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Morgan Stanley UK Group v Revenue & Customs [2007] UKVAT V20424 (08 November 2007)

20424

INPUT TAX – Partial exemption – Special method – Three-year cap – Reliance on "caretaker" special method – Caretaker method provided for interim recovery pending agreement of new "permanent" special method with adjustment to be made following such agreement – New special method agreed five years after start of caretaker method – Whether caretaker method was a special method – Yes – Whether claim for input tax more than five years later than prescribed accounting period in which tax became chargeable was capped – Yes – Appeal dismissed – VAT Act 1994 s.26 – VAT Regs 1995/2518 regs 29(1A) and 102(1)

LONDON TRIBUNAL CENTRE

MORGAN STANLEY UK GROUP Appellant

and –

THE COMMISSIONERS FOR HER MAJESTY'S REVENUE & CUSTOMS Respondents

Tribunal: SIR STEPHEN OLIVER QC (Chairman)

DIANA WILSON

Sitting in public in London on 16 and 17 October 2007

Alun James, counsel, for the Appellant

Kieron Beal, counsel, instructed by the General Counsel and Solicitor for HM Revenue and Customs, for the Respondents

© CROWN COPYRIGHT 2007

DECISION

Morgan Stanley UK Group ("Morgan Stanley"), the representative member of Morgan Stanley VAT Group, appeals against a decision of HM Revenue and Customs ("the Customs") refusing a claim for repayment of tax. The claim had been made by way of voluntary disclosure on 27 January 2006.

The question in this appeal is whether the three-year cap (VAT Regulations 1995/2518 reg 29(1A)) excludes Morgan Stanley's claim to recover £793,797 as input tax, being input tax incurred from 1 April 2001 until 31 October 2002. The basis for the claim is explained in a letter of 27 January 2006 attached to the voluntary disclosure. The relevant passage from the letter reads as follows:

"Soon after Morgan Stanley acquired Quilter, HMRC stated in a fax to Morgan Stanley, dated 13 June 2001, that an interim way of recovering input tax should be used prior to agreeing a method and that once a method was agreed, an adjustment could be made. This statement means the beginning of the period of statutory limitation for any subsequent claim should be 13 June 2001 and that Morgan Stanley is entitled to make a retrospective adjustment in respect of the period above."

The outcome of the appeal depends on two related issues. First, did the June 2001 fax establish a special method, an integral part of which was Morgan Stanley's entitlement to a retrospective adjustment going back to April 2001? Second, given that Morgan Stanley had such a prima facie entitlement, was it excluded or eliminated by the three-year cap?

The law on the first issue

Regulation 102 permits the adoption of methods of calculation as alternatives to the standard method specified in regulation 101, i.e. the standard method of "provisional" attribution for a trader with partial exemption. Regulation 102(1) permits the adoption of other methods of calculation which may be approved by the Customs or which Customs may direct a trader to use; such a method is referred to as a "special method". So far as relevant regulation 102(1) provides that "the Commissioners may approve or direct the use by a taxable person of a method other than that in regulation 101."

Regulation 102(3) provides that the special method as approved or directed under regulation 102(1) is to continue to be used unless the Commissioners approve or direct its termination. The primary legislation operating as the vires for regulations 101 and 102 is section 26(3) of VAT Act 1994. This provides that the Commissioners "shall make regulations for securing a fair and reasonable attribution of input tax to supplies within subsection (2) above …" . In St Helens School Northwood v HMRC [2006] STC 633, Warren J in paragraph 13 noted that:

"Regulation 102 provides for the use of methods of attribution other than the standard method. Customs may either approve or direct the use of such an alternative method which, in accordance with the statutory objective under section 26(3), is directed at achieving a fair and reasonable attribution when the standard method does not do so, or at least a fairer and more reasonable attribution than the standard method."

Courts and tribunals have examined alleged approvals and directions relating to special methods in their contexts to ascertain whether their meanings were sufficiently clear to make them the basis for special methods. The tribunals have accepted the existence of a special method were both parties have proceeded on the basis that the method of attribution has been adopted by those parties. In Wellington Private Hospital v Customs and Excise Commissioners [1993] VATTR 8 and in Claim 13 Plc v HMRC (2005) VAT Dec 19122 the tribunal accepted that "de facto" approval of a special method is legally possible. For this purpose the conduct of the parties has to satisfy two criteria. First, the taxable person must have knowingly adopted or sought to adopt a special method; second, Customs must have been aware what the taxable person was doing or seeking to do.

Whether the special method relied upon by Morgan Stanley existed in the present situation depends on the facts. Our summary is drawn from the evidence of Mr Simon Dyal, managing director, indirect taxes, Morgan Stanley. He had started his career in indirect tax in Customs and Excise. He was responsible for VAT issues in the UK at the relevant time and he gave oral evidence.

Background facts leading to the disputed claim

On 13 March 2001, Morgan Stanley Group (Europe) acquired the Quilter Group of companies ("Quilter") comprising six companies. Then on 1 April 2001 Morgan Stanley brought five of the Quilter companies into its VAT group; the sixth was included in the Morgan Stanley VAT group from 1 June 2001.

Quilter had been operating a special method for partial exemption purposes before its acquisition by Morgan Stanley. We refer to this as "the old Quilter method". Simon Dyal became aware of this during the due diligence process. He had doubts whether it was appropriate on two grounds. The old Quilter method of attributing input tax to taxable investment advisory services as opposed to exempt share trading (by taking the value of exempt share commissions charged to customers relative to the number of fees earned from investment advice) seemed unsophisticated to Mr Dyal. The old Quilter method had treated equity research as a zero-rated supply of books and materials and so was treated as fully taxable with a consequential benefit to the trader in its partial exemption calculations. The connections of this appeared doubtful to Mr Dyal. Mr Dyal's objective was to establish a better special method.

Morgan Stanley's VAT officer with the Customs, Michael Newbiggin, had had the same concerns when he first received a one-sheet summary of the old Quilter method. The June 2001 fax (from Michael Newbiggin to Simon Dyal) starts with a comment that "the way research is dealt with does not correspond with my understanding of the Department's position on this subject"; he went on to say that it was unlikely "that it would appear in the method we agree". The fax continues as follows:

"On the point of agreeing a method, I will have to discuss with you the incorporation of the Quilter companies into the Morgan Stanley method from 1 April 2001. I will probably have to visit the Quilter offices to gain some knowledge of their activities and accounting processes in order to do this.

We can, of course, agree an interim way of recovering input tax prior to agreeing a method; then once the method is agreed, an adjustment can be made."

We pause at this stage to comment that the fax reads as a shorthand message between two highly experienced exponents in the indirect tax field. The gist of the message appears on first reading to be this –

A proper and acceptable special method for the Quilter companies will have to be agreed. For this purpose further information will have to be made available. Pending agreement Morgan Stanley should, as regards the Quilter companies, go on using the old Quilter method. Once a formal method has been agreed an overall adjustment will be made and any advantages or disadvantages to either side that have accrued in the meantime will be put right.

Simon Dyal's understanding of the fax was that, while it did not direct a new method, it allowed Morgan Stanley to use the calculations derived from the old Quilter method to enable recovery of some input tax. So far we accept that. Simon Dyal went on to say of the fax that his understanding was that it operated as an agreement with Customs that Morgan Stanley would recover a certain amount of tax until a special method was agreed and at that time Morgan Stanley would (to use his words) "recover that tax or pay back that tax to the date of the fax". We do not understand the fax and we do not interpret the state of affairs as Simon Dyal does. In the light of our observations on the law (see paragraph 6 above) we need to explore the basis on which the parties operated after June 2001.

The matter went silent until a letter of 3 December 2001 was received by Customs from Morgan Stanley's Vice President, a Mr John Gries. This recited that Morgan Stanley were recovering VAT based on the recovery rate of the old Quilter method. The Vice President went on to say that Morgan Stanley hoped to propose an acceptable method by the year end and that this would be incorporated into the 2001 annual adjustment. The Vice President evidently had in mind a regulation 107 adjustment; at that time such an adjustment might have been possible.

Eighteen months then went by. During this time Morgan Stanley continued to recover VAT at the fixed percentage determined under the old Quilter method. On one occasion Morgan Stanley overdeclared input tax for Quilter and this was duly declared to Customs. On another occasion (January 2003) a Mr Chiu Ming Man of Morgan Stanley communicated with Customs commenting on the old Quilter method and proposing that this be changed as a matter of priority.

Nine months then went by. In late September 2003 Morgan Stanley received a visit from Mr Alex Mannings of Customs. Morgan Stanley agreed to propose a new method for Quilter, being a method that was in line with the time-based method used for Morgan Stanley's Private Wealth Management Group. This was not acceptable to Customs because apparently Quilter personnel did not complete time sheets.

Six more months passed and a meeting took place (in March 2004) between Morgan Stanley and Customs. In the course of it Morgan Stanley's proposed special method was briefly discussed.

Seven months later Morgan Stanley wrote to Customs (on 4 October 2004) attaching details of a new proposed method for Quilter which again followed the special method agreed in relation to Morgan Stanley's Private Wealth Management Group. Customs wrote back on 6 December 2004 inviting Morgan Stanley to provide further details.

Eight months later Customs wrote to Morgan Stanley (on 22 July 2005) observing that they had not had a reply to their 6 December 2004 letter about the new special method for the Quilter companies. A meeting was fixed for a date in August but no record of discussions about partial exemption was produced.

On 8 November 2005 a meeting of Morgan Stanley and Customs took place at which Morgan Stanley proposed a "headcount" basis for the proposed special method. This was followed by a further meeting on 18 November and on 30 November Morgan Stanley wrote to Customs proposing that the headcount method be used.

Morgan Stanley made a voluntary disclosure on 3 November 2005 of input tax incurred by Quilter in the previous three years. Prior to this, on 31 October 2005, Morgan Stanley had written to explain that in their view any new special method should apply to Quilter from the time the Quilter companies entered the Morgan Stanley VAT Group. Customs paid, in respect of the voluntary disclosure made on 3 November 2005, in January 2006.

On 27 January 2006, Morgan Stanley made a further voluntary disclosure in the sum of £793,797 in respect of the input tax incurred since the Quilter companies entered the Morgan Stanley VAT Group.

On 5 April 2006 Customs rejected this claim and notified Morgan Stanley of its right to appeal that decision. On 3 May 2006 Morgan Stanley appealed against this refusal.

Asked why Morgan Stanley had made two voluntary disclosures, the former for the uncapped claim and the latter for the earlier period, Simon Dyal explained (and we accept this) that Morgan Stanley had gone for the undisputed part first so as to leave it uncomplicated by the amount (comprised in the latter claim) potentially in dispute. A single claim for the entire amount could in his view have resulted in repayment being deferred for a long time on account of the dispute about capping for the earlier periods.

Positions taken by the parties

Customs say that the June 2001 fax produced no special method, either by agreement or otherwise. Insofar as any special method existed before the end of 2005 this was the old Quilter method which ran on by conduct of the parties; there was nothing in that to displace the three year cap.

Morgan Stanley contended that the terms of the June 2001 fax created a special method, either on the strength of agreement or by virtue of the de facto conduct of the parties. The method so created contained both an interim recovery method and a provision for subsequent adjustment which applied irrespective of the three-year cap.

Morgan Stanley go on to say that even if there had been no express agreement as to the existence of a special method containing those terms and nothing operating as a de facto agreement (i.e. an agreement deduced from the mutual conduct of the parties), a special method of that type remained binding under Customs as the exercise of their powers of care and management. This approach was based on the decision of the Court of Appeal in GUS Merchandise Corporation (No 2) [1995] STC 27. That it was within the care and management powers of Customs is acknowledged in the HMRC Guidance Manuals, Retail Schemes, which states:

"… the Commissioners can enter into binding agreements and … they cannot unilaterally resile from those agreements with retrospective effect.

There are three particular points to bear in mind:

firstly, that a binding agreement need not be in writing. An agreement to use a scheme in a particular way can be implied from the Commissioners' words and actions; it is not possible to list all the ways in which this might happen, but whenever you acquiesce in a retailer departing from a published method it is possible that a binding agreement might be inferred by the courts;

secondly, if an agreement exists, then any termination of that agreement must be done in an unambiguous way and must be from a current date;

the third lesson concerns the prioritisation of risk at large businesses subject to cyclical control. … but where the tax at risk is regulated by agreements (such as Retail Schemes or partial exemption) we will be able to assess retrospectively only in the most exceptional cases."

The absence of any mention of the three-year cap limitation in the June 2001 fax, it was argued for Morgan Stanley, precludes the Customs from relying on regulation 29(1A).

In this connection Morgan Stanley recognised that the determination of an appropriate special method had taken a long time to resolve. It had been a relatively minor matter when set against the many other VAT issues between Morgan Stanley and the Customs. But nothing about the delay should be construed as affecting Morgan Stanley's entitlement of full recovery of overpaid input tax for the period starting when the Quilter companies joined the Morgan Stanley VAT Group.

Then, say Morgan Stanley, regulation 29(1A) does not apply here. Claims to recover residual input tax had been made in each period commencing from 2001. Moreover, they say, the statutory scheme for partial exemption allows no scope for the application of the three-year cap. This is because adjustments may be made under regulation 107, either annual or for such longer period as the Customs may allow; regulations 108 and 109 allow for adjustments consequent upon a change of intention or use within six years.

Finally, we mention that Morgan Stanley reserves its position in relation to a possible argument that the three-year cap is in any event invalid, pending the decision of the House of Lords in Fleming (t/a Bodycraft) v HMRC [2006] EWCA Civ 70.

Conclusions

The first issue is whether there was a valid and enforceable special method that –

(i) entitled Morgan Stanley to continue using the old Quilter method until an agreement was reached with Customs that determined the appropriate special method (i.e. the new special method) and

(ii) allowed for an adjustment when the new special method was determined and

(iii) absent the three-year cap, permitted the adjustments and consequential payments to Morgan Stanley.

The term special method has been used in the course of these proceedings to refer the three different concepts. First, it has been used to describe the old Quilter method. It is however common ground (and in our view correct) that the old Quilter method as agreed between Customs and the Quilter companies terminated when the Quilter companies joined the Morgan Stanley VAT Group. Second, it has been used by Morgan Stanley to connote the arrangements as they existed from the date the Quilter companies joined the Morgan Stanley Group until the new agreement with Customs at the end of 2005. Customs have at no time conceded that there was a special method during that period. They referred to the relationship as one providing for "interim recovery". Third, the term special method has been used to cover the new special method as agreed at the end of 2005.

The starting point for us is to determine the nature of the arrangements between 1 April 2001 and the end of 2005. Was there a special method in existence during that period? What (prima facie and without prejudice to the operation of the three-year cap) were its full terms?

We are satisfied from the evidence that there was no express agreement in April 2001 between Morgan Stanley and Customs for the adoption of a special method. Simon Dyal accepted this in evidence. The letter of 3 December 2001 from Morgan Stanley's Vice President is in line with this; the Vice President referred to "some discussions" concerning a new method and of the need to review the existing old Quilter method and to propose an alternative.

What, if any, special method was approved or directed (see the words of regulation 102(1)), in the absence of any express agreement? The approval or direction of the special method must be clear, unambiguous and sufficiently certain. At the same time the statutory scheme requires that there be a method in place to secure fair and reasonable attribution of input tax to taxable supplies. There cannot be no method: regulation 101 ensures this by prescribing the standard method. Nonetheless the operation of the standard method could not, to judge from the positions taken by both parties from 1 April 2001 onwards, provide a fair and reasonable attribution. This brings us to the June 2001 fax. We gave a preliminary reaction to this earlier in this decision: see paragraph 11 above. The background facts as we have now summarised them have endorsed that reaction.

In our view the June 2001 fax contained the framework for a caretaker special method. We use the term "caretaker" to indicate something more than "provisional"; it was designed to last until agreement or direction of a proper new method. Morgan Stanley was to continue to use the recovery mechanism as contained in the old Quilter method. Once the new agreement had been reached the overall adjustments would be made in order to compensate Customs for Morgan Stanley's over-recovery of input tax or to compensate Morgan Stanley for under-recovery. The evidence shows that the parties acted on it. (The evidence also suggests that the parties had in mind that the new special method should be agreed quite soon after June 2001, i.e. well within 3 years. As already noted the Vice President had seen the caretaker special method as being replaced by the end of 2001; Mr Man in his letter of 8 February 2002 had expected the agreement of a new special method taking place in time for Morgan Stanley to make its annual adjustment.)

In summary we agree with Morgan Stanley that the words of the June 2001 fax coupled with the conduct of the parties were sufficiently clear and unambiguous and certain as to the eventual result and as to amount to a special method with a provision for adjustment being an integral part of the caretaker special method.

The operation of the three-year cap

Section 25 of VAT Act 1994 provides that a taxable person is entitled, at the end of each accounting period, to credit of so much of his input tax as is allowable under section 26.

The relevant Regulations are the VAT Regulations 1995, SI 1995/2518, as amended from time to time. Regulation 29(1A) is headed "Claims for input tax" and provides as follows:

"29(1) [Subject to paragraphs (1A) and (2) below], and save as the Commissioners may otherwise allow or direct either generally or specifically, a person claiming deduction of input tax under section 25(2) of the Act shall do so on a return made by him for the prescribed accounting period in which the VAT became chargeable.

[(1A) The Commissioners shall not allow or direct a person to make any claim for deduction of input tax in terms such that the deduction would fall to be claimed more than three years after the date by which the return for the prescribed accounting period in which the VAT became chargeable is required to be made.]"

This appeal concerns Morgan Stanley's claim in its letter of 27 January 2006. This enclosed a voluntary disclosure in respect of input tax incurred in the period 1 April 2001 until 31 October 2002. The letter continued with the words:

"This voluntary disclosure is in addition to the claim made for the period 1 November 2002 to 31 October 2005".

The wording of regulation 29(1A) is mandatory in terms. There is no indication from those words that its operation does not extend to partial exemption. Nor do the terms of the June 2001 fax give any indication that Customs were proposing (assuming they had the authority to do so) that the continued use of the old Quilter method as the caretaker method should override the primary or secondary legislation setting time limits for recovery. Indeed the words of the fax contained no mention about disapplying the capping rules; nor does it state in terms that any adjustment required by the caretaker special method must be back-dated to 13 June 2001.

In essence the words of the fax recognised an adjustment as part of the proposal. The words "once the method is agreed, an adjustment can be made" indicate that any adjustment will be conditional on a proper and acceptable new special method being agreed between Morgan Stanley and Customs. The expectations of both Customs and of Morgan Stanley (as the Vice President's letter of 3 December 2001 acknowledges) were that agreement of a new special method would be reached in time to include it in the 2001 annual adjustment. This would have enabled any shortfall, one way or the other, to have been recouped in the context of the annual adjustment for the longer period. This did not happen. It was not until the submission of the second voluntary disclosure in January 2006 that any claim was made which sought to recover input tax on the basis of the new special method agreed in late 2005.

We accept that claims for recovery based on the caretaker special method had been made quarter by quarter since April 2001. The further amounts recoverable following agreement of the new special method in late 2005 were the subject matter of the claims contained in (i) the uncapped voluntary disclosure of 3 November 2005 and (ii) the disputed voluntary disclosure of 27 January 2006. It seems to us, on the clear reading of regulation 29(1A), that the latter voluntary disclosure related to a deduction of input tax falling to be claimed "more than three years after the date by which the return for the prescribed accounting period in which the VAT became chargeable [was] required to be made."

To the extent, therefore, that the June 2001 fax can be read as waiving the three-year cap (which in our view it cannot) it is rendered ineffective by the mandatory opening words of regulation 29(1A).

We do not think that any of regulations 107 to 109 assist Morgan Stanley.

Regulation 107 requires a taxpayer for whom the longer period is applicable (under regulation 99) to adjust any provisional attribution (under regulation 101 or 102) to ensure that there has not been any over-deduction or under-deduction in the prescribed accounting periods. The adjustment is carried out for "a longer period" than the "prescribed accounting period". It is normally done on the basis of the tax year of the taxable person. See regulation 99(4). In accordance with section 26 of VAT Act 1994 these provisions are designed to enable that a partially exempt trader receives a fair and reasonable attribution for its input tax. As a quid pro quo of not paying VAT on exempt supplies, he is not entitled to claim input tax for acquisitions etc, which are solely related to those exempt supplies. In addition, only a fair and reasonable proportion of the input tax which relates both to exempt and taxable supplies must be claimed. The final adjustment ensures that only the correct amount is claimed over a longer period. Nothing in regulation 107, as just explained, has the effect either directly or by implication of waiving the three-year cap. It has nothing to do with the three-year cap.

So far as regulations 108 and 109 are concerned, we do not see that this is a case which falls within their terms. Carnwath J (as he then was) in Customs and Excise Commissioners v University of Wales College, Cardiff [1995] STC 611 at 616b-c explained the provisions as follows:

"Regulation [108] applies where a credit has been given for input tax in respect of a supply which has been attributed to "an intended taxable supply" and where within six years such supply is used or appropriated for use in making an exempt supply. Regulation [109] deals with the converse situation, where input tax has been incurred in respect of a supply which is attributed to an intended exempt supply (or to the carrying on of activities other than the making of taxable supplies), and within the six years the supply is used or appropriated for use in making a taxable supply, before the intended exempt supply is made or the intended activities carried on. In such a case the Commissioners must pay to the taxable person a sum representing the amount attributable to the taxable supply."

It follows, we think, that there is no necessary implication to be drawn from either regulations 108 and 109 that the three-year cap has no application to the partial exemption regime and to claims made in pursuance of it. Those provisions are directed at particular situations and contain specific rules for making the particular partial exemption method work fairly and reasonably.

For those reasons we dismiss the appeal.

SIR STEPHEN OLIVER QC

CHAIRMAN

RELEASED: 8 November 2007

LON 2006/0549