England and Wales Court of Appeal (Civil Division) Decisions

IN THE COURT OF APPEAL (CIVIL DIVISION)
ON APPEAL FROM UPPER TRIBUNAL
Mrs Justice Proudman
Tax and Chancery Chamber

		Royal Courts of Justice Strand, London, WC2A 2LL
		18/11/2011

Lord Justice Etherton:

Introduction

1. This appeal concerns the way in which VAT on supplies to a business, which itself makes both supplies subject to VAT and supplies exempt from VAT, is to be apportioned where the inputs are not directly attributable to either the business's taxable or exempt supplies alone but are attributable to both. In technical terms, it concerns the circumstances in which the taxpayer can establish that, rather than the standard method of attribution, which is based on the relative contribution to turnover of the different business activities, the attribution of residual input tax should be based on an alternative method, a Partial Exemption Special Method ("PESM").
2. By its decision published on 5 August 2009 ("the Decision") the First-Tier Tribunal (Tax Chamber) ("the FTT") allowed the appeal of the respondent, London Clubs Management Limited, from the rejection by the Commissioners for HM Revenue and Customs ("the Commissioners") of the respondent's application for a floor space PESM ("the proposed PESM"). The Commissioners' appeal from the Decision was dismissed by Proudman J in the Upper Tribunal (Tax and Chancery Chambers) ("the UT") on 5 October 2010. The further appeal to this Court is brought with her permission.
3. The appeal from the FTT to the UT was on a point of law only, as is the appeal from the UT to this Court: Tribunals, Courts and Enforcement Act 2007 ss. 11-14.

The factual background

4. The following account of the factual background is based on the helpful summaries of the FTT and Proudman J.
5. The respondent is the representative member of a VAT group comprising a number of companies carrying on business in the United Kingdom, Egypt and South Africa ("the Group"). The Group is ultimately owned by Harrah's Entertainment Inc, a US casino and entertainment group that runs, among other well known businesses, Caesar's Palace and the World Series of Poker. The Group operates 11 casinos in the United Kingdom. Five of these operations are in London, and there is one in each of Manchester, Leeds, Glasgow, Nottingham, Brighton and Southend. References in this judgment to the respondent are to be treated as references to all the companies in the Group.
6. The Gambling Act 2005 followed a lengthy period of consultation on the modernisation of casino gambling regulation. It was preceded by the publication of the Budd Report on gambling in 2001. That report included recommendations for, among other things, increasing the number of slot machines which could be operated on casino premises.
7. The respondent took leases of substantial premises in anticipation of a greater floor area being available for slot machines. Due to a change in government policy, however, the proposals for increased slot machine numbers were changed to a limitation of 20 such machines per casino. The respondent developed a new business strategy to enable it to make the best use of the space it had taken, namely the addition of restaurants and bars, the carrying on of an entertainment business, including corporate events, and the provision of dedicated space for poker.
8. The legislative changes permitted immediate entry into casinos, whereas there had previously been a "cooling off" period, and allowing customers to consume alcohol on the gaming floor. Furthermore, casinos were no longer required to operate as private members' clubs. As a result, all the respondent's casinos allow customers immediate access, without the requirement to produce identification on entry.
9. In consequence of those changes, the respondent regards itself as competing on a level playing field with others in the food, beverage and hospitality sectors. It seeks to target as customers not only those who wish to gamble but others who wish to attend the casinos solely to consume the food and beverage and generally to enjoy the non-gaming entertainment facilities on offer. Apart from one casino, however, the respondent has no figures for those who attend solely for the restaurants and bars.
10. As well as those customers who enter the casinos solely to use the bars and restaurants, gaming customers also expect food and beverage services to be available on-site.
11. The following supplies are made by the respondent at its casinos: gaming, such as roulette and blackjack, which is exempt from VAT but is subject to gaming duty; slot machines, which are VAT standard rated; dedicated poker facilities, which were VAT standard rated until 27 April 2009, and were then exempt from VAT but subject to gaming duty; bar sales, catering, entertainment and venue hire, all of which are VAT standard rated.
12. The FTT made the following findings on the use of space in the respondent's casinos on which they had evidence. The premises in each case had a mixed use of gaming, restaurants, bars and entertainment, all within a casino context. Some areas were physically separated, for example the restaurant area in The Sportsman casino was separated from the main gaming floor by being on a separate floor of the premises, and was separated from the poker room by a curtain. In the case of other areas, such as the bars, there was less physical separation. In all areas separate and identifiable floor space was occupied by the different parts of the business. Full restaurant dining facilities were provided, in defined restaurant areas, with extensive menus and table service. The type of restaurant differed from venue to venue, but included fine dining in Manchester and in Glasgow and a Michelin-starred chef at the Leeds casino. Customers were able to move easily between the different areas, for example from the restaurant to the gaming areas and from the gaming areas to the bar. Customers could consume drinks in the gaming area, and could be served light snacks, such as sandwiches, at the gaming tables. Use of a particular area of floor space for a particular activity was liable to change; for example, in order to increase profitability the space formerly occupied by a bar could be changed to use for gaming. Substantial areas of floor space were designated for use other than gaming, food, beverages and entertainment. Those areas included reception, toilets, staff rooms, management offices, corridors, lifts and the space occupied by the cashiers. Evidence was given that cash for all elements of the business was dealt with by the cashier function.
13. Not all of the food and drink consumed was charged for. A significant percentage was supplied free of charge to certain gaming customers. The percentage of non-charge food and beverage differed substantially between different casinos. For example, the non-charge percentage of total food and beverage sales for the period April 2008 to March 2009 varied from as little as 14.6 per cent to 94 per cent.
14. The food and beverage element of the business, comprising the restaurants and bars, was not profitable in its own right. It did, however, generate a positive return in each of the casino venues for the period in question in the proceedings (after deduction of direct costs). It made a contribution to overheads in management accounting terms, except for The Sportsman casino, which achieved a break even result.
15. A fair estimate of the proportion of the residual costs of the business that were property related was 71 per cent.
16. Under the respondent's existing PESM, residual input tax is apportioned by applying a fraction comprising taxable turnover over total turnover, with an adjustment to take account of the fact that residual input tax attributable to food and drink for which customers have not been charged is not deductible.
17. The proposed PESM moves from a turnover based method to a floor space method. The fraction to be applied to the residual input tax under the proposed PESM is, in simple terms, the area of floor within the respondent's premises occupied to make taxable supplies over the area of floor occupied to make taxable and exempt supplies, again with an adjustment to take account of residual costs associated with non-charged food and drink.
18. The Commissioners rejected the proposed PESM on the ground that it is not fair and reasonable, and certainly not more fair and reasonable than the existing method.

The legal principles

19. The applicable legislation is both European and domestic. At the relevant time the Sixth Directive 1977/388/EEC was in force. It has been superseded by Council Directive 2006/112/EC on the Common System of VAT, but without any change in substance as far as the issues in this case are concerned.
20. Article 2 of the First Directive 1967/227/EEC includes the following:

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

21. Article 17(2) of the Sixth Directive provides (so far as is relevant):

"In so far as the goods and services are used for the purposes of his taxable transactions, the taxable person shall be entitled to deduct from the tax which he is liable to pay:

(a) value added tax due or paid in respect of goods or services supplied or to be supplied to him by another taxable person;"

22. Article 17(5) of the Sixth Directive addresses the situation where costs are incurred both for transactions which are taxable and transactions which are exempt. It says:

"5. As regards goods and services to be used by a taxable person both for transactions covered by paragraphs 2 and 3, in respect of which value added tax is deductible, and for transactions in respect of which value added tax is not deductible, only such proportion of the value added tax shall be deductible as is attributable to the former transactions.

This proportion shall be determined, in accordance with Article 19, for all the transactions carried out by the taxable person."

23. The default method of attribution contained in Article 19(1) can be summarised as the fraction A/B where

(a) A is the total amount exclusive of VAT of turnover per year attributable to transactions in respect of which VAT is deductible under Article 17(2) and (3) [(3) not being relevant here], and

(b) B is the total amount exclusive of VAT of turnover per year attributable to transactions included in A and to transactions in respect of which VAT is not deductible (ie. exempt transactions).

24. Sub-paragraph (c) of Article 17(5) permits Member States to derogate from that default position and to authorise alternative methods to determine the deductible proportion on the basis of use of all or part of the goods and services.
25. The relevant domestic law is contained in the Value Added Tax Act 1994 ("VATA"). Section 24 of VATA defines input tax as tax on the supply to a taxable person of goods or services used for the purposes of a business carried on or to be carried on by him.
26. Section 25 provides that a taxable person is entitled, at the end of each accounting period, to credit for so much of his input tax as is allowable under section 26 and to deduct that amount from any output tax due from him. Section 26 provides that the only input tax for which a person is entitled to credit at the end of any period is that which is attributable to taxable supplies made by the taxable person in the furtherance of his business and not to exempt supplies. Section 26(3) provides that, where a taxable person makes both taxable and exempt supplies, the Commissioners shall make regulations for securing a fair and reasonable attribution of input tax to taxable supplies.
27. The Commissioners made Regulations pursuant to section 26(3), those relevant for present purposes being regulations 101 and 102 of the Value Added Tax Regulations 1995 SI 1995/2518 ("the Regulations"). Regulation 101 provides for what is known as "the standard method", the basis of which is set out in regulation 101(2) as follows:

"(2) In respect of each prescribed accounting period –

(a) goods imported or acquired by and goods or services supplied to, the taxable person in the period shall be identified,

(b) there shall be attributed to taxable supplies the whole of the input tax on such of those goods or services as are used or to be used by him exclusively in making taxable supplies,

(c) no part of the input tax on such of those goods or services as are used or to be used by him exclusively in making exempt supplies, or in carrying on any activity other than the making of taxable supplies, shall be attributed to taxable supplies, and

(d) there shall be attributed to taxable supplies such proportion of the input tax on such of those goods or services as are used or to be used by him in making both taxable and exempt supplies 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."

28. In other words, under the standard method, the amount of input tax which a taxpayer is entitled to deduct is the amount attributable to taxable supplies, calculated (i) by attributing to taxable supplies by the taxpayer the whole of the input tax on supplies to the taxpayer used or to be used exclusively in making taxable supplies; (ii) by providing that no part of the input tax on supplies used or to be used by the taxpayer exclusively in making exempt supplies is attributed to taxable supplies; and (iii) by providing that, where supplies to the taxpayer are used or to be used by the taxpayer in making both taxable and exempt supplies, the amount of the input tax attributed to taxable supplies is the proportion of the input tax on supplies used to make both taxable and exempt supplies which the value of the taxable supplies bears to the total value of taxable and exempt supplies. The turnover method in (iii) reflects Article 19 (1) of the Sixth Directive. Input tax on supplies to the taxpayer used to make both taxable and exempt supplies is called residual input tax.
29. Regulation 102 provides for "special" methods, that is methods of attribution other than the standard method. The Commissioners may either approve or direct the use of such an alternative method which, in accordance with the statutory objective under section 26(3), is directed to achieving a fair and reasonable attribution when the standard method does not do so, or at least a fairer and more reasonable attribution than the standard method. Regulations 102(1) and 102(1A) provide as follows, so far as relevant:

"(1) … the Commissioners may approve or direct the use by a taxable person of a method other than that specified in regulation 101 …

(1A) A method approved or directed under paragraph (1) above –

(a) shall be in writing …

(9) With effect from 1^st April 2007 the Commissioners shall not approve the use of a method under this regulation unless the taxable person has made a declaration to the effect that to the best of his knowledge and belief the method fairly and reasonably represents the extent to which goods or services are used by or are to be used by him in making taxable supplies.

30. Regulation 102A applies where a special method is in operation but does not fairly and reasonably represent "the extent to which goods or services are used by [the taxable person] in making taxable supplies". In such a case the Commissioners may serve on the taxable person a notice, the effect of which is to engage regulation 102B. Regulation 102B requires the taxable person to calculate the difference between the attribution made according to the special method in force and an attribution which "represents the extent to which the goods or services are used by [the taxable person] in making taxable supplies". Both regulations, therefore, refer to "use" of goods and services "in making taxable supplies".
31. In this case, the existing method as well as the proposed PESM are special methods.
32. There appear to be no differences, or no significant differences, of view between the parties about the substantive legal principles in the application of those legislative provisions.
33. The need for a process of attribution only arises where an item is a cost component (within Article 2 of the First Directive) of two supplies, one taxable and one exempt: Dial-a-Phone Ltd v Customs and Excise Commissioners [2004] STC 987 (especially at [28] and [71]). If the standard (turnover) method does not result in a fair and reasonable attribution of the cost component, the search is for a more fair and reasonable method of attribution. The onus is on the taxpayer to show that the proposed PESM is more fair and reasonable, that is to say, more accurate: Case C-488/07 Royal Bank of Scotland Group plc v Revenue and Customs Commissioners [2009] STS 461 at [24].
34. A fair and reasonable attribution to a taxable supply must, for the purposes of Article 17(2) and (5) of the Sixth Directive and regulation 101(2)(d) of the Regulations, reflect the use of a relevant asset in making that supply. In assessing that use, and its extent, consideration is not limited to physical use. The assessment must be of the real economic use of the asset, that is to say having regard to economic reality, in the light of the observable terms and features of the taxpayer's business.
35. These principles were well captured and applied by Warren J in St Helen's School (Northern) Ltd v Revenue and Customs Commissioners [2006] EWHC 3306 (Ch), [2007] STC 633. In that case the taxpayer school was granted planning permission to build a new swimming pool and sports hall. It envisaged commercial use of the complex as well as school use. It set up a company, which was to use the complex for club and community purposes outside the school hours. The school was registered for VAT in order to recover VAT on the building of the sports complex. The school proposed a PESM, namely a percentage recovery of VAT based on the number of hours of actual use by the company as a proportion of the total hours of use. The Commissioners refused the school's proposal. The school's appeal to the Value Added Tax and Duties Tribunal ("the Tribunal") was dismissed. Warren J dismissed the school's appeal to the High Court. At [60] he referred the decision of Patten J in Customs and Excise Commissioners v Yarburgh Children's Trust [2002] STC 207, in which it was held that the motive of a person in making a supply is not relevant to, and cannot dictate, the correct VAT treatment of a transaction. Warren J said ([60]) that the exclusion of motive or purpose did not allow the Tribunal to disregard the observable terms and features of the transaction and the wider context in which it came to be carried out. He said that applied in the context of establishing the use (for VAT purposes) to which an item of property is put and in deciding whether a proposed PESM is fair and reasonable when determining what is or is not a valid proxy for that use whether a proposed PESM is fair and reasonable. I agree.
36. Warren J accepted ([75]) the submission of counsel for the Commissioners ([63]) that physical use may reflect economic use, but does not necessarily do so, and that any allocation or special method must give a credible result in economic terms.
37. Warren J applied that approach, and the concept of economic use, in his analysis of the facts. He said:

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

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

[77] On the facts of the present case, it seems to me that the overwhelming economic use of the sports complex by the School is in relation to the provision of educational services. In that context, I agree with Miss Simor that the source of funds and the purpose of constructing the sports complex are relevant considerations. To regard those factors as relevant is not, in my judgment, to fall into the error, as Mr Thomas would say it is, of categorising the nature of a supply by reference to the purpose or motive in making it. There is no doubt that in the present case, the supplies are distinct and readily identifiable, that is to say the taxable supply of the licence to [the company] and the exempt supply of education. Nor, in my judgment, is there any question, in taking those factors into account of treating a taxable supply as an exempt supply or vice versa. The question is what 'use' is being made of the inputs in producing the outputs. It seems to me that the purpose of the School, objectively ascertained, in constructing the sports complex is a highly relevant factor in attributing cost components between the relevant outputs and is an entirely different issue from identifying the nature of the output by reference to purpose or motive (which is inadmissible), the issue addressed by Patten J in Customs and Excise Comrs v Yarburgh Childrens Trust [2002] STC 207"

38. I agree with Warren J's approach and analysis. He went on to say ([78]) that, on the evidence, it was clear that, objectively assessed, the principal purpose of the school in building the sport complex was the furtherance of its educational activities and was carried out in connection with its business of making exempt supplies of education; and, further, the capital cost of the complex was met out of funds which were either charitable funds or derived from a fund-raising exercise and which were clearly dedicated to the educational purposes of the school. He also concluded ([79]) that the income generated by the licence to the company was never intended or expected to meet a share of the capital cost proportionate to the physical use of the sports complex by the company. The licence to the company was simply putting to productive use that which had been acquired for a different main purpose. In Warren J's judgment ([80]) the standard method produced an allocation which was more fair and reasonable than the school's proposed PESM.
39. Warren J's endorsement of a test of economic use anticipated the emphasis of the Court of Justice of the European Union ("the ECJ") on "economic reality" in Joined Cases C-53/09 and C-55/09 Revenue and Customs Commissioners v Loyalty Management UK Ltd, Baxi Group Ltd v Revenue and Customs Commissioners [2010] STC 2651, which concerned the VAT treatment of supplies under customer loyalty reward schemes. The ECJ said at [39]:

"It must also be recalled that consideration of economic realities is a fundamental criterion for the application of the common system of VAT."

40. The decision of the Tribunal in Aspinall's Club Ltd (2002) (No. 17797) is another good illustration of the application of the relevant principles in the context of gaming and associated catering. The taxpayer ("Aspinall's") was the proprietor of a licensed gaming club, available for use by members and their guests. It was a particularly high class casino, with all the ambience and appearance of an exclusive private club where members and their guests could enjoy luxurious facilities. Those facilities included dining room and bar areas in which there were VAT standard rated supplies, although 90 per cent of the food and drinks were not charged for. The areas devoted to gaming were small as compared to those used for dining and bars, but Aspinall's derived its income overwhelmingly from its VAT exempt licensed gaming activities. The common areas contributed to the feeling of luxury and opulence. Some £6.5 million was spent on refurbishing the premises, including the creation of a new dining area, staff areas and office space, in respect of which VAT of nearly £1.2 million was incurred. Aspinall's wished to have a PESM which would apportion residual input tax in the ratio of the floor area used to make taxable supplies to the sum of that area and the area used to make exempt supplies. The Commissioners refused, and Aspinall's appealed. The Tribunal dismissed the appeal. The core of its reasoning was as follows:

"48.What is very apparent to us is that the catering activities by themselves are not conducted with a view to profit. No board of directors could have permitted the catering business to continue for its own sake. It could only be justified in conjunction with other activities, i.e. gaming. Consequently we do not find it credible that the board could have regarded the refurbishment expenditure as a profitable project for the catering business, since clearly there would be a negative return on such an investment. Yet Aspinall's would claim that, nevertheless, up to 55% or more of the VAT on that expenditure is recoverable.

49. … Most, if not all, the floor areas of the Club are of mixed use; they are used to make all the supplies of the business, both taxable supplies and exempt supplies. Furthermore, in running the business costs are primarily incurred to facilitate exempt gaming. This does not mean that exempt supplies are physically made from areas such as the bar and restaurant or, on the other hand, that taxable supplies are physically made from the gaming rooms. Nor, we would add, does it mean that there is for VAT purposes a single supply of gaming to which the catering is merely ancillary. But those factors do not rule out costs incurred in one area being incurred to make supplies in another area. This applies even more so in relation to costs incurred in respect of the common areas from which no supplies are directly made. Such costs are incurred and are truly 'cost components' of the exempt supplies which physically take place in the small gaming area. Those costs are funded by the gaming. That in itself does not make them cost components of those exempt supplies. But in this case it is additional proof, if any is needed, that gaming is the foundation of the business and it is the furtherance of that gaming which causes and is seen as justifying commercially the decisions to incur the expenditure. Here there is capital expenditure and ongoing expenditure incurred specifically to create and maintain the opulence and luxury, especially in the creation of spacious surroundings and general ambiance, which is seen as commercially necessary to promote the highly profitable gaming business. For these reasons, in our judgment, the Commissioners in considering the methods proposed have not confused use with purpose and have not acted unreasonably in deciding to reject them. Indeed for our part, if it is open to us to decide whether the floor area methods put forward by the Appellants are capable of achieving a fair and reasonable attribution of input tax, we have not been satisfied that they do."

41. That case and the reasoning of the Tribunal, with which I agree, is illustrative of three points of principle. First, it shows the importance in these cases of close attention to the facts in order to understand the economic or commercial reality underlying the use of the relevant VAT inputs. Secondly, identification of the source or potential source of profit in a business may be an important feature of a business throwing light on whether or not the standard method or a PESM is a more fair, reasonable and accurate method of attribution. It all depends on the facts of each case: cf. Banbury Visionplus Ltd v Revenue and Customs Commisioners [2006] STC 1568 at [68]. Thirdly, depending again on the precise factual situation under consideration, the approach of the Tribunal in Aspinall's Club at [49] may well be appropriate in a case where the taxable supplies are not, in themselves, a source of profit:

"Those costs are funded by the gaming. That in itself does not make them cost components of those exempt supplies. But in this case it is additional proof, if any is needed, that gaming is the foundation of the business and it is the furtherance of that gaming which causes and is seen as justifying commercially the decisions to incur the expenditure."

42. As both St Helen's School and Aspinall's Club show, and as was emphasised in Dial-a-Phone v Customs and Excise Commissioners [2004] STC 987 at [72] by Parker LJ (with whom the other members of the Court agreed), analysis of attribution for the purposes of Article 2 of the First Directive, Article 17 of the Sixth Directive and Regulation 101 is highly fact sensitive.

The Decision of the FTT

43. The FTT set out in [24] the task which it had to undertake, as follows:

"Accordingly, we must consider first if the proposed special method is fair and reasonable. If we decide that it is, we must compare it with the existing method, and only if the new method is in our judgment more fair and reasonable than the existing method should we allow the appeal. Otherwise the appeal should be dismissed, even if we consider that both methods are unfair or unreasonable, but the new method is less unfair or unreasonable. What we cannot do is substitute our own version of a more reasonable method …"

44. The FTT referred in several places to the judgment of Warren J in St Helen's School. It said ([32]) that the physical use of premises is not necessarily a fair and reasonable proxy for the use of inward goods and services in making taxable and exempt supplies, and referred to Warren J's use of the phrase "economic use" as a helpful approach in searching for a fair and reasonable proxy. It also said ([37]) that it was bound to have regard to the observable terms and features of the respondent's business, its output supplies and inputs, and the wider context, and that included examining the purpose for which the respondent incurred the expenditure on the goods and services in respect of which input tax fell to be apportioned.
45. The FTT in [38] accepted that the floor space PESM was fair and reasonable. It said there as follows:

"The residual costs with which we are here concerned are not one-off costs of the nature considered in St Helen's School, but are ongoing costs, such as rent, in running the business as a whole. Taking premises costs, such costs are incurred in order to provide premises for the carrying on of the whole of the Appellant's business. We have found that the food and beverage supplies made by the Appellant are made from defined and measurable parts of the Appellant's premises and accordingly we find that part of the purpose of the Appellant in incurring that expenditure is to provide space for the provision of those supplies. Although it is accepted that gaming is able to generate a higher turnover and profit for each square foot of the premises that it occupies as compared with the restaurants and bars, that does not, in our view, lead to the conclusion that gaming is the principal user or consumer of the premises costs incurred and that, as a result, a partial exemption method must reflect that in assuming greater use by the gaming part of the business. It seems to us that the proposed floor space method does provide a fair and reasonable allocation of such costs, as it reflects directly the use of those costs."

46. The FTT said ([39]) that conclusion was not affected by the fact that the catering activities could not currently support the costs that would be apportioned under the proposed PESM to those supplies. It said that, by contrast with St Helen's School, the ongoing residual costs were not incurred for the purpose, either solely or predominantly, of the gaming activities, but for the activities of the business as a whole.
47. The FTT noted ([40]) that one significant feature of the respondent's business was that the catering activities were used, to an extent, to support and foster the gaming activities by means of the provision of food and drink free of change to certain gaming customers. It said ([41]) that the effect of the proposed PESM was to recognise that feature because the effect of the formula was to apportion the food and beverage floor space between the chargeable and non-chargeable catering supplies, but to regard the element of non-chargeable catering use as economic use for the purpose of the exempt gaming activities. That is the effect of excluding the non-chargeable catering use from the numerator in the fraction, but including the whole of the food and beverage floor space in the denominator.
48. The FTT said ([42]) that the proposed PESM operates so as to take account of such changes as there might be in the use of the floor space, and that it was satisfied that the delineations made by the business in the areas of use were sufficiently clear and had a sufficient degree of permanence as to be capable of reasonably being reflected in the proposed PESM.
49. The FTT addressed as follows the issue of the proportion of the residual costs that were property-related and were not property-related:

"43.We have found that a substantial proportion of the residual costs of the Appellant's business are property-related. Although this proportion may fluctuate from quarter to quarter, we accept that the figures presented to us, which showed property-related costs at 71 % of total residual costs, are a fair representation of the position. A floor space method is, in our view, appropriate for providing a reasonable proxy for such costs. It assumes that costs that cannot be directly-attributed are used or consumed by the separate parts of the business by reference to the amount of floor space those separate parts occupy. The greater the space so occupied, the more consumption of those inward supplies is assumed.

44.For costs that are not property-related, the floor space method does not provide such a close approximation to use. The consumption of such costs is likely to depend on a number of factors, of which the area of the floor space occupied by a particular part of the business is only one. We had no evidence that in this case the use of a floor space method for non-property related costs would be so distortive as to render the proposed method, as it would operate in relation to costs in the aggregate, unfair or unreasonable. A substantial proportion of the costs in this case are property-related, for which we consider the proposed method to be fair and reasonable, and it is not prevented from being fair and reasonable by the fact that it also operates in respect of the minority of non-property related costs."

50. The FTT distinguished ([46]) Aspinall's Club on the ground that the business of the respondent was not "catered gaming". It said the following at [48]:

"In one of the Appellant's premises, Rendezvous London, in the nine months to 31 December 2006, 97% of food and drink supplied was given away. At other premises the percentage was lower; the average was 35%. We are considering a proposed method for the whole of the Appellant's business. Taking the average for the whole business, the Appellant's case is different from that of Aspinall's Club. In that case the Tribunal found that the catering activities were not conducted for profit. By contrast, in the Appellant's case, although the catering activities are not currently profitable, we are satisfied that they are businesses in their own right and are not merely ancillary to the gaming business. Unlike Aspinall's Club, we have found that the business costs are not primarily incurred to facilitate gaming, but to facilitate all parts of the Appellant's business. Furthermore, in this case, as we have described, the proposed method does provide fairly and reasonably for the fact that some elements of the catering supplies are made free of charge."

51. The FTT, having found that the proposed method was fair and reasonable, then went on to consider whether it was more fair and reasonable than the existing method. The FTT concluded that it was. The heart of its reasoning is in [52], as follows:

" … What we regard as the essential question is: which of the methods, the existing or the proposed method, is the more fair and reasonable approximation for the use of costs? We accept Mr Hitchmough's [counsel for the respondent] analysis of the assumption that effectively underlies the existing method. In our view, in the case of a business whose residual costs are predominantly property-related, the existing method does not, in our view, provide as coherent a proxy for the use of those costs as does the floor space method proposed by the Appellant. That method, as we have found, takes account of the economic use of the floor space (including the effect of the non-chargeable catering supplies) and thus the use and consumption of property-related costs, in a way that the existing method fails to do. The treatment of non-property related costs we regard as neutral as between the two methods. Accordingly, we conclude that the proposed method is more fair and reasonable than the existing method."

The UT – Proudman J

52. Proudman J found no error of law on the part of the FTT. Although the present appeal is from her judgment, it is common ground that the focus in this Court is on the reasoning and conclusion of the FTT. It is not necessary, therefore, to say more about the analysis in her clear and careful judgment.
53. Proudman J gave permission to appeal because the case raises points of general interest and importance about the proposed PESM beyond the particular circumstances of the present case.

The appeal to the Court of Appeal

54. There are two written grounds of appeal from the UT, as follows:

"1. Having accepted that an essential part of its [viz the UT's] approach was to assess the economic use made by the taxpayer of its residual costs, it failed to make a proper assessment of economic use and misunderstood the required approach.

2. It made general errors in its assessment of the decision of the First-Tier Tribunal's decision which vitiated its holding that the proposed Partial Exemption Special Method resulted in a fair and reasonable attribution of residual input tax and/or that the result of the proposed method was more fair and reasonable than the existing method."

55. The Commissioners' case on this appeal is that, even though the FTT appears to have set out the law correctly in its Decision, it is apparent from both latent and patent errors in the FTT's reasoning and approach that it did not understand the law or correctly apply it. The Commissioners submit that the FTT must have misunderstood the legal test to be applied because it manifestly failed to undertake the kind of extensive enquiry into the business of the respondent that is required, and the conclusion that the FTT reached on the proposed PESM did not reflect economic reality. Ms Alison Foster QC, for the Commissioners, who subjected the Decision of the FTT to a detailed analysis, also criticised the Decision as lacking in clarity and coherence in places.
56. The Commissioners submit that the FTT, in arriving at a decision as to whether the proposed PESM was a fair and reasonable measure for the apportionment of residual input tax, and a more fair, reasonable and accurate method than the existing method, had to carry out an intense examination of the conduct of the respondent's business and how it operated financially. They say that such an enquiry was necessary because the FTT was required to analyse, as a matter of economic reality, how the relevant overheads, that is, overheads in respect of which residual input tax were in issue, were "used" in the business, in other words, whether and to what extent those overheads were cost-components of the taxable activity of the respondent and of the exempt activity respectively.
57. Ms Foster submitted that the faulty reasoning process of the FTT is revealed in several respects. The FTT, she said, made many findings of fact about the respondent's business and the acquisition and use of its casino properties which were relevant to the economic reality test, but the FTT failed to take account of them, or at any event failed to make clear how it took account of them, in reaching its conclusion in favour of the proposed PESM.
58. Ms Foster particularly criticised the FTT for failing to take any, or at any event sufficient, note of the financial material available to it, especially the management accounts. Such material was, she said, critical to understanding whether the respondent's declared strategy to run the catering activity as a separate business, competing with other commercial catering operations, was true or realistic. Management accounts, she emphasised, are particularly important because they show the way that those managing a company view its business and operations. They show the way in which the business operates from day to day as well as over time. The financial material before the FTT, and especially the management accounts, were critical, she said, to understanding what commercially truly drove the overheads in issue.
59. Ms Foster submitted that the FTT's failure to understand the legal test, and therefore the type of intensive enquiry and analysis that it was required to undertake, is shown by the narrowness of its reasoning in reaching its conclusion. She submitted that the FTT's analysis effectively begins and ends in [38] of the Decision: namely (1) premises costs were incurred by the respondent in order to provide premises for the carrying on of the whole of the respondent's business; (2) the food and beverage supplies made by the respondent were made from defined and measurable parts of the respondent's premises; (3) accordingly, part of the purpose of the respondent in incurring that expenditure was to provide space for the provision of those supplies; (4) the proposed floor space method does provide a fair and reasonable allocation of such costs, as it reflects the use of those costs.
60. Ms Foster submitted that analysis shows that the FTT, far from carrying out a test based on economic reality, was simply looking at physical use. There was no attempt to attribute the relevant overheads to a profit centre of the respondent's business or to the commercial imperative to make a profit as a driver of expenditure.
61. The Commissioners say that, on the evidence before the FTT, the economic reality was that the respondent was not actually running a catering business in its own right, and that what drove the expenditure on the overheads in question was purely and simply the respondent's profitable gaming business. The following points were advanced in support of that proposition. The management accounts, Ms Foster said, show that the overheads were paid for, or subsidised, out of the gaming profits; the need to spend so much on the large premises was because they were acquired for gaming, and they were acquired for that purpose before the respondent had any thought of establishing a catering business; the provision of free food and drink to gaming customers illustrates the economic enmeshing of catering and gaming; over 80 per cent of the turnover was generated by gaming; the commercial reality was that the only purpose of the respondent's business was to make profits from gaming, and the overheads were incurred for the purposes of, and could only be sustained by, the gaming activity; it was doubtful that the returns from the catering activities in many of the casinos were covering even direct costs, and certainly, if any significant portion of the overheads was attributed to the catering activities, not only were those activities unprofitable, but there was no proper basis for concluding that they would become profitable in the medium or even long term; insofar as any of the catering activities did make a positive contribution to the payment of the overheads, they were undertaken only to assist payment of those overheads so as to maximise the profits from the gaming activity. In short, the Commissioners case is that, on the material available to the FTT, the only possible conclusion was that the entire business conducted by the respondent was to enable the only profitably activity, namely gaming, to be carried on in its premises.
62. On that basis, the Commissioners argue, the current PESM, which is primarily a turnover based method, is a fair and reasonable proxy for attribution of the residual input tax between the respondent's taxable and exempt supplies, but the proposed floor space PESM is not. The Commissioners further complain that, in any event, the FTT never carried out the necessary exercise of comparing the existing method and the proposed PESM in order to see whether the respondent had established that the proposed PESM would be more accurate, and hence more fair and reasonable, than the existing method. It is clear, the Commissioners say, that, had that exercise been carried out, it should have been plain that the respondent failed in that comparison. In that connection, the Commissioners raise the following further points.
63. They point out that there are large amounts of space (amounting to about 24 per cent) within each of the casinos which was not allocated to either taxable supplies or exempt supplies, such as entranceways, toilets, staff areas and back office space. There was no finding of fact by the FTT to support the suggestion that the attribution of their use to taxable supplies and exempt supplies mirrored the proportionate allocation of the other floor areas between those supplies. This means, the Commissioners say, that a substantial proportion of the whole space could not contribute to any ratio calculation at all.
64. The Commissioners further contend that, as only 71 per cent of the relevant overheads were property-related, a floor pace PESM cannot achieve a fair, reasonable or accurate result. That is particularly so, they say, in view of the last point, that is the fact that a significant amount of the 71 per cent was not allocated to either taxable supplies or exempt supplies. The Commissioners say that there is no proper or sufficient reason to suppose that the 29 per cent of costs which related to inputs other than property would be used in the same ratio as the floor space
65. Ms Foster submitted that, in comparing the suitability and reasonableness of the existing method with the proposed PESM, the FTT ought to have spotted any unrealistic, anomalous or otherwise surprising outcomes since they could be a pointer to the fact that one or other of the methods was not fair or reasonable or not as fair or reasonable as the other method. In fact, the Commissioners say, the proposed PESM does throw up a most surprising and anomalous result. The proposed PESM loads almost half the input costs of the expensive premises on to the loss-making catering activity. This would mean that the respondent would be entitled to regular payments from the Commissioners. In effect, by loading so much of the overheads on the loss-making catering activity, even though more than 80 per cent of turnover was attributable to the profitable gaming activity, the Commissioners would be obliged to fund the respondent's business and so enhance the respondent's profits from its gaming activity.
66. Finally, Ms Foster submitted that, since it was for the respondent to show that the proposed PESM would be more fair and reasonable than the current turnover method, the PESM wrongly reversed the burden of proof when it said the following in [44] of the Decision:

"For costs that are not property-related, the floor space method does not provide such a close approximation to use. The consumption of such costs is likely to depend on a number of factors, of which the area of the floor space occupied by a particular part of the business is only one. We had no evidence that in this case the use of a floor space method for non-property related costs would be so distortive as to render the proposed method, as it would operate in relation to costs in the aggregate, unfair or unreasonable. A substantial proportion of the costs in this case are property-related, for which we consider the proposed method to be fair and reasonable, and it is not prevented from being fair and reasonable by the fact that it also operates in respect of the minority of non-property related costs."

Discussion

67. Those are undoubtedly powerful submissions. The Commissioners' appeal, however, faces insuperable difficulties. Ms Foster acknowledged that the FTT set out the Commissioners' case impeccably in [31] of the Decision. She also acknowledged that the FTT correctly stated in [32] of the Decision that "the physical use of premises is not necessarily a fair and reasonable proxy for the use of inward goods and services in making taxable and exempt supplies", and that, following Warren J in St Helen's School, the phrase "economic use" is a helpful approach in searching for a fair and reasonable proxy. The Commissioners stated expressly in [37] that, in the light of St Helen's School, they were "bound … to have regard to the observable terms and features of [the respondent's] business and its output supplies and inputs, and the wider context", and that included "examining the purpose for which the [respondent] incurs the expenditure on the goods and services in respect of which input tax falls to be apportioned."
68. The Commissioner's criticism of the FTT, therefore, is not that the FTT failed to appreciate the correct test to be applied and the correct legal approach to be taken, or failed to understand how the Commissioners put their case as to the conclusions to be made on applying that test and taking that approach. Their case is simply that the FTT could not have applied that test and taken that approach and still have reached the conclusion that the FTT did reach. They say that the FTT's reasoning in [38] of the Decision shows that the FTT patently failed to carry out the task which it correctly set itself.
69. If the reasoning and findings of the FTT were limited to those in [38] of the Decision, I could see much force in the Commissioners' case. Paragraph [48] of the Decision, however, sets out the critical finding of fact that "although the catering activities [of the respondent] are not currently profitable, we are satisfied that they are businesses in their own right and are not merely ancillary to the gaming business". It was on the basis of that finding that the FTT contrasted, and distinguished, Aspinall's Club. That finding by the FTT in [48] of the Decision was a finding that the catering activity of the respondent was a potential source of profit and carried on as such, independently of the respondent's gaming activity. Unless that finding can be ignored, it is, in my judgment, plainly impossible to say that the FTT's Decision was erroneous in law and should be set aside.
70. The Commissioners attack the finding in [48] of the Decision, and seek to undermine its significance, in several ways. Ms Foster submitted that, if the FTT had carried out the exercise it acknowledged it had to carry out, namely to establish the true economic use of the relevant overheads in the respondent's business, having regard to the observable terms and features of the respondent's business, the FTT simply could never have reached the conclusion of fact that the catering activity was a potential source of profit and carried on as such, independently of gaming. Secondly, and which is really part of the first point, the FTT wrongly failed to take account, or sufficient account, of the management accounts that were in evidence. Those accounts showed, she submitted, that there was no real prospect at all that the catering activity would ever be a source of profit if overheads were apportioned between catering and gaming in accordance with the proposed PESM. Thirdly, Ms Foster submitted that the structure of the Decision was that the essential reasoning and conclusion of the FTT were stated and reached in [38] of the Decision, and the findings made subsequently in [48] were therefore not a ground for the conclusion already stated and reached in [38].
71. Having regard to the management accounts before the FTT, on which both Ms Foster and Mr Andrew Hitchmough, counsel for the respondent, addressed us in some detail, I confess that the finding of the FTT in [48] of the Decision strikes me as remarkably benign, that is to say surprisingly favourable to the respondent. It is not necessary to set out the detail here. It is sufficient to say that not only, as is common ground, was the catering activity significantly loss-making for all the three years after the commencement of the new business plan of the respondent in 2007, if overheads were apportioned to catering in accordance with the proposed PESM, but there was nothing in those accounts, and nor were we shown any other material, to indicate that there was any realistic hope of profit from catering in the foreseeable future.
72. I do not accept, however, that the FTT ignored entirely the management accounts. The FTT was taken through the management accounts by both parties. Mr Michael Rothwell, who was the respondent's finance director and an accountant, gave evidence on them. It is plain from the Decision (in particular [15]) that the FTT did have some regard to them, albeit not as much as the Commissioners say the FTT should have done. We were not shown any transcript of Mr Rothwell's evidence, and, in particular, we were not given details of any cross-examination of him on the question of any anticipated future profitability of the catering activity. This is not entirely surprising because the Commissioners have not specifically raised as a distinct written ground of appeal that the finding of the FTT in [48] was perverse, that is to say a finding which no tribunal could properly have reached on the evidence. The point was only formulated in that way, or at least clearly so, in Ms Foster's oral submissions in reply on this second appeal. That is far too late.
73. It is no answer for the Commissioners to say that, if the FTT had applied the correct test and carried out the correct enquiry, it could not have made, and would not have made, its finding in [48] of the Decision. As I have said, it is implicit in what is said in [48] of the Decision that catering was a potential source of future profit. That is a specific finding of primary fact on the evidence. It is a fact which feeds into the enquiry as to the economic use of the relevant overheads: it is not a conclusion which results from the test itself. If it is to be challenged as a perverse finding of fact, then the perversity must be raised as a distinct ground of appeal. That is particularly important in the case of an appeal from a specialist tribunal, with whose expertise as appellate court should only interfere with caution: Proctor & Gamble UK v Revenue and Customs Commissioners [20009] EWCA Civ 409, [2009] STC 1990.
74. Further, as Mr Hitchmough rightly emphasised, in order to ascertain the reasoning of the FTT, the Decision must be read as a whole. It is not to be interpreted like a statute drafted by Parliamentary Counsel. Its reasoning and sense are to be gathered by a fair reading of its entirety. This is true of every judgment, but particularly so an expert tribunal which, like the FTT, includes non-lawyers. It seems to me entirely reasonable and appropriate to assume that the FTT, in reaching its conclusion on economic use of the relevant overheads and the economic reality of the respondent's business, took into account the findings of fact in [48] of the Decision. Indeed, that would seem necessarily to follow from the fact that it was on the basis of those findings in [48] of the Decision that the FTT distinguished Aspinall's Club, on which the Commissioners relied as being analogous to the instant case.
75. I reject, as plainly wrong, the Commissioners' criticism that the FTT failed to compare the existing method and the proposed PESM in order to see whether the proposed PESM would be more reasonable, fair and accurate. The FTT expressly stated in [24] of the Decision that it had to carry out that exercise. It did so in [52].
76. I also reject the other points made by the Commissioners which I have mentioned earlier. So far as concerns the submissions about the significance of a substantial part of the whole space being unallocated to either taxable supplies or exempt supplies, and that only 71 per cent of the residual costs were property-related, those submissions were also made to the FTT. They were rejected by the FTT in the light of the evidence (including the oral evidence of Mr Rothwell, the site visit made by the members of the FTT to one of the respondent's casinos, and the management accounts) which the FTT heard, read and saw. The FTT, as a specialist body, formed a judgment on them which does not disclose any error of law.
77. I agree with Ms Foster's general proposition that, in comparing the suitability and reasonableness of the standard or another existing method with a proposed PESM, unrealistic, anomalous or otherwise surprising outcomes may be a relevant indication that one or other of the methods is not fair or reasonable or not as fair or reasonable as the other method. In the present case, however, I consider that it is impossible to disturb the finding of primary fact by the FTT in [48] of its Decision that the catering activity was carried on as a business in its own right by the respondent and with a view to profit. In view of that conclusion, and for the other reasons I have given, the Decision of the FTT cannot be disturbed. The consequences that follow are governed by legislation.
78. Finally, I do not accept that the FTT reversed the burden of proof. The FTT set out correctly in [24] of the Decision that it had first to decide whether the proposed PESM was fair and reasonable, and, if it was, whether it was more fair and reasonable than the existing method, and that the FTT could only allow the appeal if the PESM satisfied those conditions. The FTT expressed its conclusions on those requirements in [43], [44] and [52] of the Decision. I do not accept that, on a fair reading of those paragraphs, the FTT reversed the burden of proof. On the contrary, in [52] the FTT set out clearly why it considered the PESM is more fair and reasonable than the existing method.
79. For those reasons, I would dismiss this appeal.
80. Mr Hitchmough was not content, however, to oppose the Commissioners' appeal simply on the basis that it is unsustainable in the light of the FTT's findings of fact in [48] of the Decision. In particular, he submitted that the proposed PESM would still be a fair and reasonable proxy for attribution of the residual input tax, and a more fair, reasonable and accurate one than the existing method, even if there was no reasonable prospect of the catering activities ever generating a profit in themselves. The respondent's case is that its business is a multi-faceted entertainment business; the overheads are incurred for the business as a whole; the catering activity is intended not merely to serve the gaming customers but to attract a significant non-gaming customer base and to compete with other restaurant and catering businesses; and, most particularly, the catering activity is carried on in order to make the best and most commercially productive use of the available space (having regard to the history and the effect of the Gambling Act 2005), and is intended to, and does, make a significant contribution to payment of the overheads. Mr Hitchmough submitted that those are observable features of the respondent's business, which fully satisfy a test of economic use and economic reality in relation to the proposed floor space PESM and make the proposed PESM more fair, reasonable and accurate than the existing method.
81. Mr Hitchmough distinguished St Helen's School on the ground that what was under consideration in that case was the proper VAT treatment of input tax in relation to one-off capital expenditure, whereas the present case is concerned with recurrent cost. It is common ground that Aspinall's Club is distinguishable on the facts because the catering activities in that case were intended to be for the benefit of gambling customers and was provided almost entirely free of charge.
82. The respondent emphasises, correctly, that VAT is not a tax on profit. A taxable person may recover input tax on inputs used to make taxable supplies even if, as matters turn out, those supplies result in a commercial loss.
83. Although it is not necessary to express a firm conclusion on the point, I am very doubtful that it would be possible to uphold the Decision of the FTT in the absence of a finding that the respondent's catering activities had the potential to be a source of profit if the relevant overheads were apportioned in accordance with the proposed PESM.
84. As I have said earlier in this judgment, what is or is not a suitable PESM is highly fact specific. Furthermore, as I have also said, in looking at economic reality in this context, profit may be an important factor, but it is not necessarily so, and in some cases it may be entirely irrelevant.
85. On the particular facts of the present case, the absence of a realistic expectation that the respondent's catering activity could produce a profit in the foreseeable future if overheads were allocated in accordance with the proposed PSEM would, in my view, be likely to be a critical factor in favour of the existing method and against the proposed PESM. In the absence of such an expectation, I find it difficult to see how, as a matter of economic reality, any significant weight in support of the proposed PESM could legitimately be given to the avowed strategy of the respondent to run the catering activity as a separate business, making a positive contribution towards overheads.
86. Business is carried on with a view to profit. If the only activity of the respondent capable of generating a profit in the foreseeable future was its gaming activity, then the principal purpose and effect of any other activity capable of generating a positive return, short of profit, would simply be to enable a greater proportion of the profits from gaming to be retained than would otherwise be the case. The only possible purpose of the non-gaming activity would be to help to defray some of the overheads that would otherwise have to be defrayed by the gaming revenue.
87. As the Commissioners have pointed out, that would not mean that the loss-making catering function did not use any residual costs. Plainly, catering would use some of those costs. The issue is whether, on the hypothetical facts, the more fair, suitable and accurate proxy for attribution of those costs between taxable catering activity and exempt gaming activity would be the existing method, based primarily on the standard turnover method, or the proposed floor space PESM. On the hypothetical facts, without the gaming activity there would not merely be no present profit, but, more importantly, no profit in the foreseeable future, and hence no commercial purpose to the existence of respondent. In the absence of some special funding arrangements, it would presumably be insolvent and would have to be wound-up. On the hypothetical facts, the reality, in terms of the true economic use of the relevant overheads, would be that the driver for the catering activity and any expenditure associated with that activity would be the gaming activity and the enhancement of the profits to be made from the gaming activity. Adopting the language and test in paragraph 49 of Aspinall's Club, gambling would be the foundation of the business and it would primarily be the furtherance of that gaming which would cause and would be seen as justifying commercially the decisions to incur the expenditure. It would be the maintaining and enhancing of the gaming profits that would be the principal driver of all the overheads. As it presently seems to me, that would make the existing PESM, under which attribution of residual input tax is primarily related to the respective turnover of the catering and gambling activities, more fair, suitable and accurate than the proposed floor space PESM, under which (on the figures before the FTT) nearly 50 per cent of residual inputs would attributed to the loss-making catering activity.
88. On the hypothetical facts, the proposed PESM would have the startling consequence that the loss-making catering activity would generate payments from the Commissioners to the respondent for the indefinite future, as a result of the inputs for that activity inevitably exceeding VAT on supplies, thereby further boosting the respondent's profits generated by its profitable gaming activity. That would not in itself be a reason for rejecting the respondent's argument, but would be a reason for examining with particular care the economic reality against which that argument must be tested.

Conclusion

89. For the reasons I have given, I would dismiss this appeal.

Lord Justice Pitchford

90. I agree.

Lord Justice Ward

91. I also agree.