CA-2024-000806 - [2025] EWCA Civ 1259

“Article 176

The Council, acting unanimously on a proposal from the Commission, shall determine the expenditure in respect of which VAT shall not be deductible. VAT shall in no circumstances be deductible in respect of expenditure which is not strictly business expenditure, such as that on luxuries, amusements or entertainment.

…”

Domestic Law

The main implementing legislation is the Value Added Tax Act 1994 (“VATA”). Section 24(1) defines input tax to include VAT on the supply to a person of goods or services. Section 26(1) confers on a taxable person the right to a credit for so much of the input tax incurred as is attributable to supplies within section 26(2), which includes taxable supplies (at section 26(2)(a)). Section 26(3) confers on HMRC the power to make regulations “for securing a fair and reasonable attribution of input tax to supplies within subsection (2)”. It is these regulations which are in issue in this case; they apply where the question is how to apportion input tax between taxable and exempt supplies.

Section 24(5) provides for an apportionment of input tax in a different scenario, where the input tax is used for both business and non-business purposes. That is not the issue in this case (but section 24(5) is relevant to one of the authorities relied on by HCL so I mentioned it here).

The regulations referred to in section 26(3) are the Value Added Tax Regulations 1995 (SI 1995/2518) (“VAT Regulations”). The main issue raised on this appeal depends on the regulations concerning the standard method and special methods.

Regulation 101 of the VAT Regulations sets out the “standard method” for deduction of input tax attributable to taxable supplies (this is a direct implementation of Article 174.1 of the Principal VAT Directive). Regulation 101(2) requires the following steps to be taken: (i) all input tax incurred is identified, (ii) input tax used exclusively in making taxable supplies is attributed to taxable supplies, (iii) input tax used exclusively in making exempt supplies is excluded, and (iv) the recoverable proportion of any residual input tax (as that term is defined, see next paragraph) is determined according to the following formula (set out at regulation 101(2)(d)):

“there shall be apportioned to taxable supplies such proportion of the residual input tax as bears the same ratio to the total of such tax as the value of taxable supplies made by him bears to the value of all supplies made by him in the period”.

Residual input tax is defined by regulation 101(10) to mean: “input tax incurred by a taxable person on goods or services which are used or to be used by him in making both taxable and exempt supplies.”

The standard method is subject to a “standard method override” (or “SMO”) in regulation 107B, which applies where a person has made a provisional attribution of input tax using the standard method, but (see regulation 107B(1)):

“… that attribution differs substantially from one which represents the extent to which the goods or services are used or to be used by him, or a successor of his, in making taxable supplies”.

In that event, regulation 107B(2) requires the taxable person to calculate and account for the difference.

A difference is substantial if it exceeds £50,000 or 50% of the input tax falling to be apportioned under regulation 101(2(d) but is not less than £25,000 (regulation 107C).

Under the permission contained in Article 173.2 of the Principal VAT Directive, regulation 102 permits HMRC to approve or direct the use of a “special method” for deduction of residual input. However, that approval or direction is subject to a system of notices which can be given, disputing the accuracy of deduction based on that special method. These are known as “special method override notices” or “SMONs”. HMRC can serve a SMON on the taxable person if they are satisfied that the overall result of the special method is an over-deduction of input tax (see regulation 102(11) and (12) of the VAT Regulations). In addition, HMRC can serve a SMON on the taxable person if they consider the special method “does not fairly and reasonably represent” the extent to which residual input tax is used or to be used in making taxable supplies (regulation 102A(1)), requiring the taxable person to account for the difference between the attribution made in a given accounting period, and an “attribution which represents the extent to which the goods or services are used by him or are to be used by him in making taxable supplies” (regulation 102B(1)). Regulation 102C permits the taxable person to serve a SMON on HMRC, if that taxable person is using a special method which does not fairly and reasonably represent the extent of taxable use.

The subsidiary issue depends on the construction and application of Article 5 of the Value Added Tax (Input Tax) Order 1992, SI 1992/3222 (“Input Tax Order”). That article is presaged in Article 176 of the Principal VAT Directive, but Mr Donmall very properly does not rely on the Directive in his arguments on the Input Tax Order, noting that there is some ambiguity about the extent of implementation of Article 176 so that, on one view, the Input Tax Order remains a provision of domestic law only. Article 5 of the Input Tax Order imposes a restriction on input VAT used for business entertainment, in the following terms:

Tax charged on any goods or services supplied to a taxable person, or on any goods acquired by a taxable person, or on any goods imported by a taxable person, is to be excluded from any credit under [section 25] of the Act, where the goods or services in question are used or to be used by the taxable person for the purposes of business entertainment [unless the entertainment is provided for an overseas customer of the taxable person and is of a kind and on a scale which is reasonable, having regard to all the circumstances].

…

For the purposes of this article, “business entertainment” means entertainment including hospitality of any kind provided by a taxable person in connection with a business carried on by him, but does not include the provision of any such entertainment for either or both-

employees of the taxable person;

if the taxable person is a body corporate, its directors or persons otherwise engaged in its management,

unless the provision of entertainment for persons such as are mentioned in sub-paragraph (a) and (b) above is incidental to its provision for others.”