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Cite as: [2005] UKVAT V18972

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University of Southampton v Customs and Excise [2005] UKVAT V18972 (08 March 2005)

18972

VALUE ADDED TAX – input tax – whether goods or services supplied to the Appellant, and used for the purposes of publicly funded research, were used for the purpose of a business carried on by the Appellant - no – appeal dismissed – VATA 1994 Ss 24-26; VAT Regulations 1995 SI 1995 No. 2518 Reg 101

LONDON TRIBUNAL CENTRE

UNIVERSITY OF SOUTHAMPTON Appellant

- and -

THE COMMISSIONERS OF CUSTOMS AND EXCISE Respondents

Tribunal: DR A N BRICE (Chairman)

PROFESSOR R G SPECTOR MD PHD FRCP FRCPATH

Sitting in public in London on 22 – 24 November 2004

David Milne QC, instructed by Messrs Ellis Chapman & Associates, for the Appellant

Kenneth Parker QC with Paul Harris of Counsel, instructed by the Solicitor for the Customs and Excise, for the Respondents

© CROWN COPYRIGHT 2005

DECISION

The appeal

The University of Southampton (the Appellant) appeals against a decision of Customs and Excise contained in a letter dated 21 October 2003 and an assessment for tax of £1,598,366 in respect of the six consecutive accounting periods from that ending in October 2001 to that ending in January 2003.

The disputed decision and the assessment were made because Customs and Excise were of the view that publicly funded research undertaken by the Appellant was not a business and so the Appellant was not entitled to input tax credit in respect of tax on the supply of goods or services to the Appellant which were used for the purpose of the publicly funded research.

The legislation

Section 24 of the Value Added Tax Act 1994 (the 1994 Act) defines input tax as tax on the supply to a taxable person of goods or services used for the purpose of a business carried on by him. Thus tax on supplies to a taxable person of goods or services which are not used for the purpose of a business is not input tax as defined. Section 24(5) provides that where goods or services are used partly for the purposes of a business and partly for other purposes the input tax is apportioned and only so much as is referable to business purposes is counted as input tax.

Section 25 provides that a taxable person is entitled, at the end of each accounting period, to credit for so much of his input tax as is allowable under section 26. Section 26 contains the provisions which describe the input tax allowable under section 25 and, within the context of this appeal, makes it clear that the only input tax allowable is that attributable to taxable supplies and not to exempt supplies. Section 26(3) provides that, where a taxable person makes both taxable and exempt supplies, Customs and Excise shall make regulations for securing a fair and reasonable attribution of input tax to taxable supplies.

The regulations made under the provisions of section 26(3) are the Value Added Tax Regulations 1995 SI 1995 No. 2518 and particularly regulation 101.

Regulation 101 provides that the amount of input tax which a taxable person is entitled to deduct is the amount attributable to taxable supplies. This is calculated by attributing to taxable supplies the whole of the input tax used exclusively in making taxable supplies; providing that no part of the input tax used exclusively in making exempt supplies is attributable to taxable supplies; and providing that where supplies are used to make both taxable and exempt supplies the amount of input tax attributable to taxable supplies is the proportion of the input tax used to make both taxable and exempt supplies which the value of the taxable supplies bears to the value of total supplies. Input tax used to make both taxable and exempt supplies is called residual input tax.

Thus the scheme of the legislation is that it is only tax on goods or services used for the purpose of a business that is input tax. If some goods or services are used partly for the purposes of a business and partly for non-business purposes then the tax on them has to be apportioned and it is only the tax on goods or services used for the purposes of a business that is input tax. If all the supplies made by the taxable person are taxable supplies then all the input tax can be claimed. However, if the taxable person makes both taxable and exempt supplies then he is only entitled to claim the input tax attributable to the taxable supplies (and not that attributable to the exempt supplies). Where goods or services are used to make both taxable and exempt supplies (residual input tax) then the input tax is attributed to taxable supplies by applying a fraction of which the numerator is taxable supplies and the denominator is total supplies.

The issues

The Appellant argued that publicly funded research was a business and so the tax on supplies used for the purposes of publicly funded research was input tax as defined. The Appellant accepted that such supplies were not used exclusively in making taxable supplies nor exclusively in making exempt supplies but argued that they were overhead costs of a single business carried on by the Appellant. Accordingly, they were used in making both taxable supplies (of commercial research and the exploitation of intellectual property) and exempt supplies (of education) and so the input tax should be treated as residual input tax and attributed to taxable supplies by applying the fraction of which the numerator was taxable supplies and the denominator was total supplies. Customs and Excise argued that publicly funded research was not a business and so the tax on supplies used by the Appellant in undertaking that activity was not input tax as defined.

Thus the issue for determination in the appeal was whether the tax on the goods and services supplied to the Appellant and used in publicly funded research were used for the purpose of a business.

The evidence

Twelve bundles of documents were produced. There was also an agreed statement of facts which was read at the hearing on behalf of the Appellant and not objected to by Customs and Excise.

Oral evidence was given on behalf of the Appellant by:

Professor Peter Gregson, the President and Vice Chancellor of the Queen's University, Belfast; before 1 August 2004 Professor Gregson was the Deputy Vice Chancellor of the Appellant;

Professor Michael David May, Professor of Computer Science at Bristol University;

Professor David Payne, Director of the Appellant's Optoelectronics Research Centre and Chairman and Director of Southampton Photonics Inc;

Mr Allan Spencer, a Chartered Accountant and the Appellant's Deputy Director of Finance; and

Dr Siân Thomas, the Director of the Research and Enterprise Division at the University of Bristol.

A witness statement by Mr Andrew John Kempton, the Chief Noise Specialist – External Affairs of Rolls-Royce in Derby, containing evidence on behalf of the Appellant, was not objected to by Customs and Excise and so was admitted in evidence at the hearing.

Oral evidence was given on behalf of Customs and Excise by:

Mr Nigel Dismore, an anti-avoidance adviser with HM Customs and Excise;

Mr David Harman, the Financial Controller of the Engineering and Physical Sciences Research Council; and

Mr Brian Hooper, the Finance Director of the Economic and Social Research Council.

Witness statements by:

Ms Linda Arter, the Director of Finance and Mr David Phillips, the Head of Finance, at the Wellcome Trust;

Mr Neville Francis David Bloomer of the Natural Environment Research Council;

Mr Peter Burrell, a Senior VAT Assurance Officer of HM Customs and Excise;

Mr Jeffrey Francis Down, the Finance Director of the Particle Physics and Astronomy Research Council;

Mr Jerry Bernard Joel Folkson, the Business Development Manager in the Research Management Group of the Medical Research Council;

Mr Kerry Sykes, the Deputy Director of Finance of the University of Cambridge; and

Mr David Webb, an Officer of HM Customs and Excise;

containing evidence on behalf of Customs and Excise, were not objected to by the Appellant and so were admitted in evidence at the hearing.

The facts

From the evidence before us we find the following facts:

The Appellant and its business

The Appellant was incorporated by Royal Charter in 1952. It was then called the Hartley University College at Southampton. The Charter provided that the Appellant should be a teaching and examining body and should further the prosecution of research. The Charter gave the Appellant powers to award degrees and other academic distinctions; to provide instruction in such branches of learning as the Appellant might think fit; and to make provision for research and the advancement and dissemination of knowledge.

The Appellant is a charity and carries on business making supplies of education and undertaking commercial research. It has nearly 20,000 students and 5,000 staff of which 1,000 are research staff. The Appellant's total income in 2002/3 was £250 million. This included Funding Council grants of £85 million; academic fees of £50 million; research grants and contracts of £71 million; with the rest being other operating income. Of the research grants and contracts, approximately one quarter came from commercial sponsors and the rest came from public funds. About £95,000 came from the sale of intellectual property rights.

The Appellant and research

The Appellant treats all research as a serious activity and is held accountable by its sponsors for the use of research funds. Also, as many sponsors have limited funds available, the Appellant is in competition with other research establishments to obtain funds and so seeks to ensure that the results of its research are of high quality and are good value for money. The published findings of research are peer-reviewed and scrutinised and measure the Appellant's reputation as a research institution. The Appellant regards it as important that it should achieve high rankings in published research in order to support its reputation. Successful research can lead to more grants which promote further research.

A research grant is usually applied for by a member of the Appellant's academic staff who has an interest in a particular field. Such a person would put together a research proposal which would describe the work he wanted to carry out. The proposal might be tailored to meet the specific programme of funding of an individual sponsor. The research proposal would then be costed according to the sponsor's rules after which it would be reviewed by the head of school to decide whether the proposal was one to be carried out in the department. Only then would the proposal be sent to the sponsor. The same proposal might be sent to more than one sponsor.

Some commercial sponsors might be interested in commissioning a particular piece of research and so would come to the Appellant because of the Appellant's reputation for particular expertise.

Although undergraduate teaching can be successfully delivered in a university which does not undertake a great deal of research, postgraduate teaching usually relies upon academic staff who conduct research and who are up to date with research techniques.

The research assessment

A research assessment exercise is carried out approximately every five years by government to assess the research carried out by individual university schools. The assessment is quality based and two critical matters are taken into account. The first is the research results in terms of peer-reviewed publications. The second is the strategic statement which links together research aims and objectives; the way in which research is integrated; and how the research is exploited. One of the main results of publicly funded research is the report which is produced at the end of the research and there is a strong co-relation between high performance in publicly funded research and ratings in the research assessment exercise. The ratings affect the overall success of the Appellant and its ability to attract high quality staff and students.

The source of funding for research

The Appellant carries out both publicly and privately funded research projects in most of its schools. The publicly funded research is funded by grants from research councils, government departments or charities. The commercial research is funded by industry and commerce in the United Kingdom; the European Commission; the United States government; and the North Atlantic Treaty Organisation. A particular research project could have both private and public funding.

The Appellant also receives an annual grant from the Higher Education Funding Council for England of which approximately half is calculated by reference to the research assessment exercise. The purpose of this grant is to cover the cost of overheads that are not recovered in full when the Appellant undertakes publicly funded research projects. The grant pays for infrastructure, equipment and permanent academic staff carrying out research.

The Higher Education Funding Council for England published a strategic plan for 2003-2008. That stated that the Council had four core strategic aims of which two were enhancing excellence in teaching and learning and enhancing excellence in research. Throughout the report teaching and learning on the one hand were treated separately from research on the other.

The research costs which the Appellant can recover

The cost of a research project is divided into direct costs (such as research staff time and travel and the purchase of equipment for the project) and overheads (which include the cost of the infrastructure, the finance department, the personnel function, the space the project consumes, and departmental overheads such as secretarial support).

The direct costs of a research project are always recovered in full regardless of the sponsor. The only exception is that some public sponsors do not always pay for the costs of supervising staff or of existing permanent staff. The overhead costs of a research project are normally recovered in full from commercial sponsors but are not normally paid in full by a public sponsor; however, a public sponsor will normally allow the recovery of overhead costs on a "cost plus" basis, namely a fixed percentage of the direct costs. The shortfall in the recovery of the overhead costs from a public sponsor is met by the grant from the Higher Education Funding Council for England. Thus ultimately the overhead costs of both commercially sponsored research and publicly funded research are recovered in full.

The infrastructure and equipment which has been purchased for a research project can be used for future commercial or publicly funded research projects or for teaching or consultancy work, regardless of whether it was originally paid for by a public or commercial sponsor.

Every research project, whether commercially or publicly funded, is carried out at the same time, in the same manner, often by the same staff, using the same equipment, infrastructure and departmental space, and within the same guidelines.

The commercial exploitation of research

Each sponsor has its own rules about who owns the intellectual property which a research project generates. Where research is commercially funded a supply of intellectual property is almost always made to the funding organisation. Where research is publicly funded no supply of intellectual property is made to the funding organisation; the intellectual property is retained by the Appellant to exploit or use as it sees fit.

The Appellant's policy is to maximise the commercial exploitation of all research. Intellectual property can be exploited through direct sale, or through licensing in return for royalties, or by means of a number of patents being packaged together for use by a spinout company. Intellectual property derived from research also contributes towards the Appellant's consultancy activities and its future research collaborations with both commercial and public sponsors.

The spinout companies

The Appellant has found that the intellectual property generated by some research projects is sometimes at too early a stage of development for commercial companies to take up licences or pay royalties to exploit it. Accordingly in recent years the Appellant has developed the concept of spinout companies where the intellectual property rights are sold into a company in exchange for shares and the company then goes forward with venture capital partners to raise money to develop and apply the intellectual property. Because the start-up costs of spinout companies are high, and because limited funds are available, the Appellant is very selective when deciding on which activities are to be undertaken by spinout companies. Many are considered but only those with a high chance of success are chosen.

The Appellant has a family of about twelve spinout companies and in the twelve months prior to the hearing of the appeal the Appellant had spun out three companies. One was floated on the Alternative Investment Market of the London Stock Exchange with a total market capitalisation of £29M. That company was expected to use a substantial part of its funds to commission further research from the Appellant. The other two companies raised venture capital funding from a trust available to the Universities of Bristol and Bath as well as to the Appellant These two companies had raised about £500,000 and would probably spend at least £100,000 of that on commissioning further research from the Appellant The Appellant retains an interest in its spinout companies with a view to benefiting from share sales in the future.

The development of research from grant to spinout company

Publicly or commercially funded research projects which do not produce any exploitable intellectual property may lead to further research projects which may produce exploitable intellectual property. Thus all research projects may eventually lead to the creation of exploitable intellectual property.

One example of this is found in the Southampton Oceanography Centre which is one of the Appellant's academic schools. There a publicly funded research group was making a sub-sea survey of volcanic activity and studying the fundamental details of the way in which tectonic plates moved at the bottom of the oceans. The technology was developed over many years and recently has been applied to sub-surface oil exploration. This has now formed the basis of a spinout company called Offshore Hydrocarbon Mapping which achieved funding from venture capitalists and went for an Initial Public Offering at £60M. The return to the Appellant was £20M. The company is profitable after only eighteen months trading.

Another example is the Appellant's Optoelectronic research centre where research is funded by a variety of sponsors. The Centre receives about £4.2M annually as research income. Of this £2.1M comes from a research council grant and the remaining £2.1M from thirty four other contracts and grants sponsored by companies, United Kingdom and United States government departments, and the European Union. The Centre is best known for its photonics research laboratories. Professor Payne is the Director of the Centre and he is also chairman and director of Southampton Photonics Inc a $55M fibre components spinout company. The $55M was contributed by venture capitalists who received shares in the company. When the company was formed the Appellant licensed to it, in exchange for equities and royalties, about sixteen patents derived from research council funding. The licence income follows a formula; there is a minimum royalty of about £25,000 for the first year. Later the royalty stream becomes a percentage of turnover of about 1.5%. Because the Appellant is a shareholder in the company, the Appellant benefits in three ways. If there were an initial public offering the Appellant would benefit from a sale of its shares. It also benefits from the licence income received from the company. And finally the company will fund further research in the Appellant; it has already funded research up to £3M.

The Appellant's Institute of Sound and Vibration Research

Rolls-Royce provides power systems for both military and civil aircraft. It spends about £150 million annually on research and technology of which £50 million is spent in the United Kingdom. Of this between £5 million and £10 million is spent on research undertaken by United Kingdom universities. Rolls-Royce invests in universities because successful industrial development benefits from academic research as academic staff take a broader view than more narrowly focussed industrial research.. From about 1987 Rolls-Royce has introduced centres of excellence, or university technology centres, where Rolls-Royce enters into a five year commitment to fund academic research. The noise university technology centre was located in the Appellant's Institute of Sound and Vibration Research because the Institute had a proven track record developed over thirty years in sound and vibration research in general and aeroacoustics in particular. Funding for the centre is underwritten by Rolls-Royce to the amount of approximately £400,000 annually. The centre is also supported by other publicly funded grants and contracts; it supports twenty-seven staff; seven academic staff; twenty researchers and eight persons who are funded by public grants.

The financial management of the Appellant

The Appellant manages its overall finances and budgeting by treating each academic school as a separate accounting centre rather than by treating each activity undertaken by the Appellant as the primary basis for financial reporting. Thus each academic school manages itself as a business unit. From central sources of income (including the grant from the Higher Education Funding Council for England) the Appellant will provide most schools with about half of their budget. Each school has then to find other sources of income in the form of commercial or publicly funded research contracts or consultancy services to make up the balance. Each school must sustain itself, taking one year with another, through the totality of its research activities, teaching activities, consultancy and other services. In this way all research activities are seen as part of each school's budgeted activity and heads of school are charged with delivering a financially sustainable portfolio of activities allowing more or less profitable activities to coexist side by side. One example is in the School of Ocean and Earth Sciences where one of the main sources of funding is the European Union but the school also carries out other income-generating projects such as consultancy for oil companies.

It is one of the Appellant's overall objectives that the activities of each school should add to the Appellant's status as a research and teaching institution.

The Appellant and value added tax

The Appellant is registered for value added tax and makes both taxable and exempt supplies. The exempt supplies are mainly supplies of education to students. The taxable supplies include the carrying out of commercial research; the exploitation of intellectual property; commercial conferences; and consultancy work. Thus, for value added tax purposes, the Appellant is partially exempt.

The Appellant treats as taxable supplies the supplies it makes to commercial sponsors of research who require control over the intellectual property arising from the research. Thus, the Appellant recovers in full the input tax on supplies used for these purposes. However, as no supply is made to a publicly funding organisation, the funding for publicly funded research is treated as a grant and outside the scope of value added tax. The Appellant treats the input tax on supplies to it which are used in publicly funded research as residual input tax and thus recovers part of that input tax through its partial exemption calculation. It is that treatment which is in issue in this appeal.

The development of the views of Customs and Excise

When value added tax was introduced in 1973 the universities argued that they would have difficulty meeting the potentially complex record-keeping requirements in the legislation. Accordingly, Customs and Excise then agreed a simplified method for universities to use when calculating their recoverable input tax. This allowed universities to keep simplified records in return for a flat rate of recoverable input tax but there was no recovery of input tax on overhead costs including overheads associated with research.

In 1990, in Edinburgh University v The Commissioners of Customs and Excise Tribunal Decision 6559, the Tribunal decided that the simplified method did not give a fair and reasonable result. Over the next seven years some universities continued to use the simplified method while increasing numbers implemented systems which were able to apportion supplies received to business and non-business use and which were also able to attribute input tax between taxable and exempt supplies.

Accordingly in 1997 Customs and Excise withdrew the simplified method and entered into discussions with the British Universities Finance Directors Group. On 10 October 1997 Customs and Excise published a statement of practice which indicated that, if a university received grants which supported general academic research which was not for business purposes, then an apportionment of input tax between business and non-business activities should first be made to determine the input tax to go forward into the partial exemption calculation. The statement also indicated that input tax relating to the non-business research grants should be excluded from the partial exemption calculations. There were then further discussions with the British Universities Finance Directors Group and in July 1998 Customs and Excise said that each university would be considered on a case by case basis.

Between 1998 and 2001 the practice adopted by the universities was not consistent. Some claimed that publicly funded research was undertaken in the course or furtherance of a business because there was the intention of making future taxable supplies if the research was successful, for example by the exploitation of intellectual property rights. These universities also argued that research intended to be used internally, either to further additional research or to improve the provision of education, was a business because it was carried out in furtherance of the overall business of the university. It was also argued that research that utilised fee-paying postgraduate students was a business because it was closely linked to the exempt supply of education. These universities, therefore, were of the view that they did not have to make an apportionment of input tax between business and non-business use.

Other universities, on the other hand, were of the view that publicly funded research was not a business. They wanted to claim zero-rating for purpose-built research centres, under Item 2(a) of Group 5 of Schedule 8 of the 1994 Act, on the ground that they were to be used for a relevant charitable purpose otherwise than in the course or furtherance of a business. By 2001, of the nineteen universities in the Russell Group, at least half took the view that their publicly funded research was not a business.

At this time Customs and Excise took the claims of each university at face value. Those who claimed that publicly funded research was a business were allowed to do so and those that claimed that it was not a business were also allowed to do so.

The 2002 internal guidance – publicly funded research likely to be a business

In January 2002 Customs and Excise prepared some internal guidance about the value added tax treatment of research activities in United Kingdom universities. This recorded that historically Customs and Excise had taken the view that research undertaken by universities was a business even when it was grant funded. However, the guidance then stated that some of the research-led universities had contended that some of their publicly funded research was a not a business for the purposes of value added tax. The reason for such contention was to enable the zero-rating of buildings to apply to, for example, new laboratories used for charitable non-business purposes. However, some of the same universities were treating all research as a business activity for the purposes of claiming input tax.

The 2002 guidance went on to distinguish commissioned research (undertaken for an agreed consideration) where the client received the right to exploit the outcome of the research, usually the intellectual property rights, on the one hand and university-led research which was initiated by the university itself and was funded in whole or in part by grants, on the other hand. Commissioned research was considered to be a business but university-led research was not necessarily a business. It was thought that it would not be a business if it were solely grant funded; if there were no intention to produce exploitable intellectual property rights; if there were no discernible student involvement; and if the outcome of the research was not intended to directly further the university's other business activities. The guidance concluded that non-business research was the exception rather than the rule.

Between 2002 and 2003 Customs and Excise received a number of representations from universities arguing that publicly funded research was not a business. Accordingly Customs and Excise then conducted another review and this concluded that publicly funded research projects were more likely not to be a business than to be a business. By the time the review had concluded 13 members pf the Russell Group were of the view that all their publicly funded research was not a business and only six (including the Appellant) thought it was a business. At the time of the hearing the figure had changed so that fifteen were of the view that publicly funded research was not a business and four (including the Appellant) thought that it was.

The 2003 internal guidance – publicly funded research likely not to be a business

In May 2003 Customs and Excise prepared another internal guidance paper which concluded that their position with regard to publicly funded research had moved from accepting that publicly funded research was likely to be a business to accepting that the more likely position was that it was not a business. The guidance stated that grant funding did not itself make the research a non-business activity. Although grants were not the consideration for a supply the fact that a research project was funded by such non-business income did not mean that the research activity was a non-business activity nor that it would not generate supplies. Each case had to be considered on it own facts but if a university claimed that such research was a business activity it should be asked to prove it by reference to each research project. Indicators that a project was a business activity included: if it would produce commercially exploitable intellectual property rights; if the exploitation of intellectual property rights was the specific reason for the project; if the intellectual property rights were to be passed to a third party; or if the university had a track record of exploiting intellectual property rights arising from publicly funded research.

The events leading to the disputed decisions

On 26 June 2003 Customs and Excise wrote to the Appellant asking the Appellant for evidence that its publicly funded research was a business activity. On I July the Appellant replied to say that it would take some time to collate this information. Mr Dismore of Customs and Excise did some research himself and concluded that there was nothing to differentiate the Appellant from the other comparable leading universities who treated this research as a non-business activity.

Having received no substantive reply to its letter of 26 June 2003 Customs and Excise wrote to the Appellant on 21 July 2003 to say that input tax previously claimed as being attributable to publicly funded research would be disallowed and assessments would be issued for £39,072 for the year ending on 31 July 2001 and for £328,302 for the year ending on 31 July 2002. There were further exchanges of correspondence and there was a meeting on 7 October 2003 but the Appellant did not present any evidence of publicly funded research which it considered to be a business activity. Ultimately Customs and Excise wrote again to the Appellant on 21 October 2003 to say that publicly funded research was not a business activity for the purposes of value added tax; the assessment had been varied and amounted to £1,598,366 for the six consecutive accounting periods from that ending in October 2001 to that ending in January 2003. That is the decision and the assessment the subject of the appeal.

The views of another university

The undisputed evidence of Mr Sykes was that the potential impact of this appeal on the University of Cambridge and other institutions was such that it was of importance for the opposing views within the sector to be heard and considered by the Tribunal. The overall position of the University of Cambridge was that research was an activity in its own right and not a subsidiary activity undertaken to generate intellectual property for future profit or to support the education programme. Since at least 1988 the University of Cambridge had treated publicly funded research as a non-business activity for the purposes of value added tax and that was before zero-rated certificates for non-business construction work were issued in 1994. The University was of the view that charity funding for research was provided either with the aim of advancing knowledge or of looking into a matter for the benefit of the community and not with the aim of developing intellectual property for profit. Also, research councils provided funds to undertake work for the general good rather than for the benefit of the institution undertaking the research. The University would only modify the non-business treatment if deliberate steps were taken before the conclusion of a research grant to sell the intellectual property generated by that research activity. On the other hand research funded by commercial sponsors, where the funder expected a marketable result, and research conducted by spinout companies, was regarded as a business activity. Over the last three years the University had received publicly funded research income of £304 million and income from intellectual property of only £10.4 million. The University regarded teaching and the advancement of knowledge as two separate activities.

The views of the research councils

The undisputed evidence of Mr Bloomer, Mr Down, Mr Folkson, Mr Harman, and Mr Hooper was that their councils awarded research grants in order to contribute to specific research projects that were likely to lead to an advancement of knowledge. Grant holders were expected to publish the results of their research in accordance with normal academic practice and there was no requirement or expectation that results of industrial or commercial value should be obtained. If such results were generated then the institution concerned would be encouraged to exploit them or make them available for exploitation to benefit the economy of the United Kingdom. The councils would not normally make a claim to the intellectual property arising from the research they supported. The intellectual property would vest in the research institution which was entitled to retain any income arising from any exploitation arrangements. The councils were of the view that there was no supply of research by an institution to the councils and for that reason research grants were outside the scope of value added tax and tax was not added to the funds granted.

The views of the Wellcome Trust

The Wellcome Trust is an independent research funding charity and it promotes biomedical research with the aim of improving human and animal health. It funds basic and clinical research that will advance knowledge but will not have as a primary aim the development of a therapy or a diagnostic device. Any useful results from the research that it funds are to be disseminated for the public good. It is only very occasionally that the research funded by the trust will result in a discovery with the potential for therapeutic or diagnostic development. The terms and conditions of the Trust insist that when exploitable intellectual property rights are produced they cannot be exploited without the consent of the Trust. Consent is given in return for a share of the potential income. In the financial year ending on 30 September 2003 the trust had charitable expenditure of over £500 million and received income of just £150,000 from the exploitation of intellectual property rights. The Appellant has been in receipt of grants from the Wellcome Trust for many years.

The White Paper Cm 5735

In January 2003 the Secretary of State for Education and Skills presented a White Paper on the future of Higher Education. Chapter 2 considers the organisation and funding of research which is treated separately from teaching.

The arguments

For the Appellant Mr Milne argued that the undertaking of publicly funded research was integral to the Appellant's other business activities, such as the supply of commercial research and education, and so publicly funded research must also be a business activity. Education, commercial research and publicly funded research were all part of one business. The publicly funded research activity was not a hobby and was not undertaken for personal or social enjoyment. Further, all research helped to raise the profile of the Appellant and so helped other taxable and exempt activities of the Appellant. Mr Milne accepted that there was no direct link between the provider of funds and the publicly funded research, and that many public sponsors did not get a quid pro quo. However, he argued that there was no practical difference in the way in which publicly funded research and commercial research was carried out. Also, the Appellant always hoped that publicly funded research projects would produce commercially exploitable intellectual property or attract further research funding which could lead to exploitable intellectual property.

For Customs and Excise Mr Parker accepted that if a university genuinely undertook publicly funded research with the intention of producing intellectual property for commercial exploitation, rather than with the intention of disseminating the research outcomes by publishing the results in the public domain, then those projects would be a business activity. Customs and Excise also accepted that, if a university supplied research or intellectual property rights to a commercial organisation for consideration that was a business activity even if it was in part subsidised by grant funding. Customs and Excise further acknowledged that a link with other business activities could be sufficient to make the research carried out in the furtherance of the university's business activities provided that there was a clear nexus between the business activities and the research.. However, Customs and Excise were also of the view that publicly funded research was normally a non-business activity unless it was closely linked to the supply of education to the postgraduate students engaged in the research. Mr Parker went on to argue that publicly funded research was not part of a single business carried out by the Appellant. He accepted that the Appellant made exempt supplies of education and taxable supplies of commercial research and of intellectual property rights but he argued that publicly funded research did not form part of those business activities. It was a distinct activity carried out in its own right.

Reasons for Decision

The issue in the appeal is whether the tax on the goods and services supplied to the Appellant and used in undertaking publicly funded research were used for the purpose of a business; in other words whether publicly funded research is a business.

We have found it convenient to consider the arguments of the parties within the context of the development of the authorities cited to us.

1979 –1992 - the early authorities – business and non-business use

Most of the early authorities are national authorities which consider the meaning of business or non-business use.

The earliest was National Water Council v Customs and Excise Commissioners [1979] STC 157. There the appellant council was required to perform a number of statutory functions and claimed credit for all its input tax on the ground that all the supplies it made were in the course of a business. Neill J held that some of the statutory functions were not within the scope of the council's business activities and so the input tax had to be apportioned between business and non-business purposes. At 167f he said that the answer to the question whether a supply was made in the course of a business depended upon to whom the supply was made, the contract or arrangements under which it was made, and whether the service was supplied regularly or on a wide scale. At 167j he said that the word "business" was to be given a wide construction.

We accept that publicly funded research is carried out by the Appellant regularly and on a wide scale but it does not give rise to any supply; the arrangements are that the payment or grant is outside the scope of the tax. The evidence of Mr Sykes, of the research councils, and of the Wellcome Trust was that public funds for research were provided either with the aim of advancing knowledge or for the benefit of the community. We accept that publicly funded research may lead to exploitable intellectual property rights but that is the exception rather than the rule. In any event such research is not undertaken in order to acquire intellectual property rights but for the advancement of knowledge. All these factors indicate to us that the carrying out of publicly funded research is not a business.

Two years after the judgment in National Water Council came the judgment in Customs and Excise Commissioners v Lord Fisher [1981] STC 238. That authority established the principle that, in considering whether an activity was a business, six factors required consideration. These were: whether the activity was a serious undertaking earnestly pursued; whether the activity was actively pursued with reasonable or recognisable continuity; whether the activity had a measure of substance in terms of the value of taxable supplies made; whether the activity was conducted in a regular manner and on sound and recognised business principles; whether the activity was predominantly concerned with the making of taxable supplies to consumers for a consideration; and whether the taxable supplies were of a kind commonly made by those seeking to profit from them.

We are of the view that, in this appeal, the activity of publicly funded research was a serious undertaking earnestly pursued by the Appellant. It was also actively pursued with reasonable or recognisable continuity and had a measure of substance. It was also conducted in a regular manner and on sound and recognised business principles. Publicly funded research was carried out in the same way and in the same laboratories as other research. Publicly funded research was properly costed and each project had to break even. Although payment was made by means of a grant the costing was done as if for commercial research and the publicly funded research did not make a loss when the grant from the Higher Education Funding Council for England was taken into account. However, publicly funded research does not result in the making of any taxable supplies and is not predominantly concerned with the making of taxable supplies to consumers for a consideration. There is no supply of research to the providers of funds and the research is not done in return for a consideration but in order to enhance knowledge. Further, the supplies are not of a kind commonly made by those seeking to profit from them. From all these factors we would conclude that the carrying out of publicly funded research is not a business.

Later in 1981 came the judgment in Cumbrae Properties (1963) Ltd v Customs and Excise Commissioners [1981] STC 799. There a holding company employed employees and paid them; they were seconded to work with subsidiary companies and the holding company invoiced the subsidiary companies for the amounts paid. The holding company argued that these were not supplies made in the course of its business and so were not chargeable with output tax. Sir Douglas Frank QC held that the secondment of employees was a supply in the course of the holding company's business and output tax was due. At 804 a-c he held that the word "business" excluded any activity which was no more than an activity for pleasure and social enjoyment but that otherwise it had a very wide construction. Where a limited company existed exclusively for business purposes all the activities carried on by it could be viewed as part of an overall scheme to further those business purposes. One activity could be inter-related to the overall objects of the company in that it was intrinsically part of its normal business activity.

We distinguish that authority on the facts. In the present appeal the Appellant is not a limited company existing exclusively for business purposes. The Appellant is a charity and was incorporated by Royal Charter. Companies are incorporated by Royal Charter if their objects are not primarily commercial. It is also relevant that most of the income of the Appellant comes from grants and not from business. The amount of the Funding Council grants (£85M) and the amount of grants for publicly funded research (£71M) well exceed the amount received for academic fees (£50M) and for commercial research (about £20M).

Five years later, in Whitechapel Art Gallery v Customs and Excise Commissioners [1986] STC 156, a gallery was a charity and was predominantly concerned with the free display of works of art while also carrying on other business activities. The gallery claimed that it was carrying on a single business and was entitled to claim credit for all its input tax. Kennedy J held that the displays of works of art were so distinct from the other business activities that it could not be said that they were part of a single business.

In the present appeal we are of the view that the activity of the Appellant in carrying out publicly funded research is an activity which is completely distinct from its other business activities of education and commercial research and is not part of one single business. The Appellant's Charter makes it clear that research is an activity separate from teaching. The unchallenged evidence of Mr Sykes is that publicly funded research is an activity in its own right and not a subsidiary activity used either to support education or the generation of intellectual property rights. The distinction between teaching and research is recognised in public documents, including the strategic plan for 2003-2008 of the Higher Education Funding Council for England and the White Paper on the Future of Higher Education (Cm 5735). We accept that the Appellant treated commercial research and publicly funded research in a similar way and that both types of research were undertaken by the same people, in the same buildings and with the same approach. We also accept that publicly funded research enhanced the reputation of the Appellant and attracted the best students and academic staff but that was not its primary aim; its primary aim was to advance knowledge.

In this connection we have referred to the later judgment of the Court of Justice in EC Commission v Federal Republic of Germany (Case C-287/00) [2002] STC 982 at 996 paragraph 48 where the Court of Justice stated that, although the undertaking of research projects could be regarded as of great assistance to university education, it was not essential to the objective of teaching and so the undertaking of research was not an activity closely related to teaching and therefore was not an exempt supply. We accept that that is not the same issue as the issue in this appeal. We also accept that commercial research can be a business and that commercial research and teaching could be two separate businesses. However, the authority supports our view that the Appellant does not carry on one single business which includes publicly funded research..

The final authority in this early group of authorities is Imperial War Museum v The Commissioners of Customs and Excise (1992) Tribunal Decision 9097. There a museum normally charged for admission but allowed some categories of visitors, and all visitors on Fridays, to enter free of charge. The issue was whether the museum should restrict its claims for input tax. The Tribunal found that the activities of the trustees of the museum in running the museum amounted to a business. The business activities included the main activity of admitting paying visitors and the predominant concern was that of making taxable supplies. The trustees were still carrying on a business when they admitted non-paying visitors even though such admissions were not taxable supplies.

Of all the authorities cited to us we find this most favourable to the Appellant. However, in our view it can be distinguished on the ground that we do not see publicly funded research as being subsidiary to a main function of providing commercial research. About three-quarters of all research activity is publicly funded and one quarter is funded commercially. Also, in our view the predominant concern of the Appellant is not that of making taxable supplies as most of its activities are funded by grants. In Wellcome Trust Ltd v Customs and Excise Commissioners (Case C-155/94) [1996] STC 945 at 960 [40] the Court of Justice held that in order to determine whether an activity is a business it is not appropriate to consider whether it is the predominant concern of the taxable person; a taxable person could undertake taxable economic activities even though the principle occupation of the taxable person was not an economic activity. We are of the view that in this appeal the Appellant undertakes both business and non-business activities and that the publicly funded research is a non-business activity.

Our tentative conclusion after considering the early authorities on the meaning of business use is that publicly funded research is not a business. Rather it is an activity which is completely distinct from the Appellant's other business activities of education and commercial research. It is not part of one single business.

1995 – 2002 – the judgments of the Court of Justice

The second group of authorities which were cited to us were, in the main, decisions of the Court of Justice. Most of these concerned the difference between tax on goods or services used exclusively in making taxable supplies on the one hand and tax on goods or services used for the overheads of a business on the other. They were relied upon by Mr Milne to support his argument that publicly funded research was part of a single business carried on by the Appellant and should be treated as an overhead cost of that single business.

The first of these authorities is BLP Group plc v Customs and Excise Commissioners (Case C-4/994) [1995] STC 424 where the appellant claimed credit for input tax in respect of professional fees incurred in the disposal of certain shares. The issue was whether the fees were used to make an exempt supply (the sale of the shares) or for the purpose of raising funds to pay off debts arising from taxable transactions. The Court of Justice held that input tax could only be claimed in respect of goods or services which had a direct link with taxable transactions; the professional services had been used for the purpose of the exempt transaction of the supply of shares and so input tax credit could not be claimed. Mr Milne relied upon [25] where the Court made it clear that services whose costs form part of an taxable undertaking's overheads, and hence of the cost components of its products, were also used by a taxable person for its taxable transactions.

In our view the principle in [25] does not assist in this appeal. We do not regard the goods and services used in publicly funded research as being part of the Appellant's overheads nor are they part of the cost components of the Appellant's other products (education or commercial research). They are part of the cost components of what is essentially a separate non-business activity of the Appellant which does not make any supplies.

Customs and Excise Commissioners v Redrow Group plc [1999] STC 161 was a judgment of the House of Lords. There the main issue was whether the appellant, who was a builder, could claim input tax credit in respect of the tax on fees it paid to estate agents who sold the existing houses of those who purchased the appellant's new houses. The House of Lords held that the issue was whether the supplies of the estate agents had been used by the appellant in the course of its business and held that they had. Mr Milne relied upon 170h for the principle that a taxpayer who made both taxable and exempt supplies in the course of his business could obtain credit for an appropriate proportion of the input tax on his overheads; these were the costs of goods and services which were properly incurred in the course of the business but which could not be linked with any goods or services supplied by the taxable person to his customers.

At 170h Lord Millett was considering the judgment in BLP upon which we have already commented. In this appeal the Appellant makes both taxable and exempt supplies and obtains input tax credit for its overhead costs through its partial exemption calculation. In our view Redrow does not assist in determining whether publicly funded research is or is not a business.

The next relevant judgment of the Court of Justice is In Midland Bank plc v Customs and Excise Commissioners (Case C-98/98) [2000] STC 501 where the issue was whether a taxable person could deduct as input tax the tax on a supply of legal services provided to the taxable person in connection with a claim for damages arising from the carrying out by the taxable person of a previous taxable transaction. The Court of Justice held that there had to be a direct and immediate link between a particular input transaction and a particular output transaction. It was for the national courts to apply the direct and immediate link test to the facts of each case and to take account of all the relevant circumstances surrounding the transactions. The cost components generally had to arise before the taxable person carried out the taxable transactions to which they related and so in that appeal there was no direct and immediate link between an output transaction and expenditure used after the completion of the transaction. On the other hand the costs of the legal services were part of the taxable person's general costs and were, as such, components of the price of its products. Accordingly, the legal services had a direct and immediate link with the taxable person's supplies as a whole and that proportion which related to taxable (and not exempt) supplies was deductible.

Relying upon Midland Bank Mr Milne argued that there was a direct link between expenditure on publicly funded research and the Appellant's business as a whole. He accepted that in this appeal there was no direct and immediate link with supplies which were either exclusively taxable or exclusively exempt and so he argued that the input tax was residual input tax and should be apportioned under regulation 101.

We note that in Midland Bank all the supplies made by the taxable person were business supplies, either exempt or taxable, and so a supply made to the taxable person which was not used to make a taxable supply had a direct link with the taxable person's business supplies as a whole and so was treated as residual input tax and apportioned between taxable and exempt supplies. In the present appeal we are of the view that there was no direct and immediate link between the input transactions used in publicly funded research and any output transaction. Neither are the goods and services used in publicly funded research part of the Appellant's general business costs. None of the supplies used to provide publicly funded research are cost components of the other products of the Appellant, be they supplies of education or of commercial research or of the exploitation of intellectual property rights. The supplies used to provide the publicly funded research are all consumed exclusively in carrying out that research and to that extent they are not used for the purposes of the Appellant's business.

A similar point rose in Abbey National plc v Customs and Excise Commissioners (Case C-408/98) [2001] STC 297 where the issue was whether the tax on the cost of services used to transfer a going concern (not a supply of goods) was deductible. The Court of Justice held that the costs incurred formed part of the taxable person's overheads and thus in principle had a direct and immediate link with the whole of his economic activity. However, if the various services acquired had a direct and immediate link with a clearly defined part of his economic activities, so that the costs of those services formed part of the overheads of that part of the business, and if all the transactions relating to that part of the business were taxable, then the tax charged on those costs was all deductible.

Mr Milne relied upon Abbey National at 313h to 314c for the principle that although professional services used by a transferor in order to effect the transfer of assets did not have a direct and immediate link with one or more output transactions giving rise to the right to deduct, the costs of those services did form part of the taxable person's overheads and as such were cost components of the products of the business and had a direct and immediate link with the whole economic activity of the taxable person. However, in Abbey National the taxable person had no non-business activity. Everything it did was in the course of its business. We have found Abbey National to be of assistance because it appears to indicate to us that if goods and services acquired by a taxable person have a direct and immediate link with a clearly defined part of a taxable person's activities, so that the costs of those goods and services form part of the overheads of that part of its activities, and if all the transactions relating to that part of its activities are non-business transactions, then none of the tax charged on those costs is deductible. In our view the goods and services acquired by the Appellant for use in publicly funded research have a direct and immediate link with its non-business activities which is a clearly defined part of the activities of the Appellant.

The final authority in this group is Cibo Participations SA v Directeur régional des impôts du Nord-Pas-de-Calais [2002] STC 460 where the Court of Justice held that direct or indirect involvement by a holding company in the management of subsidiaries, such as the supply of administrative, financial, commercial or technical services, was an economic activity and that although professional costs incurred in the acquisition of the subsidiaries was not directly or immediately linked with the making of specific taxable supplies, nevertheless the costs were incurred for business purposes and so could be treated as cost components of the taxable person's products.

Mr Milne relied upon 461e and 475e to 476g for the principles that although there might not be a direct and immediate link between various services purchased by a holding company and any output transaction in respect of which tax was deductible, the costs of the services could be part of the taxable person's general costs and as such cost components of the undertaking's products and that the deduction system of input tax was meant to relieve the trader entirely of the burden of value added tax payable or paid in the course of all his economic activities. We entirely accept these principles but the issue in the present appeal is whether publicly funded research is a business (an economic activity). In Cibo the Court of Justice did not consider the situation of this appeal where the issue is whether there were some non-business supplies.

Our conclusion having considered these authorities is that there is no direct and immediate link between the input transactions used in publicly funded research and any output transaction. Neither are the goods and services used in publicly funded research part of the Appellant's general business costs. None of the supplies used to provide publicly funded research are cost components of the other products of the Appellant, be they supplies of education or of commercial research or of the exploitation of intellectual property rights. The supplies used to provide the publicly funded research are all consumed exclusively in carrying out that research and to that extent they are not used for the purposes of the Appellant's business.

2001-2004 - The recent authorities

The final group of authorities are the more recent national authorities which also deal with the meaning of the word business. For various reasons we have not found these to be as helpful as the earlier authorities.

In particular, we have not found West Devon Borough Council v Customs and Excise Commissioners [2001] STC 1282 of assistance in this appeal because it does not concern entitlement to input tax but rather concerns the application of section 33 of the 1994 Act (which provides that tax chargeable on the supply of goods or services to a local authority which is not for the purpose of a business carried on by it will be refunded by Customs and Excise). For a similar reason we have not found Customs and Excise Commissioners v Yarburgh Children's Trust [2002] STC 207 of assistance because it concerned the zero-rating of building works.

On the other hand, BUPA Purchasing Limited and others v Customs and Excise Commissioners [2003] STC 1203 does concern input tax and does concern the question whether goods or services supplied to a taxable person were used for the purpose of a business. The facts in that appeal were complex but the principle was stated by Park J at 1217g where he said:

"If the person who receives a supply of goods or services is a taxable person, but nevertheless he does not use the supply for the purpose of his "business", the VAT which he pays on the supply is not "input tax". "Business" has a restricted meaning in this connection, and activities which do not involve the making of taxable supplies, even if they would be business in the normal sense, do not count as business for VAT."

We rely on that recent authority for the principles that the meaning of the word

"business" in section 24 means activities which involve the making of taxable supplies. Publicly funded research carried out by the Appellant does not involve the making of taxable supplies and so is not a business.

The next authority in this group is Customs and Excise Commissioners v Southern Primary Housing Association Limited [2004] STC 209. There a taxable person purchased land and paid value added tax on the price; then sold the land to a housing association; and then contracted with the housing association to build houses on the land. The taxable person claimed to deduct as input tax the tax paid on the price of the land. The Court of Appeal held that there was no direct and immediate link between the purchase of the land and the building contract and the land purchase price was not a cost component of the building contract. At 218 [36] to [37] the Court of Appeal emphasised the need to focus on the objective transaction-by-transaction nature of value added tax law. It is necessary 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.

In the present appeal we do not find any direct and immediate link between the supplies made to the Appellant and used for publicly funded research and any taxable supplies made by the Appellant.

The judgment of the House of Lords in Beynon and Partners v the Commissioners of Customs and Excise [2004] UKHL 53 was published shortly after the hearing of this appeal. Customs and Excise sent us their comments on 6 December 2004 and the Appellant sent its comments on 7 December 2004. We do not find this authority to be of assistance to us as it does not concern input tax and the meaning of business use.

Our conclusions

Having considered the authorities cited to us we conclude that publicly funded research is not a business. Nor is it part of a single business carried on by the Appellant. Rather it is an activity which is completely distinct from the Appellant's other business activities of education and commercial research. We also conclude that there is no direct and immediate link between the input transactions used in publicly funded research and any taxable supply by the Appellant. Neither are the goods and services used in publicly funded research part of the Appellant's general business costs. None of the supplies used to provide publicly funded research are cost components of the other products of the Appellant, be they supplies of education or of commercial research or of the exploitation of intellectual property rights. The supplies used to provide the publicly funded research are all consumed exclusively in carrying out that research and to that extent they are not used for the purposes of the Appellant's business.

The application of our conclusion

It follows from our conclusion that the Appellant should apportion the tax on supplies of goods and services made to it between business and non-business use. Publicly funded research is non-business use. When the apportionment has been made only the tax relating to business use will be input tax. That amount should then be dealt with under regulation 101. As the Appellant makes both taxable and exempt supplies it is only entitled to claim the input tax attributable to the taxable supplies and not that attributable to the exempt supplies.

The Appellant asked at the hearing that if an apportionment of input tax had to be made between business and non-business use then the method outlined at paragraph 33 of Notice 700 should be used. This used the following fraction:

Income from exempt and taxable supplies

---------------------------------

All income (from taxable and exempt supplies and grants etc)

This fraction was then applied to the total amount of input tax. Customs and Excise agreed that the method in Notice 700 could be applied.

Decision

Our decision on the issue for determination in the appeal is that the goods and services supplied to the Appellant and used in undertaking publicly funded research were not used for the purpose of a business.

The appeal is therefore dismissed.

Costs

Customs and Excise are at liberty to make an application for costs.

DR A N BRICE

CHAIRMAN

RELEASE DATE: 8 March 2005

LON/2003/0881

LON/2003/1079

03.05

Released to the parties on 08.03.05

04.05

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