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Claiming pre-registration input VAT

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HMRC’s policy on the recovery of input VAT on pre-registration expenditure seems to have changed without any warning or consultation. A lively discussion online has brought this issue to the forefront, with a number of advisers confirming that HMRC is actively assessing for pre-registration input VAT that it believes has been over-claimed. The new policy apparently requires an apportionment of the input VAT for goods and services on hand at the time of registration, although this is not reflected in the legislation. HMRC’s view is flawed. It may be a literal view of the EU law, but the apportionment is neither reflected in UK legislation nor in case law.

When I mention my days as a VAT officer with HM Customs and Excise, my children roll their eyes and say ‘back when the dinosaurs roamed the earth’. They do, to some extent, have a point; those days were nearly 30 years ago.
However, in the context of this article, the experience has come in handy. As a young officer, I carried out mainly ‘000’ visits. For readers not familiar with this term, these were visits to newly registered businesses and took place between 12 and 18 months of registration. Pre-registration input VAT was, therefore, one of the areas that I frequently checked. I can clearly remember my training and the public and internal guidance available on the matter.
So why this trip along memory lane? It seems that the position on pre-registration input VAT – as I and others believed it to be – has changed recently. The change was not publicised and there was no transitional phasing in. HMRC is now instructing officers to apportion the VAT according to the use before and after registration. But is this within the law?
Under the existing rules, a number of conditions must be met in order for pre-registration VAT to be eligible for reclaim; and the rules are different for goods and for services. Goods must be on hand at the date of registration and must have been purchased in the preceding four years; while for services, the time limit is six months. For both goods and services, the VAT must not be ‘blocked’ elsewhere (e.g. input VAT on cars and business entertaining). If all of these conditions were met, and assuming that a business is fully taxable, most advisors used to be of the view that the VAT was reclaimable in full. In cases where the business was partly exempt or had non-business activities, it may have been necessary to restrict recovery under a partial exemption/non-business method.

Contradictory guidance

This adviser view is reflected in VAT Notice 700, para 11.1, which states: 
‘VAT paid on goods and services that you received before you were registered for VAT is not input tax. However, when you become registered you can treat this VAT as though it were input tax if you hold acceptable evidence (see para 19.7) and can meet the conditions set out below. You may only recover VAT you incurred before registration which is attributable to making taxable supplies. The partial exemption de minimis limits (see para 13.1) do not apply to VAT incurred before registration. Special rules apply if you become registered as a result of having exercised an option to tax for certain property transactions.’
VAT Notice 700 paras 11.2 and 11.3 go on to explain the criteria for claiming the VAT, so it looks like this supports full VAT recovery. This would be the guidance that a taxpayer would turn to when deciding whether or not the VAT is recoverable.
In addition, the section on the front page of HMRC’s VAT website says: 
‘There’s a time limit for backdating claims for VAT paid before registration. From your date of registration the time limit is:
  • four years for goods you still have, or that were used to make other goods you still have
  • six months for services
You can only reclaim VAT on purchases for the business now registered for VAT. They must relate to your “business purpose”. This means they must relate to VAT taxable goods or services that you supply.’
Again, there is no hint that the VAT may not be recoverable in full. 
However, contrast this with HMRC’s guidance in its VAT Input Tax Manual at VIT32000, which officers are now following and using to issue assessments to restrict the VAT recoverable on pre-registration costs:
‘Where a business buys goods or services before it registers for VAT to support taxable business activities it can recover the tax provided that:
  • in the case of goods (either stock for resale or fixed assets), the goods remain on hand at the date of registration and will be used in the newly registered business. These goods must have been bought within the capping limits that are set out in reg 111.
  • in the case of services, the supply was made not more than six months before the date of registration. Six months represents a period in which it is deemed that services obtained will relate to business activity carried on at the time of registration…’
It goes on to state:
‘The amount of tax that can be recovered is the amount that would have been deductible had the business been registered at the time the tax was incurred. You should consider partial exemption and non-business restrictions when you calculate the amount of tax to claim. Please note that the partial exemption de minimis limit does not apply to VAT incurred pre-registration.
‘You must also take into account any use that has been made of the goods or services prior to registration. For example, a business that is trading below the registration threshold acquires a van. After three years the business registers for VAT. The van is still on hand at the effective date of registration. The van has been used to make supplies that were not subject to VAT. The amount of VAT that can be recovered under regulation 111 should reflect the use of the van for making supplies before registration.’
This guidance itself seems to be contradictory. It states that the taxpayer should be put in the same position as if it had been registered when the VAT was incurred, taking into account non-business and exempt supplies. However, the subsequent paragraphs state that only the proportion of VAT relating to the taxable supplies post registration is recoverable, which seems at odds with this concept.

The legislation

What does reg 111 of the VAT Regulations, SI 1995/2518, say?
‘(1) Subject to paragraphs (2) and (4) below, on a claim made in accordance with paragraph (3) below, the Commissioners may authorise a taxable person to treat as if it were input tax:
‘(a) VAT on the supply of goods or services to the taxable person before the date with effect from which he was, or was required to be, registered, or paid by him on the importation or acquisition of goods before that date, for the purpose of a business which either was carried on or was to be carried on by him at the time of such supply or payment; ...’
There is no mention in reg 111 of an apportionment of the VAT between the period prior to registration and the period after. Rather this confirms the position that the taxpayer is entitled to recover the VAT to the extent that they would have been entitled to, if they had been registered at the time the cost was incurred.
I raised this with the Joint VAT Consultative Committee (JVCC) earlier this year. Its response was that reg 111 was based on art 289 of Directive 2006/112/EC, the Principle VAT Directive (PVD). Article 289 says: 
‘Taxable persons exempt from VAT shall not be entitled to deduct VAT in accordance with articles 167 to 171 and arts 173 to 177…’
In fact, HMRC seems to be relying on art 286, as well. This refers to a taxpayer being exempt if it is trading under the VAT threshold in a member state. It seems that HMRC is using the term ‘exempt’ to mean that a taxpayer is making exempt supplies when trading under the threshold; and, therefore, the VAT incurred should be apportioned to reflect this.
However, this does not stack up. VATA 1994 Sch 1 para 1 refers to the taxpayer’s ‘taxable supplies’ exceeding the VAT threshold. If HMRC’s argument is to be believed, the taxpayer is making exempt supplies at this point and would not be required to register for VAT. Following that logic, there would never be a requirement to register for VAT, as a person only making exempt supplies cannot do so. 
HMRC cannot have it both ways.
Although the interpretation of arts 282 and 289 is quite literal, it does not seem to be within the spirit of the law. Article 286 is a simplification for the purposes of small businesses and art 289 refers to the non-deductibility of input tax relating to exempt supplies in general.

Case law

What does case law have to say on the matter? In the case of Denise Jerzynek v HMRC (2004) VTD 18767, the tribunal was quite clear that no apportionment was allowed under reg 111. HMRC’s internal policy at the time was referred to and no apportionment was mentioned in the guidance. 
In the more recent case of Earl Redway v HMRC [2015] UKFTT 418 (TC), there was no dispute over the VAT that was allowed on the goods on hand at the time. One can only assume that there had been no disallowance of VAT in this case, as the taxpayer had no argument with this amount.

What does this leave us? 

So, where does this tie in with the time of the dinosaurs? Well, at the most recent JVCC meeting, the HMRC policy unit stated that the apportionment had been the policy for the last 25 to 30 years. In an ‘I am Spartacus’ moment, I and several others responded that we had been officers or advisers at that time and it was not the case. 
HMRC’s view is quite obviously flawed. It may be a literal view of the EU law, but is it necessarily correct? The apportionment is neither reflected in the UK legislation nor in case law. Therefore, should any such assessment be received, it should be challenged vigorously. There is a case going through the tribunal system at the moment; it is not due to be heard in the near future, but it will give a case that any appeal could be stood behind.
In the meantime, we need to keep chipping away at the dinosaur that is HMRC’s policy. I shall be raising it again at the JVCC. The policy is flawed and unlawful.
The views expressed in this article are those of the author and not necessarily those of Grant Thornton UK LLP.
Issue: 1277
Categories: Analysis , VAT , input tax , VAT , VAT recovery , VAT refunds