method, but where that method gives a fair and reasonable result. In this case a ‘Declaration’ will still be required." (PE47000)
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- Change of method not normally allowed to operate before beginning of current tax year
"Requests for a retrospective change of method are not normally to be allowed, except to the extent that a method may be approved with effect from the start of the tax year in which the declaration to a written application (being the approved application) is received. Requests for retrospective changes beyond this will only be allowed in exceptional circumstances. This is usually where the Department has been at fault, the method is inoperable, or where the method of calculation does not give any result, because both the top and bottom of the calculation are zero.
It may also be where there has been an exceptional natural disaster. Examples include the foot and mouth epidemic which resulted in some farm businesses ceasing to make taxable supplies and the World Trade Centre disaster where activities were temporally transferred to UK offices." (PE46500)
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"[35] Concerning those principles, it should be borne in mind, first, regarding the principle of proportionality, that it does not preclude a Member State which has exercised the power to authorise its taxpayers a right of option for a special taxation scheme from adopting legislation which makes the application of that scheme conditional upon non-retroactive, prior approval by the tax authorities, and that the fact that the approval process is not retroactive does not make that process disproportionate. Consequently, national legislation, such as that at issue in the main proceedings, which does not allow taxable persons to apply the deduction system based on actual use once the final proportion has been fixed does not go beyond what is necessary for the correct collection of VAT (see, by analogy with the exemption scheme for small enterprises, judgment of 17 May 2018, Vámos, C‑566/16, EU:C:2018:321, paragraphs 43 to 45 and the case-law cited).
...
[38] It follows that, contrary to what CTT argues in essence, the principle of fiscal neutrality cannot be interpreted as meaning that, in each situation, the most precise deduction method must be ascertained to the point of requiring the deduction method initially applied to be systematically called into question, even after the final proportion has been ascertained." (CTT - Correios de Portugal C-661/18)
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Apportionment to non-business use and exempt use
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- HMRC have power to approve a combined method
"[40]...Based on principle and the authorities, in our judgment HMRC have the power, as a result of Reg 102 and paragraph 1(1) of Sch 11 of the 1994
Act, to enter into a single agreement which is both an agreement for a special method under the regulations and also an agreement under the general powers
of care and management. To the extent that such an agreement comprises a method of attributing input tax to taxable supplies it will be a special method
within Reg 102 and Reg 102(3) will apply to it." (HMRC v. Imperial College of Science [2016] UKUT 278 (TCC), Birss J, Judge Berner)
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- Apportionment to exempt and to non-business may be dealt with in single formula
"[48] The method which was agreed is a single formula which combines attribution of input VAT between business and non-business activity with attribution of input tax between taxable and exempt supplies. It does so in a convenient and pragmatic manner. It was in fact agreed as a PESM. Insofar as the method is a means for the latter attribution it is clearly a PESM and HMRC had vires to approve it. Although, as we have explained, we have our own reservations on
this point, insofar as the method is a means for the attribution between business and non-business we have taken it for the purpose of this appeal that it is not a
PESM but we have found that HMRC had vires to agree that under their care and management powers. These powers can be used together to agree a single
combined method and so we hold that HMRC had the authority to do what they did, and that what they agreed as regards the attribution of input tax was a
special method." (HMRC v. Imperial College of Science [2016] UKUT 278 (TCC), Birss J, Judge Berner)
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Form of application
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- In writing, identify supplies, declaration
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"(1A) A method approved or directed under paragraph (1) above—
(a) shall be in writing
...
(c) shall identify the supplies in respect of which it attributes input tax by reference to the relevant paragraph or paragraphs of section 26(2) of the Act,
...
(9) With effect from 1st April 2007 the Commissioners shall not approve the use of a method under this regulation unless the taxable person has made a declaration to the effect that to the best of his knowledge and belief the method fairly and reasonably represents the extent to which goods or services are used by or are to be used by him in making taxable supplies.
(10) The declaration referred to in paragraph (9) above shall—
(a)be in writing,
(b)be signed by the taxable person or by a person authorised to sign it on his behalf, and
(c)include a statement that the person signing it has taken reasonable steps to ensure that he is in possession of all relevant information." (SI 1995/2518, r.102)
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Content of method
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- Direction must not be ambiguous
"It will be observed that, in this respect, my opinion appears to be the reverse of 'the current interpretation' referred to in the letter from the commissioners' surveyor which I have quoted earlier. If the surveyor's 'interpretation' is also tenable I should be forced to the conclusion that the critical sentence in the direction is ambiguous. I entirely agree with Mr Tyre's submission that a direction which is ambiguous cannot be characterised as one which secures a fair and reasonable attribution of input tax. It cannot be fair and reasonable to issue a direction the meaning of which is not clear." (Kwik-Fit (GB) Ltd v. CEC [1998] STC 159 at 164)
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- Overseas supplies carrying a right of recovery may be included
"(1A) A method approved or directed under paragraph (1) above—
[...]
(b)may attribute input tax which would otherwise fall to be attributed under regulation 103 provided that, where it attributes any such input tax, it shall attribute it all...
[...]
(17) In this regulation and in regulations 102A, 102B, 102C and 107, where paragraph (1A)(b) above applies, “taxable supplies” includes supplies of a description falling within regulation 103." (SI 1995/2518, r.102)
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- Exclude supplies from establishment outside UK unless using sector method
"(1A) A method approved or directed under paragraph (1) above—
[...]
(e)must exclude the value of supplies made from an establishment situated outside the United Kingdom where the method is not based on sectors." (SI 1995/2518, r.102)
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"[35] Since the methods of calculation of the proportion constitute a fundamental element of the deduction system, account cannot be taken, in calculating the proportion applicable to the principal establishment of a taxpayer established in a Member State, of the turnover of all of the taxable person’s fixed establishments in the other Member States, without seriously jeopardising both the rational allocation of the spheres of application of national legislation in VAT matters and the rationale of the aforesaid proportion.
...
[40] In the light of all those considerations, the answer to the first question is that Article 17(2) and (5) and Article 19(1) of the Sixth Directive must be interpreted as meaning that, in determining the deductible proportion of VAT applicable to it, a company, the principal establishment of which is situated in a Member State, may not take into account the turnover of its branches established in other Member States." (Le Credit Lyonnais C-388/11)
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- Exclude supplies of capital goods, incidental supplies, self-supplies, removal of goods
"(2) Notwithstanding any provision of any method approved or directed to be used under this regulation which purports to have the contrary effect, in calculating the proportion of any input tax on goods or services used or to be used by the taxable person in making both taxable and exempt supplies which is to be treated as attributable to taxable supplies, the value of any supply of a description falling within regulation 101(3)(a) to (d) and (g) whether made within or outside the United Kingdom shall be excluded." (SI 1995/2518, r.102)
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"(3) In calculating the proportion under paragraph (2)(d) or (g) above, there shall be excluded—
(a) any sum receivable by the taxable person in respect of any supply of capital goods used by him for the purposes of his business,
(b) any sum receivable by the taxable person in respect of any of the following descriptions of supplies made by him, where such supplies are incidental to one or more of his business activities—
(i)any supply of a description falling within Group 5 of Schedule 9 to the Act,
(ii)any other financial transaction, and
(iii)any real estate transaction,
(c) that part of the value of any supply of goods on which output tax is not chargeable by virtue of any order made by the Treasury under section 25(7) of the Act unless the taxable person has imported, acquired or been supplied with the goods for the purpose of selling them,
(d) the value of any supply which, under or by virtue of any provision of the Act, the taxable person makes to himself,
[...]
(g) where a removal of goods is treated as a taxable supply by virtue of paragraph 31A(1) of Schedule 9ZB to the Act, the value of that supply." (SI 1995/2518, r.101)
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- Exempt supplies outside the UK giving a right to deduct
"(2A) Notwithstanding any provision of any method approved or directed to be used under this regulation which purports to have the contrary effect, where the method attributes input tax to exempt supplies specified by the Treasury in an order made under section 26(2)(c) of the Act—-
(a)no attribution is to be made in relation to any supplies that are made within the United Kingdom unless—
(i)the supply is directly linked to the export of goods and the recipient of the goods is located outside the United Kingdom, or
(ii)the supply is between a United Kingdom based intermediary and a United Kingdom based service provider and the recipient of any supply being arranged by the intermediary is located outside the United Kingdom, and
(b)attribution may be made in relation to any supplies that are made within the European Union." (SI 1995/2518, r.102)
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- Rounding
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"[6.7] You must calculate the percentage recovery rate produced in your special method to 2 decimal places." (VAT Notice 706)
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HMRC not required to allow rounding up of the deductible proportion
"[36] The application, when determining the deductible proportion where one of the possibilities open to Member States under Article 173(2) of Directive 2006/112 is implemented, of a rule according to which the deductible proportion obtained must be rounded up to a figure not exceeding the next whole number is contrary to such an objective.
...
[38] It follows from the foregoing that, while the rounding-up rule laid down in Article 175(1) of Directive 2006/112 can be used by a Member State for all calculations of the right to deduct VAT chargeable on the acquisition of mixed use goods or services, including where one of the derogating methods set out in Article 173(2) of that directive is employed, Member States are free not to employ that rule where the right to deduct is calculated in accordance with one of those derogating methods." (Wiedenbrück C-186/15)
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Form of approval/direction
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- Must be in writing and identify itself as approval/direction
"(5) Any approval given or direction made under this regulation shall only have effect if it is in writing in the form of a document which identifies itself as being such an approval or direction." (SI 1995/2518, r.102)
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GENERAL PRINCIPLES FOR METHODS​
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Must reflect actual share of expenditure on mixed use inputs attributable to outputs giving right to deduct
"[52] ...The principle of neutrality, which forms an integral part of the common system of VAT, requires that the method by which the deduction is calculated objectively reflects the actual share of the expenditure resulting from the acquisition of mixed use goods and services that may be attributed to transactions in respect of which VAT is deductible (see, to that effect, judgment of 10 July 2014, Banco Mais, C‑183/13, EU:C:2014:2056, paragraphs 30 and 31)." (VWFS C-153/17)
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Use means economic use
"[34] A fair and reasonable attribution to a taxable supply must, for the purposes of Article 17(2) and (5) of the Sixth Directive and regulation 101(2)(d) of the Regulations, reflect the use of a relevant asset in making that supply. In assessing that use, and its extent, consideration is not limited to physical use. The assessment must be of the real economic use of the asset, that is to say having regard to economic reality, in the light of the observable terms and features of the taxpayer's business." (HMRC v. London Clubs Management Limited [2011] EWCA Civ 1323, Etherton LJ)
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- Physical use may, but need not, reflect economic use
"[36] Warren J accepted ([75]) the submission of counsel for the Commissioners ([63]) that physical use may reflect economic use, but does not necessarily do so, and that any allocation or special method must give a credible result in economic terms." (HMRC v. London Clubs Management Limited [2011] EWCA Civ 1323, Etherton LJ)
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Full apportionment to taxable or exempt may be justified
"[40] ... An examination of the economic use made of particular overheads in the business may show that it is fairer to apportion a larger proportion of them than the standard method would allow to either exempt or taxable supplies; and in some cases it may be right to conclude that the apportionment should be 100% one way or the other. None of this, in my view, is necessarily incompatible with the prior analysis at the attribution stage which led the expenditure in question to the classified as overheads in the first place. A further reason why, always depending on the facts, it may be appropriate to proceed in this way is that it is only in rather an artificial sense that the direct link test is taken to be satisfied in respect of overheads at the attribution stage. The FTT should therefore not be inhibited from examining the economic use made of particular overheads at the apportionment stage, even if it leads to the conclusion that they are largely, or sometimes entirely, used for the purposes of generating particular types of supply. If the facts justify such a conclusion, it would not be a misdirection of law to say that the direct link test is or is not satisfied to the relevant extent, although it would in my respectful opinion promote clarity of analysis and expression if that test were reserved for the earlier attribution stage of the exercise." (HMRC v. Lok'nstore group plc [2014] UKUT 288 (TCC), Henderson J)
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Logic of standard method only holds good where use of overheads by exempt and taxable supplies is broadly the same
"[52] HMRC contend that the level of taxable income to total income is generally a good measure of the economic use of goods and services. The greater the level of taxable income, the greater the economic use of the overhead costs in making taxable supplies. Equally, the greater the level of exempt income, the greater the use of the overhead costs in making exempt supplies. In our view, that proposition only holds good where the relationship between the overhead costs and the income from the taxable and exempt supplies is, broadly, the same. If the costs of goods and services used to make exempt supplies are far greater than the costs of the goods and service used to make taxable supplies then the use of a turnover method would lead to an over recovery of VAT on those costs. In such a case, the economic reality is that the use of goods and services is weighted towards the exempt supplies which cost more to make and consume more of the VAT-bearing overheads." (Lok'nstore Group Plc v. HMRC [2012] UKFTT 589 (TC), Judge Sinfield)
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PESM must guarantee a more precise determination of deductible proportion
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"[51] According to the Court’s case-law, Member States may, as a result of that provision, apply, for a given transaction, a method or allocation key other than the turnover-based method, on condition that the method used guarantees a more precise determination of the deductible proportion of the input VAT than that arising from the application of the turnover-based method (judgment of 8 November 2012, BLC Baumarkt, C‑511/10, EU:C:2012:689, paragraph 24).
[52] Thus, any Member State which decides to authorise or compel the taxable person to make the deduction on the basis of the use made of all or part of the goods and services must ensure that the method for calculating the right to deduct makes it possible to ascertain with the greatest possible precision the portion of VAT relating to transactions in respect of which VAT is deductible..." (VWFS C-153/17)
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"[24] The Sixth Directive does not therefore preclude Member States, when exercising that power, from applying, for a given transaction, a method or allocation key other than the turnover-based method, such as, in particular, that based on the floor area at issue in the main proceedings, on condition that the method used guarantees a more precise determination of the deductible proportion of the input VAT than that arising from application of the turnover-based method." (BLC Baumarkt GmbH C-511/10)
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"[13] It is well-established in the case law of the Court of Justice of the EU that a taxable person can only use a special method "on condition that the method used guarantees a more precise determination of the deductible proportion of the input VAT than that arising from application of the turnover-based method...
[...]
[64] The standard method is the default method: see Article 174 of the Principal VAT Directive and regulation 101(2). It can only be displaced by another method which gives rise to a more precise result (Baumarkt and VWFS). The comparison is therefore weighted: the standard method prevails unless it is displaced. I agree with Mr Donmall and the UT that the standard method, established by the Principal VAT Directive and enshrined in domestic law, can be relied on as giving a result which is fair and reasonable (even if a bit rough and ready). It will only be displaced if the alternative proposed is more precise in its outcome." (Hippordrome Casino Ltd v. HMRC [2025] EWCA Civ 1259, Whipple LJ)
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- Need not be the most precise possible
"[53] In that regard, the Court has nevertheless specified that the method chosen must not necessarily be the most precise possible, but that, as is apparent from paragraph 51 of this judgment, it must be able to guarantee a more precise result than the result which would arise from the application of the turnover-based allocation key (see, to that effect, judgment of 9 June 2016, Wolfgang und Dr. Wilfried Rey Grundstücksgemeinschaft, C‑332/14, EU:C:2016:417, paragraph 33)." (VWFS C-153/17)
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- If proposed method inherently flawed, no need to compare it to the standard method
"[72] In this case, the tribunal was right to start with HCL's proposed alternative. That alternative was challenged by HMRC on grounds that it was inherently flawed and incapable of yielding a fair and reasonable result. If HMRC was right, that really was the end of the case, because HCL's method could not give rise to a more precise outcome than the standard method and the latter prevailed by default." (Hippordrome Casino Ltd v. HMRC [2025] EWCA Civ 1259, Whipple LJ)
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- Unrealistic, anomalous or surprising outcomes may indicate one or other method is not fair
"I agree with [HMRC's] general proposition that, in comparing the suitability and reasonableness of the standard or another existing method with a proposed PESM, unrealistic, anomalous or otherwise surprising outcomes may be a relevant indication that one or other of the methods is not fair or reasonable or not as fair or reasonable as the other method. In the present case, however, I consider that it is impossible to disturb the finding of primary fact by the FTT in [48] of its Decision that the catering activity was carried on as a business in its own right by the respondent and with a view to profit. In view of that conclusion, and for the other reasons I have given, the Decision of the FTT cannot be disturbed. The consequences that follow are governed by legislation." (HMRC v. London Clubs Management Limited [2011] EWCA Civ 1323, Etherton LJ)
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- Only if both methods produce accurate proxies is it necessary to consider which is more accurate
"[33]The FTT then described its task:
“40. The task for this Tribunal is to determine whether the standard method and the proposed PESM produce a fair and reasonable attribution of the supplies on which LnS has incurred VAT to taxable supplies by LnS. That requires us to form a view on whether the methods are accurate proxies for apportionment according to use. If we conclude that both do so, then we must determine whether LnS has established that its proposed PESM is fairer and more reasonable, i.e. a more accurate proxy, than the standard method.
...
"[34] So far, the FTT’s approach to the issue cannot in my judgment be faulted..." (HMRC v. Lok'nstore group plc [2014] UKUT 288 (TCC), Henderson J)
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Fiscal neutrality
"The principle of fiscal neutrality requires, as recalled in paragraph 36 above, that the method by which the VAT deduction is calculated objectively reflects the actual share of the expenditure resulting from the acquisition of mixed use goods and services that may be attributed to transactions in respect of which VAT is deductible. That principle thus precludes a Member State from refusing to accept a change in the method of deducting VAT in a situation such as that at issue in the main proceedings, unless such a change does not make it possible to establish more precisely the proportion of VAT relating to transactions in respect of which VAT is deductible." (CTT - Correios de Portugal C-661/18)
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Must reflect economic reality
"[14] It is further established that a fundamental criterion for the application of VAT, including the deduction of input tax used or to be used in making taxable supplies, is that of economic reality: see Joined Cases C-53/09 and C-55/09 Revenue and Customs Commissioners v Loyalty Management UK Ltd; Baxi Group Ltd v Revenue and Customs Commissioners [2010] STC 2651 at para 39. It follows, and is not in dispute, that any method by which input tax is apportioned to taxable supplies must reflect the economic reality, assessed objectively, of the use of the relevant inputs." (Hippordrome Casino Ltd v. HMRC [2025] EWCA Civ 1259, Whipple LJ)
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PROOF OF USE/REASONABLENESS​
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- Consider what the use of costs is/is not correlated with
"[54(2)] However, where ER products are concerned there is no correlation with the size of the loan and the costs associated with it. Costs associated with the brokering of an ER transaction are driven by the vulnerability of the customer and/or difficulties associated with matching their requirements to appropriate ER products." (KRS Finance Ltd v. HMRC [2023] UKFTT 855 (TC), Judge Malek)
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- Grouping together diverse supplies without evidence they use similar input
"[56] We tend to agree with the Respondents’ submissions in this regard. Firstly, looking at Sector 1 (“Key”) of PESM1, it is clear to us that there is a range of very disparate transactions grouped together under this heading. This would tend to suggest an inherent likelihood that the transactions concerned are not broadly similar, and, therefore the costs attributable to these transactions will differ (or put slightly differently these transactions are unlikely to consume similar amounts of residual input).
[57] Secondly, we agree that there is no objective evidence to support the contention that, in particular, Sector 1 transactions consume, broadly, the same amount of residual input. This part of the Appellant’s case is based upon evidence offered up by way of, what amounts in our view, to assertion or opinion contained in witness statements filed on behalf of the Appellant. It seems to us to be self-evident that where it is sought to be asserted that two transactions take similar amount of staff hours or consume similar amounts of IT resource then these are matters which are capable of being objectively evidenced through use of software or manually recording activity. The Appellant could and ought to have produced such evidence." (KRS Finance Ltd v. HMRC [2023] UKFTT 855 (TC), Judge Malek)
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- Result of marketing costs does not necessarily correlate with inputs used
"[58] Thirdly, we agree that the marketing analysis produced by the Appellant to show that different categories of supplies consume similar marketing costs does not, in fact, do so. The analysis concerns itself with measuring how many transactions have come from a particular piece of advertising. It takes no account of how much input cost was spent in the exercise or how the residual inputs have been utilised." (KRS Finance Ltd v. HMRC [2023] UKFTT 855 (TC), Judge Malek)
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- Consider effect on profitability of allocation
"[60] Lastly, the Respondents argue that PESM1 should be tested against normal operations and that the Appellant’s position on EP supplies lack economic credibility. By economic “credibility” we assume the Respondents to be saying economic “reality”. PESM1 assumes that EP transactions, on average costing the customer £398, consume the same inputs as ER transactions, on average costing the customer £3,619. This renders EP transactions vastly less profitable. Profitability is, in our judgment, an important factor in the context of the present case acting, as it does, like gravity on unrealistic assumptions. Whilst we accept that a business might decide to engage in the sale of services or products which are less profitable as a means, for example, of selling other more profitable services this was not the Appellant’s strategy. Mr. Bibby’s evidence was that EP was not, in fact, used as loss-leading product or service. On the whole there was no cogent explanation or evidence available to show, in the face of the disparity in profit, why it was economically realistic to assume that EP and ER transactions consume the same inputs." (KRS Finance Ltd v. HMRC [2023] UKFTT 855 (TC), Judge Malek)
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- Identifying profitability and potential sources of profit may be important
"[41] That case and the reasoning of the Tribunal, with which I agree, is illustrative of three points of principle. First, it shows the importance in these cases of close attention to the facts in order to understand the economic or commercial reality underlying the use of the relevant VAT inputs. Secondly, identification of the source or potential source of profit in a business may be an important feature of a business throwing light on whether or not the standard method or a PESM is a more fair, reasonable and accurate method of attribution. It all depends on the facts of each case...
...
[83] On the particular facts of the present case, the absence of a realistic expectation that the respondent's catering activity could produce a profit in the foreseeable future if overheads were allocated in accordance with the proposed PSEM would, in my view, be likely to be a critical factor in favour of the existing method and against the proposed PESM. In the absence of such an expectation, I find it difficult to see how, as a matter of economic reality, any significant weight in support of the proposed PESM could legitimately be given to the avowed strategy of the respondent to run the catering activity as a separate business, making a positive contribution towards overheads.
...
[87] As the Commissioners have pointed out, that would not mean that the loss-making catering function did not use any residual costs. Plainly, catering would use some of those costs. The issue is whether, on the hypothetical facts, the more fair, suitable and accurate proxy for attribution of those costs between taxable catering activity and exempt gaming activity would be the existing method, based primarily on the standard turnover method, or the proposed floor space PESM." (HMRC v. London Clubs Management Limited [2011] EWCA Civ 1323, Etherton LJ)
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- Unrealistic numbers used in calculating typical figures
"[65] PESM2 is also criticised by the Respondents, rightly in our view, for adding an economically unrealistic gloss by using the £10,000 minimum release amount as the value of the mortgage when calculating ER income. This runs counter to the evidence that the bulk of the mortgages are for £30,000-£150,000 with an average of £63,677 and does not reflect economic reality.
[66]...The precise profitability of a transaction might not be possible to calculate, but it must be self-evident that using a figure of £10,000 as opposed to, say, £64,000, for the value of the mortgage in the transaction is going to have a significant (distortive) effect on profitability where the income achieved for ER transactions is calculated as a percentage of the value of the mortgage." (KRS Finance Ltd v. HMRC [2023] UKFTT 855 (TC), Judge Malek)
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EXAMPLES ​
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"[6.6] Examples of allocations and apportionments
Some examples are:
-
output values
-
numbers of transactions
-
staff time or numbers
-
inputs or input tax
-
floor area
-
costs allocations
-
management accounts
This is not a full list. If you use any of the examples, you must make sure that the resulting calculation produces a result that is a true reflection of the use to which your input tax is put. The most common apportionment methods are output values and number of transactions, although some of the others can work in some circumstances. However they are more common as allocation methods between business sectors." (VAT Notice 706)
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Sector method
"(1A) A method approved or directed under paragraph (1) above—
[...]
may be based on sectors provided that the method reflects the use made of the goods and services in the business and each sector reflects—
(i)the use made of the goods and services in that sector,
(ii)the structure of the business, and
(iii)the type of activity undertaken by that sector" (SI 1995/2518, r.102)
​
Transaction count method
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- May be appropriate where costs are fairly constant whatever the value of the transaction
"Transaction counts tend to be appropriate where the supplies and the related input tax are incurred in the same tax year and where the costs involved are fairly constant whatever the value of a supply. It is a commonly used apportionment method in the finance sector. The costs involved are often fairly constant, whatever the value of shares traded, loans made, etc. Similar examples occur throughout the finance sector, and indeed in many other sectors." (PE23000)
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- Identify what will be treated as transaction clearly
"Usually this involves counting the number of supplies made, rather than the value of those supplies. However, other ‘numbers of things’ might also be appropriate to count. For example, when considering residual input tax in respect of a landlord, the number of buildings where a taxable rental is charged divided by total number of buildings rented out.
...
When approving a transaction-based method, it is essential that both parties agree what will or will not be treated as a transaction, and that this is set out unambiguously in the special method approval letter. There are no simple answers as to what should be considered a transaction and what should not, it will depend on the supplies made, and how costs are used in making them." (PE23000)
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- Not appropriate where it assumes that diverse output use the same inputs
"[56] We tend to agree with the Respondents’ submissions in this regard. Firstly, looking at Sector 1 (“Key”) of PESM1, it is clear to us that there is a range of very disparate transactions grouped together under this heading. This would tend to suggest an inherent likelihood that the transactions concerned are not broadly similar, and, therefore the costs attributable to these transactions will differ (or put slightly differently these transactions are unlikely to consume similar amounts of residual input).
[57] Secondly, we agree that there is no objective evidence to support the contention that, in particular, Sector 1 transactions consume, broadly, the same amount of residual input. This part of the Appellant’s case is based upon evidence offered up by way of, what amounts in our view, to assertion or opinion contained in witness statements filed on behalf of the Appellant. It seems to us to be self-evident that where it is sought to be asserted that two transactions take similar amount of staff hours or consume similar amounts of IT resource then these are matters which are capable of being objectively evidenced through use of software or manually recording activity. The Appellant could and ought to have produced such evidence." (KRS Finance Ltd v. HMRC [2023] UKFTT 855 (TC), Judge Malek)
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- Different types of transaction can be weighted differently
"It should be noted that transaction counts can be weighted, such that if, for example, supply A uses four times the input tax bearing costs of supply B, each occurrence of supply A will count as 4 transactions and each supply B will count as 1 transaction." (PE23000)
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Adjusted income methods
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- Capped income approach
"Where there is the likelihood of large, distortive supplies that nevertheless use significant amounts of residual input tax, a sensible approach is to ‘cap’ the value of supplies at a level so that the method still gives a fair and reasonable result. For instance, treating any supply exceeding £10,000 as though it was £10,000 for the purpose of the calculation." (PE23000)
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- Rejected where method grouped diverse outputs together and unrealistic income assumption made
"[63] The basis of calculation of PESM2 is set out in the proposal dated 8 March 2021. The proposal continues to take a transaction based approach but seeks, it is said, to remove the distortion arising from the disconnect between the value of the income calculated by reference to the value of the advance and the costs used to originate (M2L) and broker (KRS) the advance. The distortion is removed by assuming that each advance generates the same LSP for M2L and procuration fee/customer fee for KRS. The income for each being determined by reference to the minimum transaction permitted by funders and a median average LSP, procuration and customer fee as relevant.
[64] We agree with the Respondents when they say that the adjustments made to PESM2 do not cure any of the fundamental defects identified with PESM1 and set out above. For example, PESM2 continues to use a transaction based approach grouping together a diverse range of transactions absent any objective evidence that the transactions in each sector consume broadly the same inputs.
[65] PESM2 is also criticised by the Respondents, rightly in our view, for adding an economically unrealistic gloss by using the £10,000 minimum release amount as the value of the mortgage when calculating ER income. This runs counter to the evidence that the bulk of the mortgages are for £30,000-£150,000 with an average of £63,677 and does not reflect economic reality." (KRS Finance Ltd v. HMRC [2023] UKFTT 855 (TC), Judge Malek)
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Input based method
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- Appropriate where costs incurred in different year to supplies to which they relate (e.g. property developr)
"These calculations are most commonly used where costs involved in making supplies are normally incurred in a different tax year than the year the supplies are made. To be able to produce a fair and reasonable result:
there must be directly attributable costs incurred relating to both taxable and exempt supplies;
a significant proportion of the costs must be directly attributable; and
the directly attributable costs must be incurred in about the same proportion as the residual input tax is used to make taxable and exempt supplies.
A property developer is a good example of a business for which such a method may produce a fair and reasonable result. The majority of residual input tax is likely to be incurred on staff supporting costs relating to the management of the various projects. The greater the costs relating to a project, the more time is likely to be spent managing it and thus the more residual input tax bearing costs relate to it.
Rather than costs, directly attributable input tax may be a more appropriate calculation, although this will not be the case if there are substantial exempt and / or zero-rated supplies received, or where one or both liabilities of supply is labour intensive." (PE23000)
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Floor space method
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- Where residual costs are mainly property related
"This is apportionment in the same ratio as the floor space occupied by income generating staff involved exclusively in making taxable supplies bears to the total floor space of income generating staff.
This is most likely to produce a fair and reasonable result where the residual input tax bearing costs relate primarily to buildings, such as taxable rent incurred, heating, lighting, fixtures and fittings. In order to reflect use, it requires that specific areas be used for supplies of a particular liability and that these represent the predominant proportion of the floor area...
...
When considering a floor space calculation, you should satisfy yourself that the business has correctly identified directly attributable floor space. For instance, shops that sell taxable goods and exempt insurance on those goods often claim the display areas relate only to the taxable supplies. In fact, these areas are also used to make exempt supplies, since the intention in displaying the goods is to make both types of supply. The exempt insurance could not be sold if the goods themselves were not displayed. This means that very little floor space is directly attributable and the method is unlikely to produce a meaningful result. Accordingly floor space calculations are rarely fair and reasonable for the retail sector." (PE23000)
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- Flawed where premised on exclusive use of areas, but actually dual use (e.g. hospitality areas used to support gaming)
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"[182] In reality, although the Hippodrome had a commercial drive to provide hospitality and entertainment, we have found the core part of HCL's business at the premises is gaming, and the other hospitality and entertainment facilities were also used for it. They significantly supported that core business activity and were used to provide the venue with a luxury environment designed to ensure it remained not only competitive but retained a competitive advantage in the gaming industry.
...
[186] We have accepted that the SMO is critically flawed as HMRC claim. Whilst the premise of the floorspace SMO was that the gaming business was entirely separate, for the reasons that we have already set out, that was not the economic reality. We find that here, there is substantial dual use such that the residual costs were incurred to facilitate the taxable supplies of hospitality and entertainment and the exempt gaming supplies." (HMRC v. Hippodrome Casino Ltd [2024] UKUT 27 (TCC), Judge Rupert Jones and Judge Mandalia)​
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- Flawed where floorspace used to make exempt supplies produces far more income and costs
"[17] In our view the Special Method does not achieve a fair and reasonable result. This is for a number of reasons, including the following. It achieves something over a 70% level of recovery when half the building is used to make exempt supplies. Further, the area used to make exempt supplies produces considerably more income and turnover and seemingly costs than the rest of the building. The tenant was responsible for the interior repairs, maintenance and decoration of the demised premises. There did not appear to be any other significant costs. We were not provided with any evidence of such costs. The proposed Special Method allowed even more recovery than a sectorised method. It does not reflect the economic use of the building. We find this as a fact.
We find that the Special Method proposed by the Partnership did not achieve a fair and reasonable attribution and was not a fair and reasonable method. Further it did not accord with the economic use approach of Warren J in the St Helen's case. It was a nice attempt by the Partnership to maximise their input tax recovery. However, objectively it was not fair and reasonable and we so find." (Farnham Physiotherapy and Sports Clinic v. HMRC [2007] UKVAT V20004, Judge Shipwright)
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- Storage space may be dual use to produce rent and insurance income
"[56]...It is said that the business was in effect a unitary one, which inevitably provided the opportunity to earn income from the making of exempt insurance supplies to a predictable percentage of customers. Viewed in this way, the storage space has a dual function to perform in the economy of the business, and it is unrealistic to ignore the part played by the storage space in the generation of insurance income.
[57] This is, to my mind, an attractive way of looking at the problem, and (if adopted) it would prima facie justify use of the standard method for the apportionment of overheads. But I feel quite unable to say that it is the only reasonably possible way of looking at the matter, or that the taxable floor space PESM proposed by LnS could not legitimately be preferred to it. For example, a powerful point which might have weighed with the FTT is the fact that the insurance charge related only to the value of the goods stored. It bore no relation to the amount of storage space occupied by the goods, nor did it involve any element of insurance of the premises. If the matter is viewed in this way, there is no obvious economic link between the insurance charges and the relevant storage space, and it is arguably more realistic to concentrate on the part of the premises in which the insurance is actually sold. On that approach, there is in my view no obvious flaw in the PESM proposed by LnS, and although the percentage (0.02%) of chargeable overheads apportioned to exempt supplies of insurance does at first sight look remarkably low, it must again be remembered that the bulk of the overheads attributable to the sale of insurance was composed of non-chargeable salaries." (HMRC v. Lok'nstore group plc [2014] UKFTT 288 (TCC), Henderson J)
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Staff time method ​
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- Where inputs relate to supporting staff and time recorded for another purpose
"Common residual input tax bearing costs are those that support staff, such as computers, lighting, heating, rental, telephones and training. Staff time spent on different activities is in theory a very good method of apportioning these types of costs.
However, staff time based methods are only appropriate where the staff record their time for purposes other than partial exemption calculations and the liability of the supplies they are working on can be identified. For example, solicitors and accountants will record time regularly on time sheets for fee accuracy, but most other businesses will not.
For these reasons, staff time is rarely a fair and reasonable method of attributing input tax, often being both difficult to operate and impossible to verify." (PE23000)
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Head count method ​
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- Significant proportion of staff employed in areas making supplies of one liability only
"A headcount method is similar to the staff numbers allocation method and has a similar effect to the using of staff time. However, it can be used by a business that does not keep time sheets. It is most likely to give a result that reflects the use of the input tax in the same circumstances as for staff time, but only where a significant proportion of staff are employed in areas that are involved in making supplies of only one liability." (PE23000)
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OPERATION AND DISCONTINUANCE ​
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Inaccurate operation of PESM implicitly approved by HMRC
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"[179] A person with a much greater knowledge of VAT and the working of HMRC may well have concluded on balance that HMRC were happy with DFS’ treatment of exempt inputs because it would in our view be reasonable for such a person to suppose that a reasonably competent officer would have been aware of the exempt income and would have considered whether input VAT should be blocked. Such a person (and indeed a person with reasonable VAT knowledge and only a general acquaintance with HMRC’s workings), however, would have been puzzled by HMRC’s failure to raise the issue and could reasonably have been expected to have put the matter squarely before HMRC.
[180] In our view HMRC had enough knowledge of relevant facts to have been able on reasonable investigation to conclude from 1999 that DFS’ exempt input tax was not being computed in accordance with either the applicable standard method or the Hanson method." (DFS Furniture Company Limited v. HMRC [2009] UKFTT 204 (TC), Judge Hellier, but see now, above, the requirement for written approval identifying itself as such)
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T must continue using PESM unless HMRC approve/direct termination
"(3) A taxable person using a method as approved or directed to be used by the Commissioners under paragraph (1) above shall continue to use that method unless the Commissioners approve or direct the termination of its use." (SI 1995/2518, r.102)
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- Joining VAT group held not to terminate PESM
"[2] On 1 May 2014 it joined a VAT group. HMRC’s position was that, in consequence, it was necessary for it to agree a revised PESM. Shortly afterwards the appellant’s accountants proposed a new PESM which was substantially, though we think not wholly, the same as the old method. HMRC did not consider that the proposed method would lead to a fair and reasonable rate of recovery of allowable input tax and they accordingly rejected the proposal, a rejection which was upheld on review. It was that rejection which led to the appeal before us.
...
[4] In those circumstances it seemed to us that the appeal had reached us on a false premise. The appellant still has an operative PESM which it is obliged to continue to use, also by virtue of reg 102(3), until HMRC approve or direct the termination of its use. It is, we assume, content to continue to use that PESM, since it embarked on the attempt to agree a replacement only because of HMRC’s contention that it was necessary to do so and, as we have said, the proposed replacement is materially the same as the method currently used." (Dynamic People Limited v. HMRC [2016] UKFTT 229 (TC), Judge Bishopp)
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- Termination direction takes effect prospectively only
"(4) Any direction under paragraph (1) or (3) above shall take effect from the date upon which the Commissioners give such direction or from such later date as they may specify." (SI 1995/2518, r.102)
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- HMRC may not terminate if consequence will require use of less satisfactory method
"[129] Regulation 102 does not in terms impose any fetter upon the termination by the Commissioners of an agreed or directed Special Method, and the terms of most agreed methods (including the 1999 Agreed Method) are such as to enable them to be terminated by the Commissioners without breach of contract. But in Banbury Visionplus Ltd v HM Revenue and Customs [2006] EWHC 1024 (Ch) Etherton J. held that the Commissioners could not validly terminate a Special Method, if the consequence of termination was to require the taxpayer to adopt a less satisfactory method in its place. He held that the VAT Tribunal had a full appellate jurisdiction to determine whether a decision of the Commissioners under Regulation 102 "substitutes, in place of an existing method, a method which secures, or at least better secures, a fair and reasonable attribution of input tax to taxable supplies for the purposes of s.26(3) of the 1994 Act".
...
[144] ... The termination of the 1999 Agreed Method did not require MBNA to adopt an attribution which was less fair and reasonable than the Agreed Method itself. That attack on the validity of its revocation therefore fails." (MBNA Europe Bank Limited v. HMRC [2006] EWHC 2326 (Ch), Briggs J)
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T makes supplies not covered by the PESM: recover according to use
"(6) Where a taxable person who is using a method which has been approved or directed under this regulation incurs input tax of the description in paragraph (7) below, that input tax shall be attributed to taxable supplies to the extent that the goods or services are used or to be used in making taxable supplies expressed as a proportion of the whole use or intended use.
(7) The input tax referred to in paragraph (6) above is input tax—
(a)the attribution of which to taxable supplies is not prescribed in whole or in part by the method referred to in paragraph (6) above, and
(b)which does not fall to be attributed to taxable or other supplies as specified under regulations 103, 103A or 103B.
(8) Where the input tax specified in paragraph (7)(a) above is input tax the attribution of which to taxable supplies is only in part not prescribed by the method, only that part the attribution of which is not so prescribed shall fall within that paragraph." (SI 1995/2518, r.102)
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Retrospective override where T knew/ought to have know PESM did not fairly represent use
"(11) Where it appears to the Commissioners that a declaration made under this regulation is incorrect in that—
(a)the method does not fairly and reasonably represent the extent to which goods or services are used by or are to be used by the taxable person in making taxable supplies, and
(b)the person who signed the declaration knew or ought reasonably to have known this at the time when the declaration was made by the taxable person,
they may subject to paragraph (12) below serve on the taxable person a notice to that effect setting out their reasons in support of that notification and stating the effect of the notice.
(12) The Commissioners shall not serve a notice under this regulation unless they are satisfied that the overall result of the application of the method is an over-deduction of input tax by the taxable person.
(13) Subject to paragraph (14) below, the effect of a notice served under this regulation is that regulation 102B(1) shall apply to the person served with the notice in relation to—
(a)prescribed accounting periods commencing on or after the effective date of the method, and
(b)longer periods to the extent of that part of the longer period falling on or after the effective date of the method, save that no adjustment shall be required in relation to any part of any prescribed accounting period,
unless or until the method is terminated under regulation 102(3).
...
(15) The service of a notice on a taxable person under this regulation shall be without prejudice to the Commissioners’ powers to serve a notice on him under regulation 102A and any notice served under regulation 102A shall take priority in relation to the periods which it covers." (SI 1995/2518, r.102)
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- No time limit on assessments
"(14) In relation to any past prescribed accounting periods, the Commissioners may assess the amount of VAT due to the best of their judgement and notify it to the taxable person unless they allow him to account for the difference in such manner and within such time as they may require." (SI 1995/2518, r.102)
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Change in factors used to calculate deduction (e.g. supply cancelled)
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- Tax authority arguing that output it previously said was exempt is taxable amounts to change of circumstances
"[50] The adjustment mechanism provided for in Articles 184 to 186 of the VAT Directive aims to establish a close and direct relationship between the right to deduct input VAT and the use of the goods or services concerned for taxable output transactions (judgment of 27 March 2019, Mydibel, C‑201/18, EU:C:2019:254, paragraph 27). Calling into question the exemption of postal bill-payment services had the effect of breaking that close and direct relationship between the right to deduct input VAT and the use of the goods or services concerned for taxable output transactions. Therefore, the calling into question of that exemption for the period from 2013 to 2015 brought about a change, within the meaning of Article 185 of the VAT Directive, of one of the factors initially taken into consideration when calculating the amount to be deducted. It follows that CTT was entitled to an adjustment pursuant to Article 184 of that directive (see, by analogy with a transaction incorrectly regarded as subject to VAT but in fact exempt, judgment of 11 April 2018, SEB bankas, C‑532/16, EU:C:2018:228, paragraph 39)." (CTT - Correios de Portugal C-661/18)
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- No rounding of adjustment calculation unless adjustment applied to original calculation
"[51] In the light of all the foregoing, the answer to the second question is that Article 184 et seq. of Directive 2006/112 must be interpreted as meaning that the Member States are required to apply the rounding-up rule laid down in Article 175(1) of that directive in the event of adjustment where, under their national legislation, the deductible proportion has been calculated in accordance with one of the methods set out in Article 173(2) of that directive or in the third subparagraph of Article 17(5) of the Sixth Directive, only where that rule was applied to determine the initial amount of the deduction." (Wiedenbrück C-186/15)
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