The Partial Exemption Special Method (PESM)

Organisations that make both taxable and exempt supplies are referred to as being “partly exempt” for VAT purposes which means that they can only reclaim a proportion of the VAT that they incur. The questions of ‘how much’ can be reclaimed and the method of calculating that recovery then become important.

The default position is that VAT law provides for a ‘standard method’ calculation that is based on turnover to be applied. However, this may not be suitable for organisations that have more complex arrangements. As such, a Partial Exemption Special Method (PESM) could be used whereby the recovery calculation is based on other proxies and may therefore be more appropriate for the unique circumstances of each individual organisation.

However, the operation of a PESM requires HMRC’s agreement which may not always be easy, or quick, to obtain. As an alternative, the Standard Method Override (SMO) is required to be considered, which can produce a fairer and more reasonable level of VAT recovery without the need to navigate through HMRC’s PESM application process.

Background to partial exemption

If an organisation makes, or intends to make, both taxable and exempt supplies, they are regarded as being partly exempt for VAT purposes.

If an organisation is partly exempt, it is likely that they will not be able to recover all of their input VAT, and a partial exemption method can be used to work out how much of this input VAT they are able to recover on their costs that relate to both taxable and exempt supplies. This input tax is known as residual (or unattributable) input VAT.

There are two types of partial exemption methods that an organisation can use:

• the standard method, which is specified in the law, and is suitable for organisations with more simple VAT arrangements
• a special method, which is devised by an organisation to reflect their unique circumstances.

The standard method

The standard method uses revenue as a proxy, and the calculation to determine the percentage of residual input VAT that can be recovered is:

• (Taxable supplies / Total supplies) x 100

This percentage can often, subject to conditions, be rounded up to the nearest whole number, and an organisation does not need any approval from HMRC to operate this method of residual input VAT recovery, unless they currently operate a special method.

A special method (PESM)

A PESM is any calculation, other than the standard method, that enables an organisation to calculate how much of their input VAT they can recover. A PESM is unique to each individual organisation, and it can be developed to deal with an organisation’s particular circumstances.

For example, a PESM can use different proxies to apportion the input VAT on costs including:

• using the number of taxable and exempt transactions
• by the number of staff who work relates to both taxable and exempt supplies
• the floor area in which both taxable and exempt supplies are made.

One practical example of a PESM can be demonstrated through the supplies provided by a casino. The provision of gaming supplies are exempt from VAT, so the VAT on the cost of any equipment that is needed to provide these supplies is irrecoverable, as these costs relate directly to the casino’s exempt income. However, a casino may also provide taxable hospitality services, such as through a restaurant or bar, and therefore any input VAT that relates directly to the provision of these taxable supplies can be recovered in full. Meanwhile, the residual input VAT on any overhead costs paid by the casino, such as VAT on the lease of their premises, will be eligible for partial recovery in accordance with a partial exemption method calculation. Is it fair and reasonable to base the level of recovery on the level of income generated from the gaming and hospitality services? Or would it be more appropriate to base this recovery on an alternative proxy such as the floor space given over to the different activities?

Whatever the answer, the burden is on the taxpayer to demonstrate that the standard method does not produce a fair and reasonable outcome and that its proposed special method does do so.

Organisations should be aware that a PESM can only be used or updated through written approval from HMRC, and we have recently seen increasingly long delays in HMRC’s processing times of PESM approvals. Furthermore, HMRC typically require a large volume of information for an organisation to prove that a PESM will produce a fairer and more reasonable rate of input VAT recovery.

The Standard Method Override (SMO)

The SMO deals with circumstances where the standard partial exemption method itself does not produce a fair and reasonable deduction of input tax, and the benefits of this may be achieved much quicker when compared to the use of a PESM, as an organisation does not need to have any approval from HMRC for its use.

By law, the SMO must be considered each year when the input VAT recovered in that VAT year using the standard method differs ‘substantially’ to the recoverable input VAT when using a use-based method. A use-based method of input VAT recovery is when input VAT is attributed according to the use or intended use of costs in making taxable supplies. This requires an organisation to examine its main categories of expenditure, and to determine the extent to which they relate to its taxable supplies.

It is also noted that in order for the difference between the input VAT recovered in a year using the standard method and the recoverable input VAT using a use-based method to be ‘substantial’, it will need to exceed either:

• £50,000
• 50% of the residual input tax incurred and £25,000.

The SMO calculation is not agreed with HMRC in advance; it should just be applied at the relevant time, the calculation documented and the outcome processed via a VAT return. This means that it does not provide the same level of certainty as a PESM (given a PESM is agreed in writing with HMRC) but what the SMO provides is an opportunity for organisations to determine if using the SMO does in fact produce a fairer and more reasonable apportionment of input VAT and to make an adjustment to recovery without having to agree the position with HMRC in advance. However, as adjustments are not disclosed to HMRC in any way, they will only be identified by HMRC if an inspection is carried out. As such, it is now common for HMRC to request for business’ SMO calculations in order to determine if using the SMO does in fact produce a fairer and more reasonable apportionment of input VAT. Nevertheless, given some PESM negotiations take years to resolve, the SMO could be a valuable alternative option.

Summary

In summary, a PESM may prove to be a good alternative to the standard partial exemption method in terms of input VAT recovery if it can be shown to HMRC that the standard method does not produce a fair and reasonable rate of recovery. However, as discussed above, applying for a PESM may not always be the most time-efficient alternative when the standard partial exemption method no longer provides a fair and reasonable input VAT recovery rate.

As such, the SMO (which is required by law to be considered), may be used to obtain a fairer and more reasonable rate of input VAT recovery if this produces a result whereby the input VAT recovered in a year using the standard method differs ‘substantially’ to the recoverable input VAT when using a use-based method.

For more information on VAT partial exemption matters and the use of PESMs or the SMO, please speak to Robert Marchant, or your usual Crowe contact.