Commissioners for Her Majesty’s Revenue and Customs v Frank A Smart & Son Ltd

A taxable person may deduct input VAT incurred in a fund-raising transaction outside the scope of VAT where objective evidence shows a direct and immediate link with its taxable economic activity. The link may arise because the expenditure is a cost component of particular taxable outputs or forms part of the business’s general overheads.

The right arises immediately, although the funds may be deployed later. It continues only so far as the funds are used for taxable economic activities. Exempt or non-economic downstream use may require apportionment or repayment. The taxable person must substantiate its purpose and subsequent use of the funds with objective evidence and adequate records.

Frank A Smart & Son Ltd carried on a wholly taxable farming business. It bought entitlements to Single Farm Payments, paid VAT on those purchases and used the resulting subsidies to repay borrowing and accumulate funds for proposed farming and windfarm developments. HMRC refused deductions totalling £1,054,852.28.

The First-tier Tribunal found that the purchases formed an integrated funding exercise for the company’s existing and proposed economic activities. The Upper Tribunal dismissed HMRC’s appeal. The Inner House of the Court of Session also dismissed its appeal in [2017] CSIH 77.

The central issue before the Supreme Court was whether receipt of subsidies outside the scope of VAT prevented deduction under articles 167 and 168 of the Council Directive 2006/112/EC, notwithstanding the intended use of the funds in taxable business activities.

1. The appeal was dismissed unanimously. Lord Hodge, with whom Lord Reed, Lord Wilson, Lord Briggs and Lady Arden agreed, held that the company was entitled to deduct the VAT incurred in purchasing the subsidy entitlements.

2. The deduction system relieves a taxable person of VAT incurred in its economic activities. Deductibility ordinarily requires a direct and immediate link between an input and taxable output transactions. Such a link also exists where the input cost forms part of the general overheads of the taxable economic activity and is therefore a component of the price of its products.

3. An initial fund-raising transaction outside the scope of VAT does not itself sever the link with taxable downstream activities. The relevant question is whether, viewed objectively, the expenditure is attributable to the taxable person’s economic activity. BLP Group plc v Customs and Excise Comrs (Case C-4/94) did not establish a contrary rule for fund-raising transactions outside the VAT system. The later CJEU authorities permitted the court to look beyond the initial transaction to the activities for which the funds were raised.

4. The First-tier Tribunal was entitled to find that the purchases were an integrated funding exercise supporting the company’s current and planned farming and windfarm activities. The annual subsidy receipts did not constitute an intervening transaction which broke the link between the purchases and the later taxable activities. The company was acting as a taxable person when it acquired the entitlements.

5. Under articles 167 and 168 of the Council Directive 2006/112/EC, the right to deduct arose immediately. A delay before the proposed developments came to fruition did not defeat that right. As the company neither carried on nor proposed exempt or non-economic downstream activities, no apportionment under article 173 was required.

6. The continuing entitlement depended on using the subsidy funds as cost components of economic activities. Objective evidence must support the connection between the fund-raising and the proposed activities. Adequate banking arrangements and records must also demonstrate later use. Non-business use could require repayment or be treated as a supply under regulation 3 of the Value Added Tax (Supply of Services) Order 1993.

1. United Kingdom Supreme Court: Dismissed HMRC’s appeal unanimously and affirmed the Inner House’s decision: [2019] UKSC 39.
2. Inner House of the Court of Session: An Extra Division dismissed HMRC’s appeal: [2017] CSIH 77.
3. Upper Tribunal: Lord Tyre upheld the First-tier Tribunal’s findings and dismissed HMRC’s appeal.
4. First-tier Tribunal: Allowed the taxpayer’s appeal, finding that the acquisition of the payment entitlements was an integrated funding exercise connected with its future taxable supplies.