Exempt or Zero-Rated: What’s The Difference?

1. Introduction

As it’s the summer and as 2020 has been a stressful year so far (to say the least), this month’s Update is a intended to be a bit of a lighter read…

I have summarised the key differences between the two “get-outs” in section 2, before examining zero-rating in a bit more detail in section 3, and then exemption in section 4. I also look at some of the main sectors affected by each relief – though inevitably there are many more!

In section 5, I look at some of the things you need to look out for in the sunny uplands of zero-rating, and then in section 6, some of the issues arising from exemption, and partial exemption in particular.

In section 7, there is a bit of good news, especially for smaller taxpayers, in the form of the “de minimis” rules for partial exemption.

In section 8, I take a very quick look at some of the other points to be aware of, and then summarise the whole lot in section 9.

I should add that I am focusing on domestic VAT here, rather than the zero-rating which arises from international trade. That will be the subject of a future Update…!

2. What’s The Difference?

This section is short for a simple reason: the answer is actually pretty easy!

When a supply is exempt, that means that no output VAT is charged on the supply. So good news!

However, the downside of an exempt supply is that VAT cannot be recovered on the related inputs (at least in principle). We examine this in a bit more detail in section 4 below.

A zero-rated supply is the “El Dorado” of VAT – it’s a land of gold, but sometimes it can feel almost mythical…

The reason it is a land of gold is that, just like an exempt supply, you don’t charge output VAT.

However, unlike an exempt supply, input VAT can be recovered in full (again, at least in principle).

So we know the big difference, and we know which one we want – if we have the choice.

3. Which Businesses’ Supplies Are Zero-Rated?

In a Northern Irish context, one very obvious candidate is farming. Many of us will be familiar with the typical farmer’s view of VAT, which is that it is a handy way the Government cuts the costs of running his farm.

Of course, it is a bit more complicated than that!

Apart from farming, the other big industry which benefits from zero-rating is house-building. Most of the supplies to do with the construction and sale of new dwellings are subject to zero-rating. Nevertheless, the fact that sales of land are (usually) exempt and re-sales or lettings or residential property are also exempt, means that house-builders often end up with quite messy VAT affairs.

The rules, when you fit into them, are very beneficial. When you don’t, they can cause headaches.

In fact, builders can find themselves either in El Dorado, the Land of Gold, or “El Dorado”, the fairly naff Nineties soap opera…

Another major industry which sees a lot of zero-rating is anything to do with the supply of food. The rules here have been tidied up a bit in recent years, but there is still plenty to fall out about!

Some other businesses can benefit from zero-rating where they make supplies including:

• Sales of books, newspapers, etc, including, since 1 May 2020, e-books and other digital publications
• Sales of certain drugs, aids for the disabled, etc
• Certain supplies by and to charities (again including some building work)
• Public transport

There are others, but they tend to come up less frequently.

As you will have gathered from the comments above, zero-rating does come with a few problems – this is something I look at in a bit more detail in section 5 below.

If you are not sure if your own business or that of a client could qualify for zero-rating, please give me a call to discuss.

4. Which Businesses’ Supplies Are Exempt?

The biggest contender here is anything to do with land and property. Builders are obviously affected, depending on exactly what they do – for example, many domestic conversions can end up being caught by exemption.

Nevertheless, the most obvious and straightforward exemption is the one applying to supplies of land and property. Rental income is therefore usually exempt – unless the taxpayer has made an “Option to Tax” (“OTT”). The OTT, however, is a subject for another Update.

Businesses operating in the financial and insurance sector are generally exempt, although there are often nasty surprises lurking in the rules leading to 20% VAT being chargeable (or charged) on various supplied in the sector.

Exemption also applies to dentists, doctors and many other medical and related professionals. However, doctors and others who write medico-legal reports should be aware that the exemption won’t apply to that source of income – nor does it apply, in the view of HMRC and increasingly, of the courts as well, to cosmetic treatments such as Botox, etc.

Private tuition is also exempt, as long as the subject being taught is commonly taught in schools or universities. Anything a bit more exotic (e.g.: belly-dancing or kickboxing) is liable to be treated as VAT-able.

Educational institutions are also exempt, but as most of them are publicly-funded, this is rarely an issue directly.

Exemption often applies to the activities of non-profit entities, such as charities, schools and sports clubs, though the rules can be fiendishly messy.

There are several other exemptions, but they tend to come up more rarely in practice:

• Cultural services, such as museums, theatres, etc
• Trade union and professional society subscriptions
• Funeral directors
• Certain supplies in the gambling industry (though there are other taxes here, such as Machine Games Duty)

5. Is There Anything I Should Worry About With Zero-Rating?

On the face of things, zero-rating is, as I’ve said, a kind of El Dorado. However, just as the original El Dorado was something of a myth, so too is a world where VAT comes without any complicating factors.

The real issue with zero-rating is precisely the fact that it is so beneficial. Unsurprisingly, this means that HMRC don’t particularly like it.

Farmers are generally in the clear, but most of the other businesses discussed in section 3 above can expect to face difficulties of one kind or another. I’ve done a brief summary of the kinds of things to look out for below.

Classification of Supplies

This can be a minefield, and this issue has given rise to numerous cases at the Tribunal.

Briefly, the issue can be turned into a question “what is the taxpayer supplying?”. This question has wide application, and we are all familiar with the Jaffa Cake case and whether they amounted to biscuits or cakes… This case is symptomatic of the bizarre “VAT World” you can enter when HMRC are seeking more money and the taxpayer doesn’t agree with them.

Some examples of the kinds of thing that crop up include:

• Whether what was being sold was exempt land or a zero-rated site for a new dwelling;
• Whether goods sold to disabled people qualified for zero-rating, or if they were simply “normal” standard-rated goods which happened to be sold to disabled customers;
• Whether a “protein bar” was a flapjack or a chocolate bar;
• Whether takeaway food was sufficiently cold to be zero-rated

Most taxpayers know what they are selling (hopefully!) and most customers know what they are buying. The problem typically arises where the goods or services being provided could fall into a number of possible descriptions, one of which is beneficial to the taxpayer and one which is beneficial to HMRC.

To avoid hassle in the form of HMRC challenge, and even possible penalties and recovery of underpaid VAT, it is important that:

• you and your customer know what is being supplied,
• what is being supplied qualifies for the zero-rate, and
• HMRC would agree with your interpretation

Of course, sometimes it is definitely worth taking a view of the matter which differs from HMRC’s, but that should only be done with care and where the facts justify it.

If you have a query about a supply and whether it could or should be zero-rated, please get in touch.

Single or Multiple Supplies

It would be possible to write a book on this subject, though it is doubtful it would be a bestseller. Several cases, many of the most important taking place at the European level, have covered this ground, and the rules are anything but clear.

To avoid going down the rabbit-hole, I will summarise the basic issue, with a slightly silly example.

When VAT was first introduced, some fish-and-chip shops decided to avoid VAT by charging the price of a fish supper for salt and vinegar, and offering the fish supper for free.

Salt and vinegar are zero-rated, while a fish supper is subject to the standard rate of VAT. In essence, the businesses were splitting the supply into two elements, and then reducing the price of the standard-rated element to nil, while increasing the zero-rated element. From a commercial perspective, both business and customer got what they wanted, but clearly the Crown suffered a loss of tax revenue.

Naturally, Customs took a dim view of this practice and it was promptly squashed.

However, some version of this kind of “opportunity” arises whenever a supply of more than one element with more than one VAT rate is made. Another example is where TV guides (zero-rated) were provided for satellite TV subscriptions (standard-rated), but by a separate legal entity. HMRC had to introduce special legislation to get around that bit of planning.

As we enter the post-Lockdown world, it is reasonable to expect any VAT officer to take a sceptical view of any mixed supply and to seek to maximise the tax revenue arising from it.

The key defence to such a challenge would be to demonstrate that the treatment being applied is not artificial in any way, aligns with the commercial and economic realities, and is reflective of the contractual position as well.

If you have a question about single or multiple supplies, please give me a call to discuss.

Complicated Rules

This is a general issue with any of the reliefs from VAT, whether exemption, reduced-rating or zero-rating.

As you will have gathered from the comments above, in some ways this goes to the heart of the problems with zero-rating – it’s hard to know exactly where you stand. Complicated rules create opportunities for hair-splitting and arbitrary definitions of supplies, and unfortunately the game that this can create is heavily weighted towards HMRC.

In real life, this issue can lead to difficulties for customers as well as their suppliers, such as charities purchasing construction services, for instance. I’ve given an example below:

Example 1

A church wishes to build a new church hall. The existing church hall is over sixty years old and not in good repair. The church currently generates a few thousand pounds of income per year from hiring the hall out to various local groups.

It asks Jerry, a local builder, to provide an estimate for the work.

Jerry has done this kind of work before and remembers that he didn’t charge VAT on the work he did. The church is also very keen to avoid paying VAT and some of the people involved have heard that “VAT isn’t charged to charities like a church”.

However, it is doubtful that HMRC would agree that zero-rating would apply. The rules in this area are extremely complicated and demanding.

Unless the church can either show that the hall will be equivalent to a “village hall” (not nearly as easy as it sounds) or “solely for relevant charitable purposes” (again, not as easy as it sounds), and that other conditions are met, zero-rating will not apply.

The safest thing from a VAT perspective would probably be for the church to give up any income from the church hall and to agree to allow outside groups to use it for free, or for an entirely voluntary donation (that means that if you don’t pay you can still use it).

That approach would eliminate any element of “business use” and would leave the church free to provide Jerry with a certificate which would allow him to zero-rate his supplies.

As can be seen, relying on previous experience or advice heard on the grapevine can be very risky, especially where the amounts of VAT involved are large, as in the construction sector.

6. What Happens If My Supplies Are Exempt?

Unlike zero-rating, which, although it has its complications, is generally good news, exemption comes with one very obvious downside, namely, the fact that input VAT is not fully recoverable.

Where a business’s activities are all exempt, it is reasonably straightforward. You can’t register for VAT, and any VAT you pay on your inputs is simply a cost to your business. Not great news, but not that hard to understand or manage.

Things are a bit more complicated where your activities are “partially exempt”. I discuss some of the “loopholes” with partial exemption in the next section (and there are some, and they are valuable when they apply).

For the rest of this section, however, I assume that the business is required to carry out a partial exemption calculation.

Partial Exemption

A business is “partially exempt” when some of its supplies are taxable, and some are exempt. The most obvious impact such a business will face is that it will face difficulties in recovering all of its input tax.

A partial exemption calculation should be carried out each quarter, with an annual adjustment each year to establish the correct “recovery percentage” for “residual input tax”.

Very broadly, a business in this situation will need to classify its inputs into three “pots”:

• Inputs related to taxable supplies
• Inputs related to exempt supplies
• Residual inputs, which are (largely) overheads

It will then need to work out how much of the input VAT on these three categories it can recover. This is normally done by way of the “standard method” for partial exemption calculation, which simply works out the taxable percentage of total sales by value.

The partial exemption “recovery rate” will therefore vary with the business’s level of taxable supplies. This is logical, of course, but can lead to cash-flow issues for businesses whose mix of supplies varies and whose overheads amount to a big chunk of their inputs.

It should be noted that some businesses end up with bizarre recovery rates if they apply the standard method, and they can apply for a “PESM” or “Partial Exemption Special Method”. This can be a tricky process, and specialist advice is definitely a good idea.

Another live issue with partial exemption is the Capital Goods Scheme (“CGS”).

This is a vast topic in itself, but suffice to say that partially exempt businesses which build, acquire or renovate properties spending reasonable sums of money (£250,000 plus VAT) need to be aware of the CGS and its peculiarities.

This is a very quick summary of some of the issues arising from partial exemption. If you or your client have questions about partial exemption, the CGS, or would like to discuss applying for a special method, please get in touch.

7. Is There Any Hope For The Partially Exempt?

The short answer to this question is “yes”, especially if you’re a smaller business, or you only have a small amount of exempt input tax.

The “de minimis” rules exist to allow businesses to avoid the worst impacts of the partial exemption regime, by permitting them to reclaim all of their input tax, as long as it meets the tests.

There is a “standard” de minimis rule and a couple of “simplified” versions, but broadly speaking, if your total exempt input tax in a given VAT “year” (i.e.: the 12 months to March, April or May, depending on your stagger group) is less than £7,500, then you should look into this. It could be well worth your while.

Note that one aspect which is often overlooked is the possibility of recovering VAT on otherwise exempt activities, for example, the letting of residential property. The example below explains how this can work.

Example 2

Frank Crawford and his wife Betty operate a farming in partnership and have been VAT-registered for many years. They recently jointly acquired two houses, which they are intending to let out after they have been renovated.

Ordinarily, because residential lettings are exempt, any input VAT on the renovations would be irrecoverable.

However, in this case, the standard de minimis rules look likely to help them.

In the 12 months to 31 March, Frank and Betty incurred input VAT on the farm of £35,000, and they expect a similar level of input VAT in the coming year. The farm turned over £200,000, and again they expect this to remain roughly the same.

The rental properties are expected to generate about £10,000 between them, or around 5% of the partnership’s total earnings. The renovation is expected to cost £20,000 plus VAT, meaning a VAT outlay of £4,000.

As the total exempt input VAT they are incurring is both expected to be less than £7,500, and to amount to less than 50% of the total input VAT they will be incurring in the coming year, it will be below the de minimis threshold. This means they will be able to reclaim the full £4,000.

On top of this, the actual rental income will remain exempt from VAT.

Note that the rents should be included as (exempt) outputs on the partnership VAT return, and also note that it is vital that the properties are held in the same legal “entity” as the VAT-registration, in this case, the partnership.

For VAT purposes, the letting of jointly-held property is held to be a “partnership business”, even if it would not amount to a partnership for other legal purposes.

8. Anything Else I Should Know?

Whether supplies qualify for zero-rating, the issues arising from partial exemption as well as the CGS – these are some of the most complicated areas in VAT, so the short answer to this question is definitely “yes”!

However, the aim of this Update is to give you a flavour of the kinds of things to watch out for, rather than a doom-laden list of everything that could go wrong.

One thing I would stick in here, though, is to be aware of any changes in your business model. Slight differences in activity, especially in the construction sector, can create completely different VAT outcomes. It is definitely a good idea to ask about VAT if you operate in a zero-rated or exempt business before you change anything.

One other point I would make is that there is often a misunderstanding, especially in the charity sector, of the difference between exempt and non-business. VAT is not due on either of them, and neither of them allows full recovery of input VAT. However, the processes required to handle non-business income differ from those applying to partial exemption.

If you have any doubts about zero-rating or exemption, please feel free to give me a call.

9. Summary: What Are The Key Points I Need to Remember??

The first and most important thing to know is that zero-rating allows you to recover your input tax, whereas exemption does not.

The second thing is to be aware of the kinds of sectors which are able to avail of zero-rating and exemption, as summarised in sections 3 and 4 above.

Thirdly, it is sufficient to know that – entirely unsurprisingly – HMRC generally take a view that zero-rating (and often exemptions as well) should be limited as far as possible. This translates into a need to take great care when applying zero-rating especially, but also exemptions when the position might be a bit unclear.

Fourthly, partial exemption imposes a number of important and somewhat onerous conditions on taxpayers to ensure that they do not reclaim too much VAT. A great deal of care is needed in this area to ensure that the taxpayer is on the right side of the rules.

Fifthly, do be aware of how the de minimis rules can help to reduce the cost of VAT, often in surprising ways, which mainly benefit smaller taxpayers.

The last two points I would flag up are as follows.

It is useful to be aware that changes in your activities or business model can overturn your existing VAT treatment, which can end up being very expensive if you operate in a sector which benefits from zero-rating or exemption.

It is also helpful to be aware that exemption and non-business are different concepts in VAT law and have different consequences, even though superficially they are very similar…

Hopefully this Update has been helpful, and should you wish to discuss any of the issues arising – or indeed anything else VAT-related – please don’t hesitate to contact me for a free, no obligation initial enquiry.