Government departments, NHS Trusts, devolved administrations and Highways England are currently allowed to recover VAT on non-business activities if the expenditure relates to one of a long list of services specified in the Treasury Direction of 2 December 2002. These are typically referred to as the Contracted-Out Services (COS) headings.

This limited form of VAT recovery was first introduced in 1984. The intention of this form of recovery was to encourage public bodies to outsource services that it was felt could be carried out more efficiently by the private sector. The idea was that, by removing the VAT burden on paying a third party to carry out those services, public bodies would be more inclined to contract-out these services.  Initially, the headings were limited to 11 types of services but this has grown over time to include 76 service headings.

In 2017, the Office for Tax Simplification carried out a review of the VAT system which singled out the COS rules as an area of particular complexity. There was concern that these could distort procurement decisions and the way in which goods or services are provided to the public sector.  This prompted the Treasury to consider reform of the COS rules and it released a policy paper setting out its proposals on 27 August 2020.

Issues with the COS rules

The paper identifies a number of issues with the existing COS approach:

• administrative burdens – the complexity involved in applying the COS rules requires significant resource within both HMRC and public bodies;
• productivity – the paper expresses concern that public bodies are effectively incentivised to outsource services with significant goods costs in order to facilitate recovery of the VAT cost of those goods (VAT on a supply of the goods alone would not be recoverable under the COS rules);
• policy – there is a risk that the complexity of the COS rules can adversely affect or delay the implementation of policy;
• legal disputes – inherent uncertainty in cases where the application of the COS rules is not clear, making it difficult to plan for financial liabilities; and
• national crisis response – the paper cites that COVID-19 has demonstrated the importance of flexible government and cross-Whitehall response but that the fear of incurring irrecoverable VAT costs has interfered with the manner in which public bodies have managed resource and service between themselves.

Options for reform

The proposal in the paper is that the COS rules are replaced with what is referred to as the Full Refund Model – i.e. that VAT on all goods and services used by public bodies for non-business purposes is recoverable in full.  Essentially, this appears to be a similar approach to that already applying to local authorities, police authorities and fire and rescue authorities.

Initially, the paper posits two alternative approaches but quickly dismisses them – they are:

• Zero-rating supplies to public authorities – this is dismissed because business would need to identify the VAT treatment for the purchaser rather than of the goods or services being supplied. The paper suggests that this approach would increase the administrative burden for businesses (though it is worth noting, there are other areas of VAT legislation where suppliers have to do this, such as in the case of supplies of certain goods and services to charities); and
• Removing VAT recovery in its entirety for goods or services supplied in connection with non-business activities – whilst this would reduce the administrative burden associated with the COS rules, it would act as a disincentive to public bodies outsourcing to the private sector. It is felt this could distort decision making.

Full Refund Model

In theory, the model itself is fairly straightforward – public bodies are able to recover VAT on all costs other than those attributable to business activities.

However, areas of uncertainty will inevitably remain, such as the dividing line between business and non-business activities and the attribution of expenditure between those activities (where it is attributable to both).

Also, it is important to note that this reform proposal is intended primarily as a simplification exercise and, as such, it is intended to be fiscally neutral.  Inevitably, therefore, the increased flow of VAT refunds to public bodies (classed as Annually Managed Expenditure or "AME"), will be counterbalanced by a reduction in departmental budgets (Departmental Expenditure Limits or "DEL").

Accordingly, a careful accounting exercise will be required to estimate the likely increase in AME expenditure per public body as a result of moving to a Full Refund Model, in order that a corresponding downward adjustment can be made to DEL for that public body.  The paper states that HM Treasury is currently gathering the data necessary to establish the impact of the proposed reform and the scale of likely budget adjustment required.  The paper indicates that HM Treasury will provide further information on this process in due course.

The paper does not reach any set conclusion on the timeline for implementing the Full Refund Model, simply recognising that stakeholders are split over whether to implement over one fiscal event cycle or over a longer time frame.  The paper is similarly non-committal about whether the changes would be initially cover all public bodies or whether it would be staggered, citing the potential for unfairness if staggered but highlighting that changes to the NHS and related bodies should not be implemented until the conclusion of the current COVID-19 crisis.

What should public bodies do next?

Based on the tone of the paper, it is likely the Government will proceed with the Full Refund Model.  Accordingly, public bodies should be thinking in advance about how they may be affected by this. Key actions for public bodies are:

• exploring now how you can identify and evidence the level of irrecoverable VAT attributable to non-business activities. This will give you data to hand in advance of discussions on adjustments to DEL;
• think about what accounting and procedural adjustments may be needed to reflect a move to a Full Refund Model;
• review your existing out-sourcing and captive subsidiary structures to ascertain whether there are more optimal approaches available after a move to a Full Refund Model;
• assess the potential impact of the Full Refund Model on your existing procurement exercises and structures and consider building in flexibility to restructure where the Full Refund Model might result in alternative structures becoming preferable.

We are fully entrenched in the public sector world, acting on a wide variety of matters including tax, outsourcings and insourcings. If you are a public authority considering your approach to VAT in light of the proposed reform discussed above, we would be delighted to discuss this with you in further detail.