Vat and Single Farm Payment Entitlements
The Court of Session in Scotland has delivered a judgement which has far-reaching consequences for a range of taxpayers including farmers, the not-for-profit sector and any VAT-registered organisation which has outside the scope income streams. The case was originally handled by Croner Taxwise Ltd prior to its referral to the higher courts, whereby counsel was engaged.
In HMRC v Frank Smart & Son Limited  CSIH 77 the Court rejected an appeal by HMRC. The case concerned the rights of a farming company to reclaim VAT on the purchase of Single Farm Payment Entitlements (SFPEs). HMRC argued that the VAT incurred on the purchase of SFPEs had a direct and immediate link to the subsidies which the taxpayer earned as a result. As those subsidies are outside the scope of VAT, HMRC believed that VAT on the purchases was irrecoverable as it did not directly relate to any VATable sales activity.
The Court rejected HMRC’s arguments, relying on a line of cases decided by the European Court of Justice. Whilst all parties agreed that subsidies were outside the scope, the key test was how the income from those subsidies was to be used. In Frank Smart’s case, the income was invested in his taxable farming activities including construction of new cattle sheds and the erection of wind turbines to generate electricity for the national grid. The costs should therefore correctly be treated as a general overhead of the business.
Whilst the facts of the case are relatively unusual, the outcome is good news for taxpayers generally. In respect of farming, HMRC’s defeat is important, because they had argued that any farmer buying SFPEs would not be entitled to reclaim the VAT incurred on its purchase; given that the trade in SFPEs has been a regular feature of farming economics, if HMRC’s argument had succeeded, a very large number of farms could have faced assessments from the VAT Office.
Secondly, the case undermines HMRC’s current attack on businesses which are profiting from the Renewable Heat Incentive (RHI). Under this government initiative, businesses were encouraged to install devices such as biomass boilers and heat pumps with the promise of subsidy as renewable energy was produced. HMRC have again argued that the capital expenditure on the energy equipment has a direct and immediate link to the receipt of subsidy, but the judgement in Frank Smart demonstrates that a wider view must be taken. If the subsidies are invested in ongoing taxable activities, then no input tax restriction should apply.
There is a connection between this judgement and the ongoing litigation in HMRC v Masters & Scholars of the University of Cambridge  UKUT 305, in which HMRC’s appeal is due to be heard by the Court of Appeal this month. The University incurred VAT on professional fees relating to the management of an investment fund. HMRC have argued that input tax could not be deducted on those fees, because the fund generated income which is outside the scope of VAT (similar to the subsidies in Frank Smart’s case). So far, the Courts have adopted the same ‘look through’ approach – the taxpayer is entitled to look through an outside the scope investment activity and recover VAT according to the actual business undertaken downstream using the funds generated.
Finally, there are potential benefits from the judgement in Frank Smart to the not-for-profit sector. The traditional view has been that no VAT can be claimed on costs which generate non-business income, but that may now be over-restrictive. It is always worth looking beyond the cost itself, and to understand how the income generated is used, before reaching a conclusion on input VAT recovery.