The cost-sharing exemption has been a mandatory provision of the Principal VAT Directive since 1977 but it has not yet been introduced by the UK. However, draft legislation to implement the exemption now forms part of the current Finance Bill. There are six conditions to benefit from the exemption; of these, the two conditions which have provoked the greatest comment and are likely to have the most impact are the requirement for an ‘independent group’ and the requirement that any services supplied by the independent group must be ‘directly necessary’ for exempt or non-business activities. The exact detail of how the exemption will operate is still unclear but is likely to evolve as both HMRC and taxpayers become involved in specific projects.
I have a vested interest in assessing the impact of the cost-sharing exemption. From July 2010 I was the lead policy adviser in Treasury, on secondment from Grant Thornton, responsible for looking at the options for implementing Article 132(1)(f). Having devoted a considerable part of my career to it I certainly hope that organisations that could use it are up to the challenge.
In this article I want to explain some of the background to the exemption and the UK implementation and then examine certain aspects of how HMRC intends to operate it.
The cost-sharing exemption has been a mandatory provision of the Principal VAT Directive since 1977. The UK has not introduced it essentially because of uncertainty over its scope and purpose. It is not just the UK that has difficulty understanding it, you only have to look at the diverse ways in which it has been implemented in other Member States. In some it represents a valuable means of reducing VAT costs on shared services, whereas in others its narrow implementation means that it is hardly used. Clearly this inconsistency fails to create a level playing field for organisations operating across the EU and also provides planning opportunities. The Commission has shown increased interest and has set out how it believes the cost-sharing exemption conditions should be interpreted. Member States that do not conform to the Commission's view face the threat of infraction. Indeed Germany and Luxembourg are currently the subject of Infraction Proceedings.
Increased interest from the Commission, combined with potential beneficiaries' growing awareness of the relief, prompted HMRC and HM Treasury to look at the exemption and review options for implementing it. After what must have seemed, from the outside, a long period of review and consultation, the decision to implement was announced in the recent Autumn Statement. Draft legislation followed which is now part of the Finance Bill which should receive Royal Assent in the next two months.
The UK legislation contained in clause 196, creates a new Group 16 in VATA 1994 Sch 9 with the slightly misleading title of ‘Supplies of services by groups involving cost-sharing’. The title reflects the wish to draft the clause as closely as possible to the text of Article 132(1)(f) even though its use of the word groups is very different to other references in VATA 1994 such as ‘VAT groups’ as defined by s 43. The wording of the new Group 16 also follows very closely the Principal VAT Directive and does not provide any detail of how the exemption is to be applied in the UK. This detail will be set out in guidance. A draft was circulated to interested parties by HMRC just after the Budget with a closing date for comments on 18 May. It is hoped that the final version will be published just prior to Royal Assent. However the fact that operation is contained in guidance means that it will be relatively easy to change. Whatever is published in June should therefore only be regarded as HMRC's current position. This in itself is likely to put off some potential users.
Introducing the exemption HMRC stated that it wants it to be available and useful for a wide range of organisations. However it is limited by the wording of the Directive. By not attempting to restrict membership of cost-sharing groups to particular sectors one of the objectives appears to have been met. It, therefore, can be used by a diverse group which includes banks, universities and charities. The big question though is whether it will, or can be, used in practice?
There are many ways that organisations can collaborate to improve efficiency and effectiveness. Whether the exemption is useful will depend first upon the types of collaboration it promotes actually making commercial sense and if they do will HMRC's interpretation of the conditions allow it to be used?
The draft guidance produced by HMRC is consistent with the Consultation Responses Document issued on 6 December 2012.
Based on the draft legislation, to benefit from the exemption there are five conditions to be satisfied:
HMRC has, however, introduced a sixth condition that apart from having exempt or non-business activities a member must also receive a qualifying service. This is defined as being a service which falls within Group 16 and is exempt. This condition, whilst appearing reasonable and relatively minor, will have an important impact on how the exemption operates. I will look at this in more detail later.
There are two conditions which have provoked the greatest comment and are likely to have the most impact on use: firstly what is actually meant by an independent group and secondly how should ‘directly necessary’ be defined?
It remains HMRC's view that an independent group must be separate from its members. More precisely it must be regarded as a taxable person not within the UK definition of a person that is or is required to be VAT registered but using the Article 9 definition ‘any person who independently carries out in any place any economic activity, whatever the purpose or results of that activity’.
HMRC resisted calls for them to relax this condition to allow members of the group to supply qualifying services to each other without the requirement to form a separate entity, despite these arrangements being allowed in some Member States. Whilst adopting the same approach would have made it much easier to use the exemption it is HMRC's view that Article 132(1)(f) does not allow them to do so. One of the grounds that the Commission is infracting Luxembourg infers that it shares HMRC's opinion.
The type of entity is not specified by HMRC, and is left for the members to decide. The only restriction being that it is capable of being registered by HMRC on its own account.
One of the criticisms of HMRC’s proposals is that the exemption could not be easily accessed by organisations looking to share services on a one-off or short-term basis because of the costs associated of setting up the cost-sharing vehicle. The position taken in the formal consultation document was that not only was it required to be separate from its members but it also had to be commercially independent as well. It could not be under the control of one of its members. Maintaining this position would have made the exemption unusable by corporate groups. It was also said to close the door on arrangements where a larger organisation wanted to share services with smaller bodies.
HMRC has reviewed its position and provided the entity is wholly owned by the members it will leave it to them to decide the proportion each holds. This relaxation allows the exemption to be accessed by corporate groups. It also means that the cost-sharing entity could be controlled by one member and where it is a corporate body it could be included within that member's VAT group. This change should allow the exemption to be used in much wider circumstances than originally proposed.
The interaction of the exemption with VAT groups appears to present opportunities to mitigate the VAT costs of forming and operating the shared service arrangements.
Services provided by the cost-sharing group can only be exempt from VAT if they are directly necessary for its members exempt or non-business activities. The guidance definition is consistent with that proposed in the Consultation Responses Document. HMRC has taken the view that is not the nature of the service which determines whether it is directly necessary, but it is the use to which it is put by the recipient. This avoids the need to define individual services but increases the complexity of operating the exemption.
In detail HMRC has said that if the member uses the service wholly and exclusively for its exempt activity it will qualify for the exemption. This is consistent with the Commission’s current position judging by the wording of the Infraction against Luxembourg. However, the test, if applied strictly, would render the exemption of little practical use.
This is because organisations are more likely to share general overhead services. As most have an element of taxable activity the exclusivity test would be impossible to meet. To make the exemption more accessible HMRC has chosen to use powers contained within Article 131. This Article allows Member States to introduce regulations for the purposes of ensuring the correct and straightforward application of the exemption. To allow a wider use of the exemption a service will, as a result, also qualify if the member's taxable use is less than 15%.
HMRC has not specified how taxable use should be determined. It has indicated that any reasonable method can be used. This can mean looking at the organisation's activities as a whole but if necessary also seeking to attribute the cost to part of the organisation with taxable activity below the threshold. This may involve reviewing existing partial exemption methods or even restructuring to isolate the taxable portion from the exempt and non-business activities. HMRC has, however, stopped short of allowing a single supply of services supplied to the whole business being apportioned so that the proportion with a taxable use of less than 15% qualifies for the exemption with the remainder being taxable.
Overall the flexibility of approach is welcome but it does place considerable onus on the cost-sharing group to determine the correct liability of its supplies – particularly where a member has taxable activity which fluctuates or hovers around the 15% threshold.
Some other Member States have adopted a similar route but it is not certain that the Commission will agree as they are infracting Luxembourg partly because they allow all services provided to a member with up to 30% taxable activity to qualify for the exemption. HMRC has admitted that adjustments may be required to the UK position in the future, but any change would not be retrospective. This uncertainty may restrict use of the exemption particularly where collaboration projects require significant investment.
According to Article 132(1)(f) a supply can only fall within the exemption if it is made by an independent group to its members for the purposes of their exempt or non-business activities. It is therefore perfectly possible for the cost-sharing group to make supplies which fall outside the exemption for example when:
Whilst the Directive does not contain any restriction on the level of exempt or non-business activity that a member should have, HMRC has insisted that it should be at least 5%. The justification for this is to ensure that there is a consistent and substantial exempt or non-business activity. There is no expectation that it will present a serious barrier to organisations joining a group.
There is an additional condition that to remain a member it must, in a 12-month period, receive a qualifying service. A qualifying service is defined as one which falls within the exemption.
If it does not receive a qualifying service the member is required to leave the group by relinquishing its interest in the cost-sharing entity.
This seems an unnecessary restriction as the member is punished because the supplies it receives will have been taxable. There is no threat to tax receipts and it will result in added cost and uncertainty. HMRC's principal concerns would be relieved if the condition was only that the member should receive a service from the cost-sharing group.
The exact detail of how the exemption will operate is still unclear and I would expect it will evolve as both HMRC and taxpayers become involved in specific projects.
While, in principle, the introduction of the cost-sharing exemption is a very big deal for eligible taxpayers, as it removes a tax barrier, I believe that it is too early to make a precise assessment of the impact that the exemption will have on promoting collaboration.
Mark Hampson, VAT Senior Manager, Grant Thornton
