St Helen's School Northwood Ltd v Revenue & Customs

This is an appeal from the decision dated 7 February 2006 (“the Decision”) of the VAT & Duties Tribunal (Stephen Oliver QC and Catherine Farquharson ACA) (“the Tribunal”). The case concerns a claim by St Helen’s School Northwood Ltd (“the School”) to deduct 54% of the VAT payable on the cost of construction of a sports complex, the construction cost of which was £2,635,013 including a VAT element of £454,921. The School applied to use a “partial exemption special method” which produced that result; that application was rejected by HMRC (“Customs”) in a letter dated 3 February 2005. Following a voluntary disclosure, to which a separate decision referred to below was given, the VAT was reduced by a small amount. The School then applied to use a “standard method override”. By a separate decision letter dated 22 November 2005, that application was rejected by Customs.

The Tribunal’s summary of the facts is set out in paragraphs 4 to 22 of the Decision. For completeness, I set out that summary in the Appendix to this Judgment. I would make these additional observations:

The UK legislation to which I come in a moment implements the provisions of the First Council Directive (67/227/EC) of 11 April 1967 and the Sixth Council Directive (77/388/EC) of 17 May 1977 and must be construed in the light of those Directives.

As the First Directive, Article 2 includes the following:

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

As to the Sixth Directive, Article 2, so far as relevant, subjects to value added tax “the supply of goods or services effected for a consideration….by a taxable person acting as such.” Under Article 4(1), a taxable person is a person who independently carries out any economic activity within Article 4(2) whatever the purpose or results of that activity. The economic activities referred to comprise, under Article 4, all activities of producers, traders and service providers.

Deduction is dealt with under Article 17: Article 17(2) allows deduction in respect of inputs “used for the purpose of his taxable transactions”; and under Article 17(5), there is to be an apportionment in the case of mixed use both for transactions in respect of which VAT is deductible (ie taxable transactions) and transactions in respect of which VAT is not deductible. It then provides that “such proportion….shall be deductible as is attributable to the [taxable] transactions”.

The default method of attribution is found in Article 19(1). It is in effect the fraction A/B where

However, Article 17(5) also provides that Member States may make certain other specified provisions as set out in paragraphs (a) to (e): paragraph (c) provides that a Member State may authorise or compel a taxable person to make the deduction on the basis of the use (a term which is not defined) of all or part of the goods or services.

The relevant domestic legislation is found principally in sections 24, 25 and 26 Value Added Tax Act 1994 (“VATA”) and in Regulations 101 and 102 of the Value Added Tax Regulations 1995 (SI 1995 No 2518) (“the Regulations”). Reference will also need to be made to section 83 VATA and to some of the later Regulations.

Section 24 VATA defines input tax as tax on the supply to a taxable person of goods or services used for the purposes of a business carried on or to be carried on by him. Thus, tax on supplies to a taxable person of goods or services which are not used for the purposes of a business is not input tax as defined. Section 24(5) provides for apportionment in cases of mixed use for business and non-business purposes; only so much as is referable to business purposes counts as input tax. The section uses the concept of business whereas the provisions of the Sixth Directive which I have referred to focus on economic activities but they come to the same thing.

Section 25 provides that a taxable person is entitled, at the end of each accounting period, to credit for so much of his input tax as is allowable under section 26. Section 26 contains the provisions which describe the input tax allowable under section 25 and, so far as relevant to this appeal, makes it clear that the only input tax allowable is that which is attributable to taxable supplies made by the trader in the furtherance of his business and not to exempt supplies. Section 26(3) provides in effect that, where a taxable person makes both taxable and exempt supplies, the Commissioners shall make regulations for securing a fair and reasonable attribution of input tax to taxable supplies. They have done so in the form of the Regulations.

Regulation 101 provides that the amount of input tax which a taxable person is entitled to deduct is the amount attributable to taxable supplies. This is calculated by attributing to taxable supplies by the trader the whole of the input tax on supplies to the trader used or to be used exclusively in making taxable supplies; by providing that no part of the input tax on supplies used or to be used by the trader exclusively in making exempt supplies by him is attributable to taxable supplies by him; and by providing that, where supplies to the trader are used or to be used by the trader in making both taxable and exempt supplies by him, the amount of the input tax attributable to taxable supplies by him is the proportion of the input tax on supplies to him used to make both taxable and exempt supplies which the value of the taxable supplies bears to the total value of taxable and exempt supplies. Input tax on supplies to the trader used to make both taxable and exempt supplies by him is called residual input tax. This method of apportioning residual input tax between taxable and exempt supplies is known as the standard method.

Regulation 102 provides for the use of methods of attribution other than the standard method. Customs may either approve or direct the use of such an alternative method which, in accordance with the statutory objective under section 26(3), is directed at achieving a fair and reasonable attribution when the standard method does not do so, or at least a fairer and more reasonable attribution than the standard method.

I should mention Regulations 102A and 102B. Regulation 102A applies where a special method is in operation but does not fairly and reasonably represent “the extent to which good or services are used” by the taxable person “in making taxable supplies”. Regulation 102B then requires the taxable person to calculate the difference between the attribution made according to the special method in force and an attribution which “represents the extent to which the goods or services are used” by the taxable person “in making taxable supplies”. So one sees in both Regulations the same wording referring to “use” of goods and services in “making taxable supplies”.

Regulations 107A to 107E provide for an override of the standard method in certain circumstances. Regulations 107A and 107B apply, using similar words to Regulations 102A and 102B, where the standard method results in an attribution which “differs substantially from one which represents the extent to which the goods or services used” by the taxable person “in making taxable supplies”.

What one can conclude from this is that the UK legislation envisages the “fair and reasonable” attribution of input tax on goods and services to taxable supplies to reflect the extent of the use of those goods and services in making taxable supplies, an approach which is consistent with the Sixth Directive. The standard method can be viewed in one way as a proxy for an apportionment according to the relative uses (whatever that word may mean) in making exempt and taxable supplies.

The jurisprudence of the ECJ establishes that there must be a “direct and immediate link” between the goods in question (ie those in respect of which input tax, or some of it, is sought to be deducted) and the taxable outputs of the taxable person: see for instance BLP Group plc v C&E Comrs [1996] 1 WLR 174 and Midland Bank plc v C&E Comrs [2000] STC 501. This aspect is also connected with the “cost component” concept articulated in Article 2 of the First Directive. Thus, in Midland Bank, the ECJ said this:

"29.

It should be borne in mind that, according to the fundamental principle which underlies the VAT system, and which follows from art 2 of the First and Sixth Directives, VAT applies to each transaction by way of production or distribution after deduction of the VAT directly borne by the various cost components

30.

It follows from that principle as well as from the rule enshrined in the judgment of [BLP] para 19, according to which, in order to give rise to the right to deduct, the goods or services acquired must have a direct and immediate link with the taxable transactions, that the right to deduct the VAT charged on such goods or services presupposes that the expenditure incurred in obtaining them was part of the cost components of the taxable transactions. Such expenditure must therefore be part of the costs of the output transactions which utilise the goods and services required. That is why those cost components must generally have arisen before the taxable person carried out the taxable transactions to which they relate.”

As it is put by Jonathan Parker LJ in Dial-a-Phone v C&E Comrs [2004] STC 987, at paragraph [28]

“…..in applying the ‘used for’ test prescribed by art 17(2) of the Sixth Directive the relevant inquiry is whether there is a ’direct and immediate link’ between the input cost in question and the supply or supplies in question; alternatively whether the input cost is a ‘cost component’ of that supply or those supplies. [Underline emphasis supplied] It is clear from the judgments of the ECJ in BLP and Midland Bank, as I read them, that there is no material difference between these alternative ways of expressing the basic test.”

Thus there are two separate tests but each is reflective of the other and they come to the same thing: the one seeks a direct and immediate link between the goods or services acquired and the output transactions giving rise to the right to deduct; the other seeks to identify the cost of acquiring those assets as a cost component of the output transaction.

At paragraph [71] Jonathan Parker LJ deals with attribution in this way:

“The word ‘attributable’ and ‘attributed’ in reg 101 fall to be interpreted by reference to art 2 of the First Directive and art 17 of the Sixth Directive, and in accordance with the principles enunciated by the ECJ in BLP and Midland Bank. Those authorities establish that the appropriate test of attributability in this context is the ‘direct and immediate link’/’cost component’ test referred to in [28] above……Moreover, as the ECJ made clear,,,,,, it is for the national courts to apply [that] test to the facts of the case, ‘and to take account of all the circumstances surrounding the transaction at issue’.”

Then, at paragraph [74] he observed that “the quest is not for the closest link, but for a sufficient link”, referring to paragraph 35 the opinion of the Advocate General (Jacobs) in Abbey National plc v C&E Comrs [2001] 1 WLR 769 set out at paragraph [29] of his Judgment.

It should also be mentioned for completeness, that overhead costs of a business which cannot be attributed to any particular supplies (whether exempt or taxable) are nonetheless cost components of supplies and thus deductible in whole or in part: see Midland Bank, Abbey National and also the decision in Kretztechnik AG v Finanzamt Linz Case C-465/03 [2005] STC 1118. Since they are cost components of the supplies, there is the necessary direct and immediate link.

Mr Thomas, who appears for the School, referred me to European Commission v France Case C-50/87 [1988] ECR 4797. That decision of the ECJ shows that the right to recovery of input tax cannot be restricted by national legislation so that if there is the necessary direct and immediate link between an input and a taxable output is established, it is not admissible, by reference to other criteria, to restrict the right to recover the input tax. In that case the ECJ held invalid a provision of French law which restricted the amount of input tax on the acquisition of land which was recoverable in respect of letting the land when the annual rent was less than a specified proportion of the vale of the land.

I was referred also to C&E Comrs v Southern Primary Housing Association Ltd [2004] STC 209 (“Southern Primary”). Adopting the summary of this case found in the judgment of Hart J in The Mayflower Theatre Trust Ltd v HMRC [2006] EWHC 766 (31 March 2006), input tax had been incurred by the taxpayer on its acquisition of certain land. It had then sold the land (an exempt supply) to a housing association and, simultaneously, entered into a development contract with the housing association under which it made taxable supplies. The question was whether the inputs were sufficiently connected to the taxable outputs to enable them to be deducted in their totality. Hart J observed that no question seems to have arisen as to the possibility of treating the inputs as overheads and thus apportionable. Both the Tribunal and, on first appeal, the High Court held that there was a sufficient link, essentially because the sale of the land and the entering into the development contract were part of one overall commercial transaction. On appeal to the Court of Appeal, Customs argued that the decisions below had wrongly:

"(a)

focused on the taxpayer's overall commercial aim; (b) treated the two separate supplies as if they were one; (c) asserted that the question whether two supplies are commercially linked is the same as the question whether inputs are attributable to either or both supplies; (d) applied a test of attribution for which there is no authority—namely whether the input enabled the taxpayer to make a taxable supply; (e) failed to appreciate that the taxpayer's use of the land was exhausted on its sale and the land could not thereafter be attributed to construction works carried out thereafter.”

Jacob LJ (with whom Mantell LJ and Lord Phillips MR agreed) rejected point (a), but concluded:

The decision of Customs refusing to approve a proposed partial exemption special method or to apply a standard method override can be appealed to a tribunal under section 83 VATA (see paragraph (e) of that section). The nature of such an appeal was considered by Etherton J in Banbury Visionplus Ltd v Revenue and Customs Commissioners [2006] STC 1568. He concluded that an appeal was not “limited” in the sense identified by him (ie an appeal where the tribunal is confined to considering whether Custom’s decision was reasonable, in the sense that they did not take into account any irrelevant matters, they took into account all relevant matters and made no error of law and reached a decision which they could properly have reached); instead, the appeal was “full” in the sense that, “even if the disputed decision was a reasonable one, the tribunal should itself decide whether it secured a fair and reasonable attribution of input tax within the meaning of [section 26 VATA]”. In other words, the tribunal can substitute its own view of what is fair and reasonable, in the context of the question before it, for that of Customs notwithstanding that Customs decision was within the range of decisions which a body properly directing itself could reach. I propose to follow that approach without any further discussion.

This is not to say that the tribunal is able to put forward its own version of a more reasonable special method (if there is one). It cannot do so, as the Tribunal recognised in paragraph 43 of the Decision. Accordingly, a tribunal can substitute its own view for that of Customs in deciding whether a proposed special method is fair and reasonable. If on an appeal by a taxable person from a refusal of Customs to allow a proposed special method the tribunal decides that the method is fair and reasonable and also that it is more fair and reasonable than the method in operation (be it the standard method or some other special method), the appeal should be allowed. But if the tribunal thinks that both the existing method and the proposed method are unfair or unreasonable, it could not allow the appeal even if it considers that the proposed special method is less unfair and unreasonable than the existing method.

I should mention some of the correspondence between the School and Customs since it is relied on by Mr Thomas. It is in that correspondence that the School’s proposed special method is set out and contains Customs’ reasons for rejecting it. The correspondence was before the Tribunal and its contents are clear.

Customs were informed that a contract was about to be entered into for the construction of the sports complex by a letter dated 31 January 2003 from the School’s accountants. Customs were told that the School’s planning permission allowed the use of the facilities between 6.00 am 11.00 pm. The School would use the complex for its own exempt educational purposes during school hours and the facilities would be available for third party use outside those hours. There was no reference to the planning restriction which restricted use to purposes ancillary to school use. It was explained that use outside school hours would be through SHEL which would be granted a licence to occupy. The licence fee would be subject to VAT because the School would opt to tax the building. Any profit of SHEL would be gift-aided to the School and the corporate structure would protect the School from third party claims (eg personal injury claims by users of the facilities). Since there would be mixed use (exempt educational supplies and taxable use in relation to the licence to SHEL) the School sought approval of a special method of partial exemption. The proposal at that stage was for a percentage recovery of VAT that is to say A/B x 100% where A = Number of hours let to SHEL and B = Total number of hours of use by School and let to SHEL. This would be subject to annual adjustment over a period of 10 years since the building is an item to which the Capital Goods Scheme applies.

Customs responded on 10 April 2003, following a meeting with the School. The relevant officer, Miss Miller, agreed with the view that any special method would need to be based on intended use (the contrast, I think being between intended use and actual use since, as Miss Miller stated, the input tax was being incurred long before any supplies were likely to be made). She expressed reservations about the School’s suggested formula and made observations about an alternative formula (albeit one also based on physical use) which she considered to be more realistic. And she sought a considerable amount of further information.

Mr Moore, the senior VAT manager at the School’s accountants, wrote again on 23 May 2003: he took issue with this response and sought to persuade Miss Miller of the fairness of the School’s approach. She responded to that on 9 June 2003, pointing out that, although she had said at the meeting with the School that the proposals appeared to be fair and reasonable to her, she had also said that she was inexperienced in this type of application and would need to seek further advice. I mention this to dispel any suggestion that Customs, in taking the stance which it now does, is in any way going back on what it had, in principle, agreed early on.

On 18 July 2003, Mr Moore wrote a long letter to Miss Miller putting, eloquently, the School’s case. Whilst maintaining that the School’s original proposal was fair and reasonable he put forward in his letter, in order to achieve finality, an alternative partial exemption method. The proportion of VAT recoverable in respect of the construction costs would be calculated on the basis of “actual” use of the facility by SHEL (which at that stage would have been a projection, subject to adjustment) as a proportion of the total hours of use. The details of the method were fleshed out in an Appendix to the letter. I would note only that actual use was to be calculated, in the first year, as hours of licence x 76%, that percentage being the projected percentage of capacity which would be utilised during that first year.

The correspondence with Ms Miller continued but Mr Moore was not satisfied with the outcome and the matter was referred to a higher level. On 28 May 2004, Mr Gaskell, a senior officer at Regional Business Services, wrote to Mr Moore. He recognised that the standard method had its limitations in the present case and agreed that a special method would be preferable, suggesting that a head-count would be more reflective of actual use than hours used by SHEL. He then wrote this:

“Ideally I would prefer to agree a realistic method with you and, although a headcount appears suitable, I would be prepared to consider any other proposals which measure actual use. Failing that, we cannot approve your existing proposal. Although it is certainly not ideal, the standard method applies unless and until an alternative special method is approved and has the potential to adjust its outcome by means of the override…………”

The School might detect a slightly hollow ring in that last observation given that Customs have subsequently refused to apply the override which the School suggests and have not themselves implemented any other adjustment.

Following further exchanges, Customs, acting through Mr Rowe, another officer at Regional Business Services, formally refused the School’s request to adopt its special method in a letter dated 3 February 2005. After describing the proposed special method based on hours of use by SHEL and the School, he gave his analysis of the position, leading to the conclusion that the proposed partial exemption method would not give a fair and reasonable recovery of “residual” input tax and that the proposal would not therefore be one which he considered prudent to authorise. Since Mr Thomas is highly critical of the reasons given for reaching that conclusion, I should look at Mr Rowe’s reasoning.

On the second to fourth pages of his letter, Mr Rowe sets out those reasons which I summarise as follows:

On 31 October 2005, Mr Warner, a partner in the School’s accountants, wrote to Mr Rowe arguing that the standard method was not reasonable. He referred to the standard method override in Regulations 107A-E; he asked that the letter be treated as a voluntary disclosure for the repayment of over £245,000 of VAT. His letter was replied to by Mr Rowe on 22 November 2005, in which the voluntary disclosure was formally rejected. Customs declined to accept that the length of time of use in the present case was a reflection of how the assets are used, or could ever be used, or could form the basis for a fair proxy of use (as that word is used in the legislation).

The case was presented to the Tribunal in a very different way from the way it was presented to me. They accordingly expressed their conclusions in a way which may not deal fully with the way in which the case is now put. Further the Tribunal in fact adopted the “limited” approach to an appeal since discussed by Etherton J in Banbury Visionplus Ltd (and held by him to be an incorrect approach): see paragraph 29 of the Decision.

The reasons why the Tribunal found that the Commissioners had acted lawfully in refusing to accept the special method proposed by the School are to be found in paragraphs 29-37 of the Decision. Mr Thomas suggests that, in essence, the Tribunal gave two reasons for rejecting the School’s argument which may be seen as different aspects of a single reason:

Mr Thomas’ description of the first reason seems to me to be correct. But his description of the second reason gives a slightly unfair impression because it is a somewhat curtailed description. What the Tribunal say in paragraph 37 is this:

Paragraphs a to c are, I think, entirely correct. Paragraphs d and e also appear to me to be correct: the School did not supply to any end user, an individual, the use of a sports facility. What it did supply was a licence to SHEL for SHEL to supply to an end user the use of a sports facility. Those are different things. Paragraph e would also appear to me to me correct; and, indeed, the licence may be the closest direct and immediate link with the building which is “the goods” of the School.

The case was, I think, presented to the Tribunal on the basis that there was a direct and immediate link between the construction of the sports complex and the use made by SHEL of the complex, almost as though the supply by the School was a supply to end users rather than to SHEL; alternatively, there was to be a “look through”, SHEL’s use being the School’s use. It was on that basis that the Tribunal expressed the views which they did as I have set them out in paragraphs g and h. I think that, on the basis on which the case was put to them, they reached the right conclusion.

However, Mr Thomas now puts the argument for the School in a different way as will appear (essentially that the use by SHEL is simply a proxy for use by the School and provides a basis for a fair and reasonable special method).

Mr Thomas’ starting point is the alleged unfairness of the standard method. He says that it is quite clear that the standard method does not produce a fair result. Thus parents of the pupils are not paying the School £7 million or £8 million a year to have swimming lessons. Indeed, before the Tribunal, the School calculated that 1.2% of the total annual school fees related to swimming lessons and training for pupils, or some £87,600 for the relevant year: see paragraph 26 (ii) of the Decision. There is no finding about that but, whatever the correct percentage, the point can be made that no reasonable apportionment of fees would produce a large attribution to the physical use made by the School of the sports complex in the education of its pupils. Mr Thomas also says that it is equally clear that no part of the costs of constructing the sports complex is properly attributable to a number of distinct aspects of the School’s activities such as the boarding fees or school meal charges. And yet, he says, the standard method attribution incorporates the whole of the fee income in its denominator whilst including only the taxable income from the use of the complex in its numerator.

On the one hand, that real-world analysis has much, superficially, to commend it. On the other hand, also in the real world, notional allocation of part of the fees paid by parents to swimming and sports activities in the complex may be of little relevance. One can well imagine that the School has a commercial imperative in providing these facilities in order to retain its reputation and remain competitive in the education market. Indeed, the actual costs were met out of the School’s assets or out of fund-raising activities or the School’s foundation. The application of these monies must have been in furtherance of the School’s charitable educational objectives notwithstanding that, as part of a business plan, the School would raise some money through out-of-hours use. And, as the business plan indicated, the financial objective was to make the complex self-sufficient in terms of its day to day running costs, but there was never any suggestion that the out-or-hours activities would support any significant part of the capital funding of the project.

Mr Thomas points out that the Tribunal recognised that ‘from an early stage in the planning exercise’ the School had in mind a commercial use for the sports complex: Decision paragraph 34. It therefore accepted, he submits, that the costs of constructing the complex were (in VAT terms) ‘cost components’ of both the taxable supplies which the School would make by licensing the complex to SHEL and of the exempt supplies of education it made to its pupils. That may be true, but, as I have just pointed out, the commercial use was never going to support the real, overall, economic costs of the complex including its construction even though it was hoped that the commercial use would support the annual running costs.

Reverting to the two reasons given by the Tribunal for rejecting the School’s argument before it (see paragraph 38 above) Mr Thomas remarks that it will immediately be seen that the Tribunal adopted none of the reasons given by Mr Rowe for rejecting the proposed method. This, he says, is manifest from the last sentence of paragraph 33 of the Tribunal’s decision: “This is the reason why we are against the School”. The only reason found by the Tribunal for rejecting the School’s appeal against the first decision was, he says, this apparent anomaly – that the use on which the method focussed was the use by SHEL and not by the School.

What he says is correct, I consider, in relation to the first reason given. But given the way that the argument was presented, this is not entirely surprising since it was not, as I understand it, argued that the actual physical/time use by SHEL was a proxy for the use, for VAT purposes, by the School. Instead, it was argued that the apparent imbalance between the input tax deduction sought and the output tax to be paid on licence fee income was explained by looking through the licence to taxable supplies that SHEL would in due course make. It was that argument which the Tribunal held to be illegitimate (unsurprisingly in the light of the way the arguments were put).

But in relation to the second reason, I think that the position is slightly more complex. The second reason depends on the absence of a direct and immediate link between the building and the use made of it by SHEL. However, what Mr Thomas submits in relation to the first reason applies equally to the second reason. It is that the Tribunal fell into error in failing to appreciate that the use made of the premises by SHEL was a valid and reasonable proxy for the use made of the premises by the School.

Under the School’s proposed special method, the projected “actual use” by SHEL is to be taken as a proxy for the use (for VAT purposes) of the building in granting the licence. In this context, the “actual use” is established on the basis set out in the letter dated 18 July 2003 (ie hours of licence x 76%). That “actual use” is of no help in ascertaining the attribution of input tax unless it is taken as a proportion of some larger use. Under the proposed special method, that larger use is the total of SHEL’s “actual use” (as just described) and the School’s own “actual use”: that, in turn, is to be ascertained under the proposed special method by reference to availability of the complex to the School between certain hours on weekdays during term time and certain Saturdays throughout the year. This too, must, I think, be regarded simply as a proxy for the School’s use of the building in the provision by it of educational services.

I see no reason why an attribution method along the lines proposed is to be ruled out of consideration in limine as an alternative method for the purposes of Regulation 102. It may be that, on the facts of a particular case, the physical use of a building or a chattel by a third party may be a very good proxy for the use, for VAT purposes, of the taxable person. I therefore agree with Mr Thomas that the Tribunal’s first reason for rejecting the School’s proposed special partial exemption method cannot be supported.

The Tribunal’s second reason for rejecting the School’s proposed special method was that the costs of construction were not directly and immediately linked to the use made by SHEL of the sports complex in the course of its business. However, if it is accepted that the use by SHEL of the complex is simply a proxy for the use by the School of the complex in making its taxable supply by granting the licence, it can be seen that this reason is not an objection at all.

Mr Thomas submits that there can be no doubt that when dealing with the apportionment of residual input tax one is always seeking a reasonable proxy for the use made by the taxable person of the goods and services in question. This is most clearly the case with the standard method which looks at values of outputs and not at the use of the goods and services on which the input tax has been incurred: the values are a proxy for the use and nothing more. But the test sanctioned by section 24 seeks to establish to what extent the taxable person is using the goods and services, in respect of which the claim to recover input tax is made, in making taxable supplies. I agree with that submission subject to this: that there may be cases where actual use for VAT purposes can be clearly identified and there is no need for a proxy of any sort.

Mr Thomas says this in his skeleton argument:

“To be fair and reasonable, any partial exemption method used in this case must offer an effective means of comparing the use of the premises in making taxable supplies with their use in making exempt supplies. There may be circumstances in other cases in which an overhead will be more intensively used in making one kind of supply than another and where this is reflected in the price of each supply (or ‘output’).”

This, I think, is the first time one sees any suggestion on behalf of the School that the construction costs might be regarded as overheads. The question of expenditure on overheads usually arises in cases where the supply of goods or services to a taxable person cannot be seen to be reflected in an output (as, for instance, in Kretztechnic). However, where a cost is incurred which for the benefit of the business as a whole, then it is an overhead and is therefore, according to the case, a cost component of the supplies and the necessary direct and immediate link is established. Where a taxable person makes both taxable and exempt supplies, that overhead cost has to be apportioned between them. In the present case, it does not seem to matter whether it is correct to describe the construction costs as overheads. The point is that the whole of the VAT on those costs is input tax of the School and the question is how that input tax is to be allocated between exempt and taxable supplies. The answer cannot depend on the label attached to the expenditure since, whichever way one looks at it, the expenditure is a cost component of the taxable and exempt supplies between them.

Mr Thomas then makes the point that an apportionment of overheads by reference to the value of outputs may be sensible in a case such as he identifies in paragraph 53 above. He says that that is not the present case where the onward supply does not exhaust or even diminish the value of the asset which is being used in the supply ie the sports complex. In other words, the use for VAT purposes of the sports complex does not consume it. In such a case Mr Thomas submits that there is no reason to compare the value of the outputs generated from making exempt supplies with the sports complex with the value of the outputs generated from making taxable supplies with the sports complex.

As he puts it:

“Neither contains a greater element of the costs of construction than the other. If one takes the straightforward approach that a capital item, such as the swimming pool complex, depreciates at a uniform rate over its life, one hour’s use in making taxable supplies may be seen to expend precisely the same amount of the input tax incurred on the capital cost of the premises as one hour’s use in making exempt supplies with the premises. There is, in other words, precisely the same value of input expenditure in each hour’s use, whatever the value of the outputs from the hour’s use may be.

It follows that it is fair and reasonable when dealing with the attribution of input tax on a capital item which does not significantly diminish in value to apportion the expenditure in the period in which it is incurred between the taxable and exempt use to be made of the item by comparing the time it is to be put to each use.”

Mr Thomas then says that although it is strictly true that the proxy put forward by the School did have reference to use made of the premises by a third party, SHEL that is not to say that such use cannot also stand as a reasonable proxy for use by the School:

“It inevitably follows from the fact that SHEL can only use the premises during hours for which it is licensed to do so by the School that the hours in which SHEL uses the premises are a sub-set of the hours in which the School uses the premises by licensing them to SHEL. Thus the hours of use by SHEL are an adequate proxy for the use of the premises by the School for taxable purposes.”

It is, according to Mr Thomas, in this respect that the Tribunal erred in law. They should have appreciated that the use by SHEL was a sound proxy for taxable use by the School. However, it seems to me that Mr Thomas is missing out a step in the argument.

Having done so, it should have concluded that, there being no other reason it had been able to identify which made the School’s proposal unfair and unreasonable, it was wrong of the Commissioners to reject the School’s special method. The Appellant’s appeal against the Commissioners’ first decision should therefore have been allowed.

For completeness, Mr Thomas dealt with the reasons (as he listed them and I show them in italics as he did – in a way slightly different from that which I have set out above) actually given by Customs for denying the School the right to use its proposed special method, none of which, he said, had any substance:

According to Mr Thomas, therefore, each of the reasons relied on by Mr Rowe was irrelevant to the question which he had to ask: namely, whether the method proposed by the School was fair and reasonable. Furthermore, in many instances, the reason was not simply irrelevant but was, he says, wrong in law. As appears from the comments I have made in considering his criticisms, I do not entirely agree with him on all his criticisms. Moreover he does not list and deal separately with one other factor relied on by Mr Rowe as set out in paragraph 35(g) above, an aspect which, again, I shall return to in the course of considering Miss Simor’s submissions to which I now turn.

Miss Simor says that a special method would not produce a fair and reasonable result if its effect was to allow the supplier to recover tax on inputs that did not form “true cost components” of the taxable supply. To allow such a method would be to allow for over-recovery and would be contrary to the fundamental principle of neutrality which emerges from the cases before the ECJ to which I have already referred. Like Mr Thomas, who uses the word “actual”, Miss Simor attaches an epithet to “cost component” as though to distinguish cost components which are “true” from something else. I do not find this added word helpful. Either something (or its cost) is, for VAT purposes, a cost component of a supply or it is not. Where an item is a cost component of two supplies, one taxable and one exempt, a process of attribution has to be found. The search for an appropriate method (if the standard method is unsuitable) will, if successful, result in a fair and reasonable attribution. One can then say that the part of the item (or its cost) apportioned to the taxable supply is a cost component of that supply, or if you like, a true costs component of it. But adding the epithet “true” does not assist one in the task of identifying a fair and reasonable method of attribution.

Miss Simor acknowledges that a fair and reasonable attribution to a taxable supply has to reflect the use of a relevant asset in making that supply. She refers to the use which is to be identified for VAT purposes as the economic use. She accepts that physical use may reflect economic use but says that it does not necessarily do so; and she submits that any allocation or special method must give a credible result in economic terms.

Her submissions, in a nutshell, are as follows:

As to “use” in Article 17 of the Sixth Directive and section 25 VATA, Miss Simor refers to the need for a “direct and immediate link”. She puts it as link between the cost and the supply or between the input and the output. It must be remembered that is all shorthand for what the courts have actually said, namely that there has to be a direct and immediate link between the goods or services acquired and the output transactions giving rise to the right to deduct or to put it another way, the cost of the goods or services acquired is part of the cost components of the output transaction which utilises the goods and services acquired..

In the present case, Miss Simor says that the direct and immediate link between the cost of the sports complex and the licence supplied to SHEL is very limited in nature:

The first of those is contentious. The Tribunal in fact recognised that the School had in mind a commercial purpose for an early stage in the planning process; and it has in fact, consistently with that concept, made taxable supplies in respect of the sports complex.

Similarly, the last of those statements is controversial notwithstanding that Customs say it has never been disputed. Even if it is true, as Miss Simor says, that the School paid for the complex using its charitable funds (although Mr Thomas says it was funded out of donations and a foundation with no borrowings required), that there was never any intention that SHEL contribute to those costs and that the licence, being for only £18,600 p.a. could not in any event, commercially contribute to those costs, it does not necessarily follow that construction costs are not a cost to any significant degree of providing the licence.

Miss Simor seeks to make good factual assertion (that SHEL would not contribute to the construction costs commercially) by an analysis of the figures which she puts in her skeleton argument:

The criticism of the method proposed by the School is that it wrongly assumes that physical use of an asset is the same as economic use (or, as I would put it, use for the purposes of VAT). On Custom’s approach, the question is not how long or how much SHEL might physically use the sports complex but rather the extent to which the construction costs and running costs of the complex are economic costs or cost components of the supply of the licence to SHEL for its physical use of the complex by its members.

Reliance is then placed on Southern Primary, in particular paragraphs 32 and 35 set out at paragraph25above in support of the proposition that, although the construction of the complex may have been necessary to make the grant of the licence possible, it does not follow that the costs of construction were a cost component of granting the licence.

If that is correct, then it follows that no part of the VAT on the construction costs is allowable as input tax in relation to the grant of licence. Consistently, however, Customs have taken the position that some of the input tax is attributable to the grant of the licence otherwise even the standard method would not be applicable. I think that that they are correct to have done so and that this was not simply a matter of concession. The present case is distinguishable from Southern Primary. One distinction is that, in that case, the taxpayer’s use of the land was effectively exhausted on the sale of land to the housing association: this was Mrs Hall’s point (e) which like all of other points (apart from point (a) – commercial aim) the Court accepted had substance whereas in the present case, the grant of the licence is actually a supply of the building. Another distinction is that, in that case, the Court held that the carrying out of the development was on the land but did not utilise the land whose ownership was irrelevant, whereas in the present case the whole purpose of the licence is to grant the enjoyment of the land to SHEL during the periods of its licence. To my mind, particularly bearing in mind that commercial use of the sports complex was contemplated from an early stage, the construction of the sports complex does have a direct and immediate link with the grant of the licence to SHEL. The School’s case is not to be defeated on the basis that there is no such link and that the costs of construction are not capable of being costs components of the licence. That unfortunately does not help resolve the question of what is a fair and reasonable attribution of those costs between taxable and exempt supplies.

Then it is said that to allow the special method proposed by the Appellant would be to allow a net VAT reclaim to be made by an exempt supplier in respect of elements of cost (construction cost and in the future other costs) that did not form a cost component of its taxable supply (the licence). The School would be a net beneficiary in VAT terms of a very substantial sum, with no possibility of that VAT ever being repaid. The method is in any event not a proper measure of use. Under the proposed method SHEL could be charged any licence fee and could have one member or no members; the recovery rate would be the same. Hours of opening do not even reflect ‘physical’ use, let alone economic use.

Taking the proposed special method to its logical conclusion, it is submitted that if the local planning authority amended its planning permission to allow all night opening, SHEL’s licence could be extended to cover all night and, whether the facility was open or not, the Appellant could claim an even higher percentage of VAT recovery. Indeed SHEL would never have actually physically to use the facilities at all, merely paying some small consideration for the exclusive right to use them being sufficient. That may be true, but it is not a fair criticism of the proposed special method. That special method is put forward in the context of the facts as they are in accordance with which, on the School’s case, the formula based on hours of use takes into account only hours during which, realistically, the sports complex can be expected to be used and which, in any case, allows for only 76% capacity in year 1. If the local planning authority were to change the scope of the permission, and if the licence to SHEL was altered in the way suggested, the proposed special method might then be inappropriate: but those are not the facts against which the proposal has to be judged.

I agree with Mr Thomas that the search in the present case is for a fair and reasonable proxy for the “use” of the sports complex in making the exempt and taxable supplies made by the School. However, I also agree with Miss Simor that the physical use of the complex is not necessarily a fair and reasonable proxy for that use. I consider that her use of the phrase “economic use” is a helpful approach to establishing what the search is for.

In that context, it is instructive, I consider, to look at the position had the School not granted the licence at all and had not allowed any out-of-hours use. In those circumstances, there would have been no taxable supply at all. In consequence, none of the input tax would fall to be attributed to taxable supplies as a result of Regulations 101(2)(b) and (c), Regulation 101(2)(d) not applying. However, the sports complex is used for the purposes of the School’s (exempt) business. It is so used not because there is a supply to parents of the physical use (by their daughters) of the sports complex to their children, but because the availability of the complex is part of the package of benefits which is acquired by parents for the fees they pay and which constitutes the exempt supply by the School. The use made by the School, for VAT purposes, of the sports complex is its use in providing that package of services, a single supply. There is, of course, no need to identify a proxy for use when there is only an exempt supply since questions of allocation under Regulation 101(2)(d) do not then arise. Nonetheless, one can see that the “use” referred in Regulation 101 (as elsewhere) is not physical use but some special VAT use. It is, I think, the same as what Miss Simor terms “economic use”.

On the facts of the present case, it seems to me that the overwhelming economic use of the sports complex by the School is in relation to the provision of educational services. In that context, I agree with Miss Simor that the source of funds and the purpose of constructing the sports complex are relevant considerations. To regard those factors as relevant is not, in my judgment, to fall into the error, as Mr Thomas would say it is, of categorising the nature of a supply by reference to the purpose or motive in making it. There is no doubt that in the present case, the supplies are distinct and readily identifiable, that is to say the taxable supply of the licence to SHEL and the exempt supply of education. Nor, in my judgment, is there any question, in taking those factors into account of treating a taxable supply as an exempt supply or vice versa. The question is what “use” is being made of the inputs in producing the outputs. It seems to me that the purpose of the School, objectively ascertained, in constructing the sports complex is a highly relevant factor in attributing cost components between the relevant outputs and is an entirely different issue from identifying the nature of the output by reference to purpose or motive (which is inadmissible), the issue addressed by Patten J in Yarburgh Children’s Trust.

On the evidence, it is clear that, objectively assessed, the principal purpose of the School in building the sports complex was the furtherance of its educational activities and was carried out in connection with its business of making exempt supplies of education. That conclusion is clear from the way the matter was put in the first draft of the business plan and the approach of the School to the generation of funds by out-of-school use which was designed to meet the running costs of the complex and, if possible, something over and above that. Further, the capital cost of the complex was met out of funds which were either charitable funds or derived from a fund-raising exercise and which were clearly dedicated to the educational purposes of the School. The generation of income by out-of-school use was essentially a secondary consideration, albeit that the benefit thereby produced was an aspect of the whole project from the beginning.

Moreover, it is also clear, I consider, that the income generated by the licence to SHEL was never intended or expected to meet a share of the capital cost proportionate to the physical use of the sports complex by SHEL. The relevance of this is that it is supportive of the view that the principal, objective, purpose of the expenditure on the sports complex was in furtherance of the School’s main function of providing education to its pupils and that the license to SHEL was secondary, simply putting to productive use that which has been acquired for a different main purpose. In terms of VAT, the provision of an exempt supply of education was the principal use of the sports complex and the taxable supply of the licence to SHEL was a secondary use.

Any method of allocation between the exempt and taxable supplies made by the School must, in my judgment, reflect that use. Given the approach of Etherton J in Banbury Visionplus Ltd, the questions for me are whether the standard method and the School’s proposed special method each produce a fair and reasonable attribution and if so whether the School’s method is more fair and reasonable than the standard method. In my judgment, the standard method, whatever its shortcomings, does produce a fair and reasonable apportionment which does reflect the economic use which is made by the School of the sports complex. Further, without saying that the School’s proposed special method is not a fair and reasonable method, the standard method produces, in my judgment, an allocation which is more fair and reasonable than the schools proposed special method.

Accordingly, the School’s appeal against Custom’s rejection of the proposed special method fails.

The School then says that a standard method override should be applied under Regulation 107B. The Regulation applies where the attribution which is being applied produces a result which “differs substantially” from one which represents the extent to which the goods or services are used by the taxable person in making taxable supplies. In other words, the override will apply in the present case if the standard method results in an allocation under the standard method which differs substantially from one which represents the extent to which the sports complex is used by the School in granting the licence to SHEL.

For the same reasons as I have given in deciding that the School’s proposed special method is not to be preferred to the standard method, I do not consider that the standard method, whatever its shortcomings, can be said to produce a result which differs substantially from the one which represents the extent of the School’s economic use of the sports complex in granting the licence. Certainly, the way in which the School seeks to calculate that difference does not, in my judgment, represent a proper calculation of any such difference and is to be rejected.

Accordingly, the School’s appeal from the rejection by Customs of their rejection of the override also fails.

The School’s appeals from the Decision and from the consequent order of the Tribunal are dismissed.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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