Understanding Outside the Scope of VAT

Navigating the intricacies of Value Added Tax (VAT) can be a complex affair for many businesses and organisations. While much of economic activity is subject to VAT, a significant portion of income falls 'outside the scope' (OSC) of the UK VAT system. Understanding what constitutes OSC income is vital, as it has distinct implications for an entity's VAT registration, input tax recovery, and overall financial reporting. This article aims to demystify OSC income, exploring its various forms and the impact it has on organisations, particularly charities and non-profit entities.

What Exactly is Outside the Scope of VAT?

Put simply, income which is outside the scope (OSC) of VAT is UK VAT-free. This status arises in two primary scenarios: firstly, where there has been no supply in respect of that income, often referred to as non-business (NB) activities. Secondly, OSC arises if a supply has been made, but its 'place of supply' (POS) is determined to be outside the UK. It is crucial to distinguish OSC from supplies that are exempt or zero-rated. While all are VAT-free, their treatment and implications for input tax recovery differ significantly.

Charities and Non-Profit Organisations

Charities and non-profit (NFP) organisations are frequent recipients of OSC income. A prime example is receiving donations, where the donor provides funds without receiving any tangible benefit in return. For VAT purposes, an organisation, even if non-profit-making, can still be considered to be carrying on a business activity. This is true even if the activity benefits the wider community. Therefore, it's imperative for charities to meticulously determine whether their transactions constitute business or non-business activities. This assessment is critical both when considering VAT registration (as only business activities can lead to registration and the recovery of input tax) and after registration.

The definition of 'business' for VAT purposes is broad. An activity can be deemed business even if the amount charged merely covers the cost of supply or is less than the cost. If no charge is made whatsoever, the activity is unlikely to be classified as business. A common area of complexity for charities is the receipt of grant funding, which we will explore further.

The Nuances of Grant Funding

There is no one-size-fits-all approach to the VAT treatment of grants. The correct VAT treatment hinges entirely on the specific terms and conditions of each grant agreement. The pivotal question is whether the grantor receives any form of consideration in return for the payment. If a grantor simply wishes to contribute to an organisation's valuable work, akin to a donation, the grant is likely to be OSC. Conversely, if the grant recipient is contractually obliged to provide a specific good or service in return for the funding, then this constitutes a supply that is not OSC, and may be subject to VAT.

A helpful perspective is to consider what the organisation does for the grant money, rather than simply what it does with it. This focus on the reciprocal nature of the transaction is key to determining its VAT status.

Inter-Company Charges and Management Fees

Transactions between companies that are members of the same VAT group are treated as outside the scope of VAT. Furthermore, charges between companies that are not part of a VAT group can also be OSC, particularly if they are structured as 'management charges'. The VAT treatment of these charges is fact-dependent.

Often, management charges are employed as a mechanism to transfer 'value' between associated companies. If such a charge is levied arbitrarily, without a formal written agreement, and no identifiable service or good is provided, the income is likely to be OSC. If, however, there is a clear supply of goods or services, it will generally be a taxable supply. It is important to remember that the method of calculating a management charge – whether it's a simple pro-rata allocation between subsidiaries or a complex formula outlined in a contract – has no bearing on its VAT treatment. The fundamental VAT principle remains: what is actually being supplied?

Place of Supply Outside the UK

When the 'place of supply' for a transaction is determined to be outside the UK, any payment received for that supply is considered OSC. The rules governing the place of supply can be exceptionally complex, requiring careful consideration to identify the correct jurisdiction for declaring output tax. In some instances, the 'Reverse Charge' mechanism may apply. A significant benefit of supplies where the POS is outside the UK is that any input tax incurred on costs directly related to these supplies is generally recoverable, subject to the normal VAT rules. This distinguishes this type of OSC from others where input tax recovery might be restricted.

Transfer of a Going Concern (TOGC)

A Transfer of a Going Concern (TOGC) is a special provision in VAT law. For VAT purposes, a TOGC is treated as neither a supply of goods nor a supply of services; consequently, it is OSC. Any input tax incurred on costs associated with making a TOGC is typically viewed as an overhead of the business for partial exemption calculations. It is not automatically disallowed simply because it relates to a 'non-supply'.

Supplies by Non-Taxable Persons

Sales made by a business person who is not liable to be VAT registered are also outside the scope of VAT. This typically applies to individuals or small businesses whose turnover falls below the VAT registration threshold.

Insurance and Indemnity Payments

Payments made between parties under a contract of indemnity, such as sums paid under an insurance policy, are considered OSC. This is because these payments do not represent consideration for a supply of goods or services; rather, they are intended to compensate for a loss.

Private Transactions and Gifts

Transactions conducted purely privately between individuals, or gifts received by an organisation, are outside the scope of VAT. These are not business activities and therefore do not attract VAT charges.

Statutory Fees

Certain statutory fees are also classified as OSC. Examples include the London congestion charge, MOT testing fees, some road tolls, and parking fines. These are payments for regulatory or administrative services that are not considered business supplies in the VAT sense.

The Critical Issue of Input Tax Recovery

A crucial aspect of OSC income is its impact on input tax recovery. VAT incurred on costs that are directly attributable to OSC activities cannot be recovered as input tax. There are no de minimis limits applicable here; the principle is that if a cost relates solely to non-business (OSC) activity, the VAT on that cost is irrecoverable. This process is distinct from partial exemption calculations and requires a two-tier approach: first, determining the business versus non-business split, and then applying partial exemption rules where applicable.

HMRC has provided guidance on the reclaimable amount of input tax when an element of expenditure is attributable to NB activities. For entities engaged in both business and NB activities (e.g., a charity running a shop and also providing free advice), the inability to recover VAT attributable to NB activities means that not all incurred VAT can be reclaimed. It is therefore essential to accurately calculate the proportion of VAT attributable to business and NB activities.

Overhead VAT, which cannot be directly attributed to either business or NB activities, must be apportioned between them. VAT legislation does not prescribe a single method for this apportionment. Organisations can consider various fair and reasonable methods, such as allocation based on income, expenditure, time spent, floor space occupied, or the number of transactions. These methods are similar to those employed in partial exemption calculations, and the chosen method must be justifiable and applied consistently.

Overall Impact and Key Considerations

Income classified as OSC should not be included in the 'value' boxes on VAT returns, nor does it contribute towards the VAT registration threshold. Crucially, OSC activities can often negatively affect an entity's ability to recover input tax on its overheads and other expenses. The distinction between business and non-business activities is therefore paramount. A clear understanding and correct application of these principles will significantly influence an entity's overall VAT position, affecting cash flow and profitability.

Frequently Asked Questions

Q1: Is all income received by a charity considered outside the scope of VAT?
No. While donations are typically OSC, other income streams, such as from trading activities (e.g., a charity shop), may be subject to VAT if they constitute business activities.

Q2: Can I recover VAT on expenses incurred for my business if I also have OSC activities?
Yes, you can recover VAT on expenses directly related to your taxable business activities. However, VAT incurred on expenses directly related to OSC activities is not recoverable. For shared overheads, apportionment is necessary.

Q3: What is the difference between OSC and exempt supplies?
OSC means the transaction is not within the scope of UK VAT at all. Exempt supplies are within the scope of UK VAT, but no VAT is charged on them, and input tax related to exempt supplies generally cannot be recovered.

Q4: How do I determine the place of supply for international services?
The place of supply rules are complex and depend on the nature of the service and the status of the customer (business or consumer). Professional advice is often recommended for international transactions.

Q5: Does income from a TOGC affect my VAT registration threshold?
No, as a TOGC is outside the scope of VAT, it does not count towards the VAT registration threshold.

Further Reading

For a deeper understanding of specific case law and related business/non-business issues, consider exploring the following:

• Wakefield College
• Longbridge
• Babylon Farm
• A Shoot
• Y4 Express
• Lajvér Meliorációs Nonprofit Kft. and Lajvér Csapadékvízrendezési Nonprofit Kft
• Healthwatch Hampshire CIC
• Pertempts Limited
• Northumbria Healthcare