An insurance or reinsurance business operating in the UK cannot avoid being deemed “partially exempt,” nor can it avoid the resulting cost of irrecoverable VAT, but it can take steps to minimise that cost. This article considers the partial exemption guidance (“Guidance”) for the insurance sector, written and compiled jointly by the Association of British Insurers (“ABI”) and HM Revenue & Customs (“HMRC”), and explains some of the unique issues faced by businesses operating in this sector.
A business is partially exempt if it is entitled to recover some, but not all, of the VAT it pays to its suppliers. Generally, VAT paid by a UK business to its suppliers (“input VAT”) is recoverable either as a credit against VAT charged to its customers (“output VAT”) or as a repayment direct from HMRC. However, a business is not entitled to recover input VAT suffered on costs which are “used or intended to be used” in making supplies which are exempt for VAT purposes (“Exempt Supplies”). Any business which makes both exempt and non-exempt supplies will be partially exempt, and it will need to operate either the partial exemption “standard” method or some other “fair and reasonable” method for calculating the amount of its input VAT which it can recover.
Most supplies made by a UK-based insurance or reinsurance business to UK customers are likely to be Exempt Supplies, with only a small proportion of UK supplies being standard or zero-rated and, therefore, carrying a right to recover corresponding input VAT. However, a UK insurance business which make supplies to overseas customers or operates offices overseas should keep its recovery position under regular review because it may be entitled to recover significantly more input VAT than would be the case if it operated solely within the UK.
In particular, input VAT is recoverable if it is incurred on goods or services which are “used or intended to be used” for the purpose of supplying insurance services which are linked to the export of goods to a place outside the European Community or are made to a customer who belongs outside the European Community. Accordingly, an insurance business should seek to maximise the input VAT which it is entitled to recover by identifying, to the fullest extent possible, its vatable costs which are “used or intended to be used” for the making of such non-EC supplies or UK supplies which are standard or zero-rated (together, “Taxable Supplies”).
Standard v Special Method
The Guidance provides a useful outline of the basic principles of partial exemption and explains a number of methods for determining the proportion of input VAT incurred in respect of costs which are “used or intended to be used” in making Taxable Supplies.
The initial stage in the standard method of input VAT allocation is to identify, first, any input VAT which is wholly recoverable (because it relates to costs which are directly attributable to the making of Taxable Supplies) and, secondly, input VAT which is wholly irrecoverable (because it relates to costs which are directly attributable to Exempt Supplies). For many partially-exempt businesses, the majority of their input VAT will fall in one or other of these direct attribution categories, leaving a relatively small residual amount of input VAT which is referable to both Exempt and Taxable Supplies. This residual input VAT, for example input VAT on “overheads”, falls to be apportioned between Exempt and Taxable Supplies using a “fair and reasonable” allocation method.
However, the nature of insurance business and the way in which insurers are generally organised both within the UK and internationally, means that relatively few costs are used wholly to make Exempt Supplies or wholly to make Taxable Supplies and, therefore, the standard partial exemption method will rarely be appropriate. Consequently, HMRC and the ABI have agreed a relaxation of the standard method so that the direct attribution of input VAT need not always be the first step in applying a special method for insurance businesses. Any insurance company which has relied on the standard partial exemption method since it began operations should consider whether this relaxation would be beneficial as its business expands or its corporate structure becomes more complicated.
Input VAT which is not directly attributable to particular onward supplies falls to be allocated according to a special method agreed with HMRC. The Guidance explains the types of method which HMRC expects to be used, although it is not prescriptive so, in theory, an insurance company could agree a different method with HMRC provided that it results in a “fair and reasonable” allocation of input VAT.
HMRC will only approve the use of a special method after the taxpayer has made a declaration that he has taken reasonable steps to ensure that the proposed method is fair and reasonable. By agreeing to a proposed method HMRC does not represent that the method is in fact fair and reasonable, only that it has not been identified as being unfair or unreasonable in the circumstances. Familiarity with the Guidance should enable an insurance company to declare with increased confidence that its chosen special method meets the “fair and reasonable” test.
Any proposed special method should, of course, be “fit for purpose”. This means that it should be able to cope with reasonably foreseeable changes in the insurer’s business, provide definitive apportionment for all input tax likely to be incurred, be capable of operation without undue difficulty by the business, admit of double-checking without undue difficulty by HMRC, and, finally, should reflect the economic use of costs in making Taxable or, as the case may be, Exempt Supplies.
The Guidance recognises that insurance businesses are typically divided into business sectors for the purposes of internal reporting and decision making. Where this is the case, the first step in an appropriate special method is likely to be the allocation of input VAT between the company’s operational sectors.
HMRC encourages the use of a sector-based allocation method because it enables each part of a business to adopt a separate partial exemption calculation appropriate to its circumstance. Although it is recognised that the sector approach increases complexity and compliance costs, HMRC considers that it produces greater accuracy and lessens the risk of distortion.
A sector-based special method should reflect the actual business sectors within an organisation and should not try to impose sectors solely for VAT allocation purposes. However, a UK insurer would be well advised to give due consideration to the VAT consequences when considering its internal organisation. By way of example, the Guidance says that it is good practice for sectors to be defined in terms of the activities they cover, rather than their status within the relevant entity. It may also be advisable to recognise certain “use basis” sectors for major projects outside the day-to-day insurance business. This effectively ring-fences the VAT treatment of the relevant project, enabling the insurer to agree with HMRC on a suitable basis for input VAT apportionment separate from its wider activities. Whereas a small insurance company might have only business-based sectors, a large company would be expected also to have overhead sectors such as “head office matters” and “firm-wide support.”
HMRC expects that the allocation of input VAT between business sectors will usually be based on a business’s internal management cost accounting systems, because this is likely to represent the business’s best view on the economic use of its costs. The Guidance notes that an appropriate allocation method is likely to distinguish between sectors which are cost centres, profits centres or a combination of both.
The process of allocation may be particularly difficult where UK costs are incurred for the purpose of overseas offices, so HMRC typically accepts a method which treats all input VAT used for non-EU branches as recoverable and all input VAT incurred for EU branches as irrecoverable. Although this clearly simplifies the allocation process, it may not always give the best result, so an international business should consider whether there may be an alternative “fair and reasonable” method which would increase its overall input VAT recovery percentage.
Once costs have been allocated to sectors, the usual methods of apportionment between Taxable and Exempt Supplies can be carried out within each sector.
Inevitably, some costs will relate to more than one sector and for those costs the relevant input VAT may be allocated between the sectors in alignment with economic usage and only then apportioned between Taxable and Exempt Supplies. A similar process of allocation and apportionment is followed for overhead costs which are incurred for the benefit of all business sectors. Finally, input VAT on costs incurred in providing inter-sector supplies are identified and allocated.
HMRC’s favoured allocation method determines economic usage by reference to internal cost accounting, but it will accept departures from this method if it proves to be distortive or too complex. For example, headcount may, in certain circumstances, operate as a substitute for any use-based allocation. Similarly, for costs related to a single operating location, a floor space allocation may be appropriate if different sectors occupy specific floor areas.
Inevitably, the quarterly allocation and apportionment which applies to input VAT on costs which are not directly attributable to either Taxable or Exempt Supplies will represent an approximation based on a “fair and reasonable” methodology. To increase the accuracy of the calculation over the longer term, an annual adjustment is required at the end of each 12 month period to allow the quarterly calculations to be revisited and appropriate adjustments made.
The Guidance, which the ABI and HMRC have undertaken to update regularly, is a welcome insight into how HMRC applies the “fair and reasonable” test to proposed partial exemption special methods within the insurance sector. As an insurance business expands into new markets or geographic locations, or reorganises its internal structures, VAT compliance may not naturally be high on its list of priorities. However, appropriate consideration of the Guidance at times of change may help a company to reduce costs by avoiding both unnecessary VAT leakage and unexpected compliance costs at a later stage