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Easyjet PLC v Customs & Excise [2003] UKVAT V18230 (17 July 2003)

VAT – input tax – attribution – share issue – accountancy fees covering share issue and audit – basis for attribution where some shares issued outside EU – whether complete code in VAT Regulations 1995 SI No 3518 Reg 103, or additional attribution under Reg 101

LONDON TRIBUNAL CENTRE

EASYJET PLC Appellant

- and -

THE COMMISSIONERS OF CUSTOMS AND EXCISE Respondents

Tribunal: JOHN CLARK (Chairman)

MICHAEL SILBERT F.R.I.C.S

Sitting in public in London on 19 May 2003

Rupert Anderson QC, instructed by KPMG, for the Appellant

Kenneth Parker QC, instructed by the Solicitor's Office of HM Customs and Excise, for the Respondents

© CROWN COPYRIGHT 2003

DECISION

EasyJet plc (strictly, easyJet plc, referred to in this decision as "the Appellant") appeals against a decision rejecting a voluntary disclosure claiming credit for input tax on the supply of services in relation to a global offer of new ordinary shares. The issue in this appeal is whether the relevant regulation provides an exclusive code for the attribution of input tax, or whether, once an attribution has been made under that regulation, a further attribution can be made under the more general attribution regulation.

The law

The European provisions relevant to this appeal are contained in Articles 17 and 19 of EC Council Directive 77/388 ("the Sixth Directive"). Article 17 provides:

"2 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 within the territory of the country in respect of goods or services supplied or to be supplied to him by another taxable person;

. . .

3 Member States shall also grant every taxable person the right to the deduction or refund of the value added tax referred to in paragraph 2 in so far as the goods and services are used for the purposes of:

(a) transactions relating to the economic activities . . . carried out in another country, which would be deductible if they had been performed within the territory of the country;

. . .

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.

However, Member States may:

. . .

(c) authorise or compel the taxable person to make the deduction on the basis of the use of all or part of the goods and services;

(d) authorise or compel the taxable person to make the deduction in accordance with the rule laid down in the first sub-paragraph, in respect of all goods and services used for all transactions referred to therein;"

Article 19 of the Sixth Directive provides:

"1 The proportion deductible under the first sub-paragraph of Article 17(5) shall be made up of a fraction having:

—as numerator, the total amount, exclusive of value added tax, of turnover per year attributable to transactions in respect of which value added tax is deductible under Article 17(2) and (3),

—as denominator, the total amount, exclusive of value added tax, of turnover per year attributable to transactions included in the numerator and to transactions in respect of which value added tax is not deductible."

The relevant domestic provisions are the following. Section 4(2) of the Value Added Tax Act 1994 ("VATA 1994") provides:

"(2) A taxable supply is a supply of goods or services made in the United Kingdom other than an exempt supply."

The relevant parts of section 26 VATA 1994 provide:

"(1) The amount of input tax for which a taxable person is entitled to credit at the end of any period shall be so much of the input tax for the period (that is input tax on supplies, acquisitions and importations in the period) as is allowable by or under regulations as being attributable to supplies within subsection (2) below.

(2) The supplies within this subsection are the following supplies made or to be made by the taxable person in the course or furtherance of his business—

(a) taxable supplies;

(b) supplies outside the United Kingdom which would be taxable supplies if made in the United Kingdom;

(c) such other supplies outside the United Kingdom and such exempt supplies as the Treasury may by order specify for the purposes of this subsection.

(3) The Commissioners shall make regulations for securing a fair and reasonable attribution of input tax to supplies within subsection (2) above . . . "

Under section 26(2)(c) VATA 1994 the Treasury has made the Value Added Tax (Specified Supplies) Order 1999 (SI 1999/3121). The provision relevant to this appeal is article 3:

"3 Services—

(a) which are supplied to a person who belongs outside the member States;

(b) which are directly linked to the export of goods to a place outside the member States; or

(c) which consist of the provision of intermediary services within the meaning of item 4 of Group 2, or item 5 of Group 5, of Schedule 9 to the Value Added Tax Act 1994 in relation to any transaction specified in paragraph (a) or (b) above,

provided the supply is exempt, or would have been exempt if made in the United Kingdom, by virtue of any item of Group 2, or any of items 1 to 6 and item 8 of Group 5, of Schedule 9 to the Value Added Tax Act 1994."

Part of the implementation of Articles 17 and 19 of the Sixth Directive in the United Kingdom ("UK") is by means of certain provisions of the VAT Regulations 1995 (SI 1995/2518) ("VATR"). (References in this decision to numbered regulations are to those in VATR.) The general provision governing the attribution of input tax to taxable supplies is regulation 101, the relevant parts of which are the following:

"101—(1) Subject to regulation 102, the amount of input tax which a taxable person shall be entitled to deduct provisionally shall be that amount which is attributable to taxable supplies in accordance with this regulation.

(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

(3) In calculating the proportion under paragraph (2)(d) above, there shall be excluded—

. . .

(b) any sum receivable by the taxable person in respect of any of the following descriptions of supplies made by him, where such supplies are incidental to one or more of his business activities—

. . .

(v) any supply which falls within Group 5 of Schedule 9 to the Act,

. . ."

Regulation 103 VATR deals with the attribution of input tax to foreign and specified supplies. It provides:

"103—(1) Input tax incurred by a taxable person in any prescribed accounting period on goods imported or acquired by, or goods or services supplied to, him which are used or to be used by him in whole or in part in making—

(a) supplies outside the United Kingdom which would be taxable supplies if made in the United Kingdom, or

(b) supplies specified in an Order under section 26(2)(c) of the Act, [other than supplies of a description falling within regulation 103A below,]

shall be attributed to taxable supplies to the extent that the goods or services are so used or to be used expressed as a proportion of the whole use or intended use.

(2) Where—

(a) input tax of the description in paragraph (1) above has been incurred on goods or services which are used or to be used in making both—

(i) a supply within item 1 or 6 of Group 5 of Schedule 9 to the Act, and

(ii) any other supply, and

(b) the supply mentioned in sub-paragraph (a)(i) above is incidental to one or more of the taxable person's business activities,

that input tax shall be attributed to taxable supplies in accordance with paragraph (1) above notwithstanding any provision of any method that the taxable person is required or allowed to use under this Part of these Regulations which purports to have the contrary effect,

(3) For the purpose of attributing to taxable supplies any input tax of the description in paragraph (2) above, it shall be deemed to be the only input tax incurred by the taxable person in the prescribed accounting period concerned."

The facts

At the hearing, as the facts were agreed, the facts were referred to only in summary form. For the purposes of this decision we find it necessary to deal with the facts in greater detail. The evidence consisted of the agreed bundle of documents, which included a witness statement made by Hugh Green, a partner within KPMG LLP and an Audit Director of KMPG Audit Plc. No oral evidence was given at the hearing. From the agreed evidence we find the following facts.

The Appellant's group operates a low-fare scheduled airline business. All of its companies in the UK were at the material time (and remain) registered as a VAT group. The principal business activities of the VAT group are taxable for VAT purposes.

On 22 November 2000 the Appellant made an Initial Public Offering ("IPO") on the London Stock Exchange. Approximately 23.65% of the new shares issued by the Appellant were issued to investors located outside the European Union ("EU").

The total of the professional fees incurred in relation to the IPO was in the region of £14 million, although of this approximately £11 million did not bear VAT as the services supplied were exempt from VAT under Group 5 of Schedule 9 VATA 1994. On the remaining professional fees, the VAT incurred by the Appellant was approximately £615,000.

Within this balance of fees which were subject to VAT, there was a total of approximately £1.7 million exclusive of VAT in respect of KPMG's fees. Their estimate provided to the Appellant in April 2000 had been £1.5 million, although the invoices rendered to the Appellant also showed a total of over £65,000 on "outlays", which were not referred to in the estimate. All the invoices rendered by KPMG were in the name of KPMG Audit Plc.

The letter to the Appellant containing the estimate was written by Hugh Green. The copy in the agreed bundle of documents contains typed annotations against the figures. From the tenor of the comments, we conclude that these were made on behalf of the Appellant, possibly by Chris Walton, to whom the letter was addressed. The figures in the estimate were:

"Phase Process £000

I Identification and resolution of US GAAP differences 50
I Consolidation of 5 years figures 70
I Additional financing/operating data 60
I Business/IT risks review 60
I Other preparatory work 30
II Long form report 320
II Short form report 190
II Working capital 85
II Indebtedness/Financial reporting procedures 35
IIB Update Phase 2 reports 60
III Prospectus drafting/other comfort letters 260
on-going Meetings/planning/project management 105
IIB/IV UK audit July 2000/September 2000/Reporting 175
1.500"

The annotations are set out next to the figures. Against the items covered by Phase I, the note is: "Overall KPMG have quoted £370K for fin info prep – seems steep". Against some of the items in Phase II the note is: "this seems very high to me". Finally, against the item for audit, there is the question "includes full y/e audit sign off?"

In their "Flotation engagement letter" dated 30 October 2000 KPMG stated that their fee estimate was the subject of a separate letter dated 19 April 2000 (the letter referred to above). Under the heading "Significant change in financial or trading position" KPMG stated

"The scope of this work is different from that for an audit and it does not, therefore, provide the same level of assurance as an audit."

Despite this limitation of their function in the context of the IPO itself, KPMG did carry out audit work in relation to the Appellant. This was because, for the purposes of the IPO, the Appellant was required to prepare and include a KPMG report within the IPO listing particulars covering the group's financial statements for the three years up to and including 30 September 2000. The short interval between that date and the date of the IPO imposed a very tight deadline on KPMG for the audit of the year to 30 September 2000, which was required both for the IPO and for the Appellant's normal purposes. The approach followed was to focus initially on the position at 31 July 2000 and then to "roll the position forward" to 30 September 2000 so that the financial information at the latter date could be audited very rapidly. Although there is no correspondence in the evidence dealing with the question, it is clear from subsequent events, including the invoices rendered by KPMG, that the answer to the question in the final annotation mentioned at paragraph 15 above was that the work on the IPO, including the element of "normal" audit for the year ending 30 September 2000, would be carried out as a single project for a single fee.

The invoices do not separate the charges for the various elements set out in paragraph 14 above. Each shows only the relevant instalment payable on account, and where appropriate an amount in respect of "outlays". Other than the references to the latter, there is nothing to link the amounts shown in the estimate and the amounts finally invoiced in order to show specific variances leading to the original estimate being exceeded. There is no narrative describing the work done, and only the first invoice is headed "Proposed flotation". In his witness statement Hugh Green explained the basis of the work carried out by KPMG and the manner in which this was done. The audit and the reporting processes in relation to the IPO had to operate as a single seamless exercise. The integrated approach to completing KPMG's responsibilities for the audit and reporting processes in relation to the IPO was reflected in KPMG's approach to billing the Appellant for the work. KPMG did not consider it practicable or meaningful to attribute the final amount billed between the many different tasks.

On 7 September 2001 KPMG wrote to the Commissioners on behalf of the Appellant to make an input tax claim in respect of certain fees relating to the IPO. The total, exclusive of VAT, was just over £3.5 million, the VAT in respect of which amounted to the figure mentioned above of approximately £615,000. Of this VAT, KPMG explained that £288,926.17 was exclusively attributable to the IPO. As the proportion of shares sold outside the EU was 23.65%, that percentage of the exclusively attributable amount, namely £68,331.04, was recoverable. The claim concerning the balance of input tax in respect of professional fees related solely to KPMG's fees. There is a discrepancy between the amounts shown in the schedule to this letter and the amount mentioned elsewhere as the total of KPMG's fees. In the schedule to the letter, the total exclusive of VAT is £1,866,157.20, with the VAT shown as £326,577.52. The amounts shown include two that are not reflected in the invoices included in the agreed bundle of documents. One is shown as "KPMG Tax", the amount being £66,850, plus VAT of £11,698.75. The second is shown simply as "KPMG", for £93,986.21, plus VAT of £16,447.59. There is nothing in the agreed bundle to show why these amounts are thought to fall within the same category as the invoices rendered by KPMG Audit Plc. As the total quoted in the body of this letter is £1.7 million plus VAT, which is the total arrived at by subtracting these two amounts from £1,866,157.20, we question whether these two amounts, and the VAT incurred by the Appellant in respect of them, should have been included in the input tax claim with the KPMG Audit Plc fees. It may be that they should have been dealt with in the same way as the other costs associated with the IPO, and the input tax recoverable should have been based on the 23.65% attribution. In the absence of evidence, we are unable to resolve this. We simply say that the amount of £326,577.52 may prove to be excessive; if it is, it should be reduced by £28,146.34 to £298,431.18.

The reason for treating the KPMG fees separately is that in their letter, KPMG argued that the attribution of this input tax should be carried out on a different basis from that applying in respect of the other taxable fees rendered in respect of the IPO. KPMG argued that after an apportionment in respect of their fees had been carried out under regulation 103 VATR, the remainder of the input tax was residual input tax as it was attributable both to the issue of shares in the EU (exempt supplies) and the normal business activities of the Appellant (taxable supplies). That residual input tax therefore had to be apportioned using the standard partial exemption method then in use by the Appellant, which was the standard method set out in regulation 101. The detailed reasons for this are set out in the parties' contentions considered below, so are not set out here. In their letter, KPMG contended for the Appellant that the whole of the £326,577.52 was recoverable, less an amount of £46,956 already claimed by the Appellant as input tax.

Following exchanges of correspondence, the Commissioners wrote to KPMG on 5 November 2001 stating that the Commissioners could not agree with the proposed treatment of the VAT on KPMG's costs. Regulation 103(2) stated that the attribution to taxable supplies should be done in accordance with the regulation 103(1) use based calculation. The use-based calculation was applied to the whole of the input tax, so there was no balance to which regulation 101 would apply. The only input tax claims which they could accept were the £68,331.04 claimed on the basis of the 23.65% attribution, and the same percentage of the £326,577.52 in respect of the KPMG fees.

In their letter dated 5 December 2001, KPMG requested a reconsideration of the decision, setting out arguments that have since been put to us, and additionally mentioning the reason for the introduction of regulation 103 VATR. (We consider this below.) After further correspondence, the Commissioners wrote on 8 March 2002 to confirm their view that all the VAT on KPMG's invoices should be apportioned on the basis of "use" under regulation 103, and that the method of apportionment set out in KPMG's letter dated 5 December 2001 could not be accepted. They indicated that they were prepared to consider an alternative method of apportionment, calculated on the basis of use, which secured a fair and reasonable result. One suggested method that they offered for consideration was to attribute all of the tax to supplies that conferred the right to deduct input tax on the basis of use. As a formal matter, the Appellant's appeal is against the decision contained in this reconsideration letter.

In KPMG's reply dated 19 March 2002, they did not respond to the Commissioners' offer to discuss an alternative method of apportionment. They requested a reconsideration of the ruling in the 8 March letter in the light of a number of points corresponding to those subsequently put to us in argument. The Commissioners' reply dated 28 May 2002 dealt with those points and restated the Commissioners' view that the attribution should be based solely on use in accordance with regulation 103.

Arguments for the Appellant

Mr Anderson referred to regulation 101(2)(d) VATR. This provided for the attribution of input tax on goods or services used in making both taxable and exempt supplies. It provided for attribution based on "value". Regulation 103 provided for the attribution of input tax on goods or services used in whole or in part in making certain foreign or specified supplies. The attribution under regulation 103 was based on "use". Where input goods and services were used in part in making foreign or specified supplies and in part in making in-country non-specified supplies, the issue arose as to whether regulations 101 and 103 required:

(1) the regulation 103 use-based attribution to be applied only in respect of foreign or specified supplies, with the regulation 101 value-based attribution applicable in respect of other supplies (ie in-country non-specified supplies), or

(2) that attribution of input tax be carried out solely on the basis of the regulation 103 use-based approach, with there being no role for the regulation 101 value-based approach.

He referred to the Commissioners' letter dated 8 March 2002, which had indicated that KPMG's work related to four categories of supply. These were (in his order) the audit work, supply of shares outside the EU, supply of shares within the UK, and supply of shares outside the UK but within the EU.

The first purpose for which he cited the KPMG work as having been used was the preparation of statutory accounts, ie the annual audit. The Commissioners had acknowledged that such work was a general overhead which was attributed to all of the Appellant's principal business activities and related to taxable supplies. In Customs and Excise Commissioners v Liverpool Institute of Performing Arts [2001] STC 891 ("LIPA"), the House of Lords had held that the words "taxable supplies" in what is now regulation 101(2)(d) have the same meaning as in what is now section 4(2) VATA 1994. He pointed out that the Appellant's principal business activities constituted taxable transactions for the purposes of Article 17 of the Sixth Directive. He argued that as a matter of principle, input tax incurred in relation to the audit should be recoverable by the Appellant to the extent that the Appellant's principal business activities constituted "taxable supplies", whether it was attributed to the audit work by value or by use. This appeared to be accepted by the Commissioners in their letter dated 28 May 2002. However, he contended that the audit preparation work did not fall within the scope of either regulation 103(1)(a) or (b). This was because the audit and/or the Appellant's principal business activities did not constitute supplies outside the UK or supplies specified by an Order under section 26(2)(c) VATA 1994.

The second purpose for which the KPMG work had been used was the issuing of shares to investors located outside the EU. It was agreed by both parties that this work fell within the scope of regulation 103(1)(b), because it was a supply specified by an Order under section 26(2)(c) VATA 1994, ie Article 3 of the Value Added Tax (Specified Supplies) Order 1999. In the light of LIPA, the parties agreed that the wording "shall be attributed to taxable supplies" in regulation 103(1) meant "shall be attributed to section 26(2)(b) and (c) VATA 1994 supplies". The parties therefore agreed that input tax apportioned to the supply of shares to investors located outside the EU was recoverable by the Appellant.

Thirdly, the KPMG work had been used for the purpose of issuing shares to investors located inside the UK. The Commissioners had stated in their letter dated 28 May 2002:

"The issue of shares to persons located within the UK are supplies that do not confer the right to deduct input tax, since they fall to be exempt under item 6 of Group 5 of Schedule 9 to the Act. The input tax relating to such supplies is, in principle, wholly irrecoverable."

Mr Anderson argued that this supply did not fall within the scope of regulation 103(1)(a) or (b), being a supply inside the UK which was not specified in an Order under section 26(2)(c) VATA 1994. However, the supply of shares to investors located in the UK did trigger the operation of regulation 103(2), being a supply within item 1 or 6 of Group 5 of Schedule 9 that was incidental to one or more of the Appellant's business activities.

Fourthly, the KPMG work had been used for the purpose of issuing shares to investors located outside the UK but inside the EU. The Commissioners had stated in their letter dated 28 May 2002:

"The issue of shares to persons located within other Member states are supplies that fall outside the scope of UK VAT and which do not confer the right to deduct input tax since they do not fall within section 26(2). Again, the input tax relating to such supplies is, in principle, wholly irrecoverable."

Mr Anderson argued that this supply also did not fall within the scope of regulation 103(a) or (b) because, first, it was not a supply specified in an Order under section 26(2)(c) VATA 1994, and secondly, although a supply outside the UK, it would have been exempt if made inside the UK.

He then considered the position that the Commissioners had adopted. Where input tax was incurred on work used for several purposes, some of which constituted supplies falling within the scope of section 26 VATA 1994, he argued that input tax should be attributed to those supplies. Any interpretation of the legislation that resulted in input tax not being attributable to such a supply would be wrong. For example, in the present case, any interpretation of the legislation which resulted in no input tax being attributable to the audit work would be wrong. The Commissioners appeared to accept this. The difference between the parties was precisely how the input tax in respect of the KPMG invoices should be attributed. He reviewed the history of the correspondence, and said that although the Commissioners' position had changed in certain respects, their position in respect of the correct interaction between regulations 101 and 103 had remained constant. Their view was that all the KPMG input tax fell to be attributed solely on the basis of the use or intended use under regulation 103(2), and that there was no possibility for attribution also on the basis of value under regulation 101(2)(d). The Commissioners appeared to believe that under regulation 103(2) input tax could be attributed on the basis of use both to the supply of shares to investors located outside the EU, and to the audit work.

He maintained that on a correct reading of the legislation, regulation 103(2) was not capable of apportioning input tax to the audit work. The parties agreed that regulation 103(2) was applicable. Consequently, under regulation 103(2), input tax was to be attributed to taxable supplies (ie attributed to section 26(2) VATA 1994 and therefore recoverable) "in accordance with paragraph (1) above". He argued that therefore regulation 103(2) did not prescribe its own method of attribution: rather, it prescribed the method of attribution set out in regulation 103(1) for input tax falling within the scope of regulation 103(2). In accordance with regulation 103(1), input tax was to be attributed to taxable supplies "to the extent that the goods or services are so used". It was therefore necessary to construe the meaning of the words "are so used". He argued that these words referred back to the wording in the opening clause of regulation 103(1), and must therefore mean "are used for the purpose of making supplies of the type described in regulation 103(1)(a) and (b)". In LIPA, the House of Lords had stated: "The reg 32 [now 103] use-based apportionment applies only in respect of out-of-country supplies" (Lord Scott at [37]). In that case the House of Lords had been concerned only with out-of-country and in-country supplies, and not with specified supplies. Mr Anderson said that in fact it was more accurate to state that the use-based attribution applies only in respect of out-of-country and specified supplies, ie supplies specified in regulation 103(1)(a) or (b); such an interpretation was in line with the heading of the regulation, "Attribution of input tax to foreign and specified supplies". He referred back to his argument that the audit work did not fall within the scope of regulation 103(1) (paragraph 26 above). It followed that the Commissioners' position that the KPMG input tax could be attributed solely by the regulation 103 use-based method would have the consequence that no input tax would be attributed to the audit work (in respect of which he said that input tax was recoverable under section 26(2) VATA 1994). The Commissioners' position must therefore be wrong.

On the question whether it was possible to apply regulation 101 to a "balance", he quoted from the Commissioners' letter dated 5 November 2001 (paragraph 21 above). Their statement misunderstood the operation of regulation 103(2). Although there was only one body of work (the KPMG work) and one body of input tax attaching to it (he referred to this as "the KPMG input tax"), that single body of work had been used for the purposes of several transactions, in respect of some of which input tax was recoverable, and some of which it was not. He repeated his contention that regulation 103(2) attributed input tax only in respect of supplies falling within the scope of regulation 103(1)(a) and (b). It followed that on the facts of this case, regulation 103(2) attributed input tax only to the issue of shares to investors located outside the EU. For the reasons he had given, regulation 103(2) could not attribute input tax to the preparation of the audit. There therefore remained a balance of the KPMG input tax to be attributed by the application of the regulation 101 value-based approach. In LIPA, the House of Lords had confirmed two points. First, what were now regulations 101 and 103 resulted in the attribution of input tax by a two-stage approach. Secondly, there was nothing in the scheme of the Sixth Directive to preclude that two-stage approach. He cited Lord Scott's speech at [37] as authority for the proposition that two regimes could be used.

He pointed out that the Commissioners, in their letter dated 5 November 2001 and in their Statement of Case, had misunderstood the transaction in respect of which the Appellant contended that regulation 101 fell to be applied. The UK and EU share issue was not that transaction. What the Appellant was contending was that, following the application of regulation 103(2), regulation 101 fell to be applied in respect of the preparation of the audit. This contention had been clearly set out by the Appellant in its correspondence with the Commissioners.

He then set out the Appellant's position as to how regulations 101 and 103 operated and interacted. The KPMG input tax was input tax of the type described in regulation 103(1), having been incurred on the KPMG work which had been used in part in making supplies specified in an Order under section 26(2)(c) VATA 1994, namely the supply of shares to investors located outside the EU. The KPMG work had been used in making both (i) a supply within item 1 or 6 of Group 5 of Schedule 9 VATA 1994 (the supply of shares to investors located in the UK), such supply being incidental to one or more of the taxable person's business activities, and (ii) any other supply. It followed that regulation 103(2) applied, and the KPMG input tax should be attributed to taxable supplies in accordance with regulation 103(1) notwithstanding any provision of any method that the taxable person was required or allowed to use under this Part of these Regulations purporting to have the contrary effect. Consequently, the effect of regulation 103(2) was that where input tax of the type described in regulation 103(1) was incurred in respect of work of the type described in regulation 103(2)(a) and (b), it should be attributed in accordance with the use-based method set out in regulation 103(1) (the latter being that considered by the House of Lords in LIPA). The fact that regulation 103(2) referred to "taxable supplies" and/or "any other supply" could not affect that conclusion. Nor could it be affected by the inclusion in regulation 103(2) of the wording "notwithstanding any provision of any method . . ." That merely removed any doubt that the regulation 103(1) method of attribution was applicable. The wording also made it clear that the provisions of regulation 103 overrode the provisions in regulations 101(3) and 102(2) which required the value of incidental exempt financial transactions (such as share issues) to be ignored. The provisions of regulations 101(3) and 102(2) were intended to apply to the attribution methods referred to in those regulations, but would have the effect of rendering completely ineffective the method of attribution prescribed by regulation 103(2).

Once the regulation 103(1) use-based method of attribution was triggered by regulation 103(2), it operated in precisely the same way as set out by the House of Lords in LIPA. For the reasons already given, the method of attribution set out in regulation 103(1) was capable of attributing input tax only to supplies falling within the scope of regulation 103(1)(a) or (b). Consequently in the present case the regulation 103(1) method of attribution prescribed by regulation 103(2) attributed input tax only to the supply of shares to investors located outside the EU, because none of the other purposes for which the KPMG work was used fell within the scope of regulation 103(1)(a) or (b). It could not therefore attribute input tax to the audit preparation work.

Mr Anderson gave the reasons supporting the Appellant's approach. Regulation 103(2) did not prescribe its own method of attribution. Rather, it prescribed the regulation 103(1) method in respect of input tax falling within its scope. The Commissioners' case that attribution must be carried out only by the regulation 103(1) use-based approach was therefore inconsistent with the House of Lords' judgment in LIPA, which held that a two-stage approach was required. In relation to the work on preparing the audit, for the reasons already given the method of attribution prescribed by regulation 103(2) in conjunction with regulation 103(1) was not capable of attributing input tax to the preparation of the audit. This work was a general overhead that was attributable to the Appellant's principal work which itself constituted taxable supplies. The Appellant was entitled to recover input tax relating to such work under Article 17 of the Sixth Directive and section 26 VATA 1994. The Commissioners' interpretation could not therefore constitute a "fair and reasonable attribution of input tax" within the meaning of section 26, and must therefore be wrong.

He argued that the Commissioners' position was inconsistent with their own guidance on the operation of regulations 101 and 103; that guidance supported the Appellant's position. He cited a notice which the Commissioners had published when the predecessor of regulation 103(2) was introduced. This referred to businesses having to isolate input tax in respect of their financial transactions, where incidental to their business, and to determine separately the amount of tax that they could deduct, according to actual use. He also cited Business Brief number 12/2001, containing a section headed "VAT: Partial Exemption: Supplies to be excluded from the standard method calculation", which contained a review of the implications of LIPA. It included the following:

"What if I make supplies that fall under both Regulations 101 and 103(1)?

If you make taxable and exempt supplies in the UK as well as making supplies outside of the UK, then both Regulations 101 and 103(1) need to be applied. Regulation 103(1) is always to be applied first . . ."

He criticised the practical implications of the Commissioners' approach by means of an example. If a fully taxable UK business received a single advisory service in the course of conducting both an "incidental" exempt issue of shares and its normal taxable business, it would be able to recover all of the input tax on the adviser's invoice provided that it refrained from issuing any shares outside the EU. This followed from the decision of the High Court in RAP Group plc v Customs and Excise Commissioners [2000] STC 980. The adviser's invoice would not fall within regulation 103, and the input tax would therefore fall to be attributed solely by the partial exemption method set out in regulation 101 (standard method) or regulation 102 (special method). Either method required a business to ignore incidental financial supplies for the purposes of calculating the recoverable amount. Consequently, the business would achieve a full input tax recovery on the adviser's invoice. However, if the same fully taxable business issued shares of which some were bought by non-EU persons, thereby increasing the value of its supplies carrying the right to deduct, on the Commissioners' approach that business would suffer a considerable irrecoverable VAT cost. The business would not be able to recover VAT in relation to the exempt supply of shares to investors located inside the EU, which would usually be ignored for the purposes of the standard value-based partial exemption method in regulation 101, or the special partial exemption method in regulation 102.

Finally, he argued that the Appellant's approach would sit more easily with the general scheme set out in Articles 17 and 19 of the Sixth Directive. These suggested that attribution should generally be carried out by value, with attribution by use being the exception to the general rule. Regulation 103(1) and (2) could be seen as use-based exceptions for the purpose of attributing input tax only to the foreign and specified supplies described in regulation 103(1)(a) and (b), with the more general value-based method applicable in respect of all other supplies. This was consistent with the exclusion of the value of incidental financial supplies from the Article 19 use-based apportionment by virtue of Article 19(2).

Arguments for the Commissioners

Mr Parker agreed that there had been a single supply of services to the Appellant, and that this had been used for the four different purposes already mentioned. He further agreed that the supply had been used for the following purposes. In the case of the first purpose, the audit work, it had been used to make taxable supplies. For the second, the supply of shares outside the EU, it had been used to make a supply within regulation 103(1)(b) VATR. For the third, the supply of shares inside the UK, it had been used to make an exempt supply. For the fourth, the supply of shares outside the UK but inside the EU, it had been used to make a supply outside the scope of UK VAT. Therefore, following long established principles of EU and UK law, the Appellant was entitled to deduct the input tax on the relevant supply to the extent that it was used for the first and second of these purposes. That was precisely the result achieved by the way in which the Commissioners sought to apply regulation 103(2) to the relevant supply. The fundamental point of difference between the parties was that the Appellant was saying that the Commissioners' application of regulation 103(2) was unfair, while the Commissioners were saying that it enabled a use-based attribution. It was necessary to step back and look at the effects of the Appellant's contention. If the Appellant's construction of regulation 103(2) were followed, the Appellant would be entitled to deduct the whole of the input tax, notwithstanding that the relevant supply was used, to a very substantial extent, for the third and fourth of these purposes.

The Commissioners' case was that regulation 103(2) constituted a complete and exclusive code for dealing with the attribution of input tax where it applied. The Appellant's case was that it was only partial; it dealt with part (and part only) of that residual input tax. He submitted that this was inconsistent with the language of the regulation. The Commissioners' case rested on a straightforward application of regulation 103(2), following its precise language. He referred to regulation 103(2)(a), which provided: "Input tax of the description in paragraph [103](1) above has been incurred on goods or services . . ." Here, input tax incurred on the relevant supply had been used in part for making a supply within regulation 103(1)(b), namely the supply of shares outside the EU. The following words of regulation 103(2) were "which are used or to be used in making both – (i) a supply within item 1 or 6 of Group 5 of Schedule 9 to the Act . . ." (which in this case was the supply of shares in the UK) "and any other supply . . ." (which here was both the supply of shares outside the UK and the audit work). Regulation 103(2) continued: "(b) the supply mentioned in sub-paragraph (a)(i) above is incidental to one or more of the taxable person's business activities . . ." Here the supply of shares inside the UK was incidental to the Appellant's main business activity. The remainder of regulation 103(2) stated: "that input tax shall be attributed to taxable supplies in accordance with paragraph (1) above notwithstanding any provision of any method that the taxable person is required or allowed to use under this Part of these Regulations which purports to have the contrary effect." This meant that the whole of the input tax, not limited to that used for the purposes set out in sub-paragraphs (a) and (b) of regulation 103(1), had to be attributed on the basis of use; one must not apply a value-based method. The Appellant's argument was putting a gloss on the language; this was saying that the reference to paragraph (1) of the regulation restricted the input tax to which the use-based attribution applied. Mr Parker criticised this as an utterly strained interpretation. The final words of regulation 103(2) beginning with "notwithstanding" confined the attribution to a use-based method. He pointed out that the "ring fencing" of the input tax under regulation 103(2) was emphasised by regulation 103(3); this referred to "input tax of the description in paragraph (2) above", and deemed it to be the only input tax incurred by the taxable person in the period concerned. It "ring fenced" the input tax as a whole, not in pieces. It was the Commissioners' case that the language of regulation 103 required an exclusive approach to the attribution.

The Appellant's resistance to this straightforward application was based on what appeared to be four grounds.

The first was alleged inconsistency with LIPA. Mr Parker commented that at no stage in LIPA was regulation 103(2) considered by the House of Lords, nor had it been raised by either party. He could not recollect it being raised in the Court of Appeal. From the papers, it did not appear to have been raised in the decision of the Tribunal nor in the judgment of the High Court. The case had concerned only the relationship between regulation 103(1) and regulation 101. Nothing said in LIPA was inconsistent with the application of regulation 103(2) as contended for by the Commissioners, and the case gave no assistance on the construction of regulation 103(2).

The second was alleged inconsistency with Business Brief 12/2001. Mr Parker indicated that this sought to explain the practical implications of LIPA; it did not purport to analyse or explain regulation 103(2).

The Appellant's third ground was alleged deprivation of the right to deduct input tax in respect of the audit work. Mr Parker commented that this would be a very powerful point if it were correct. However, it was plain that regulation 103(2) required an attribution to be made of the relevant input tax to the audit work, to the extent that the relevant supply had been used for that purpose (his emphasis). He explained that it was a matter for the Appellant, in the first instance, to specify the extent to which the relevant supply had been so used and to claim an appropriate deduction in respect of the specified use. The Commissioners were not seeking to deny the Appellant the right to deduct in so far as the relevant supply was used for that purpose. The language of regulation 103(2) enabled the whole of the input tax to be attributed on a use basis. So far as the input tax relating to the audit was concerned, there was no need to have recourse to any other provision in order to arrive at the attribution. The Appellant's argument amounted to an incorrect application of regulation 103.

The fourth ground was alleged anomaly when the result was contrasted with the circumstances in RAP Group plc v Customs and Excise Commissioners. Mr Parker argued that the circumstances in that case had themselves been anomalous. Input tax on a supply used as to a substantial part in making exempt supplies had been allowed to be deducted in full. Had there been two supplies, one in respect of shares and one in respect of more general legal work, input tax on the first supply would have been irrecoverable. He contended that there was no good reason to extend the anomaly to the circumstances of the present case.

The parties' further arguments

In his reply, Mr Anderson maintained that the Commissioners' "complete code" argument on regulation 103(2) ignored the wording in 103(1). The words "are so used" referred to use either for the purpose in (a) or that in (b). The Commissioners were not attaching any meaning to these words. As the audit fees could not be "so used", this left a balance in limbo, not attributed to anything. He argued that the regulation 103(1) attribution should be applied, then the balance should be dealt with under regulation 101. It was not correct to say that the "tailpiece" to regulation 103(2) merely supported the use-based attribution. It was directed to a case where there was an incidental supply of shares; this would create a conflict with regulation 101(3).

On the Commissioners' point concerning regulation 103(3), if they were correct on their interpretation of regulation 103(2), there would be no need for regulation 103(3). He questioned what was meant by "ring-fenced"; the Appellant was not suggesting that any additional input tax should be introduced, it being only the KPMG input tax that was in question, so this shed no light. He argued that regulation 103(3) was there for the purposes of regulation 106, the de minimis provision.

Although the Commissioners were saying that according to the Appellant's construction it would be able to deduct the whole of the input tax, this was against Article 19.2 of the Sixth Directive, which excluded incidental share issues from the deductible amount. Effectively the Commissioners were resisting Article 19.2. In his final remarks he indicated that the Appellant was seeking costs if successful in its appeal, whereas the Commissioners were not in the event that they succeeded.

Mr Parker explained the Commissioners' view of regulation 103(3). It only applied to the attribution exercise in regulation 103(2). It treated the input tax as the only input tax, no other being concerned. The Commissioners said that regulation 106 should be ignored. He pointed out that if the Appellant were correct, the application of the de minimis provisions of regulation 106 would be denied by regulation 103(3). On the Commissioners' view, this was not the case. The restriction in regulation 103(3) was only for the purposes of attribution; established authority showed that the process of deeming was not unlimited. The deeming was for the purposes of input tax.

Conclusions

We agree that the key question is the interpretation to be placed on regulation 103, and in particular whether it can be read as providing for an exclusive code for attribution of input tax for every element of the supply. First, what input tax is under review in regulation 103? The introductory words of 103(2)(a) are "input tax of the description in paragraph (1) above". This in turn requires the words in 103(1) to be examined. This refers to "input tax on services . . . used or to be used . . . in whole or in part in making [the supplies specified in sub-paragraph (a) or those in (b)]", in the present case the latter, under the Specified Supplies Order.

The next stage in establishing whether the input tax falls within the regulation 103(2) attribution process is to ask whether the input tax was incurred on goods or services used for the purposes set out in 103(2)(a) (i) or (ii). In the present case it was, as the services were used both for the share issue and for the audit. In addition, the share issue was incidental to the Appellant's taxable business activities, thus meeting the qualification in 103(2)(b). As a result, the input tax is to be attributed to taxable supplies in accordance with 103(1) notwithstanding any partial exemption attribution method that would otherwise apply. What meaning do the words "in accordance with paragraph (1) above" bear? If they import the whole of 103(1), as argued by the Appellant, the process under that paragraph is a limited attribution, requiring some further basis for attributing the balance of input tax not dealt with by 103(1), so that the code could not be described as exclusive. The alternative needed in order to keep the regulation 103(2) process exclusive and self-contained is to read those words as importing into the process a more limited element from 103(1). This element is the use-based attribution. In other words, regulation 103(2) should be read as if it specified the full details of the attribution: " . . . that input tax shall be attributed to taxable supplies to the extent that the goods or services are so used or to be used expressed as a proportion of the whole use or intended use." If this reading is correct, it raises a further question: what meaning should be attributed to the phrase " . . . are so used or to be used"? The Appellant argued that those words referred back to the uses specified in 103(1). However, if what is happening under 103(2) is an adaptation of the process specified in 103(1), it is more logical to read those words as referring to the uses set out in 103(2). If regulation 103(2) is to be construed as providing for a separate self-contained attribution code, we would comment that the drafting shorthand of referring to the use-based attribution method in 103(1) by the words "in accordance with paragraph (1) above", without the further phrase "mutatis mutandis" or words with similar effect, makes 103(2) less transparent in its meaning than it needs to be. We think that it would have been preferable to set out in full in 103(2) words explaining how the use-based attribution should work, thus making it largely self-contained.

However, it could not be regarded as completely so, as the effect of 103(3) has to be taken into account. This restricts the apportionment exercise under 103(2). It deems certain input tax to be the only input tax incurred by the taxable person in the period concerned. The input tax in question is "of the description in paragraph (2) above". As the reference in 103(2) is to "input tax of the description in paragraph (1) above", it might be assumed that what is really meant is the latter. However, we read that reference as being to the combination described in 103(2). In other words, it is input tax on goods or services used in whole or in part in making supplies within the Specified Supplies Order, where the goods or services are used or to be used in making both a supply within item 1 or 6 of Group 5 of Schedule 9 and some other supply, and the Group 5 supply is incidental to a business activity carried on by the taxable person. Any other input tax incurred by the taxable person is to be ignored; where appropriate, this means that the input tax left out of account for the purposes of the regulation 103(2) attribution has to be dealt with on the basis of the taxable person's normal partial exemption attribution method. It would be at this point that the possible application of regulation 106 would have to be considered.

Which of the two approaches is correct, the Commissioners' "exclusive code" contention, or the Appellant's "incomplete provision" argument? The background to the legislation may assist. As mentioned at paragraph 21 above, KPMG in their letter dated 5 December 2001 referred to the history of regulation 103. It had been introduced specifically to prevent "Golden Share" VAT avoidance schemes whereby a taxpayer issuing shares in the EU would temporarily sell a single share to a non-EU resident. This would result in any input tax paid on the advisers' fees relating to the share issue being moved into the residual category, as non-EU supplies with an entitlement to input tax recovery were at that time normally treated as "true" UK supplies for partial exemption purposes. As receipts from the issue of shares would normally be treated as being incidental and consequently ignored under the partial exemption standard method, the taxable person would then be able to recover the input tax on its advisers' services based on its residual recovery rate, thereby achieving a disproportionate recovery. KPMG pointed out that this question was covered in some detail in the Commissioners' own guidance on share issues. (This guidance was not cited to us, so we have not referred to it.)

We bear this history in mind in considering the effects of the Appellant's arguments. As KPMG's supply of services was a combined supply, the Appellant contends that the first stage is the attribution under regulation 103(1), pursuant to the "tailpiece" of regulation 103(2). As this leaves a residue of the KPMG input tax that cannot be attributed under regulation 103(1), that residue must be dealt with according to the standard attribution method under regulation 101. Without quantifying the amount attributable under the regulation 103(1) process, the Appellant claims that the whole of the residue is attributable to taxable supplies under regulation 101. The reason is that the exempt outputs relating to the share issue are ignored for the purposes of establishing the extent of the Appellant's partial exemption. As the Appellant's business, ignoring these exempt outputs, is fully taxable, the Appellant argues that the whole of the residual input tax is recoverable. The overall result is that in the Appellant's view the whole of the KPMG input tax is recoverable. Is this result consistent with the apparent intention behind the introduction of regulation 103?

For the Appellant, Mr Anderson used an example (paragraph 40 above). We feel that it is helpful to consider other examples, although we approach this exercise cautiously, bearing in mind the warning given by Carnwath LJ in IRC v Eversden [2003] STC 822 at [25]—

"Experience shows that the court's task of applying a particular statutory provision to a particular set of facts is rarely assisted by considering the hypothetical application of other provisions to other hypothetical sets of facts."

If the Appellant had made an issue of shares exclusively in the UK, and had paid for professional services solely related to that issue, no part of the input tax would have been recoverable (regulation 101(2)(c)). To a large extent this was the result in the recent case of Actinic PLC (VAT Decision 18044). (This decision was not referred to by the parties in the present case; we cite it as an example of a dispute as to whether a taxable person's circumstances fell within regulation 101(2)(c) or (d).) If instead the Appellant had made an issue of shares exclusively in the UK, and had paid for professional services related both to that issue and to other matters, the input tax would have been recoverable under regulation 101(2)(d), as in RAP Group plc. If the Appellant had made an issue of shares to investors in the UK, in the EU outside the UK, and outside the EU, and the professional services paid for had related solely to the share issue, the circumstances would have fallen within regulation 103. Under this, as the issue of shares to non-EU investors would have fallen within section 26(2)(c) VATA 1994 and the Special Supplies Order, the input tax on those fees would have had to be attributed to taxable supplies (ie supplies treated as taxable) on a "use" basis. This would be under regulation 103(1). To the extent that the services were used for the other purposes, the issue to investors in the EU but outside the UK, and the share issue in the UK, nothing in regulation 103 would allow an attribution to taxable supplies. If the latter hypothesis is compared with the Appellant's actual circumstances, the Appellant is likely to be in a better position whichever of the parties' contentions is correct, as there should be some measure of input tax recovery because some elements of the services were used for the purposes of the Appellant's taxable business. The distinction would appear entirely reasonable if the element of input tax recovery corresponded to the extent to which the audit services were used for that taxable business; the distinction would appear more odd if most or all of the KPMG input tax were to be treated as recoverable. In that latter circumstance, the fortuitous combination of the share-related services with other services would have enabled a substantial input tax recovery to be made, in the same way as in the second hypothetical UK case above (following RAP Group plc).

We feel that there would need to be good reasons for us to accept an interpretation of regulation 103 that would produce such an odd result. Mr Parker described such a result as anomalous, and we agree. If regulation 103 is capable of being construed in a way that produces a more logical result, our view is that such a construction is strongly to be preferred. Regulation 103 was introduced to counteract avoidance, and we do not think it surprising that it should introduce special rules to be applied where the facts fall within the circumstances contemplated by it. Nor is it surprising that differences should occur between the treatment of cases falling within regulation 103(2) and that of those dealt with wholly under regulation 101 or regulation 102.

We accept Mr Parker's contention that no assistance can be derived from LIPA in relation to the construction of regulation 103(2); it related solely to what is now regulation 103(1). Similarly we accept his argument that Business Brief 12/2001 does not assist in relation to regulation 103(2), as it was dealing with the effects of LIPA in the context of regulation 103(1). We further agree that regulation 103(2) can be construed in a way that enables input tax recovery in respect of the audit element, so that there is no deprivation of the right to deduct in respect of the audit work. We are not persuaded by Mr Anderson's argument on the scheme of Articles 17 and 19 of the Sixth Directive; we read the words following "However" in Article 17(5) as rendering it entirely at the option of any Member State whether to adopt a use-based or a value-based method of attribution.

Thus we are persuaded that the correct approach is to treat the regulation 103(2) attribution method as an exclusive, self-contained code for the attribution of input tax falling within it. We apply the "separate code" construction of regulation 103 set out at paragraphs 54 and 55 above. This means that the KPMG input tax falls to be attributed to taxable supplies to the extent that the services were used for the purposes of making taxable supplies (ie the audit element), and to supplies treated as taxable supplies to the extent that the services were used for the purposes of the issue of shares to persons outside the EU. To the extent that the services were used for the purposes of supplying shares in the UK (exempt), and within the EU but outside the UK (outside the scope), the input tax is not recoverable.

The result is that there will be some input tax recovery in relation to the audit element of the KPMG fees. However, as the Appellant did not accept the Commissioners' view on the use-based apportionment, there has been no agreement on what proportion of the KPMG input tax related to the audit and so could be regarded as used by the Appellant in making taxable supplies. KPMG's estimate (paragraph 14 above) is not a reliable guide to the proportion of the fees relating to the audit, partly because the fees ultimately paid were greater than the estimate, and partly because the figures as set out in the estimate do not in any event show how much of the charges labelled "audit" related to the statutory audit for the year to 30 September 2000. (In addition, there is the matter of the two amounts mentioned at paragraph 19 above that are not shown in the copy invoices produced before us.) It does appear from the estimate that a significant proportion of the fees related to items other than the audit. In order to determine what proportion of the KPMG input tax related to that statutory audit and so could be regarded as used by the Appellant for the purposes of making taxable supplies, the parties need to agree an appropriate attribution, as the Commissioners offered to do in their letter dated 8 March 2002. All we can do is to decide the question as a matter of principle, leaving the parties to agree a figure. If they are unable to do so, we give them liberty to apply for a further hearing before this Tribunal. Whatever figure is agreed, it will affect the proportions of the KPMG input tax attributable to the other uses, and in particular it will probably mean that the 23.65% attribution used for other fees to the extent that they related to supplies of shares outside the EU will not be appropriate here, despite the Commissioners' proposal in their letter dated 5 November 2001 (paragraph 21 above).

Summary

We hold that where some part of the services supplied to the taxable person are used for the purposes of a supply falling within the Special Supplies Order, regulation 103(2) VATR is to be construed as providing for a separate and exclusive code for the attribution of input tax on a use basis. That attribution is to be carried out on the restricted basis provided by regulation 103(3). The KPMG input tax incurred by the Appellant requires to be attributed on this use basis; if the parties are unable to agree the proportion relating to the audit and therefore used for the purposes of the Appellant's taxable business, they may apply to the Tribunal for a further hearing. Subject to this, the appeal against the Commissioners' decision in their reconsideration letter dated 8 March 2002 is dismissed. Mr Parker did not ask for costs, so we make no order as to costs.

JOHN CLARK

CHAIRMAN

RELEASED:

LON/02/504