KRS Finance Ltd v The Commissioners for HMRC

VAT is a tax on consumption and, therefore, intended to be neutral for taxpayers making taxable supplies. However, where the person making supplies is making both taxable and exempt supplies problems can arise in identifying the input tax used in making taxable supplies so as to determine the recoverable proportion of input tax in order to maintain the tax neutrality of the tax for suppliers. The problems that can occur can either be because of attribution or apportionment. The Marketing Expenditure Appeal is concerned with the attribution problem.

The basic relevant principles were not in dispute. They derive from the EU legislation applicable to VAT, which in the present case is Council Directive 2006/112/EC, often called the Principal VAT Directive (the “PVD”), as interpreted by the Court of Justice of the European Union (“CJEU”) and by our domestic courts. Effect is given to the PVD by national legislation. Whilst the timeframe of the dispute straddles the UK’s departure from the EU there was no dispute that the relevant principles to be applied remain matters of retained EU law.

Art 1(2) of the PVD provides that:

Art 168 gives the right to deduct input tax as follows:

As Richards, LJ neatly summarised in the Court of Appeal’s decision in Revenue and Customs Commissioners v Royal Opera House Covent Garden Foundation [2021] EWCA Civ 910 (“ROH”):

Our findings of fact in relation to the Marketing Expenditure Appeal are as follows:

The Appellant’s primary position is that the contested marketing expenditure was incurred by the Appellant for the purposes of marketing the KRS business as a whole and it is properly, therefore, overhead expenditure. That is to say that this expenditure has no direct or immediate link with any particular supply, but does have such a link with the whole of the economic activity carried on by the Appellant. Accordingly, such overhead expenditure is deductible and in the case of businesses making both taxable and exempt supplies (such as the Appellant) the overhead expenditure falls to be apportioned between the two types of supply.

In support of this the Appellant argues that:

In the alternative, the Appellant contends that there is also a sufficient and direct link to both EP and SMF income. It is argued that a sufficient link may exist despite it not being the closest link and the basis of the link to EP services is rooted in the objectively determined purpose underpinning the marketing strategy, the basis on which the budget is set and how the return on investment is measured.

With regards to the link to SMF income the Appellant argues that the obligation to “endeavour to use not less than seventy five (75%) of the Marketing Fee for the purposes of promoting equity release mortgages and public awareness thereof” (with a right to audit), the fact that the SMF is in addition to the Referral Fee and Introduction Fee both point to a direct and immediate link with ER only marketing expenditure. This is similar to the situation in Town and County Factors Limited v The Commissioners for Her Majesty’s Revenue and Customs [2006] UKVAT V19616 (“ T&C” ) whereby the Appellant is committed to marketing as a consequence of the contract with the solicitors.

The Appellant further emphasises the point that when considering the question of a specific link that it is the use of the costs which is relevant and not whether and to what extent the costs may, or may not, be incorporated into the price of the product.

The starting point, it seems to us, is firstly to properly define the “contested” marketing expenditure. This was because there was some confusion, at least on the part of some of the witnesses, as to what that expenditure, exactly, comprised. The Appellant say that the “contested” marketing expenditure, for these purposes, includes expenditure (in so far as it does not reference EP services) incurred on: TV, radio and press advertising, direct mail, paid social media advertising, and pay per click. This is, in our judgment, the same as ER only advertising as referred to in the Respondents’ skeleton argument. In this judgment we will use the phrase contested marketing expenditure or ER only advertising interchangeably. They mean the same thing.

The logical way in which we approach the central question is to consider whether, firstly, the contested marketing expenditure has a direct and immediate link with ER, EP, SMF or a combination of the three supplies. We need only consider whether there is a direct and immediate link with the whole of the economic activity carried on by the Appellant if we find that there is no direct and immediate link with any of the three supplies identified. Succour for this approach can be found in the speech of Carnwath LJ in Mayflower Theatre Trust Ltd v HMRC [2007] STC 880 at paragraph 33.

We were referred to a number of first instance decisions (in particular N Brown Group Plc v HMRC [2011] UKFTT 172 (TC) and Sofology Ltd v HMRC [2022] UKFTT 153). These cases were, in our judgment, of passing interest only given that they are neither binding upon us nor serve to establish any points of principle. Nevertheless, they served as useful illustrations as to how the relevant principles had been applied in other cases with some comparable (but nevertheless different) facts.

We agree with the Respondents that the marketing material relating to the contested marketing expenditure, viewed objectively, is designed to attract those customers who are looking for ER services. The evidence clearly shows this to be the case: the advertising material focusses on ER supplies and makes no refence to EP services or the SMF. However, whilst the content of marketing material is an important factor it is not, by itself, determinative in establishing a direct and immediate link.

The evidence also shows that the typical customer journey for a customer who views ER advertising starts when an interest is shown in the Appellant’s ER product by the customer contacting the Appellant (typically either by telephone or by filling in an online contact form). Following initial contact the customer is then booked into their first meeting with an advisor. It is at this point that the Appellant’s EP services are introduced, for the first time, to the customer. Therefore, whilst a customer may end up purchasing ER, EP, both or neither service and the purchase (or failure to purchase) one service is not dependant on the other; it is fair to say that the customer only booked the initial appointment with an advisor because s/he wished to purchase an ER product or, at the very least, enquired about one. To that extent any subsequent sale of an EP service is dependent upon and subservient to the ER product/service. More than that, the selling of EP services takes place at the initial advisor meeting. It cannot have been any earlier because, as already set out, the ER only advertising did not refer to any EP services at all. This, again, seems to us to be an indicator that there is a direct and immediate link between the contested marketing expenditure and ER services.

The marketing strategy adopted by the Appellant uses a “funnel” approach and what is described as a “hero” product approach. The “hero” product in this case is clearly the ER product or suit of products. This strategy is grounded in the Appellant’s belief, as shown by the evidence, that its ER services provide the main emotional drivers for the purchase of the Appellant’s services by consumers. This requires the Appellant’s marketing efforts to be focussed on ER products in order to create an initial interest to, eventually, enable other services (such as EP) to be cross-sold. Whilst we accept that general advertising expenditure (of say a brand name) would tend to make it difficult to establish a direct link with a particular product and or service and, therefore, such expenditure would tend to be better categorised as residual overhead, the same cannot be said where the advertising expenditure in question relates to a prominent (or hero) product or service. The natural inference must be that the expenditure is directly linked to the product or service that is the feature of the advertising. The subjective motive of the advertiser (to enable cross-selling whether or not by using a “funnel approach” or increase footfall for example) seems to us to be irrelevant. The fact that the Appellant couches its argument in terms of “the objectively determined purpose” of the marketing strategy does not assist it.

Nor is the Appellant helped by looking at the budget process. We accept that the Appellant’s marketing strategy drives the budgeting process. It may also show how marketing is used by the Appellant. However, all that can be said on that score is that marketing is concentrated on ER services or products with a view to enable the cross-selling of EP services.

After taking a holistic view of all the circumstances and taking into account the facts as we have found them, we come to the conclusion that the contested advertising expenditure has a direct and immediate link with ER products and services. Further and for the reasons already given no direct link can be established between the contested marketing expenditure and EP products or services.

It is, of course, possible that the contested marketing expenditure has a direct and immediate link with ER products and services as well as the SMF. It is to this possibility that we turn next.

There was some argument about whether the SMF had been “rebranded” in the Appellant’s skeleton argument (from initially being described as a Solicitor’s Referral Fee (“SRF”) to a Solicitor’s Marketing Fee. We entirely accept Ms. Brown’s submissions that this was done simply in order to more accurately reflect the Appellant’s position and what was said on the face of the document. There was nothing nefarious or underhand in the way the Appellant’s case was advanced or put by Ms. Brown. In any event, it is the substance of the documents or agreement that lead us to conclusions as to their nature or characteristics which in turn enable us to categorise them. The descriptors used by the parties (helpful as they are when there is consensus) must play second fiddle to that analysis when there is a dispute. To that end we prefer the Respondents’ analysis. We agree, applying the test in Card Protection Plan Ltd v CCE (No2) [2002] 1 AC 202, that the essential feature or dominant purpose of the agreement was to be appointed to the Appellant’s panel for the purpose of receiving referrals of clients. It was not to advertise ER products or services without more. This is clear when one reads the agreement as an objective whole. In particular, the evidence shows that the consideration payable by solicitors for appointment onto the panel is calculated by reference to the number of referrals anticipated to be made to the solicitors. We use the term SMF in this judgment because that is the term used in the solicitors’ panel appointment letter, but, as we have made clear, it can properly and more accurately be described as a referral fee.

Whilst we accept that the Appellant has an obligation under the panel agreement to use its best endeavours to use not less than 75% of the SMF to promote ER products we do not think that this provides a direct and immediate link. Firstly, the Appellant’s obligation extends only to using its best endeavours and in that sense there is no binding requirement for it to use the fees for ER marketing (the only binding requirement being to use its best endeavours to do so). Secondly, and most compelling, the referral to the solicitor in relation to ER takes place once the customer has already bought or committed to buying an ER product or service from the Appellant. The direct and immediate link with the SMF exists as between the SMF and the process of referral not the disputed marketing expenditure. At the point that disputed marketing expenditure is taking place there is in no sense a promotion of the services provided by the solicitors. That comes later. Any link between the disputed marketing expenditure and the SMF is tenuous at best, at least one step removed and, therefore, not immediate or direct.

For the reasons given we conclude that the contested expenditure has a direct and immediate link solely with ER products and services (or supplies to be more accurate). Given that conclusion, and for the reasons already given, we do not need to go on to consider whether the contested expenditure is general overhead expenditure. Accordingly, the Marketing Expenditure Appeal must be dismissed.

As set out earlier in this decision where input tax is attributable to both taxable transactions and those for which there is no entitlement to recover VAT, it becomes necessary to consider how the input tax incurred is to be apportioned.

Article 173 of the PVD provides that “...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”.

Articles 174 of the PVD provide that, subject to certain exceptions, the deductible proportion is to be determined by a fraction of which the numerator is the turnover, exclusive of VAT, attributable to taxable transactions and the denominator is the turnover, exclusive of VAT, attributable to taxable transactions and the turnover attributable to exempt transactions.

These principles have been enacted into domestic law by virtue of sections 24-26 of the VATA. Section 26(3) provides the Respondents with the power to “make regulations for securing a fair and reasonable attribution of input tax”.

Regulation 101(2)(d) of the Value Added Tax Regulations 1995 (the “Regulations”) provides that “there shall be attributed to taxable supplies such proportion of the residual input tax as bears the same ratio to the total of such input tax as the value of taxable supplies made by him bears to the value of all supplies made by him in the period,” thereby, essentially, establishing the standard method of assessment of VAT.

Regulation 102(1) provides for special methods as follows:

In the version in force prior to the start of the transitional period Regulation 102(1A) of the Regulations states:

“1A) A method approved or directed under paragraph (1) above—

the structure of the business, and

the type of activity undertaken by that sector...”

In summary, then, the combined effect of the legislation set out above is that the standard method results in attribution of input tax to taxable supplies, as a percentage, based upon the value of those taxable supplies using the residual inputs in comparison to the total value of supplies using those residual inputs. The Respondents, however, can approve or direct the use of a special method (including one based on sectors).

The various authorities establish the following principles:

The evidence shows that:

The Respondents contend that PESM1 is not fair and reasonable and does not produce a result guaranteed to be more accurate than the SM when considering the economic credibility of the method. Fundamentally, it is argued, the Appellant, uses a transaction count method grouping together a range of diverse supplies without persuasive objective evidence that those supplies use the same amount of residual inputs.

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).

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.

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.

Fourthly, and more fundamentally, it appears that the marketing analysis also includes those customers who initially saw ER only marketing. Given that we have already concluded that there is a direct link between ER only marketing and ER supplies any special method must also attribute ER only marketing solely to ER supplies before we can hold that it is fair and reasonable. PESM1 makes no attempt to do so.

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.

There was some argument before us about whether the Respondents took into account irrelevant considerations and whether or not, in fact, these considerations were in fact irrelevant or misguided. Whether or not the Respondents took into account irrelevant considerations when coming to a decision to refuse to apply PESM1 is not, in our view, germane to this appeal. We are hearing this appeal de novo and not exercising a review only function. That is to say we are not considering the merits of the decision-making process adopted by the Respondents, but rather the decision itself. Put another way, the decision could have been arrived at by the Respondents after carefully considering only the relevant matters and yet still be wrong in the sense that we are compelled to allow the appeal because the decision came to the wrong conclusion. Likewise, the decision could have taken into account all sorts of irrelevancies (and/or not considered any relevant matters) and yet still be the right decision in the sense that we agreed with the outcome and we would be required not to disturb it on appeal.

In summary, we agree that the Appellant has failed to show that PESM1 is fair or reasonable and is guaranteed to produce a more precise determination of the deductible proportion of the input VAT than that arising from the application of the standard method.

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.

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.

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.

It was also suggested that in approaching the economic use element of their decision in the way that the Respondents had they had fallen into error and failed to apply the test in London Clubs. For the reasons set out at paragraph [61] above we do not concern ourselves with whether or not the Respondents have fallen into error, but confine ourselves to properly applying the test to the facts as we have found them. 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.

In so far as there any variations proposed to the PESMs (whether through witness statements or via skeleton arguments) we take the view that these are more than very minor and ought, therefore, to be properly put directly to the Respondents first. Only after the Respondents have had adequate time and opportunity to consider them and made a decision would it be appropriate for this Tribunal to consider these variations on appeal.

We further trust that our decision in relation to the main issues before us disposes of both the ECN Appeal and any quantum issue that might have arisen. If, for any reason, it does not do so then we direct that the parties attempt to agree suitable directions for the disposal of such outstanding issues and failing agreement the parties be at liberty to apply for further directions.

For the reasons given we dismiss the appeals.

We have taken care, given our ruling on the preliminary issue, to try and not to refer to any commercially sensitive information in this decision. However, we have had to make some reference to certain commercial information in order to ground our reasoning in the relevant facts. It may be that it is appropriate to further redact some of that information before publication of this judgment. Before taking a decision on that point we think it only fair that the parties (and the Appellant in particular) be able to make submissions on that point. To that end we direct that a draft of this judgment be circulated to the parties in advance so that written submissions can be made, if necessary, about further redaction of our judgment.

Last, but not least, we would like to take this opportunity to publicly thank Ms. Brown and Ms. McArdle (as well as their respective teams) for the helpful and professional way in which they have sought to present their respective cases and assist this Tribunal in coming to a decision.

This document contains full findings of fact and reasons for the decision. Any party dissatisfied with this decision has a right to apply for permission to appeal against it pursuant to Rule 39 of the Tribunal Procedure (First-tier Tribunal) (Tax Chamber) Rules 2009. The application must be received by this Tribunal not later than 56 days after this decision is sent to that party. The parties are referred to “Guidance to accompany a Decision from the First-tier Tribunal (Tax Chamber)” which accompanies and forms part of this decision notice.