Lok’nStore Group Plc [2014] UKUT 288: Establishing Fair Apportionment through Partial Exemption Special Methods in VAT Accounting

Introduction

The case of Revenue And Customs v. Lok’nStore Group Plc ([2014] UKUT 288 (TCC)) addresses the methodology for apportioning residual input Value Added Tax (VAT) incurred by a taxable entity engaged in both taxable and exempt activities. Lok’nStore Group Plc ("Lok’nStore" or "LnS"), a company providing self-storage services and selling insurance to its customers, sought to adopt a Partial Exemption Special Method (PESM) to allocate residual VAT more accurately than the standard turnover-based method prescribed by the VAT Regulations. Her Majesty's Revenue & Customs ("HMRC") contested this approach, leading to an appellate process that culminated in a decision by the Upper Tribunal (Tax and Chancery Chamber) to dismiss HMRC's appeal, thereby upholding the Tribunal for Tax and Chancery ("FTT")'s endorsement of Lok’nStore's proposed PESM.

The central issues in this case revolve around the legality and fairness of the PESM proposed by Lok’nStore, specifically whether it provides a more equitable apportionment of residual input VAT compared to the standard method, and whether the FTT erred in law in supporting this method.

The parties involved are:

Appellant: The Commissioners for Her Majesty's Revenue & Customs
Respondent: Lok’nStore Group Plc

Summary of the Judgment

The Upper Tribunal (Tax and Chancery Chamber) examined HMRC's appeal against the FTT's decision to accept Lok’nStore's PESM for apportioning residual input VAT between its taxable supplies (self-storage services) and exempt supplies (insurance services). The Upper Tribunal scrutinized whether the FTT appropriately applied the law and whether the PESM indeed provided a fairer and more reasonable apportionment than the standard turnover-based method.

After a thorough analysis of the legal principles, relevant precedents, and the specific facts of Lok’nStore's business operations, the Upper Tribunal found that the FTT did not err in law in upholding the PESM. The tribunal concluded that Lok’nStore's method better reflected the actual economic use of overheads associated with constructing, maintaining, and operating its storage facilities, thereby providing a more accurate VAT apportionment. Consequently, HMRC's appeal was dismissed.

The judgment reinforces the acceptability of PESMs that more precisely mirror a company's economic realities, provided they are fair and reasonable under the VAT regulations.

Analysis

Precedents Cited

The judgment extensively references both European Court of Justice (ECJ) decisions and significant domestic cases to establish the legal framework for VAT apportionment. Key precedents include:

BLP Group Plc v Customs and Excise Commissioners ([1996] 1 WLR 174): Introduced the "direct and immediate link" (BLP) test for attributing input VAT.
Southern Primary Housing Association Ltd ([2004] STC 209): Highlighted the necessity of an objective link beyond mere commercial associations.
Dial-a-Phone Ltd ([2004] STC 987): Reinforced the factsensitive nature of input VAT attribution.
Mayflower Theatre Trust Ltd ([2007] STC 880): Distinguished between specific attribution and overheads, emphasizing economic reality.
London Clubs Management Ltd ([2012] STC 388): Provided detailed guidance on partial exemption and the fairness of PESMs.
Volkswagen Financial Services (UK) Ltd ([2013] STC 716): Clarified the distinction between attribution and apportionment stages in VAT recovery.

These cases collectively establish the principles that VAT apportionment must reflect the economic use of input costs and that methods deviating from the standard must be justifiable as fair and reasonable representations of such use.

Legal Reasoning

The court's legal reasoning centered on distinguishing between two critical stages in VAT apportionment:

Attribution: Determining whether input VAT is exclusively attributable to taxable or exempt supplies, or if it relates to overheads applicable to the business as a whole.
Apportionment: Allocating residual input VAT (linked to overheads) between taxable and exempt supplies based on an equitable method.

The FTT utilized the economic use test, assessing how the overheads related to the actual operations generating taxable incomes. Lok’nStore's PESM, which based VAT apportionment on the proportion of floor space dedicated to taxable supplies, was deemed more representative of the economic realities of the business compared to the standard turnover method.

The Upper Tribunal addressed HMRC's contention that the FTT erroneously applied the "direct and immediate link" test at the apportionment stage. It clarified that while the test is primarily for attribution, considerations of economic use naturally influence apportionment. The Tribunal found that the FTT appropriately focused on the real economic relationships between overheads and taxable activities, thereby justifying the acceptance of Lok’nStore's PESM.

Impact

This judgment has significant implications for VAT accounting, particularly for businesses engaged in both taxable and exempt activities. It:

Affirms Flexibility: Validates the use of PESMs tailored to reflect the economic use of inputs, offering an alternative to the rigid standard turnover-based method.
Sets a Precedent: Provides a clear example of how a PESM can be structured and justified, encouraging other businesses to develop bespoke methods that accurately represent their operations.
Guides Future Disputes: Serves as a reference point for tribunals and courts in assessing the fairness and reasonableness of proposed VAT apportionment methods.
Enhances Compliance: Encourages businesses to engage in detailed financial planning and documentation to support their chosen VAT apportionment methods.

Overall, the judgment underscores the judiciary's recognition of diverse business models and the necessity for VAT regulations to accommodate such variability through fair apportionment practices.

Complex Concepts Simplified

Residual Input VAT

Residual input VAT refers to the portion of VAT paid on expenses (inputs) that cannot be directly linked solely to either taxable or exempt outputs. For businesses offering both types of supplies, residual input VAT must be apportioned accordingly.

Partial Exemption Special Method (PESM)

A PESM is an alternative method approved by HMRC that allows a business to allocate residual input VAT in a manner that more accurately reflects the actual economic use of its inputs. Unlike the standard method, which is typically based on turnover ratios, a PESM can employ different metrics, such as floor space, to achieve a fairer apportionment.

Direct and Immediate Link (BLP) Test

Originating from the BLP Group Plc case, this test assesses whether a specific input (expense) has a direct and immediate connection to a particular output (supply). If such a link exists, the VAT on that input is fully deductible against the VAT on that output. This test is pivotal in determining the initial attribution of input VAT.

Attribution vs. Apportionment

Attribution: The process of assigning input VAT to either taxable or exempt supplies based on direct links or generalized business use.
Apportionment: The subsequent allocation of residual input VAT (linked to overheads) between taxable and exempt supplies using a fair and reasonable method.

Economic Use Test

This test evaluates how business inputs (costs) are economically utilized in generating taxable versus exempt outputs. It emphasizes the real-world application and economic reality over mere statutory criteria, ensuring that VAT apportionment reflects the true nature of business operations.

Conclusion

The Revenue And Customs v. Lok’nStore Group Plc judgment marks a pivotal moment in VAT accounting, highlighting the judiciary's willingness to recognize and uphold apportionment methods that align more closely with the economic realities of businesses. By endorsing Lok’nStore's PESM, the Upper Tribunal not only validated a more nuanced approach to VAT apportionment but also set a benchmark for fairness and accuracy in tax assessments. This decision encourages businesses to adopt tailored VAT practices that genuinely represent their operational dynamics, fostering a more equitable tax environment.

Moreover, the judgment serves as a guiding framework for future cases, emphasizing the importance of detailed economic analysis over rigid regulatory adherence when determining VAT allocations. This balance between regulatory compliance and economic fairness is essential for the adaptability and integrity of the VAT system.