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Cite as: [2008] UKVAT V20619, [2008] BVC 2307

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Lincoln Assurance Ltd v Revenue & Customs [2008] UKVAT V20619 (17 March 2008)

20619

VALUE ADDED TAX – input tax - Appellant made exempt supplies of finance (the sale of securities) outside the member states with a right of recovery of input tax (specified supplies) as well as taxable and exempt supplies - no goods or services supplied to the Appellant were used exclusively in making specified supplies - whether the input tax on goods or services used in part in making specified supplies was to be attributed to specified supplies by reference to the proportion which the value of the specified supplies bore to the value of total supplies – yes – appeal allowed - VATA 1994 Ss 24-26; VAT (Input Tax) (Specified Supplies) Order 1992 SI 1992 No. 3123; VAT General Regulations 1995 SI 1995 No. 2518 Regs 101 to 103.

LONDON TRIBUNAL CENTRE

LINCOLN ASSURANCE LIMITED

Appellant

- and -

THE COMMISSIONERS FOR HER MAJESTY'S

REVENUE AND CUSTOMS

Respondents

Tribunal: DR A N BRICE

MR R L JENNINGS FCA FTII

Sitting in London on 3 and 4 December 2007

Roderick Cordara QC with Paul Key, Counsel, instructed by Deloitte & Touche LLP, for the Appellant

Ian Hutton with Phillip Woolfe, Counsel, instructed by the Solicitor of HM Revenue and Customs, for the Respondents

© CROWN COPYRIGHT 2008

DECISION

The appeal

Lincoln Assurance Limited (the Appellant) appeals against a decision of the predecessors of The Commissioners for Her Majesty's Revenue and Customs (Customs) dated 26 April 1999. The decision was that, for the accounting period ending on 31 March 1999, the values of securities should not be included in the fraction used under the Appellant's partial exemption method to determine the deductible proportion of residual input tax. Although the decision was in wide terms the only part of it which was the subject of the appeal was the decision was to deny the Appellant input tax on supplies made to it which were used for the purpose of making supplies of securities outside the member states.

Although the Appellant disputed the decision it has, since the date of the decision, calculated its deductible input tax in accordance with it. However, the Appellant has also made voluntary disclosures in respect of input tax which it claims has been under-claimed. The amount of that under-claimed input tax is £1,583,029.85 before interest. Customs have refused to pay these voluntary disclosures.

The legislation

The legislation about input tax

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. Section 25(2) provides that a taxable person is entitled, at the end of each accounting period, to credit for so much of his input tax as is allowable under section 26 and then to deduct that amount from any output tax that is due from him. Section 26 contains the provisions which describe the input tax allowable under section 25 and the relevant parts of section 26 provide:

"26(1) The amount of input tax for which a taxable person is entitled to credit at the end of any period shall be so much of the input tax for the period … as is allowable by or under regulations as being attributable to supplies within subsection (2) below.

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

(a) taxable supplies;

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

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

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

(4) Regulations under subsection (3) above may make different provisions for different circumstances and, in particular… for different descriptions of goods or services; … . "

Thus section 26(2) makes it clear that the only input tax for which credit may be given is that attributable to taxable supplies; to supplies outside the United Kingdom which would be taxable supplies if made in the United Kingdom (sometimes called foreign or out-of-country supplies); and to such supplies outside the United Kingdom and such exempt supplies as are specified by order (specified supplies). Section 26(2) thus means that input tax attributable to exempt supplies does not give any entitlement to credit. The supplies at issue in this appeal are specified supplies.

The regulations about specified supplies

At the relevant time the regulations made under section 26(2)(c) of the 1994 Act were the Value Added Tax (Input Tax) (Specified Supplies) Order 1992 SI 1992 No. 3123 (the 1992 Order). The 1992 Order specified the supply of services to a person who belongs outside the member states provided the supply was exempt or would have been exempt if made in the United Kingdom by virtue of any of the items 1-7 of Group 5 of Schedule 6 of the Value Added Tax Act 1983 (the 1983 Act). Items 1 to 7 of Group 5 of Schedule 6 of the 1983 Act specified certain services relating to finance including the sale of securities. In this Decision we call the supplies of securities made by the Appellant outside the member states "specified supplies" as they are the supplies specified by the 1992 Order.

The regulations about partial exemption

At the relevant time the regulations made under section 26(3) of the 1994 Act were regulations 99 to 111 of the Value Added Tax Regulations 1995 SI 1995 No 2518 (the 1995 Regulations) and particularly regulations 101 and 103.

The standard method

Regulation 101 is headed "Attribution of input tax to taxable supplies" and it deals with the attribution of input tax between exempt supplies and supplies within the meaning of section 26(2)(a), namely taxable supplies. It provides that, subject to regulation 102, 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; by providing that no part of the input tax used exclusively in making exempt supplies is attributable to taxable supplies; and by providing that, where supplies are used to make both taxable and exempt supplies, the amount of input tax attributable to taxable supplies is that 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. Thus the calculation required by regulation 101 is based on the value of taxable and exempt supplies made. Input tax on supplies used to make both taxable and exempt supplies is called residual input tax. The method of attributing input tax to taxable supplies described by regulation 101 is called the standard method.

A special method

Regulation 102 provides that Customs may approve or direct the use by a taxable person of a method other than that specified in regulation 101. Where Customs approve, or direct, a method under regulation 102 it is called a special method. Before 1996 the Appellant used a special method for the calculation of its input tax. However, that special method was withdrawn by Customs on 1 January 1996, since which date the Appellant has used the standard method. As mentioned, the calculation required by the standard method is based on the values of taxable and exempt supplies made.

The method for specified supplies

Regulation 103 is headed "Attribution of input tax to foreign and specified supplies" and it deals with the attribution of input tax relating to supplies within the meaning of section 26(2)(b) and (c). Regulation 103(1) provides:

"(1) Input tax incurred by a taxable person … on … goods or services supplied to him which are used … by him in whole or in part in making-

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

(b) supplies specified in an Order under section 26(3)(c) of the Act …

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

Thus regulation 103 provides for a method of attribution of input tax where goods or services are used in whole or in part to make specified supplies. There is no provision similar to that in regulation 102 and so there is no provision for Customs to approve or direct the use by a taxable person of any special method of attribution where goods or services are used in whole or in part to make specified supplies.

The issue

It was accepted that the Appellant had no input tax used exclusively in making specified supplies and so the issue in the appeal concerned only input tax used in part to make specified supplies and in part to make other supplies (both taxable and exempt) in the United Kingdom and other member states. Thus the input tax at issue in the appeal is residual input tax. It was also not disputed that the calculation under regulation 103 of the attribution of input tax on goods or services used partly in making specified supplies had to be based on use. What was in dispute was how use was to be determined.

The Appellant argued that the value of the specified supplies as a proportion of total supplies represented a fair and reasonable measure of the use to which the supplies made to the Appellant were put. Customs argued that a values-based method did not adequately reflect the use of the supplies made to the Appellant because few, if any, of those supplies were consumed directly in making specified supplies.

Thus the issue for determination in the appeal was whether the attribution of input tax to specified supplies under regulation 103 should be made by reference to the proportion which the value of specified supplies bore to the value of total supplies (as argued by the Appellant) or by some other method which more accurately reflected the use by the Appellant of the supplies made to it when making specified supplies (as argued by Customs).

The evidence

The Appellant produced a blue bundle of documents and Customs produced another black bundle which contained witness statements and exhibits. Oral evidence was given on behalf of the Appellant by Mr Michael Robert Geoffrey Tallett-Williams FCCA BSc the Managing Director of Lincoln Insurance Services Limited. Oral evidence was given on behalf of Customs by Mr Donald William Bryant an Officer of Customs employed as a senior policy adviser on partial exemption issues since 2003. A witness statement containing evidence for Customs and given by Mr Joseph Patrick Loftus, an Officer of Customs, was not objected to by the Appellant and so was read as evidence of the facts stated in it.

After the hearing we received documents from the parties following requests made by us during the hearing. On 6 December 2007 the Appellant sent us a statement by Mr Nevill Kent, Finance and Investment Director of the Appellant, about the activities of Capita Life and Pension Services Limited (Capita). On 14 December Counsel for Customs sent us (1) a note of references to passages in the transcript of the hearing which Customs considered to be of particular relevance and (2) a response to Mr Kent's statement. The response indicated that Mr Kent's statement had not been tested by cross-examination and that, although it could provide background information, it should not form the basis of the Tribunal's Decision. Correspondence between the parties followed and it was ultimately agreed on 21 December 2007 that the Tribunal should consider the contents of all the documents and that the Tribunal should not be asked to reconvene.

The facts

From the evidence before us we find the following facts.

The Appellant and its business

The Appellant is a subsidiary of Lincoln National (UK) plc which is part of Lincoln National Corporation which is listed as LNC on the New York Stock Exchange. Lincoln National (UK) plc was formed from a number of companies and manages assets in the region of £5 billion.

The Appellant is the principal trading company of the group in the United Kingdom and is the representative member of the group for value added tax purposes. The group has registered offices in Gloucester. The main companies in the group are:

The Appellant which is a life assurance company regulated by the Financial Services Authority. It provides long term insurance cover and writes life assurance, pensions, annuity and permanent health business. Mr Tallet-Williams estimated that, as a group, the business of the Appellant was split approximately equally between life assurance and pension business. The group currently has about 600,000 policies. The liability in respect of these policies was £5.5 billion as at 31 December 2006 of which £4.5 billion was in respect of unit-linked policies.

Lincoln Unit Trust Managers Limited (Unit Trust Managers) which is also regulated by the Financial Services Authority. It manages a range of authorised unit trusts and has about 15,000 clients; it holds investments totalling £200 million. It also provides unit-linked individual savings accounts (ISAs).

Lincoln Insurance Services Limited (Services) which is an internal management company and which provides management and administrative services to, and employs all the employees of, the Appellant and Unit Trust Managers.

Lincoln Investment Management Limited which is also regulated by the Financial Services Authority and provides investment management services to the Appellant and Unit Trust Managers.

There is also a company called Barnwood Properties Limited which receives rental income on investment properties owned by the group.

The work of the group before 1999

We first describe the work of the group before 1999 by reference to the four stages in the life of a typical policy sold by the Appellant. These were: product development; sale; administration; and termination.

The Appellant has a range of insurance products which were developed and priced by reference to risk, investment performance, expenses and tax. Before 1999 the Appellant had a direct sales force of self-employed agents which sold all its policies.

When a policy was entered into the appropriate records were prepared by the Appellant's Customer Administration Department which also collected the premiums. The Finance Department maintained accounting records for all the funds and undertook unit pricing. The price of each unit in a policy was determined by adding the total value of all the investments in a fund, the income received from those investments, and realised gains and losses from the disposal of those investments. From that was deducted administration charges and tax liabilities. Unit pricing of the funds was done on a daily basis. During the life of the policy premiums were invested and the investments were managed to achieve the best return for the policyholders. Before 1999 each fund had a fund manager and day-to-day investment decisions were taken by the fund manager.

When a policy terminated the amount due under the policy was paid by the Appellant and investments might be sold to meet this liability.

Before 1999 the group had about 1,500 employees and a direct sales force of self-employed agents of about the same number.

The changes made in 1999

In late 1999 LNC announced that it proposed to leave the United Kingdom. The group's sales force was disbanded and the number of employees fell to about 600.

In the event LNC did not sell Lincoln National (UK) plc and later decided to maintain its presence in the United Kingdom. Since 2000 the Appellant has sold policies either directly to existing policyholders or through independent financial advisers but has not written significant amounts of new business. The amount of new premiums in 2004 was £30 million as compared with over £200 million in 1997.

Because of the long-term nature of life assurance business the Appellant's liability to all its policyholders remains and could remain for at least fifty more years. Accordingly, the Appellant continues to invest actively in a range of different investments in order to meet its obligations to its policyholders and to maximise the returns on investments for them. For this reason the Appellant invests in commercial property, unit trusts and securities.

1999 – Outsourcing of investment management

About four-fifths of the Appellant's business is unit-linked and the Appellant manages a number of funds. The essence of a unit-linked policy is that investment performance determines the end value. Each fund has its own investment objectives. The Appellant owns the assets (securities or property) in which the funds are invested and maintains the records. The policyholder decides which fund his premiums are invested in. Most policy holders invest in a managed fund which could, for example, consist mainly of United Kingdom quoted securities with some fixed interest securities and some real property. Or a policyholder could decide to invest half of his premiums in a United Kingdom fund and the other half in a United States fund. The securities held by the Appellant could be held for many years or for a little as one year. Securities are sold on the advice of investment managers.

In November 1999 the Appellant entered into an agreement with Goldman Sachs Asset Management Limited (Goldman Sachs) for the provision by Goldman Sachs of investment management services to the Appellant. The Appellant continues to own the assets in which the funds are invested, maintains the records and deals with the administration of the funds but receives investment advice from Goldman Sachs. In addition to its arrangements with Goldman Sachs the Appellant also has arrangements with some other investment advisers and advisers on commercial property.

At the present time all the Appellant's unit-linked funds are managed by external fund managers and internal managers monitor their decisions. Non-unit-linked funds are managed internally. Where funds are managed by external fund managers the Appellant manages the relationship with the external fund managers. Funds managed internally have a fund manager and day-to-day investment decisions are taken by the fund manager.

In addition to investing in securities the Appellant also invests in commercial real property and instructs external advisers on commercial property. The Appellant has exercised the option to tax on most of its investment properties. There is one property (The Quays) where there is no option to tax. That property is let by the Appellant to Capita who sublets part back to the Appellant who occupies it.

2002 - Outsourcing of administration and finance

On 24 July 2002 the Appellant outsourced the majority of the work of its Customer Administration Department and Finance Department to Capita. About 500 of the group's employees became employed by Capita. Capita charges the Appellant £20m per annum for its services (which we were told was exempt for value added tax purposes)..

Capita undertakes the work related to policy administration, collection of premiums, approval and payment of claims, payment of annuities, management accounting and pricing of policies, Capita provides a call centre and answers telephone enquiries from the Appellant's customers and from independent financial advisers. It also collects premiums (which are mostly paid by direct debit) and deals with the financial areas that relate to premium collection and direct debits. It also undertakes the daily pricing of unit funds and exercises some functions of an actuarial nature. Finally, it maintains the investment records and deals with the administration of the funds and investment accounting activities. Capita advises the external fund managers of all client investment fund movements including fresh premiums in, payments out and switches between various funds. The work outsourced in 2002 related to then existing policies and some subsequent business up to 2006.

In addition to the annual fee of £20m, Capita makes separate charges for additional services. For example, we saw an invoice for the month of December 2004 where Capita's charges for information technology services were £82,106.61, value added tax was £14,368.64 making a total of £96,475.15

Capita does not deal with any functions relating to the valuation of policies at termination. Also, Capita does not provide services relating to policies written by the Appellant from 2007 onwards.

The Appellant's present structure

In 2006 the group had about 131 employees employed in the following functions:

Finance 16

Investment management 6

Actuarial 15

Business development 36

Legal and compliance 15

Relationship management (customer services) 10

Unit Trust Managers 25

Internal audit 3

Human resources 3

Managing director's office 2

The number is about 150 today. The investment managers manage the relationships with the external companies that provide investment management services to the Appellant. The relationship management team and the internal audit function work in conjunction with Capita.

If a customer took out a single premium investment for a term of twenty years there would be little contact with the customer during the life of the investment other than the sending of annual statements and dealing with matters such as change of address. However, the investment of the single premium would be monitored throughout the period.

The supplies made by the Appellant

The Appellant now makes three main types of supply. First it supplies insurance policies to policyholders for which it receives premium income. Most of the policyholders are resident in the United Kingdom and these are exempt supplies. A few policyholders belong in other member states and a very few policyholders belong outside the member states; these latter supplies are specified supplies. Secondly the Appellant lets out its investment properties and receives rental income; these supplies are taxable if there is an option to tax; otherwise they are exempt. Thirdly, the Appellant sells securities in the course of managing its investments. Securities may be sold to persons in the United Kingdom in which case the supplies are exempt supplies; or to persons in other member states; or to persons outside the member states and these are specified supplies.

As an example of the volume of supplies made by the Appellant we saw a schedule of supplies made in the period ending in December 2004 where the figures were:

Exempt supplies

Sales of securities in the UK and EC £ 954,541,811.00

Premiums £ 79,734,167.78

Commissions £ 18,881,588.23

Investment properties* £ 230,650.00

Miscellaneous (1)`` £ 6,666.00

Miscellaneous (2) £ 52,539.27

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

£1,053,447,724.28

Specified supplies

Sales of securities outside EC £ 105,985,899.99

Taxable (standard-rated) supplies* £ 6,422,777,72

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

Total of all supplies £1,165,857,401.93

* As mentioned above, there is an option to tax for most investment properties but not all.

The supplies made to the Appellant

Most of the amounts paid by the Appellant are to employees. Some supplies made to the Appellant are associated solely with the real property held by the group as investment property. We were informed that the Appellant is able to directly attribute its property investment costs on a property by property basis.

The other supplies made to the Appellant are supplies of information technology; fund managers' services (including Goldman Sachs); consultants' services (including Capita); advertising and publications; utilities; photocopying, stationery and telephone; and audit and actuarial services. The Appellant incurs marketing costs associated with the development of its financial products. There are costs associated with the provision of information for investment management purposes and there are also costs when information is provided by investment managers to sales and marketing teams concerning the Appellant's investment policy.

Group costs are borne by Services and are allocated to the relevant group entity in accordance with group policy on cost centre allocation. The cost centre allocation is used for both management and financial accounting purposes

The Appellant and value added tax

Until 31 December 1995 the Appellant used a special method under regulation 102 to attribute its residual input tax between taxable and exempt supplies. On 1 January 1996 Customs withdrew the special method. After 1 January 1996 the Appellant used the standard method under regulation 101 and the same method for specified supplies.

On 17 March 1999 the Court of Appeal decided that, for the purposes of the standard method, taxable supplies did not include foreign supplies (see Customs and Excise Commissioners v Liverpool Institute for Performing Arts [1999] STC 424.) On 31 March 1999 Customs published business Brief 8/99 and on 26 April 1999 wrote to the Appellant with the disputed decision.

Since the disputed decision the Appellant has used the standard method to attribute its residual input tax between taxable and exempt supplies under regulation 101. However, since the date of the disputed decision it appears that the Appellant has not received any credit for input tax in respect of specified supplies (except that after 2002 the input tax on investment managers' fees was repaid in the proportion that the number of sales of securities outside member states bore to the total number of sales of securities).

In the years that followed the disputed decision, discussions took place between the Appellant and Customs in an attempt to agree a special method under regulation 102 which would also deal with specified supplies under regulation 103. Many suggestions (the figures of seven or eight were mentioned) were made by the Appellant but none were agreed by Customs. We now mention three of these proposals; two were made by the Appellant in 2001 and 2002 and one was made by Customs in 2006.

The Appellant's 2001 proposals - sectorisation

On 6 August 2001 the Appellant suggested that the group's activities could be divided into business sectors as opposed to using the companies in the group. Six business sectors were proposed, namely, life and pensions; investment management, property, unit trusts, The Quays and other business. The proposal was that there should first be direct attribution of input tax between taxable and exempt supplies (by attributing to taxable supplies the whole of the input tax used exclusively in making taxable supplies and by attributing to exempt supplies the whole of the input tax used exclusively in making exempt supplies); after that costs and expenses would be allocated to the business sectors and there would be individual partial exemption methods for each business sector. That proposal was not accepted by Customs

The Appellant's 2002 proposals - still current

On 25 January 2002 the Appellant suggested the following method of calculating its deductible input tax under both regulation 101 and regulation 103:

Step 1 – Attribute to taxable supplies the whole of the input tax used exclusively in making taxable supplies and attribute to exempt supplies the whole of the input tax used in making exempt supplies.

Step 2 - the regulation 103 calculation - Calculate the recoverable amount of residual input tax that relates in part to making specified supplies by using the following fraction:

Total value of specified supplies

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

Total value of all supplies

Step 3 – the regulation 101 calculation – Calculate the recoverable amount of residual input tax that relates in part to making taxable supplies by using the following fraction:

Total value of taxable supplies

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

Total value of all supplies except specified supplies

This method is that argued for by the Appellant in this appeal. This was not accepted by Customs in 2002 and discussions continued leading to other proposals by the Appellant.

Customs' 2006 proposals

Further discussions between the Appellant and Customs took place in 2006 and there was a meeting on 8 March 2006 attended by representatives of the Appellant and Customs. On 2 October 2006 Mr Bryant of Customs wrote to the Appellant saying that Customs wished to make interim payments pending the outcome of this appeal and suggested an outline basis of a calculation as:

"(a) Allocate wholly attributable input tax directly to taxable and exempt supplies and treat appropriately.

(b) Allocate residual input tax directly to the following sectors "Life and Pensions" and "Unit Trust Management Business" where it is wholly used in those sectors.

(c) Allocate remaining residual input tax to these two sectors according to the allocation of costs within Lincoln's internal cost accounting system used for its management and statutory accounts.

(d) Further allocate input tax within "Life and Pensions" to two sub-sectors: "Policies (ie Customer Facing Products such as pension plans, investment plans, endowment plans, etc)" and "Investments" (ie transactions undertaken by Lincoln in securities and property within the "Life and Pensions" sector) as specified at (e), (f) and (i) below.

(e) Treat outsourced costs of investment management and property management under "Investments" as related solely to supplies of securities and to supplies of interests in land respectively and carry out separate apportionments of input tax for securities and interests in land on an appropriate basis.

(f) Treat costs of policy administration, marketing, maintenance of products and claims settlement under "Policies" as related solely to supplies of policies (ie customer facing products) and carry out an appropriate apportionment of input tax based on customer facing supplies. These are now outsourced but a similar calculation needs to be applied to the past when they were in-house.

(g) Treat outsourced costs of unit trust management as directly related to "Unit Trust Business" and carry out an appropriate apportionment based on values of related supplies in that sector.

(h) Carry out an appropriate apportionment of input tax allocated to the "Unit Trust Management Business" sector under (b) and (c) above based on values.

(i) Further allocate remaining input tax allocated to "Life and Pensions" at (b) and (c) above (but not of the kind described at (e) and (f) above) between "Investments" and "Policies" on the basis of the respective total tax-exclusive costs of expenditure allocated to those two sub-sectors under (e) and (f) above whether or not those costs are subject to VAT. Then carry out suitable apportionments."

In this appeal Customs put forward the view that this was an example of a more appropriate method than the method suggested by the Appellant which was based on values.

The arguments

For the Appellant Mr Cordara accepted that regulation 103 required the attribution of supplies in respect of which input tax was claimed to different types of supply made on the basis of actual use but argued that that was not possible in this appeal. He went on to argue that the Appellant should be able to calculate the input tax attributable to specified supplies by reference to values as that was a fair proxy for use within the meaning of regulation 103. Because the Appellant had to use the standard method for attributing input tax between taxable and exempt supplies under regulation 101 the values of (exempt) securities was used in that calculation to the detriment of the Appellant; it followed that values should also be capable of use in the regulation 103 calculation. He argued that Customs' 2006 method did not recognise that the Appellant had a unitary business model and that the insurance element and the investment element of each insurance policy were inextricably linked. Mr Cordara relied upon Articles 17 and 19 of the Sixth Directive (77/388/EEC) and relied upon National Provident Institution v The Commissioners of Customs and Excise (2004) Tribunal Decision 18944 at [94] and [95].

For Customs Dr Hutton argued that a values based method was not a good proxy for use in this case as the use of the values of securities produced a distortive effect because it implied that a substantial proportion of supplies to the Appellant were used in making supplies of securities when in fact a relatively small proportion of the supplies to the Appellant were used for this purpose. Customs had suggested a method of sectorisation based on customer-facing activities the costs of which were directly related to the sale of the policy. In this appeal the sale of a policy and the sale of securities might be linked in the sense that one would not have happened without the other but they remained distinct transactions. When a customer purchased a policy he received a supply of insurance and investment services. There was no sufficient link between the sale of a policy and some future disposal of the securities purchased with the premium moneys. Dr Hutton went on to argue that the use of values did not create distortion in the standard method calculation because there was such a large amount of exempt supplies and such a small amount of taxable inputs that the result would always be a rounding up to 1% of recoverable input tax. The potential distortion in regulation 103 was much greater.

Reasons for decision

In considering the arguments of the parties we first consider the framework of the legislation. We then consider the judgment of the House of Lords in Customs and Excise Commissioners v Liverpool Institute for Performing Arts [2001] STC 891 as that is the authority of most direct relevance to our decision. That leads us on to a consideration of the nature of our jurisdiction in this appeal. We then consider the methods proposed by the parties, beginning with the Appellant's 2002 proposals and then Customs' 2006 proposals. In the context of the latter we consider the authorities cited to us which are relevant to the Appellant's argument that sectorisation is not appropriate because of the Appellant's unitary business model. We then reach our conclusions on the issue in the appeal.

The framework of the legislation

In considering the framework of the legislation we start with the Sixth Directive. Since the date of the disputed decision the Sixth Directive has been replaced by the Council Directive of 28 November 2006 on the common system of value added tax (2006/112/EEC) (the 2006 Directive). However, we continue to refer to the Sixth Directive as that was in force at the date of the disputed decision.

The Sixth Directive

Article 17 of the Sixth Directive describes the origin and scope of the right to deduct input tax. Article 17.2 states the general rule and provides that, in so far as goods or services are used for the purposes of his taxable transactions, the taxable person is entitled to deduct, from the tax which he is liable to pay, tax due or paid in respect of goods or services supplied to him by another taxable person. Thus the concept of use is brought in at a very early stage and applies to all claims for input tax. Article 17.3(c) goes on to provide that there is also a right to deduct input tax in so far as goods or services are used for the purposes of any exempt transactions relating to finance when the customer is established outside the Community. This is the authority for the right to deduct input tax relating to specified supplies.

The first sub-paragraph of Article 17.5 provides that where goods or services are used by a taxable person, both for transactions mentioned in Articles 17.2 (taxable supplies) and Article 17.3 (specified supplies) and for transactions in respect of which input tax is not deductible (exempt supplies), only such proportion of the tax shall be deductible as is attributable to the former transactions (taxable and specified supplies); the proportion is to be determined in accordance with Article 19. Thus the first sub-paragraph of Article 17.5 treats taxable supplies and specified supplies in the same way because Article 17(3)(c) provides that the same right to deduct input tax applies to specified supplies as it does to taxable supplies.

Article 19 of the Sixth Directive contains the provisions for the calculation of the deductible proportion under the first sub-paragraph of Article 17.5 (that is where goods or services are used to make taxable, specified and exempt supplies). Article 19.1 provides that the deductible proportion shall be made up of a fraction having as its numerator the total amount of turnover each year attributable to transactions in respect of which tax is deductible under Article 17.2 and 17.3 (taxable and specified supplies) and having as its denominator the total amount of turnover each year attributable to transactions included in the numerator and to transactions in respect of which tax is not deductible (taxable, specified and exempt supplies).

Thus Article 19 establishes that where goods or services are used to make taxable and exempt supplies, or taxable, specified and exempt supplies, the normal method of attribution is by way of a fraction of which the numerator is the value of taxable supplies (and specified supplies if applicable) and the denominator is the value of all supplies (taxable and exempt and specified if applicable). As the concept of use has already been established in Article 17.2, the Directive thus indicates that, in the words sometimes used in this context, values can be a good proxy for use both for the normal purposes of partial exemption (attributing input tax between taxable and exempt supplies) and for the purposes of attributing input tax between taxable, exempt and specified supplies.

However, Article 17.5 continues by providing that member states may, among other things, "(c) authorise or compel the taxable person to make the deduction on the basis of the use of all or part of the goods or services". Thus the later part of Article 17.5 permits member states to depart from the values-based fraction mentioned in Article 19 and to compel a taxable person to make the deduction on another basis including that mentioned in Article 17.5(c), namely on the basis of the use of all or part of the goods or services. This is the authority for the power to direct a special method, found in regulation 102.

The 1994 Act and the regulations

Turning now to the national legislation we begin with section 24 of the 1994 Act. That section defines input tax as tax on the supply to a taxable person of goods or services used for the purposes of his business. So again the concept of use is introduced at a very early stage. Section 26 provides that a taxable person is entitled to credit for so much of his input tax as is attributable to taxable and specified supplies and that Customs and Excise shall make regulations for securing a fair and reasonable attribution of input tax to these supplies. So the over-riding principle underlying the regulations is that the taxable person is entitled to credit and that there should be a fair and reasonable attribution to taxable and specified supplies.

Regulation 101 applies only to attribution between taxable and exempt supplies and enacts the standard method set out in Article 19, namely the values-based method. However, in cases where a values-based method does not give a good proxy for use, regulation 102 enacts the later provisions of Article 17.5 and provides that Customs and Excise can agree or direct a special method to attribute input tax between taxable and exempt supplies on the basis of use.

Regulation 103 deals both with foreign and specified supplies and only the latter is relevant in this appeal. (Foreign supplies are those supplies outside the United Kingdom which would be taxable supplies if made in the United Kingdom and supplies of securities in the United Kingdom are exempt.) The regulation provides that where input tax is incurred on goods or services used in part to make specified supplies the input tax is recoverable to the extent that the goods or services are used to make specified supplies expressed as a proportion of the whole use. The whole use must be of those goods or services, that is the goods and services used in part to make specified supplies. Thus regulation 103 requires a comparison of the use to which inputs were put as between specified outputs and total outputs Thus whereas the calculation of the fraction for residual input tax in regulation 101 is based on the value of the supplies made, the calculation of the fraction in regulation 103 is based on the use of supplies received.

There is no equivalent of regulation 102 for specified supplies. Thus the legislation does not appear to give Customs power to compel a taxable person to make the calculation of the recoverable proportion of input tax attributable to the making of taxable supplies in a particular way.

Liverpool Institute for Performing Arts

The most relevant authority in this appeal is the judgment of the House of Lords in Liverpool Institute for Performing Arts. The facts in that appeal were slightly different from the facts in this appeal as there the appellant made taxable and exempt supplies but did not make specified supplies although it did make supplies outside the United Kingdom which would be taxable supplies if made in the United Kingdom (foreign supplies). Thus it made supplies under section 26(2)(b) and regulation 103(1)(a) whereas the supplies at issue in this appeal are specified supplies under section 26(2)(c) and regulation 103(1)(b). However, in our view that difference does not affect the applicability of the judgment to the facts of this appeal. The issue in Liverpool Institute for Performing Arts concerned the way in which input tax was to be attributed to the foreign supplies. The Tribunal and the High Court decided that what is now regulation 103 should first be applied to determine the proportion of residual input tax attributable to the foreign supplies and after that the value of the foreign supplies should be treated as taxable supplies and included in both the numerator and the denominator of the regulation 101 partial exemption calculation. That fraction was then applied to all the residual input tax after the deduction of the amount determined under regulation 103.

The Court of Appeal and the House of Lords, however, decided that regulation 103 was a separate regime for foreign (and specified) supplies. Article 17.5 and Article 19 of the Sixth Directive did not insist on a values-based approach to the apportionment of residual input tax but permitted member states to institute a regime under which the deduction was made on the basis of use. Also, a use-based apportionment could be prescribed in respect of the input tax on some goods or services leaving the input tax on other goods or services to be apportioned on the values-based method. Foreign supplies should not appear in the regulation 101 partial exemption calculation because they were to be dealt with separately under regulation 103. However, there was no discussion in the House of Lords of the meaning of use in regulation 103 nor did the House of Lords say that a values-based calculation could not be made under regulation 103.

From that authority we derive the principles that there have to be separate calculations under regulations 101 and 103 and that it is permissible to have a values-based apportionment under regulation 101 and a use-based apportionment under regulation 103. In the present appeal the Appellant accepted that there had to be separate calculations under regulation 101 and regulation 103 and the main area of dispute was how to undertake the use-based apportionment in the regulation 103 calculation.

The nature of our jurisdiction

Having identified the principles we should apply we turn to examine the nature of our jurisdiction in this appeal. Both parties accepted that we had jurisdiction but the jurisdiction of the Tribunal is statutory and the parties cannot confer on us a jurisdiction that we do not have.

We therefore start with section 83 of the 1994 Act which gives the right to appeal to the Tribunal. The relevant parts provide:

"83 … an appeal shall lie to the tribunal with respect to any of the following matters:- …

(c) the amount of any input tax which may be credited to a person …

(e) the proportion of input tax allowable under section 26."

It is generally accepted that these provisions give the Tribunal jurisdiction to decide on the way in which the standard method under regulation 101 is applied to a taxable person. In Banbury Visionplus Ltd v Revenue and Customs Commissioners [2006] EWHC 1024 (Ch) Etherton J considered the extent of the jurisdiction of the Tribunal when considering an appeal about the special method under regulation 102 and concluded at [52]:

"I can see no practical or jurisprudential difficulty in conferring on the tribunal a full appellate jurisdiction to determine, on the basis of all the facts and matters found by it at the time of its decision, whether a decision of the Commissioners under regulation 102 substitutes, in place of an existing method, a method which secures, or at least better secures, a fair and reasonable attribution of input tax to taxable supplies for the purposes of section 26(3) of the 1994 Act. That would be consistent with the unqualified wording of the appeal provisions in section 83(e) of the 1994 Act. It imposes an objective test which … is consistent with the provisions of articles 17 and 19 of the Sixth Directive, and which the tribunal, as a body with the requisite specialist expertise, is well qualified to conduct."

Of course, regulation 103 differs from regulation 102 because under regulation 103 Customs do not have power to direct the use of any method but, apart from that, the general statement about the jurisdiction of the Tribunal appears to be equally applicable to regulation 103. As was said by Briggs J in MBNA Europe Bank Ltd v Revenue and Customs Commissioners [2006] STC 2089 at [141] :

"As I have already stated, regulation 101 imposes a standard value based proxy for a use based apportionment, which may when applied to any particular business be a good, bad or indifferent (ie reasonable or unreasonable) basis for attribution of residual inputs. But regulation 103 does not impose a proxy at all. It merely requires the taxpayer to use any fair and reasonable way of attributing his residual inputs to specified out of country supplies that corresponds with his use of those inputs. He may choose any rationally fair method; there is no mandatory formula."

Thus whereas under regulation 102 it is for Customs to direct the use of a special method, under regulation 103 it is for the Appellant to choose any rationally fair method that corresponds with his use of the residual inputs.

Accordingly we conclude that our jurisdiction in this appeal is to decide whether the method chosen by the Appellant of attributing its residual inputs to specified supplies is a rationally fair method that corresponds with the use of those inputs. The method chosen by the Appellant is the method proposed in 2002 to which we now turn.

The Appellant's 2002 method

The method proposed by the Appellant in 2002 is :

Step 1 – Attribute to taxable supplies the whole of the input tax used exclusively in making taxable supplies and attribute to exempt supplies the whole of the input tax used in making exempt supplies.

Step 2 - the regulation 103 calculation - Calculate the recoverable amount of residual input tax that relates in part to making specified supplies by using the following fraction:

Total value of specified supplies

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Total value of all supplies

Step 3 – the regulation 101 calculation – Calculate the recoverable amount of residual input tax that relates in part to making taxable supplies by using the following fraction: