ON APPEAL FROM THE VAT & DUTIES TRIBUNAL
Strand, London, WC2A 2LL
B e f o r e :
| ST HELEN'S SCHOOL NORTHWOOD LIMITED
|- and -
|THE COMMISSIONERS FOR HER MAJESTY'S REVENUE & CUSTOMS
Ms Jessica Simor (instructed by The Solicitor for HM Revenue & Customs) the Respondent
Hearing dates: 2nd and 3rd November 2006
Crown Copyright ©
Mr Justice Warren :
a. As long ago as 29 January 2002, the School's architect wrote to the local planning authority (London Borough of Hillingdon) saying this:
"The school have close links with the existing community as demonstrated in the attached paper. They wish to make the new facilities available under a strict club regime to friends of the school."
b. Draft 2 (dated 29 November 2002) of the outline business plan contained the following among other matters:
- A suggestion that the following overall aim could be adopted "To provide a fully flexible and accessible Sports Centre which will, primarily, accommodate a wide range of activities as part of the School's curriculum and extra-curriculum programme but would also provide opportunities for appropriate out-of-school use by pupils, parents and "friends" of the School, all at the lowest appropriate capital and revenue cost".
- A number of short-term objectives were identified (see paragraph 4.7 of the draft) which in summary were: ensuring the design would met present and foreseeable School needs; providing a programme of activities to meet the needs of the target market (ie non-School use); developing management arrangements to enable utilisation of the facilities within and outside School time and setting up an operating regime to ensure out-of-school use contributed positively to the overall running costs.
- A number of longer term objectives were also identified (see paragraph 4.8 of the draft), including ensuring "primacy of use for the School and its pupils whilst acknowledging the value of out-of-school use to the School".
- Under the heading "Financial Objectives", a fundamental choice was identified as needing to be made regarding the extent to which the School was seeking to obtain income from out-of-school use. A number of options were identified, the business plan itself saying that it had been determined that "the most appropriate level at which to pitch the financial aspirations is to ensure that costs of out-of-school use are covered, to seek to cover all the School's own costs and, if possible, generate sufficient income to fund future developments of the complex". In other words, as a minimum, the costs of running the sports centre for school and out-of-school use would be covered so that, as the plan puts it, the School has "use of the new facilities for free in revenue terms".
- Paragraph 5.2c. of the draft business plan states "school boarders would be able to use the sports facilities at all times they are open to members (at no charge….)".
- The financial projections showed an operating surplus in relation to provision, for a money consideration, of facilities to members and others of £18,000 in year 1 to over £95,000 in year 5.
c. Mary Morris, the deputy head of the School, gave evidence. The Notes of her evidence taken by the Chairman, Mr Oliver, include a reference to boarding pupils at the School. In relation to out-of-school use, Ms Morris stated that these boarders had to be members of the club with annual renewal.
"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."
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) (although (3) is not relevant for present purposes) 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).
"29. It should be borne in mind that, according to the fundamental principle which underlies the VAT system, and which follows from art 2 of the First and Sixth Directives, VAT applies to each transaction by way of production or distribution after deduction of the VAT directly borne by the various cost components
30. It follows from that principle as well as from the rule enshrined in the judgment of [BLP] para 19, according to which, in order to give rise to the right to deduct, the goods or services acquired must have a direct and immediate link with the taxable transactions, that the right to deduct the VAT charged on such goods or services presupposes that the expenditure incurred in obtaining them was part of the cost components of the taxable transactions. Such expenditure must therefore be part of the costs of the output transactions which utilise the goods and services required. That is why those cost components must generally have arisen before the taxable person carried out the taxable transactions to which they relate."
"…..in applying the 'used for' test prescribed by art 17(2) of the Sixth Directive the relevant inquiry is whether there is a 'direct and immediate link' between the input cost in question and the supply or supplies in question; alternatively whether the input cost is a 'cost component' of that supply or those supplies. [Underline emphasis supplied] It is clear from the judgments of the ECJ in BLP and Midland Bank, as I read them, that there is no material difference between these alternative ways of expressing the basic test."
"The word 'attributable' and 'attributed' in reg 101 fall to be interpreted by reference to art 2 of the First Directive and art 17 of the Sixth Directive, and in accordance with the principles enunciated by the ECJ in BLP and Midland Bank. Those authorities establish that the appropriate test of attributability in this context is the 'direct and immediate link'/'cost component' test referred to in  above……Moreover, as the ECJ made clear,,,,,, it is for the national courts to apply [that] test to the facts of the case, 'and to take account of all the circumstances surrounding the transaction at issue'."
"(a) focused on the taxpayer's overall commercial aim; (b) treated the two separate supplies as if they were one; (c) asserted that the question whether two supplies are commercially linked is the same as the question whether inputs are attributable to either or both supplies; (d) applied a test of attribution for which there is no authority—namely whether the input enabled the taxpayer to make a taxable supply; (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."
" But there is substance in Mrs Hall's [counsel for Customs] remaining points which, by and large, are different ways of looking at the same question. I particularly consider that point (d) is right. The land purchase transaction was commercially necessary to make its performance commercially possible, but it was not a cost component of the contract itself in the same way as the costs of materials used. There is a link with the contract but the link was not direct and immediate. The development contract would not have been made but for the associated land purchase and sale. But 'but for' is not the test and does not equate to the 'direct and immediate link' and 'cost component' test.
 One can look at it another way. There is nothing about the development contract as such which makes the land purchase and sale essential. If the housing association had already owned the land or had bought it from some third party, the inputs of the development contract would have been just the costs of carrying it out. The fact that there were commercially linked land transactions does not mean that those transactions are directly linked to the costs of the development contract. One would not say that the cost of buying the land was a cost of the development contract itself. It follows that the input tax on that cost is not a cost of the contract.
 Other guidance from the ECJ supports that conclusion. Thus in BLP para. 26 the Court reaffirmed the principle of neutrality – namely that "all economic activities, whatever their purpose or results, are taxed in a wholly neutral way". That principle would be violated if this development contract were taxed differently from an exactly similar "freestanding" contract.
 Again if one applies the "fundamental principle" that "VAT applies to each transaction by way of production or distribution of deduction of the VAT directly borne by the various cost components" (Midland para 29) one is driven to ask whether the land purchase price is a cost component of the development contract – which to my mind it is obviously not. And, if one adapts Midland para.30 to the case the test is whether the expenditure on the land purchase was part of the costs of the development contract which used the land acquired. It did not. The carrying out of the development was on the land acquired, but did not utilise the land, whose ownership was irrelevant. My common sense differs in this respect from Sir Donald Rattee's.
 Midland para. 31 is also in point – there the Court said that lawyers' fees were not "generally part of the costs of the output transaction" and "therefore" did not have any direct and immediate link with the output transaction." Again the Court is focussing on the objective, transaction-by-transaction nature of VAT law. The price of a land purchase is not "generally" part of the costs of a development contract and therefore does not have any direct and immediate link with it.
 Turning back to the tribunal, it concluded that there was a direct and immediate link between the land purchase and both the land sale and development contract, with both an exempt and a non-exempt transaction. 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 the main transaction can one disregard the distinct nature of each transaction (see Card Protection Plan Ltd v Customs and Excise Comrs (Case C-349/96)  STC 270,  2 AC 601, para 29). 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."
The Appellate Jurisdiction
"Ideally I would prefer to agree a realistic method with you and, although a headcount appears suitable, I would be prepared to consider any other proposals which measure actual use. Failing that, we cannot approve your existing proposal. Although it is certainly not ideal, the standard method applies unless and until an alternative special method is approved and has the potential to adjust its outcome by means of the override…………"
The School might detect a slightly hollow ring in that last observation given that Customs have subsequently refused to apply the override which the School suggests and have not themselves implemented any other adjustment.
a. He expresses the opinion that, to determine whether the proposed special method gives a fair and reasonable result, it would appear that the primary purpose of the construction of the sports complex is a major factor in reaching a decision.
b. The primary purpose of the facilities is for the School's own use, reliance being placed by him on the restriction in the planning permission and paragraph 4.8 of the business plan.
c. The facilities were financed entirely out of the School's budget the provision of which will have been mainly for educational purposes and not primarily for commercial use.
d. The charge for the licence had yet to be fixed but would result in full recovery of the VAT paid by SHEL as its input tax.
e. SHEL had made taxable supplies of £10,000 in the first 5 months to December 2004 and its ability to contribute an open market licence fee at the level suggested by the proposal (ie the proposed special method) is questionable. [Mr Rowe comments that this might be academic "in that it is arguable that ideally what is required is some way of identifying the value of the facilities to the School, and comparing this with the value received under the licence…"]
f. Not only does the School have exclusive use during the school day, pupils who board have the unrestricted right to use the facilities during non-school hours and non-term time. In that context, Mr Rowe relies on paragraph 5.2c. of the draft business plan.
g. There is a fundamental difference in regarding the desirable incidental additional income which can be derived from the sports facilities as allowing some (minor) level of input tax recovery, and seeking to represent this as the main reasons for the construction of the facilities and therefore allowing a substantial majority of input tax recovery.
h. The terms and conditions of membership confirm that to become a member of the club the applicant has to meet the eligibility criteria which establish that the individual is part of the "school's recognised community".
i. There is a question as to whether the licence is truly to an independent third party: not only is SHEL a wholly owned subsidiary but it gift-aids profits to the School. It also finances its activity by third-party hire income and partly from the School's own resources by billing the cost of staff to the School.
[Mr Rowe stated expressly, however, that he places no weight on consideration of the mechanism by which the tax recovery is sought or to the reality (for VAT purposes) of the setting up of the licence or whether it is indicative of tax planning.]
j. There is "no consideration at the outset that the capital costs of the project can be recovered by the out of hours use so that it would appear unreasonable to allow any recovery of the capital cost under the suggested method".
k. The actual hours of operation detailed in the business plan are inconsistent with those in the proposed special method; in Mr Rowe's opinion, that method gives an illogical result when compared with the financial aim of third party letting.
The Tribunal's decision
a. That the statutory provisions in VATA, the Regulations and in Article 17 of the Sixth Directive require one to focus on the use by the taxable person of the goods or services for the purposes of his taxable transactions. Accordingly, a method that brings into account the use of the goods and services by a third party 'goes beyond what is authorised'; and that was what the proposed special method sought to do: paragraphs 32 and 33.
b. The costs of construction of the premises were directly and immediately linked to the grant of the licence by the School to SHEL; but not to the use made by SHEL of the complex in the course of its business. The use made by SHEL of the benefits of the licence was not what the School supplied. So the proposal (which looked to use made of the premises by SHEL) went beyond the permitted limits for a use-based method: paragraph 37.
a. The licence would never have been granted "but for" the fact that the School had built the complex (the Tribunal having expressly recognised in the preceding paragraph, when addressing Southern Primary, that the "but for" test is not the test and does not equate to the 'direct and immediate link' and 'cost component' tests).
b. The School's expenditure (its outlay of the costs of the construction works) resulted in the sports complex being created for the School.
c. That expenditure provided the School with the means by which to make its supplies of education and the licence.
d. But the licence was the limit of the School's standard rated supply and the licence fee was the limit of the consideration obtained for that supply.
e. The use SHEL chose to make of the benefits of the licence is not what the School supplied by granting the licence.
f. The corollary is that the costs of construction are directly and immediately linked to the grant of the licence.
[I would remark here that the "direct and immediate link" which the cases discuss is between (i) the goods acquired by the taxable person, not the cost of such goods and (ii) the goods or services he provides. But I think the sense of what the Tribunal is saying is clear. I would also add that another way of putting this is that the costs of construction were not reflected in the cost of providing the licence which might be thought to be the same as saying, in the language of the ECJ, that the cost of the construction work is not a cost component of the taxable supply, that is to say the licence.]
g. But they are not so linked to the use made by SHEL of the sports complex in the course of its business.
h. On that basis, the School's proposed special method goes beyond the permitted limits.
The School's case on the proposed special method
"To be fair and reasonable, any partial exemption method used in this case must offer an effective means of comparing the use of the premises in making taxable supplies with their use in making exempt supplies. There may be circumstances in other cases in which an overhead will be more intensively used in making one kind of supply than another and where this is reflected in the price of each supply (or 'output')."
"Neither contains a greater element of the costs of construction than the other. If one takes the straightforward approach that a capital item, such as the swimming pool complex, depreciates at a uniform rate over its life, one hour's use in making taxable supplies may be seen to expend precisely the same amount of the input tax incurred on the capital cost of the premises as one hour's use in making exempt supplies with the premises. There is, in other words, precisely the same value of input expenditure in each hour's use, whatever the value of the outputs from the hour's use may be.
It follows that it is fair and reasonable when dealing with the attribution of input tax on a capital item which does not significantly diminish in value to apportion the expenditure in the period in which it is incurred between the taxable and exempt use to be made of the item by comparing the time it is to be put to each use."
"It inevitably follows from the fact that SHEL can only use the premises during hours for which it is licensed to do so by the School that the hours in which SHEL uses the premises are a sub-set of the hours in which the School uses the premises by licensing them to SHEL. Thus the hours of use by SHEL are an adequate proxy for the use of the premises by the School for taxable purposes."
a. The fact that the primary purpose of the facilities was for the School's own use is, Mr Thomas submits, an irrelevance. He says, quite correctly, that entitlement to deduct input tax is not determined by motivation or purpose relying on in Dial-a-Phone Ltd  STC 987 and the decisions of the ECJ Abbey National and BLP. One sees this objective approach being adopted in many other cases including the decision of the ECJ in Halifax plc v Customs & Excise Commissioners (Case C-255/02) which shows that the meaning of the term "activities" in the Sixth Directive is very wide and is objective in character in the sense that the activity is considered per se without regard to its purpose or results. I would also mention the decision of Patten J Customs & Excise Commissioners v Yarburgh Children's Trust  STC 207 albeit that it was not cited to me. Patten J clearly holds that the motive of a person in making a supply is not relevant to and cannot dictate the correct tax treatment of a transaction. This is perhaps another way of saying what the ECJ said in Halifax. But, as the judge says, the exclusion of motive or purpose does 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. Although what the judge said was in the context of deciding whether a transaction was an economic activity or not, similar remarks can, I think, be made in relation to establishing the use (for VAT purposes) to which an item of property is put and in determining what is or is not a valid proxy for that use in determining whether a proposed special method is fair and reasonable. I do not, therefore, consider that the establishment of the primary purpose of the construction of the facilities is to be excluded from consideration.
b. The source of the funding for the construction of the premises is, Mr Thomas submits, equally irrelevant. The question is not how the premises were paid for; but whether the premises were used in making taxable supplies. The Tribunal, as he says, found to be the case: they accepted (see paragraph 37 of the Decision) that there was a direct and immediate between the costs of construction and the grant of the licence (but not to the use made by SHEL of the sports complex). However, it does not follow from that the source of the funding is irrelevant in considering whether a proposed special method produces and fair and reasonable attribution. This is a matter to which I will need to return when considering the submissions of Mss Simor on behalf of Customs.
c. That the (value of the?) taxable supplies made by SHEL had been small in the first months of opening: this was, Mr Thomas submits, on any analysis irrelevant and contains the alleged error of considering use by a third party as use by the School – but without the saving grace that it constituted an adequate proxy for the use by the School. That is, I think, an unfair criticism since the italicised words are Mr Thomas' précis of what I have set out more fully at paragraph 35(e) above and are not quite accurate. Indeed, Mr Rowe did go on to say that this point was probably academic as mentioned in that paragraph.
d. That the charge to be made by the School to SHEL had yet to be fixed; but would be recoverable in full as input tax by SHEL. Mr Thomas remarks that it is unclear why it mattered when determining whether a proposed special method was fair and reasonable that output tax charged by the School would be recovered by SHEL. This simply reflected the fact that SHEL itself was a taxable person making taxable supplies. I agree and do not understand the relevance of this factor.
e. That the licence was to be to a subsidiary of the School who was not a 'truly independent third party'. Mr Thomas says that to assert this is to fall into the error of treating separate taxable persons as a single person for VAT purposes. Authority that this is impermissible may be found in cases such as the decision of the Court of Justice in Staatssecretaris van Financiën v Heerma (Case C-23/98)  STC 1437 paragraph  and of the Court of Appeal in Telewest Communications Plc v Customs and Excise Commissioners  STC 481, per Arden LJ at paragraph . I do not think, however, that Mr Rowe was falling into that error; in any case, he attached no weight to this point (see paragraph 35(i) above).
f. That the capital costs of the project had not been considered to be recoverable out of the out of hours use. Mr Thomas says the issue is not, again, whether the costs are recovered out of the use; but whether the goods and services are used to make the supplies. That is clearly correct.
g. The School had potentially access at all hours through its boarders. Mr Thomas' riposte to that is that, if the boarders were using the swimming pool out of hours, they did so not because the School was educating them but because they were on the premises. This use by individuals did not constitute the provision of exempt education by the School or use by the School. I would add that the evidence was, in any case, that boarders had to be members of the Club and thus enjoyed out-of-hours use through the licence to SHEL not by virtue of the supply of education.
h. The membership of the club run by SHEL would be restricted to persons connected with the School community. Mr Thomas observes that this may have been so; but it did not mean, he says, that the taxable supplies to SHEL were sham or that this was in some way the indirect provision of exempt education by the School. I agree with that. It is, however, part and parcel of the context in which the "use" for VAT purposes of the sports complex has to be ascertained.
i. That the hours referred to in the School's business plan for the project were inconsistent with those used or to be used in the apportionment fraction. Mr Thomas says that this could only have been relevant to a computation of the apportionment fraction and not to the question whether the apportionment method was fair and reasonable. I agree with that.
Custom's case on the proposed special method
a. The Tribunal were correct in finding that the only relevant supply for the purposes of determining deductible input tax was the supply by the School to SHEL and that supplies or physical use by SHEL were not an appropriate proxy for 'use' by the Appellant.
[As to that, the Tribunal did not use the word "proxy" in the Decision. It is not at all clear to me that it had in mind, and rejected, the approach which Mr Thomas now advocates. Indeed, the Tribunal seem to have rejected looking at the use made by SHEL of the complex as a matter of principle which, as I have already said, I do not think is correct.]
b. The cost of constructing the sports complex did not form a cost component of the supply of the licence to any significant extent, albeit that no licence for the use of the complex could have been granted without the existence of a complex.
c. Accordingly, the 'special method' proposed, whereby the hours during which the School could not use the sports complex (and which hypothetically could be used by SHEL) were used as a proxy for the percentage of VAT on inputs (in particular, construction costs) that the school was entitled to deduct, was not reasonable or legitimate.
a. The complex was constructed wholly for the purposes of an exempt supply namely, education. VAT paid in respect of its construction is therefore a cost that is almost entirely directly attributable to an exempt supply. It is therefore not recoverable, save for any minor amount.
b. The only taxable supply made by the School was the grant of the licence, which contains no specific fee but which appears to give rise to an annual fee of around £18,600 per annum. Only input tax that is attributable to the grant of that licence can be reclaimed.
c. The costs of construction were incurred for the purposes of educational supplies not in relation to the taxable supply of the licence. Put another way, those costs cannot be said to be a cost component of supplying the licence to any significant degree.
a. The taxable rentals are £1530 per month (as at 31 March 2005) or £18,360 per year.
b. The VAT bearing cost of the asset was £2,635,013.12
£2,635,013.12 x 54% = £1,422,906 [54% being the proportion attributable to the licence under the School's proposed special method]
c. The taxable rental required to meet 54% of the capital expenditure would run for a period of 77.5 years (£18,360 x 77.5 (years) = £1,422,906).
d. This is said to be a conservative figure since it assumes that there are no capital financing costs, and that all of the funds are used to repay capital and that there are no other contingencies that need to be covered by these funds. But the licence is for 10 years and there is nothing to suggest that it would continue after that period. Assuming that SHEL was wound up after 10 years and assuming all rental fees were used to cover the capital costs of the building, only £180,360.00 would be recovered. Put in terms of VAT this means that the Appellant would recover £245,657.46 VAT but would only contribute £31,563.00 VAT.
Standard Method Override
The first business plan
Special method - application and rejection
Construction work on the sports complex
Letter agreement to grant licence to SHEL
The Athis draft business plan
SHEL's and the School's responses to the business plan
"In principle the commercial letting of the sports complex outside School hours be approved".
Further consideration of the business plan and the financial arrangements took place at a meeting of SHEL's board on 26 April 2004. The board agreed to open the sports complex to commercial use.
Option to tax
Construction completed and opening of sports complex
The licence commences
Financing the sports complex: the School's contributions and receipts
SHEL's payments to and receipts from the School
SHEL's other supplies