UK: VAT Cost Sharing Exemption

Last Updated: 27 July 2012
Article by Christopher Connors

UK businesses and organisations making and receiving supplies will, most likely, be subject to VAT. Often, such VAT costs will be no more than a cash-flow issue for businesses, as most will be able to recover any VAT their incur through making VATable supplies themselves, thus passing the VAT cost onwards.

However, certain types of businesses and organisations have more onerous VAT positions, not least charities, which will ordinarily not be able to recover VAT in the same way as a 'standard' business. European VAT legislation sometimes contains VAT concessions for these types of organisations.

One such concession is the VAT Cost Sharing Exemption ("CSE"). This exemption was introduced through a European directive some time ago, but is only now (as at July 2012) being integrated into UK law.

Where charities make use of certain services (such as payroll, human resources or bookkeeping, for example), there could be cost savings if services were pooled and supplied to a number of charities – doing so would theoretically reduce administration and overall costs for each charity through economies of scale.

However, without the CSE, the supply of these services to charities would be VATable supplies, with each recipient charity being unable to recover the VAT. The principle behind the CSE is that this VAT charge would be removed, enabling the services supplied to be exempt from VAT. It is important to note that the CSE applies only to services and to the extent that any goods are supplied to the charities, there will be no exemption from VAT. The CSE also only applies to services which are supplied to the charities, and any supplies made by the charities will not fall under the exemption. It is worth noting that, apart from 'traditional charities', the CSE also applies to VAT exempt businesses, and the application of the CSE therefore covers such participants as universities and educational establishments, housing associations and even businesses such as banks and insurance companies.

In line with European legislation, HM Revenue & Customs have identified that there are five basic conditions which must be met for the CSE to apply:-

An 'independent group' must supply services to persons who are members of it

By way of example, two completely separate charities, which are independent from each other and with no inter-connection, should satisfy the "independent group" requirement – the charities also fall into the definition of 'person' for the purposes of the CSE.

A separate legal entity (which must be capable of being separately registered for VAT) should be set up to provide the services to the group, and all charities receiving the supplies should be 'members' of this separate entity (e.g. shareholders in a company, or partners in a partnership). HM Revenue & Customs have confirmed that a wide ranging number of entities can be used to provide the services, such as:

  • Corporate entities, including a UK limited company and an English Limited Liability Partnership;
  • Partnerships (other than LLPs);
  • Joint ventures;
  • Unincorporated associations; or
  • European Economic Interest Groups

There is no requirement for the members to hold a share in the supplying entity in proportion to the value of the services they receive, nor is there a prohibition on one charity being a 'controlling' member of the supplying entity (by means of having a larger shareholding in the supplying entity than other charities, for example).

The members have to make exempt or non-business supplies

To become a member of the supplying entity, there is a minimum requirement that the recipient charity makes at least 5% VAT exempt and/or non-business supplies – this requirement is based on an historic 12 month period. If this historic requirement is not satisfied, the charity may still be eligible if it intends to make a 5% supply of the same sort within the 12 months from the date it becomes a member.

This 5% test should not be an issue for charities.

The services supplied to the members must be 'directly necessary' for the exercise of the members' exempt or non-business activities

To the extent that the supplying entity provides services to a member charity, and the services are not related to the charity's exempt/non-business activities, the CSE will not apply and VAT will be chargeable to the charity in the ordinary manner.

There is, however, another proposed threshold which will make the CSE more flexible. To the extent that 85% or greater of the member charity's activities are exempt and/or non-business in nature, then the whole of the charity's activities will be treated as such – put simply, there is a 15% allowance built into the legislation. Again, the 85% test is applied either on a 12 month historical basis, or a 12 month prospective basis from the day that the charity becomes a member.

The services supplied must be at cost, i.e. an 'exact reimbursement'

At its most basic, this requirement means that there should be no profit margin or markup added by the supplying entity on the services it provides to its member charities. Furthermore, any discount which the supplying entity benefits from should also be passed on to the member charities.

However, strict application of this 'exact reimbursement' requirement could cause practical problems, and as such there are some points worth highlighting:

  • The overall level of charges by the supplying entity can be set so that they also cover general overheads incurred in supplying the services to the charitable member;
  • There may well be timing differences between expenses being incurred and being reimbursed under the arrangements. There is concession by HM Revenue & Customs on this point, which will accept evidence that the 'exact reimbursement' requirement has been complied with over a reasonable periodof time; and
  • At any one time, the supplying entity may operate with a cash surplus or deficit (as a natural consequence of the timing differences above). To this end, the supplying entity may be well advised to build up a cash reserve to protect against adverse contingent events, and HM Revenue & Customs has stated that doing so would not necessarily breach the 'exact reimbursement' requirement.

Use of the exemption must not cause (or be likely to cause) distortion of Competition

Although this has been identified as a separate requirement, in practice adhering to the 'exact reimbursement' requirement should, to a large extent, ensure that there is no distortion of competition.

HM Revenue & Customs have also highlighted relevant European case law which supports the position that "providing a service at cost and VAT free, which is also supplied by a business required to charge VAT, would not [in itself] necessarily lead to a distortion of competition."

Points to Note

  • The above is only a basic synopsis of the rules, which are complex.
  • The detailed rules are set out in HM Revenue & Customs guidance, which could be subject to change.
  • Whilst HM Revenue & Customs has identified a partnership as being a suitable vehicle for use as the supplying entity, the normal position for a partnership is that it carries on a business with a view to making a profit. Accordingly, if a partnership is to be used as the supplying entity, then it will need to supply some small amount of services (with VAT) to persons who are not members (which is possible due to the fact that there is no prohibition on the entity supplying services to non-members, although the CSE exemption will not apply in respect of the supplies to nonmembers).
  • Current commentary on the CSE suggests that there are two models which may benefit most from the favourable VAT treatment
    • A larger charity which already has all required services (such as payroll an book-keeping) fully established within its structure, establishes a new company ("Newco") within its pre-existing VAT group. The charity would then supply services to Newco, and Newco would subsequently act as the supplying entity for other charities (which would become minority members of Newco so that the VAT group continues); or
    • A new entity (which could be a company, a partnership or any of the other permitted types of entity mentioned above) ("the Supplierco") is set up as the supplying entity but using its own independent resources, including staff. Using this model, no charities would have to supply staff to the Supplierco, but could benefit from the CSE by becoming members in Supplierco.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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