VAT for partially exempt businesses, such as those in the finance, insurance, health and welfare and land sectors, does not come without its complexities. One of these is the distinction between overhead costs and residual costs when it comes to deduction of VAT. In this article, we share the details of the Royal Opera House Covent Garden Foundation case, which provides welcomed guidance on this issue and helps those grappling with the thorny question of deduction of VAT on costs, to understand the tests to apply when considering entitlement to VAT deduction.

The effect of the decision is to reduce the amount of VAT that ROH can deduct; but the case has wider implications for other cultural organizations that have exempt admission income, and all partly exempt businesses grappling with the thorny question of deduction of VAT on costs.

In the past, HMRC took the view that VAT incurred on theatrical production costs was directly attributable to ticket sales only, and where these were exempt there was no entitlement to VAT deduction. This policy changed following challenges by Mayflower Theatre and Garsington Opera, and HMRC issued a Business Brief 62/09, confirming that such costs were partly recoverable, where they were partly attributable to production-related taxable supplies, such as sales of programmers and touring income.

As many theatres use the ‘standard’ income-based partial exemption method to determine the extent of VAT recovery, HMRC advised that where this results in an over-recovery of input tax, which is classed as ‘substantial’, then the recovery must be re-calculated in accordance with the ‘actual use’ of the costs in question. In such cases, HMRC advised that a ‘sectorised’ turnover calculation for production costs must be used, which excludes bar and catering income. 

Royal Opera House Covent Garden Foundation’s claim

Following recent case law, in particular the decisions in North Of England Zoological Society (aka Chester Zoo), Sveda and Associated Newspapers, ROH concluded that the test for input tax deduction set out in Mayflower and Garsington had been superseded, and submitted a retrospective claim for under-recovered VAT. This was on the basis that catering and bar income should be included in the partial exemption calculation because the correct test was to consider the business activities of the organization as a whole, and the economic use of the costs. 

ROH argued that the staging of its operas increased the sale of bar and catering income by attracting customers, and this income in turn ultimately funded part of the cost of productions. ROH were effectively arguing that the production costs were incurred to attract customers to both types of supply – the exempt ticket sales and the taxable bar/catering services, which together formed “a fully integrated visitor experience”. ROH’s argument was therefore that there was a direct and immediate link between production costs and bar and catering income, and thus this income could be used in calculations to determine the percentage of VAT recovery. This was accepted by the First Tier Tribunal (FTT), but HMRC then appealed to the Upper Tribunal (UT).

The Upper Tribunal decision

The UT carried out a detailed review of the case law and considered whether there had been any change to the test in determining whether costs had a direct and immediate link to a supply. It concluded that there are two alternative bases for establishing a link to taxable supplies:

1. Where the costs concerned are general costs, i.e. overheads, there is a right to VAT recovery on the basis of a direct and immediate link with a taxpayer’s economic activity as a whole.  
2. Where the costs concerned are attributable to a particular supply or supplies, i.e. residual costs, then the expenses must form part of the cost components of specific taxable transactions, which utilise those goods or services. 

It had been agreed between ROH and HMRC that the production costs were ‘residual’ and not overheads.

The UT concluded that the production costs only had a direct and immediate link with the exempt supply of tickets (and other production-related taxable supplies), not the catering and bar income. In fact ROH made two supplies, one of exempt ticket sales and one of taxable catering, which were parallel and not part of the same chain of supplies. The production costs were not cost components of the catering supplies. 

As the First Tier Tribunal had found, there was an indirect link to the catering and bar supplies, in that without the operas those supplies would not be made; but the UT stated that this is an indirect link, and was not sufficient to enable increased recovery of VAT incurred on the production costs. Therefore, the FTT’s decision was overturned.

What does this mean?

Despite the negative outcome, the case does not mean that VAT on production costs (or for example exhibition costs in museums and galleries where admission is exempt) is non-deductible. Most exempt theatres are able to deduct a proportion of VAT on production costs as HMRC accept there are taxable supplies that are directly linked, such as programmer sales, as mentioned above. 

In addition, there are some organizations where the level of input tax incurred on productions/exhibitions does not trigger the ‘substantial’ test; these entities will not be affected by this decision. Generally, the difference in input tax between the standard method and another method needs to be more than £50,000 before HMRC can trigger these provisions. 

Otherwise, this case demonstrates that recovery of residual VAT cannot be increased in a pro-rata income method simply by including taxable income, where there is no evidence of a link between that income and the costs. 

What should you do?

Any partly exempt business which is unsure about the deduction of VAT on costs may want to read the ROH judgement (Royal Opera House Covent Garden Foundation (ROH) [2020] UKUT 132 (TCC)) as it contains a detailed review of legislation and case law, and clearly sets out the reasons for the decision and the tests applied. It is particularly useful for reiterating the distinction between overhead costs and residual costs, a distinction also made in the HMRC Business Brief referred to above.

Given that ROH were essentially making the argument that the link from production costs to catering supplies is an economic one, it is surprising perhaps that in the First Tier Tribunal there was little or no reference to figures, accounts or records that demonstrated that economic link, as had been provided to the Tribunal in Chester Zoo. The Upper Tribunal can only deal with appeals on matters of law, not fact, so the UT could not consider this aspect. 

At the time of writing, it is unclear whether ROH will appeal. However, as the UT commented, these cases are decided largely on matters of fact, and we are aware that there are other theatres with similar claims, and it is possible that there may be further litigation on this issue regardless of whether ROH appeals.

Get in touch

For more information on the above, or to speak directly with one of our experts about the deduction of VAT on costs, please contact our Business Consulting Partner (Mr. K Kwan) at tax.hk@landiskadwell.com for representative and we will be happy to help.