A method produces a fair and reasonable attribution of input
tax to taxable supplies if it satisfies the principle of use. The
principle of use means that input tax is attributed in accordance
with the 'use or intended use' of input tax bearing costs in making
taxable supplies. The principle of use comes from European
legislation supported by a wide body of European and domestic case
law.
In simple terms, the principle of use means examining the
main categories of business expenditure and determining how they
relate to business supplies. In many ways this is no more than an
exercise in cost accounting.
The trick is to identify 'what drives the cost' and then to
use that 'cost driver' to attribute the input tax between the
taxable and exempt supplies. For example, a business that buys an
expensive computer system in order to handle its high volume of
transactions, may judge that a transaction count is a fair basis
for attribution whereas a sales value for the different
transactions may not be.
Most businesses, especially the largest and most complex,
focus carefully on costs and understand the importance of reliable
'cost drivers'. These businesses prepare management accounts to
manage costs, plan investments and forecast profits. A robust
system of management reporting that is logical, objective and
transparent is invariably an ideal basis for a fair and reasonable
method.
A fair and reasonable method should take account of risks or
potential events that might otherwise undermine its effectiveness.
For example, if a business occasionally acquires new businesses
then it could structure its method to deal with this possibility.
One easy way to do this is to include within the method a
'catch-all' sector which stipulates that input tax on the costs of
the newly acquired businesses is to be attributed in accordance
with the principle of use, but does not specify how that is to be
achieved. The actual basis for attribution can be determined after
the event without risk of under or over-recovery. Accordingly, the
relevant input tax will be dealt with in a similar manner to the
way input tax on foreign and specified supplies is attributed under
regulation 103.
Very large businesses typically include a 'use based' sector
to deal with board-level projects that cannot be disclosed in
advance. Then, if the project becomes a permanent feature, the
business can amend its method and there is no risk to input tax
recovery either way.
Few methods need to be complex and the vast majority of fair
and reasonable methods are straightforward and typically comprise a
single sector with a single basis of apportionment. Very large
businesses or those with diverse activities and rapidly changing
cost structures will need more complexity. As a rule of thumb, the
complexity of a fair and reasonable method will mirror that of the
cost accounting systems that are relied upon for decision-making
purposes.
Some businesses choose methods that hive-off some categories
of cost to boost recovery rates. However, a method will not be fair
unless it treats all categories of significant cost in a consistent
manner, so if 'high recovery' costs are hived-off then so too must
the 'low recovery' ones. This can quickly result in complexity
without materially affecting the tax result, but this remains a
decision for the business provided HMRC audit action is not
compromised.
Fair and reasonable does not mean that there is only one
acceptable method for a business, rather there are likely to be a
number of fair and reasonable methods that are equally acceptable.
They may give different tax results, although variances are
unlikely to be large. The business can choose between them and will
probably do so with regard to complexity and compliance cost, as
well as tax result.
If a business has doubts over whether its proposed method is
fair and reasonable, it should tell HMRC who can explain how the
principles work and highlight relevant guidance and Revenue and
Customs Brief articles.
