Littlewoods Limited v The Commissioners for HMRC

There is no dispute between the parties that the statutory provisions relevant in this appeal are contained in sections 25 and 26 Value Added Tax Act 1994 (VATA). Those sections and the relevant authorised regulations provide that a taxable person is entitled to recover the VAT incurred on the goods and services it purchases as part of its business insofar as those goods and services are used for the purposes of making taxable as opposed to exempt supplies.

No question of EU law arises as the parties accept that the UK provisions reflect Articles 168 – 174 of the Principal VAT Directive.

In accordance with these provisions, recovery of input tax will be determined by a two-stage process:

This case is an attribution case.

The parties also substantially agreed on the broad legal principles to be derived from the case law:

Attribution principles

These principles have been variously applied in the context of marketing costs and costs incurred by integrated businesses in the following cases, the facts of which are relevant to the determination of this appeal:

We consider the facts and analyses of the respective courts and Tribunals in these appeals and by reference to the more detailed articulations of the principles provided in the earlier cases in our analysis set out in paragraphs 92 - 123 below.

We were provided with a bundle containing 2,481 pages.

In addition, we received witness statements from Mr Mark Stocker, Senior Creative Manager for SDHS, and Mr Andrew Prescott, Finance Director for SDFC. Both gave sworn oral testimony; their statements were taken as read. Mr Prescott was asked a few clarification questions. Both witnesses were cross examined. We found both witnesses to be honest and straight forward. They both did their best to assist the Tribunal by providing information within their knowledge and experience. Neither witness was a statutory director of any of the companies within the Appellant’s VAT group and were not involved in setting overall business strategy or the associated marketing strategy.

Given the volume of evidence made available to us, this judgment contains, necessarily, only a summary. We have carefully considered all documents from the bundle to which we were specifically referred by the parties including every one of the numerous documents cross referenced in HMRC’s skeleton. We have not, however, read every page in the bundle. In doing so we are satisfied that we have acted in accordance with the overriding objective and cognisant of the guidance provided by the Upper Tribunal in Adelekun v HMRC [2020] UKUT 244 (TCC) in which it was stated:

We have not excluded from our consideration any document to which we were referred unless so indicated in our consideration of the evidence. However, we do not refer to every document; rather we refer to those on which we rely on to form our view.

The burden of proof in this appeal rests with the Appellant to establish that it is entitled to claim the input tax which is the subject of the Claims. In order for that burden to be met, we must be satisfied, on the balance of probabilities that the input tax is properly attributable only to the taxable retail supplies and not attributed to supplies of interest-bearing credit and/or insurance intermediation.

We were provided with the Annual Reports for each year of business relevant to the appeal. We were not taken to each one and the parties referenced different years. From the various statements to which we were taken by the parties (in the hearing or by HMRC’s skeleton argument) we extract the following themes, or specific points:

This document, dated 27 October 2017, concerns Shop Direct Funding Plc, a newly formed public limited liability company.

Unsurprisingly, the document reflects the position taken in the Annual Reports spanning pre and post 2017. In particular, it confirms that the Appellant’s business is a digital department store offering products and “unique financial services products offering flexible ways to pay aiming to “make good things easily accessible to more people”. The business objectives were described as growing the mobile shopping platform, driving supply chain and stock management efficiency, improving credit product offering and exploring diversified and complementary revenue streams. It was stated that the business had established innovative e-commerce capabilities such as tailored, personalized shopping experiences across the digital department stores and mobile channels to drive customer demand and sales.

It was noted that the credit product offering enabled the Appellant to maintain product margin thereby limiting the use of deep discounts. The credit offering was described as a key contributor to the digital retail offering enabling the Appellant to “make products more easily accessible to an underserved customer base”. Potential investors were informed that in 2017 Very had a credit score distribution geared more towards the higher risk than the UK population generally. Credit customers are noted as having a higher net promoter score than cash customers indicating a stronger sense of loyalty from credit customers. Credit risk was stated to be well and responsibly managed to mitigate bad debt risk. Customer information was utilised through enhanced data analytics to allow targeting of customers with the highest lifetime value. However, all marketing was considered to be personalised once the customer connects to the Appellant’s websites.

The document observes that in 2017 “we attract customers with a particular demographic bias. This bias appears similar across our brands, but differs quite markedly from the overall UK shape. Our customers are typically younger, majority female and of a certain socio-economic group. Their credit scores tend to cluster in the low-mid range.”

It was confirmed that 95.4% of all retail sales are made with a credit account.

We were shown a confidential board report for SDFC from 2015. The report was treated in confidence for the purposes of the hearing, and it is not necessary to discuss it in this judgment, suffice to say that it corroborates the symbiosis of credit and retail within the Appellant’s business. It demonstrated that the Appellant was seeking to identify its accessible market at the intersection of those needing or wanting flexible payment options to facilitate the purchase of retail products. It confirmed that access was achieved through sensitive marketing of flexible payment options appropriate to the retail products being paid.

Board papers for SDFC in 2017 demonstrated that the profile of customers taking flexible payment offerings was changing with less risky credit customers increasingly taking interest free credit options. The paper describes customers in the mid-range risk for credit (credit sets 6 – 8) as “sweet spot”. This trend continued as reported in 2018 SDFC board papers.

Within the bundle were several screen shots of home/landing pages. We consider that we can take judicial notice of knowledge that a landing page is often a “dynamic” environment produced by algorithms related to internet activity of the individual taken to the page. It is therefore with some caution that we describe landing pages.

However, the first landing page we were shown displayed the following:

The second was similar. The banner was “gift dilemma” and rather than 12 tiles there were four. Across the bottom was what was referred to as a dynamic feed for the “Men’s Vans Collection” displaying 5 different photograph links with prices and a further link to “View All Men’s Vans Collection”. The photographs so used were product specific; they may have been provided by a supplier or been a Photograph.

There were further examples similar to this page. On one such page the banner was for “Take 3”, one of the Appellant’s finance offers, pursuant to which customers have the option to defer payment for goods purchased over 3 months by 3 payments. Interest is not charged if the three payments are made on the due date for payment. A celebrity is sitting on one of three cubes displaying the information about Take 3. The cubes bear pictures, but it was uncertain whether they were Photographs or not.

A further one included a banner for VeryPay promoting 20% off a first credit order. This one, as with some of the others, bore a series of smaller picture links to the retail departments. These displayed a mix of photographs some of which were Photographs, others were provided by suppliers.

HMRC informed us, and the Appellant confirmed, that when navigating to any of the home or landing pages for the first time (or from a different URL/after a clearing browsing history) a pop up would be shown inviting the new customer to open a credit account and thereby achieve a discount off their first order.

We were provided with a single “truncated” screenshot taken from a Google search of “black dress”. The “ads. Shop black dress” identified four black dresses sold by the Appellant and one by a third-party online retailer. Each of the advertised products showed a photograph of a dress, price information and link to the relevant product page. Three of the four Appellant links showed product specific photographs (again potentially Photographs or provided by a supplier).

The layout of the product pages on both the Very and Littlewoods websites are broadly similar:

Some web pages are laid out differently, but all broadly provide the same information with similar balance in terms of information about the product and informing about finance (and as relevant) insurance options.

Once a customer has added products to their basket, they can review the contents of the basket from the link on the top right of the screen. The basket shows each item which has been added to the basket showing a small product specific photograph (this may be a Photograph, or one provided by the supplier), brief description of the product, and the price. Where insurance is available for the product, an option to purchase it is displayed. At the bottom of the basket is a choice to check out securely or continue shopping.

Following the account link also on the top right of each screen gives the customer an option to sign in, if an existing customer, or register as a customer. The offer to register refers to an ability to pay in full or with a finance option with the ability to check eligibility for the finance options.

As indicated, so far as relevant to the appeal, in the period 2008 – 2015 the Appellant sold goods through catalogues. Flexible payment options were referenced in the catalogues. The promotion was consistent with that on the websites discussed above. Full pages were devoted to its promotion and references to the payment options were made on the same pages as product was pictured. On the limited catalogue pages we were provided with finance was referenced either proximate to the products in a similar fashion to those on the website or separately in a line across the bottom of the page. .

We were provided with a series of documents concerning the creative content for the production of the Photographs.

The Fashion Gallery Guide includes information on how models are cast. Models are to vary in size, be relatable, reflect diversity and “pitch to reflect” brand identity and segmentation. Guidance/direction is given as to the gallery aesthetic for each category of clothing. Use of props, e.g. chairs, seating blocks are covered, together with “angles and crops”.

Each type of product for which a Photograph is produced is subject to its own “asset rule”. These provide very detailed requirements for the photographing of the products i.e. that individual items of adult clothing should be photographed on a model from front and back, as a “still life (on a hanger), as an outfit and providing detail of fabric or embellishments etc. There are asset rules for packs of clothes and individual items of furniture. Furniture is styled into a room setting. At the relevant time, the asset rules for the Photographs of children’s clothes stated that the Appellant did not use child models (such models may have been used where suppliers provided the photographs). 4 - 6 photos will be produced within each asset rule.

In April 2016 the Appellant undertook a second stage test of its imagery. The document itself did not identify whether the focus of it was aspirational photography or Photographs. The first stage had been a qualitative assessment. The Appellant recruited a number of customers to “uncover what works and doesn’t work for [the selected customers] and how they shop online”. Stage 1 had identified that its customer base could be divided into four segments each with their own buying preferences and needs from the visual imagery offered by the Appellant. From these certain “dos and don’ts” were identified i.e. “no headless models”, white backgrounds not grey, modern style shots and everyday context. Stage 2 tested the style of imagery identified for use following stage 1. From this testing it was confirmed that the guidelines for imagery were to be maintained.

The Appellant provided us with photographs taken in high street retailers from which they sought to demonstrate that within such a setting finance offerings are displayed alongside physical product. The photographs demonstrated this to be the case. We do not consider these documents to assist us greatly in this appeal which we consider must be determined on its own facts.

In a document entitled “Littlewoods – An introduction to our customers”, a previous strategy encapsulation was “we are the hero that makes the good stuff affordable for every family”. At that time the “bulls-eye target audience” was said to be “female shoppers 25 – 50 C1C2DE (demographic) young and older family. She always puts family first”. These customers are stated to fall within the “striving” and “aspiring” categories. A similar document for Very customers identified the bulls-eye target as “female shoppers 25 – 45. Style Confidence seekers. They want fashion to lighten up and have some fun”. These customers too were striving and aspiring. From and following the document, “good things easily accessible to more people” was born.

We were provided with a later document (or certainly part of it): “The Very Group, Our Customers – A view of all our segments”=. That document identified seven customer groups: Tertiary customers are noted as “trend led ‘pay now’ shoppers” and “fashion enthusiasts”; Secondary: “Tech enthusiasts” and “deal driven shoppers”; Core customer groups are identified as “interest free seekers”, “convenience credit shoppers” and “families on a budget” with families on a budget shown at the apex of a pyramid. Each segment is then analysed:

Both core and secondary customers are credit users.

In order to engage with the accessible market, the Appellant uses a marketing funnel, building awareness through TV, radio, outdoor, digital display and paid social. Search engine optimisation, paid social, affiliates app marketing and owned social aims to pull potential customers to a position of considering the Appellant’s brands resulting in a purchase and followed up with marketing targeted at loyalty.

The document further explains within section 25 the call-to-action approach which integrates credit marketing with specific product groups. The first order discount is explained – a 20% discount being offered against a first credit order. It also refers to direct mail marketing (which we note does not include product specific photography).

Section 25 also covered retention and described the target audience as “existing credit customers displaying signs of lapsing, based on their usual browsing and ordering behaviour defined by models”. There is also a section titled “Cash to Credit Programme” which states that the “early life of a cash customer includes education and incentives to upgrade to a credit account, and regular trading comms to engage and bring them back to shop.” The Take 3 sample campaigns focus on a price divided simply by 3 payments.

We were not taken to the information request itself and were directed only in a limited way to the responses. However, we extract the following information:

Mr Stocker’s evidence predominantly concerned how the Photographs were produced and differences between such images and images described as aspirational images. He confirmed in cross examination that he had no role the development or implementation of the Appellant’s marketing strategy or website design. Whilst Mr Stocker’s statement exhibited the documents referred to in paragraphs 45 - 50 above he admitted he knew little more about them than that which could be determined directly from them as he was not involved in that aspect of the Appellant’s business.

Through the Appellant’s websites and pre 2015 catalogues, between 125,000 and 155,000 product lines are offered. Within each product line there may be variants of colour and/or size. In the online environment the only means of displaying product is by way of photographs and visual imagery with accompanying narrative description of the product. Every product available through the website (and previously in catalogues) is displayed in this way. For a significant (and over time increasing) majority of products, the images for inclusion on the website are provided by the Appellant’s suppliers. Currently that proportion represents 80% of all product specific images used. These images are provided free of charge by the supplier. The Appellant produces the images as set out below for its own brand products and/or where the third-party supplier does not provide them.

When producing the images in-house, the Appellant uses the services of in-house staff and, as required, freelance models, stylists, photographers, set builders etc. to shoot the Photographs. The Appellant has a space known as the Lightbox established in 2011 in which to produce the images. The production of Photographs for each product line category is subject to an individual asset rule. As set out above (see paragraph 40 above) the asset rules provide prescriptive requirements for each set of Photographs taken of each product line. Between 4 and 6 Photographs will be produced. Consistent with the feedback provided (as referred to in paragraph 41) the asset rules and associated guidelines were produced which detail how Photographs are to be shot. For example, all Photographs of clothing are shot against a white background, and the photos include minimal props. The models used will be age relevant and diverse in terms of ethnicity and body shape and size. Furniture and household items will, however, include shots taken in a room setting to convey a sense of size and provide context facilitating a better buying decision.

The Lightbox was established, and the asset rules and associated guidelines were developed to ensure and improve consistency of the Photographs taken and the imagery thereby produced of the products displayed. The objective of each Photograph set taken of each product line is to provide an accurate and complete depiction of the product ensuring that the products are attractively displayed to generate customer engagement whilst, so far as possible, minimising the risk of customer dissatisfaction prompting returns which are administratively burdensome and costly for the Appellant.

The catalogues did not use the full set of Photographs shot. However, the website will show a complete set of Photographs (i.e. one meeting each of the asset rule requirements). Individual shots, usually the modelled or still life front Photograph, will also be used in a dynamic feed (of the type described above at paragraph 28) and on search engine optimised adverts or shopping search results (see paragraph 32 above). They are also used on picture links for the department in which the product or that category may be found.

The effectiveness of the Photographs is measured by conversion rates and returns statistics, not by uptake of credit products. In FY22, the Appellant’s returns rate was 16.38%, with only 0.5% attributed to items “not as pictured or described,” demonstrating the accuracy and utility of the imagery.

The Photographs do not depict the financial services offered by the Appellant through SDFC. However, Mr Stocker accepted, as was obviously the case, that the Appellant’s website promoted its flexible payment offerings and, where relevant insurance, on the same page and in physical proximity to the Photographs. He also accepted that a customer wanting to purchase a particular product may proceed to buy because of the flexible payment options available such that the availability of payment options has an effect on making retail sales which, in turn, enabled the Appellant, dependant on the flexible payment option chosen, to generate interest income.

Mr Stocker explained the difference between the Photographs and what he termed “aspirational” photography. As explained, product specific photos are taken of the product alone (in the case of furniture and household items there will also be setting photographs). Aspirational photographs are likely to be multi model, multi product photographs taken in location settings. He observed that the aspirational photographs conveyed the brand, they are shot subject to different criteria and not subject to the asset rules. He informed us that the document referred to at paragraph 43 concerned aspirational photography but that the findings of the report informed the guidelines for Photographs.

Mr Prescott explained the interaction between the Appellant’s retail and finance offerings. He accepted that whilst the retail and finance businesses operated through separate legal entities, the retail and finance businesses are symbiotic to one another. The aim of the finance business is to provide flexible payment terms for retail customers. Some of the flexible payment terms are interest bearing and others are interest free.

Customers are required to have an account either a cash or credit account. There is value to the Appellant in requiring customers to have an account as the account agreement authorises the Appellant to retain the customer’s information and permits direct marketing (we assume subject to GDPR opt in or opt out). Customers with a cash account must pay for their purchases with debit or credit cards at online checkout. A customer with a credit account too can pay immediately with a debit or credit card but also has a range of options available, and those options differ slightly as between the Very and Littlewoods brands.

Littlewoods credit account customers choosing not to pay immediately can spread the costs over 20 weeks on an interest free basis, Buy Now Pay Later (interest bearing), and more traditional interest free and interest-bearing finance.

As an alternative to pay now, Very provides for buy now pay later (this will be interest bearing only if payments on the agreed programme are missed), pay monthly (pay nothing, interest free, until the statement due date and then interest bearing in following months if the full account amount is not settled) and Take 3 (three equal monthly instalments paid over 3 months; interest bearing only if payments are missed and then interest is backdated to the date of purchase).

In each case, whenever a customer chooses to pay immediately, they are provided a further reminder of the flexible payment options.

Mr Prescott accepted that the Appellant operates its retail and finance businesses to “make good things easily accessible to more people” with the focus of the “to more people” aspect of the strategy addressed at providing flexible payment options to those who, for whatever reason, preferred not to pay immediately. He accepted in cross examination that “for whatever reason” would include those unable to pay without the ability to spread the cost of the purchase. Thus, and consistent with that strategy, the provision of flexible payment options facilitates the sale of retail goods and that thereby the sale of retail goods also facilitates the provision of financial services.

The strategy to offer flexible ways to pay to customers of SDFC is an important one to the Appellant group. Consistently, approximately two-thirds of all sales by SDHS are made on non-interest bearing terms via a credit account.

In cross examination it was repeatedly put to Mr Prescott that the Appellant had “bull’s eye”, “target” or “sweet spot” customers. He confirmed that the terms put to him were used within the business generally but considered them to be used primarily in a marketing context. He accepted that in certain, but not all, periods the Appellant modelled its marketing to attract certain types of customers, particularly the household budget holder (usually female) of a family. In more recent periods these customers were “labelled” as “families on a budget”.

He also accepted that in all periods the Appellant segmented its accessible market identifying those who were most valuable to the business. The measure of value including retail spend, loyalty, and propensity to pay interest. His view was that some loyal and long-term customers of value to the business only used interest free credit options.

However, Mr Prescott’s evidence was that from an SDFC perspective the business focus was on ensuring that credit was advanced responsibly and to customers who would generally meet their debt obligations. In this context customers are assessed by reference to a “credit set”. Individuals in credit set 1 are the most likely to default with those in credit set 11 least likely to default. Mr Prescott explained that SDFC does not extend credit to those assessed at the outset as in credit sets 1 – 5, though customers with existing debt previously advanced may move into such credit set ratings. Individuals in credit sets 6 – 8 are more likely to pay interest on the credit advanced to them and are moderately likely to default. Those in credit sets 9 – 11 more frequently take advantage of interest free credit offerings and are less likely to default.

Mr Prescott considered that offering flexible ways of payment was now almost an imperative for online retailers in order to stay competitive. He observed that some online retailers make such facilities available through external third-party providers such as Klarna and PayPal credit.

All finance marketing is strictly regulated. The Appellant, through Mr Prescott and his team operating from within SDFC, is responsible for the innovation, development and management of the finance products offered to support flexible payment for goods sold by SDHS together with the insurance offering made in respect of predominantly sales of electrical products. Any marketing of finance products is carefully curated and limited in scope. It is funded from a separate budget to both product specific and aspirational marketing. The language used to promote the flexible payment offers on every page of the retail shop is signed off by SDFC to ensure regulatory compliance.

In response to HMRC’s cross examination Mr Prescott explained that customer lifetime value (as per the Bond Offering Memorandum) is enhanced through length of relationship, volume of purchases and interest income. However, he was clear that customers with a higher credit set rating using flexible payment options could easily have a customer lifetime value greater than a customer with lower credit set ratings who purchase less frequently even where they do so on interest bearing credit terms.

From the evidence outlined above we make the following findings of fact:

We are grateful to both Counsel for their clear skeletons, submissions, and willingness to engage with our questions. We set out below our summary of those submissions. The parties should, however, be assured that when preparing this judgment, the terms of the skeletons were reread and the transcript reviewed. Because we do not deal specifically with any point does not mean that it was not considered in the round when reaching our decision.

The Appellant contends that when determining whether there is a direct and immediate link between the Costs and exempt supplies of interest-bearing credit and/or insurance we should objectively determine the function and use of the inputs in respect of which the Costs have been incurred and not the commercial context or ultimate aim of the business.

The Costs in this case are, as explained and evidenced by Mr Stocker, product specific to goods sold by way of taxable retail sales; the Photographs display the goods serving as a substitute for the physical display of goods in a bricks and mortar shop. That is the very purpose of the asset rules. The Photographs allow customers to inspect products virtually, view them from multiple angles, and make informed purchasing decisions. This reduces returns and enhances the customer experience.

The Photographs are not used to generally promote the business as a whole and make no reference to the exempt supplies of finance/insurance. The costs incurred in the production of photographs used to promote the brand are accepted as attributable to taxable and exempt supplies and thereby subject to residual recovery.

The Appellant rejects HMRC’s argument that the integrated nature of the business, or the commercial links between retail and finance, are sufficient to render the Costs residual. The correct test, as determined by the case law, does not operate on the basis of general commercial or economic links and requires a component-by-component analysis of use. In this regard, the Appellant relied on the analysis and conclusions of the Court of Appeal in ROH.

The further argument advanced by HMRC as to co-location of the Photographs with messaging concerning credit and/or insurance is also rejected by the Appellant. The Appellant submits that the cases of Skipton and DaP demonstrate that it is appropriate to look at what the incurred costs are used for. In Skipton and DaP the costs concerned the placement of adverts referring to both taxable and exempt supplies and concluded that they were residual costs. The cases did not concern the component costs making up the content of the adverts so placed. In the view of the Appellant, it is impermissible to look at the website as a whole to determine how the various components feeding into the website are used. The Photographs are no more directly linked to the supply of credit than the curated pop ups providing information about the finance are directly linked to the sale of goods. However, it is right that the cost of laying out and hosting the website are residual applying the analysis in Skipton, and DaP.

The Appellant considers that the leading and relevant authorities to be applied are those of Southern Primary and ROH. These precedents from the Court of Appeal provide the route map to determine this appeal. It was submitted that Sofology is an example of the application of those principles in the context of the costs of advertising on Google. However, the Appellant is of the view that the analysis in N Brown does not survive ROH as it placed too great an emphasis on wider economics of the taxpayer’s business when determining the existence of a direct and immediate link.

On the evidence the Appellant contends that the inputs giving rise to the Costs are used exclusively in the making of taxable supplies. The Costs are incurred in the production of Photographs which are objectively used only to promote the retail sale of the goods. Any connection to credit or insurance sales are necessarily indirect because credit and insurance is not displayed or promoted by the Photographs but by the pop ups and the website more generally.

HMRC’s case is that the Costs are not used exclusively for taxable supplies. Rather, they are used to promote both the Appellant’s taxable supplies of goods and its exempt supplies of credit and insurance intermediary services.

HMRC’s case is predicated on two core submissions:

HMRC emphasises that the Appellant’s supplies of goods and financial services are two aspects of a single, integrated business. The provision of credit is not ancillary to the supply of retail goods but central to the Appellant’s customer proposition and marketing strategy which is designed to promote both goods and credit simultaneously. This is confirmed by the way in which the Appellant describes its business in its annual reports, the statement to investors in the Bond Offering Memorandum, and internal papers concerning the marketing strategy.

HMRC highlight that the Appellant’s marketing strategy targets “core” or “bullseye” customers who are most likely to use credit and pay interest. These customers meet a particular demographic profile, often younger and with lower credit scores, who it was said are more likely to use credit and pay interest. The business closely monitors customer behaviour and uses advanced data analytics to target what are described as high-value customers. The marketing materials, including product specific photographs, are used throughout the customer journey to promote both goods and credit, driving both sales and interest income.

As was the case in N Brown the only conclusion available to us is that the Photographs used in the catalogues and on the website have a direct and immediate link to both taxable and exempt supplies due to the two-way relationship between them.

HMRC accepts that product specific photographs are essential for displaying goods but contends that their use is not limited to taxable supplies. Every example of their use on the Appellant’s website or catalogues is accompanied by prominent references to credit offers. The photographs and credit offers are presented together, and in some cases, credit offers are superimposed on the photographs or appear as pop-ups. The photographs are thus used to market both goods and credit, and the associated costs are mixed use.

To consider the photographs in isolation is wrong as they are incorporated into webpages and catalogues that promote both goods and credit. The costs cannot be separated from the mixed-use context in which they are deployed. Any attempt to treat product specific photographs differently from other marketing costs is artificial and unsupported by the facts.

HMRC contend that the marketing materials, including product specific photographs, are used throughout the customer journey to promote both goods and credit, driving both sales and interest income and, where relevant, insurance.

Whilst HMRC caution against the Appellant’s attempt to draw parallels to costs incurred by bricks and mortar retailers they rely on DaP, Skipton, Sofology and particularly N Brown as laying the rails on which we should travel; these cases, they say, determining what they consider to be a short and easy point for which there is already clear authority namely that the marketing expenditure of a partially exempt business will be determined in accordance with the objectively observed features of the marketing i.e. if the marketing material references both taxable and exempt supplies all the associated costs of producing the material will be mixed use. In this case the photographs are used in environments where both taxable and exempt supplies are marketed.

HMRC submits that the Appellant has failed to meet the legal burden to prove exclusive use for taxable supplies. They contend that the Appellant failed to tender the relevant witnesses to address critical questions as to the marketing strategy and the integration of the retail and finance businesses. However, they contend that the documents speak for themselves in this regard putting beyond doubt that the degree of integration of the business, the obvious marketing strategy to target customers most likely to use flexible payments options, often resulting in exempt supplies of interest bearing credit, through websites that use the Photographs on which the Costs have been incurred sit alongside materials promoting the use of credit amply demonstrated that the objective use to which the Costs are put is in making both taxable and exempt supplies.

We start by reviewing the key cases to which we were referred and from which we distil the approach we should adopt in evaluating the evidence presented to us in reaching our conclusions in this case.

We start with Southern Primary. The taxpayer in that case was involved in three related transactions: (1) the purchase of a plot of land on which it bore VAT; (2) the sale of the land to a housing association on which it did not charge VAT; and (3) a development contract with the housing association for the construction of houses on the land. The three contracts were commercially connected. The purchase and sale of the land were conditional on the granting of the development contract and the fact-finding tribunal determined that the sale of the land and the development contract were commercially a single transaction. The taxpayer sought to recover the VAT incurred on the purchase of the land as attributable, in part, to the development contract and thereby recoverable in accordance with the relevant partial exemption calculations. The Tribunal and first level appeal concluded that the input tax was attributable to the development contract.

HMRC challenged the decision on attribution contending that such a conclusion impermissibly (a) focused on the taxpayer's overall commercial aim; (b) treated the supply of the land and the development contract as if they were one supply; (c) elided the question of commercial connection with the question of attribution; (d) considered there to be a direct and immediate link where an input enabled a taxable supply; and (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.

The Court of Appeal concluded that whilst the land purchase was necessary to make performance of the development contract commercially possible that was not the relevant test which focused on the direct and immediate link between the VAT incurred on the purchase and the taxable supply of development services. The direct and immediate link requires more than a “but for” relationship between the cost and the taxable supply. The development contract was carried out on the land purchased; the ownership of the land ultimately made no difference to the works carried out under the development contract. Viewed transaction by transaction the land purchase was exclusively attributed to the onward sale of the land by way of an exempt supply.

Allowing HMRC’s appeal, the Court of Appeal concluded:

“37.

VAT law does not work in such a generalised way. You have to look at transactions individually, component transaction by component transaction. They may be linked in the sense that one would not have happened without the other, but they remain distinct transactions nonetheless. Only if one transaction is merely ancillary to a main transaction can one disregard the distinct nature of each transaction … If that were not so, the principle of neutrality would be violated. Moreover there would be intractable problems as to which input was being attributed to which part of the 'overall transaction'. You may find, as here, taxable and exempt transactions all mixed up in the same 'overall' transaction which is illegitimate.”

DaP concerned VAT incurred on the placing of adverts in the national press, leaflet distribution, direct response TV, the internet and other sources. The taxpayer’s business was the marketing of mobile phone handsets and airtime contacts, accessories and associated services including insurance. Income was earned from the mobile service providers and the insurance companies to whom the taxpayer introduced customers through its activities. The adverts placed prompted customers to contact the taxpayer. Such customers would sign up to an airtime service contract. Having so agreed, the customers were offered free insurance for three months if they agreed to sign a direct debit for continued insurance. The insurance contract could be cancelled within the 3-month period. If it was cancelled, no insurance commission was earned.

The taxpayer contended that it should be entitled to recover the VAT incurred on the marketing costs in full because the cost of the adverts was attributed first to the airtime service commission earned when the taxpayer successfully introduced a customer making contact as a consequence of the marketing. It was contended that the insurance commission was earned only indirectly and in consequence of the customer agreeing to proceed with the contracting for the use of the phone and network charges. Further, the insurance commission could only ever be earned three months after the airtime contract was entered and only if the customer did not cancel in the free period.

The Court of Appeal determined that DaP had effected an introduction to the insurance company upon the signing of the direct debit and was entitled to earn a commission and a share of profits in respect of customers who continued beyond the free insurance period. On that basis, the Court considered it indisputable that marketing material which, where relevant, referred to the free insurance, was attributed to both the taxable and exempt supplies made. Whilst the airtime service commission was more closely linked to the marketing costs, there was a sufficient link to the insurance commission particularly given the importance of the insurance commission economically and commercially. Arguments that the commercial connection was akin to that in Southern Primary were rejected by the Court.

The final Court of Appeal authority is ROH on which the Appellant heavily relied. ROH concerned the deductibility of the production costs incurred in staging ballet and opera performances. The taxpayer contended that such costs were in part attributable to its catering facilities. It was HMRC’s position that there was no direct and immediate link between the production costs and the catering services. The unchallenged evidence before the First-tier Tribunal had been that a visit to the ROH was a “fully integrated visitor experience” and the catering facilities were “a key element for anyone attending a performance”. The income from catering and retail sales was required to support the taxpayer’s artistic output. It was accepted factually that the relationship between the productions and catering was a “virtuous circle, whereby the high quality of the artistic output drove demand for the catering offered by the ROH, which in turn increased the income available for spending on the artistic output.”

It was this accepted interdependency between the production costs and the catering income which formed the basis of the taxpayer’s conviction that there was a direct and immediate link between the cost of the production inputs and the catering supplies.

The Court of Appeal opened its analysis referring to the Supreme Court judgment in WHA Ltd v HMRC [2013] UKSC 24 and noting that “decisions about the application of the VAT system are highly dependent upon the factual situations involved. Small modification of the facts can render the legal solution in one case inapplicable to another”.

In its analysis of the agreed facts the Court of Appeal observed: “the production costs are incurred in order to create productions and to stage performances of them. Customers purchase tickets to attend those performances. Those costs do not relate directly to the catering supplies … they are not, for example, costs incurred in advertising the catering services nor do they provide any of the contents for the catering supplies.” As such there was no direct and immediate link between the production costs and the catering services despite the strong economic link and the commercial necessity that productions costs be incurred to drive the catering income.

We analyse these three precedents as requiring us to objectively determine whether there is a direct and immediate link between inputs and outputs by looking at the nature of the cost incurred and tracing it through and identifying in connection with which supplies the input was used. Commercial context will be relevant, but we must avoid taking a macro view of a business’s operations, equating commercial or economic necessity as establishing the necessary connection.

In Southern Primary, despite the commercial interdependence of the three contracts, this did not mean that the onward sale of the land did not represent the exclusive use to which the purchase of the land was put. In DaP the supplies of intermediary services to the airtime service providers and the insurance company were made in parallel and objectively the marketing inputs promoted both. In ROH a two-way relationship between staged events and catering in an integrated customer experience was insufficient to establish a link between production costs and catering but could have been sufficient for other heads of cost i.e. marketing, as referred to by the Court.

Moving on to the series of First-tier Tribunal decisions, Skipton considered marketing costs. In terms of chronology, it falls between DaP and ROH however, we do not see that the analysis in ROH would have altered the approach of that Tribunal. The case concerned whether the cost of placing adverts in local newspapers was attributed both to supplies of estate agency services and mortgage broking services. The case did not concern the costs of creating the adverts. The advertising space purchased (and under consideration) was typically used to display details of the local branch of the estate agency, a series of pictures showing a small photograph of the property, brief details and price;, most pages (in a particular period) also included a strap line communicating the range of service offerings available through the estate agency business including mortgage broking.

The Tribunal accepted that the provision of mortgage broking services represented a supply made by Skipton independent of and not ancillary to the estate agency services. There was a noted relationship between the mortgage services and estate agency services both in terms of the importance of the income derived and the ability to cross sell services. However, the question of whether there was a direct and immediate link between the newspaper placement costs and the mortgage services was not, as observed by the Tribunal, dictated by the commercial relationship between the services.

It was concluded that a direct and immediate link necessarily existed between an advert specifically mentioning mortgage services and the provision of such services. Whilst the primary purpose of the advert placement was to drive house sales, by referring to the mortgage broking business the adverts were objectively used to promote such services. Where, however, there was no mention of the mortgage services there was no similarly objective link between the placement costs and the exempt mortgage services despite the opportunity of cross selling mortgage services to potential buyers contacting the taxpayer as a consequence of seeing the adverts so placed.

The analysis in Skipton demonstrates that objectively assessed use is critical. An advert which does not refer to mortgage broking cannot be said to market such services and be attributed to them in the context of a business predominantly as an estate agent offering additional connected services.

The next case is Roald Dahl. It concerned costs incurred in refurbishing and maintaining museum exhibits which the taxpayer contended were in part attributable to taxable supplies made from the museum shop. The taxpayer gave evidence that the costs were incurred to improve the attractiveness of the museum and with a mind to available merchandise which would drive sales from the shop.

The Tribunal found that much of the merchandise sold in the shop was also available for sale by other retailers. As such the costs of the relevant museum exhibits could not form a cost component of the merchandise (produced by a third party) and simply sold by the taxpayer. The commercial interdependence between admission and museum sales could not create a direct and immediate link.

One of the items on sale in the shop were postcards of “lenticular” pictures also exhibited in the museum the creative design of which had been undertaken by a third party. The taxpayer sought to attribute the costs of creative design of the pictures in part to the production and sale of the postcards. The Tribunal determined on the evidence that the creative design company had been contracted only to create the pictures but not the postcards, albeit that the taxpayer was entitled to use the same design content to produce the postcards. Further, the postcards used the same ideas as were used for the pictures in the museum gallery, but the pictures did not form the “very subject matter” of the postcards. There was therefore no direct and immediate link between the expenditure on creative content and the postcards or their sale.

However, as regards what was referred to as “the Hut Book” the Tribunal was satisfied that there was a direct and immediate link between the museum design costs and the book. The book was produced and used in the museum itself to facilitate navigation and interpretation of the exhibits; it was also on sale in the shop – it was found to have “a curatorial as well as a commercial” function. Unlike the postcards, the costs of producing the concept for the book was explicitly provided for in the third-party design contract.

In our view, Roald Dahl demonstrates the very fine nuances that must be applied in these cases. Design costs for the lenticular pictures exhibited were not cost components of the lenticular postcards because the payment under the design contract did not relate to the postcards, despite the similarity between the picture exhibits and the postcards. The position was different with the Hut Book; there the museum guide and retail book were the same and the creative costs were incurred with both uses in contemplation.

HMRC contend that the present case can be assimilated and determined in the same way as in N Brown. The Appellant submits that the analysis in the case is unreliable following ROH. We have therefore very carefully considered this case cognisant of both the warning that small factual differences may mean conclusions in one case are inapposite in another case and with a mind to the rules of comity. In summary, comity requires that whilst courts of competent jurisdiction are not bound by the legal conclusions of one another’s judgments, such conclusions will be highly persuasive and should be followed unless the second court is convinced that they are wrong.

N Brown concerned an online retailer which provided financing arrangements to its customers. N Brown sought to fully deduct input tax across a range of costs all broadly considered to be marketing costs on the basis that the costs were incurred exclusively in connection with the retail sale of goods. Relevant to this appeal is the Tribunal’s consideration of the attribution of the input tax in question though there was also an apportionment question. On the facts, it was established that customers in the latter period covered by the appeal could pay for the goods with a debit or credit card at the point of order, whereas all sales in the earlier period and the significant majority of sales in the later period were made on credit terms. The credit operated similarly to a credit card i.e. it was on interest bearing terms, but interest did not accrue if the customer cleared the account within 28 days of the issue of the statement.

The case considered 15 broad ranging heads of marketing expenditure including the cost of placement of adverts through various media, physical marketing materials etc. Of relevance in this appeal were photo-shoots for both product specific and aspirational photographs.

The Tribunal found that the taxpayer had a broad strategy of attracting customers, particularly those likely to pay interest on the credit offered and then retaining them in the long term. Customers who routinely took advantage of the paid for credit offering were referred to as “rollers”. These customers were particularly important to the business, and, it was found, drove the marketing strategy; with increased marketing directed at this group of customers. The Tribunal was satisfied that there was a strong correlation between the retail and finance aspects of the business given the high proportion of rollers.

When considering the categories of cost the Tribunal noted, in the context of physical marketing material, that the taxpayer had accepted that any material expressly referring to the credit offering was properly treated as residual input tax. The case therefore concerned materials making no reference to finance. HMRC contended that such materials were nevertheless attributed to finance transactions because the taxpayer operated a “unitary business” in which the retail and finance businesses were inextricably linked; the opportunity to make retail sales being facilitated by the availability of credit and the sale of goods resulting in a predictable percentage of exempt finance income from such sales.

The Tribunal expressed that it had not found the attribution issue easy and that the issue was genuinely debatable. It concluded that the costs of producing physical marketing was attributed to both taxable and exempt supplies but “central to its conclusion [was] that the Group’s business as a whole demonstrated that there was a two-way relationship between sales of goods and sales of credit” as the core customer base were rollers taking paid for credit and these customers represented the focus of the taxpayer’s marketing. The Tribunal considered that viewed objectively the taxpayer was using the marketing to attract precisely the customers who predictably took credit. The Tribunal rejected the taxpayer’s argument that the credit sold itself given the relationship between credit and sales. The Tribunal distinguished between marketing expenditure and the cost of the products themselves on the basis that the products themselves were not used by the taxpayer to promote the overall business unlike the marketing expenditure.

A similar analysis was applied to the placement of advertising in which it was concluded that whether or not the adverts referenced finance, they were promoting the business. The costs associated with photo-shoots were dealt with very briefly in paragraph 218 and in 4 lines. The same analysis was applied to the photos produced as for marketing generally. There was no consideration of the separate categories of photographs and as such we have no means of knowing whether the Tribunal, had it turned its mind to it, would have attributed product specific photo-shoots in the same way as for the “black dress” or in the way it attributed the other more generalised marketing costs.

We address the asserted similarity of this case and N Brown below.

Finally, we consider Sofology. It concerned pay-per-click costs incurred by the taxpayer in connection with the sale of sofas. The taxpayer’s business model provided for the promotion of insurance provided by a third-party insurer from which it earned commission. The pay-per-click costs under consideration were only the payments made to the online search companies.

In a lengthy judgment the Tribunal reviewed the case law on attribution. As we too have, the Tribunal observed of Southern Primary that the Court of Appeal emphasised the need to look at transactions individually, component by component and that a dependence (short of one supply being ancillary to another) between transactions was insufficient to establish a direct and immediate link. Concerning ROH, the Tribunal observed that the essential relationship between the production costs and the catering supplies in a fully integrated business was not enough to allow a conclusion that there was a direct and immediate link between them.

The Tribunal distilled the legal test to be derived from the case law. We summarise the various propositions made by the Tribunal as requiring that the direct and immediate link is to be objectively ascertained from all the circumstances including the economic context and consequences of the expenditure. However, a close, necessary or essential economic link is not sufficient to establish a direct and immediate link which will be determined by reference to the relationship between the input and the output. Once a direct and immediate link is established, the economic relationship between the outputs and the inputs will play more of a role to determine the fair and reasonable apportionment of the costs as between the taxable and exempt supplies.

When considering the evidence, the Tribunal noted that none of the material viewed by the potential customer from a general internet search from which a “click” was generated referenced the insurance offering. Rather, on the evidence, the promotion of insurance was carried out later in the process and usually after a customer had decided to purchase a particular sofa. Nevertheless, the insurance commission earned by the taxpayer was significant economically and could reasonably predicably be determined. The Tribunal concluded that insurance transactions were economically significant for the taxpayer and that there was a substantial economic connection between the adverts resulting in the clicks and the insurance intermediary supplies. The supplies of the sofas were closely connected to the supplies of insurance, but the Tribunal determined that, however strong these connections, there was only an indirect link between an advert which did not reference insurance and the supply of insurance intermediary services.

Having considered the case law to which we were referred, and as noted by the panel in Sofology, the test to be applied is easily stated. We consider that we must objectively determine how the costs are used by the Appellant. We must take account of all the circumstances, including the commercial context, in which the inputs are incurred, and the outputs are made to determine if the inputs are used in the making of finance transactions in the sense that there is a direct and immediate link between the individual inputs and the outputs of the business.

HMRC essentially contend that this appeal is relevantly indistinguishable from N Brown and the conclusion of the Tribunal in that appeal has equal application here.

We do not agree. As we have found, the Appellant operates a business model founded on offering flexible payment options to the very significant majority of its customers. Over the periods covered by the various Claims the Appellant has identified those customers which represent the greatest value to its business. However, and unlike N Brown, a majority of the Appellant’s customers choose a payment option the terms of which enabled them to meet the cost of the goods purchased without bearing interest. As noted in ROH even a small factual difference can make the conclusion in one case inapposite in another.

However, even were we to have concluded that there was no relevant factual difference, and with respect to the Tribunal panel in N Brown, we consider that it applied the wrong legal test as now explained in ROH. Whilst we consider that ROH did not represent a paradigm shift in the test to be applied it has provided an extended narrative to the approach dictated in Southern Primary.

When seeking to identify a direct and immediate link the principal focus is a myopic one. How were the Costs used for the purposes of making supplies in the course of a business? Thus, whilst the business sets the context for the supplies, it is identification of the link between the input in respect of which a particular cost was incurred and the supply to which that input is directly and immediately linked or of which it forms a component which determines the attribution question.

The direct and immediate link test is not driven by the economic interdependency of business operations. Take as an example a struggling house builder which chooses to manufacture bricks because it is struggling to buy them because of a shortage of bricks. It uses the bricks in its house building operations and profitably sells the excess produced. Whilst the costs of manufacturing the bricks may have a direct and immediate link to the house sales and brick sales, the costs of roofing tiles, plumbing equipment etc would not be directly linked to the manufacture of bricks. This is so despite an objective assessment that, without the manufacture of bricks, the business would have been unable to build houses and having decided to manufacture bricks it now has a profitable second line of business. The fact that both supplies are taxable matters not one jot because the direct and immediate link is assessed on a transaction-by-transaction basis and not on a liability-by-liability basis.

In ROH, at HMRC’s invitation, the Upper Tribunal and Court of Appeal were urged not to consider the possible existence of a direct link on a business macro level. HMRC contended that the costs incurred for staging productions could not form a cost component of a supply of catering despite the integrated nature of the business or the economic dependency of the supplies. The Court of Appeal accepted that the correct approach was to look at a micro transactional level. It concluded that a customer of the ROH could neither eat nor drink the production and so there was no direct and immediate link between production costs and catering.

In N Brown the Tribunal predicated its decision on the existence of a two-way relationship between the supplies of goods and credit pursuant to which those who wanted to buy goods needed credit to buy them such that the credit facilitated the sale of goods and the sale of goods facilitated the granting of credit. That conclusion was reached because the taxpayer’s core base of customers predictably took paid for credit. We cannot reasonably distinguish that approach from that taken by the First-tier Tribunal in ROH in which it was accepted that there was a two-way relationship between productions and catering with customers attending productions wanting to dine thereby facilitating the sale of tickets. If that approach was wrong in ROH, it was similarly wrong in N Brown rendering the analysis in N Brown unsafe.

Thus whilst we accept that the Appellant’s business in this case is one predicated on offering flexible payment options some (but not a majority) of which result in the exempt supply of credit with such exempt credit thereby facilitating sales and sales facilitating the provision of credit, we do not consider that that is enough to establish a direct and immediate link between the Photographs or the associated Costs.

In order for the Costs to be mixed use we would need to be satisfied that the Costs were used to make exempt supplies of credit and insurance.

When determining how the Costs are used, we need to bear in mind the nature of the Costs i.e. modelling, studio, props etc. As such they are not costs of the type considered in DaP or Skipton. At the first stage of the analysis, the Costs are used to produce the Photographs and in accordance with the detailed requirements of the asset rules they accurately depict a single product for retail sale by the Appellant. The Photographs are used by the Appellant as a component element of their website and formerly the catalogues. When so used they display the item depicted to potential customers in a manner consistent with the documents and evidence demonstrating their purpose. Together with the narrative description of the product, the Photographs provide the potential customer with the details and specifications of the product to facilitate a decision whether to buy the goods. The Photographs are also used to visually display the types of products sold within generalised departments, by way of dynamic feed to display a range of items likely to be of interest to the customer, and in search engine adverts. In our view and by reference to the objective features of the Photographs, even when put to their various uses they are used to inform and display the product.

The Photographs do not mention or promote the credit/insurance services and, as already determined, the symbiotic relation between the sale of the goods and credit where it is taken is not enough on its own to establish a direct and immediate link to the credit transactions.

We then must consider whether use of the pictures alongside, and in close proximity to, information about flexible payment options is enough to establish a direct and immediate link to those financial services. It appears to us that we are urged by HMRC to equate the joining of various components of cost onto the website or into the catalogue, as an act of consumption.

In our view such an approach is not justified by any of the case law to which we were referred. In Southern Primary, the VAT was incurred on land which was sold then developed. The VAT was consumed in the exempt supply of the land. In Skipton and DaP, the costs were of a nature where there was an objectively assessed connection to the exempt supplies because they were placement/distribution costs for adverts mentioning the exempt supplies. On the other hand, in Roald Dahl the creation costs of the lenticular pictures were not attributed to lenticular postcards despite the apparent connection between them.

In each case, the conclusion is driven by the nature of the costs being attributed. We note that neither DaP and Skipton tell us how, for example, the photographs and collation of information about each of the houses or telephones shown on the advertisement spread were attributed.

When we consider the Costs, there is no immediate connection to interest bearing credit. Even for a customer that can only afford to buy the product over an extended period thereby requiring them to take interest-bearing credit, the Photographs do no more than inform the customer about the product depicted triggering a curiosity of how the purchase might be funded. The information facilitating a decision as to which payment option to take is provided discretely alongside the Photographs, and, if more information about those options is required, the Photographs are obliterated or partly obscured by the provision of that information.

Using the Photographs on a website or in a catalogue that also refers to credit/insurance does not consume the inputs in the way identified in Southern Primary because the website is not a supply.

Undertaking the multifactorial exercise beholden upon us, we cannot see that a set of Photographs of, for example, a dress/bedside cabinet/pack of t-shirts, produced with the objectively discernible purpose of ensuring that the product is accurately displayed to a prospective customer is somehow converted from being exclusively linked to the supply of that product by being displayed with products of a different character whether exempt supplies or otherwise.

Our position is not relevantly altered by the use of the Photographs as examples of products sold in a department. This use is as a gateway to products of the same type as the Photograph. The position is even stronger where the pictures are used to produce search engine advertisements – they do not even reference credit or insurance.

We consider each use made of the Photographs to be exclusively in the making of taxable supplies of retail goods. Any link to credit or insurance is, in our view, at the most, indirect but given the nature of the Costs probably non-existent.

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.