Guidance: Insurance sector partial exemption framework

Introduction

This guidance has been written and compiled jointly by the Association of British Insurers (ABI) and HMRC. The guidance is relevant to those dealing with partial exemption for insurers, including business and HMRC when discussing how partial exemption applies in practice for an insurer.

The guidance is intended to help insurers gain approval for a fair and reasonable partial exemption special method (PESM) with the minimum of cost and delay.

The guidance is neither mandatory nor binding and HMRC will consider whether to approve any PESM that an insurer declares fair and reasonable. HMRC cannot approve a PESM unless accompanied by a declaration. Further information on what is meant by fair and reasonable is provided in Annex 1.

This guidance will be updated regularly by ABI and HMRC jointly to reflect new issues arising and to help ensure consistency of treatment across the insurance industry.

Insurance definitions and activities

Basic definitions

Insurance:

The following are extracts from the FCA’s Perimeter Guidance Manual (PERG) 6 Guidance on the Identification of Contracts of Insurance:

PERG 6.3.3 01/07/2005

The courts have not fully defined the common law meaning of insurance and insurance business, since they have, on the whole, confined their decisions to the facts before them. They have, however, given useful guidance in the form of descriptions of contracts of insurance.

PERG 6.3.4 01/07/2005

The best established of these descriptions appears in the case of Prudential v Commissioners of Inland Revenue (1904) 2 KB 658. This case, read with a number of later cases, treats as insurance any enforceable contract under which a provider undertakes:

• in consideration of one or more payments

• to pay money or provide a corresponding benefit (including in some cases services to be paid for by the provider) to a recipient

• in response to a defined event the occurrence of which is uncertain (either as to when it will occur or as to whether it will occur at all) and adverse to the interests of the recipient

For the purposes of VAT, corresponding benefit includes goods as well as services.

Premium

Consideration paid for a contract of insurance.

Gross premium income is:

These outputs are not reduced by:

• brokerage or commission retained by the broker or agent for placing the business with insurer or reinsurer

• claim payments

• taxes (but see the paragraph about Insurance Premium Tax in this guide)

• reinsurance payments to reinsurance

The gross premium can be reduced by discounts or refunds provided for in the contract.

For reinsurance only, the gross premium must be reduced by:

• reinsurance commission (known as treaty, ceding or overriding commission) which is agreed between the reinsurer and reinsured to cover the cost of obtaining the original business and is, therefore, regarded as a discount

• profit commissions, which is a contingent discount reducing the amount the reinsured pays for reinsurance

Brokers

These are insurance intermediaries who advise their clients (the insured) and arrange their insurance. They are expected to find the best policy at the best price.

Although the broker acts as the agent of his client, he is typically remunerated by a commission or set fee from the insurer. However, it is possible that as a consequence of the Retail Distribution Review fees received from the insured will become common in the life insurance business.

Insurer

Person permitted (by law) to carry on insurance business in the UK under the Financial Services and Markets Act 2000. The act is presently administered by the insurance division of the Financial Conduct Authority (FCA), however this administration is under review.

Insurance activities

This section describes the business units and activities of a typical large insurer. This information is helpful when determining the sectors that might be needed in a fair and reasonable PESM.

All insurers are different, their business units will differ, the scale and type of their activities will differ, their costs and charging arrangements will differ, and so will their plans for the future.

The insurance market is dynamic and competitive and as a result many insurers have diversified in their activities and the insurance products they provide continue to evolve.

Some insurers have been subject to mergers and acquisitions further widening their range of activities. A good understanding of the insurer’s business is a prerequisite to formulating a fair and reasonable PESM.

General insurance

General insurance includes any insurance which is not life assurance. Many insurers ring fence certain specific types of general insurance separately from their wider general insurance business, for example marine, aviation and transport insurance.

General insurance is also typically subdivided between retail insurance, aimed at consumers, and commercial, or corporate, insurance, aimed at businesses and other institutions and will often be subdivided by the different types of distribution channel and product.

For consumers, general insurance companies principally provide:

• property and home insurance to protect buildings and their contents, separately or together

• motor insurance which is compulsory if you want to drive a vehicle in the UK

• travel insurance, protecting belongings and paying compensation if travel arrangements are disrupted

• payment protection insurance, for example, repaying your loan if you are ill or become unemployed

• pet insurance

• medical insurance (although this can sometimes be linked with the life and pensions business)

For commercial customers, Insurers principally provide the following types of insurance:

• public, employers’ and product liability insurance, which pays compensation when someone or something has been held legally liable for an adverse event such as an industrial injury

• professional indemnity insurance, to protect against claims of negligence in business, for example doctors, lawyers or other professionals

• business interruption insurance, to enable commercial enterprises to protect their income at times when they are unable to trade

• commercial property insurance — buildings and contents insurance for business and industrial premises

• commercial vehicles insurance — motor insurance for fleets of vehicles

Life and pensions

This concerns insurance products where the risk is linked to the life of an individual and also provides services of administering pensions. It is often referred to as long-term business.

Principle types of product include:

• life assurance policies (life cover) — these provide a lump sum of money, or a monthly income in the event of death before an agreed date

• income protection policies — these can be taken out to ensure an income is maintained in the event of a loss of income due to long term illness, injury or disability

• investment products — these are products where the premium is invested in some form of collective investment product or fund so, as well as a payout in the event of death, the customer will get an investment return depending on the performance of the product or fund

• pensions, providing the services of administering pensions, normally either for an individual, or for a commercial institution on behalf of its employees

• annuities — this provides a stream of income to the customer, normally until death, in exchange for a lump sum which is usually the result of the funds administered as part of a pension scheme, thus generating an income stream commonly referred to as a pension

Reinsurance

Frequently, the scale of risks underwritten is too great for one insurer to carry safely. In these circumstances, companies use reinsurance to mitigate their own risk exposure.

Accordingly, the reinsurance business deals with insuring the risks underwritten by the primary insurers.

Specialist reinsurance companies take on part of the risk that the primary insurers assume from their personal or commercial clients. Reinsurers can do this by sharing the losses among several carriers in the event of a claim. For this service, the reinsurer is paid a share of the insurance premium in accordance with its level of participation in the risks.

Block insurance

The term block policy was used by the European Court of Justice (ECJ) to define the policy held by Card Protection Plan Ltd (CPP) (case C-349/96). The term can be used within the insurance industry to mean other types of policy.

Similarly, terms (such as master policy) can be used to describe the type of policy held by CPP. It is important therefore to be clear what is meant by the term block policy when used with reference to the ECJ decision in CPP and its wider implications for the insurance exemption in this area.

The key characteristics of a block policy are that:

• there is a contract between the block policyholder and the insurer which allows the block policyholder to effect insurance cover subject to certain conditions

• the block policyholder, acting in their own name, procures insurance cover for third parties from the insurer

• there is a contractual relationship between the block policyholder and third parties under which the insurance is procured

• the block policyholder stands in place of the insurer in effecting the supply of insurance to the third parties

This type of policy is commonly used within the industry. It is often taken out by a supplier of goods or services to cover a number of small transactions over a set period.

The decision of the ECJ in CPP also has implications for supplies made by holders of block insurance policies. CPP were holders of a block insurance policy and, as such, were given authority by the insurer to arrange for their customers to become insured under the policy.

The ECJ found that CPP were making supplies of insurance transactions to their customers even though they were not themselves insurers.

Following the ECJ decision, HMRC regard supplies made by block policyholders as being insurance transactions for the purposes of the VAT exemption. This means that block policyholders are acting as principals when they are effecting insurance transactions rather than as intermediaries arranging supplies of insurance

Warranties and guarantees

In a guarantee or warranty arrangement the purchase price of the goods includes an amount in consideration of which the manufacturer or retailer undertakes to replace or repair defective goods within a specified period.

In an extended warranty arrangement the provider enters into a distinct contract under which they undertake, for a consideration, to be subject to the same (and possibly some additional) obligations as covered in the original warranty. If it is sold as a separate product; for a separate consideration; and under terms consistent with insurance, it will constitute an exempt supply of insurance even though it is agreed in the context of a sale.

For more information on warranties and guarantees see paragraph 3.7 of the Public Notice 701/36.

Run-off

This is business that has been closed to new business but still settling claims.

International written insurance

Insurers may treat general and life insurance business provided to overseas customers as distinct business streams to keep them separate from domestic business.

Investments in securities

Insurers may invest in securities to meet solvency requirements in respect of future liabilities. Such investments will include liquid (cash or near-cash) and illiquid holdings in securities.

The most common illiquid investment used for longer term investment is land and property. The majority of insurers’ portfolios will be in low-risk items, however, they may also invest smaller sums on ring fenced developing areas.

Investment management

Whilst some insurers buy in investment management services from third party providers, many have business units (including separate companies) within the group structure that provide these services. Often these will also provide similar services to third parties as well. It is common for different types of investments to be handled by different teams.

More information regarding types of insurance policy used for investment can be found within HMRC’s Insurance Policyholder Taxation Manual IMPTM1400.

Engineering inspections

These inspections are carried out on high value pieces of equipment (for example, aircraft, industrial machinery, lifts) to ensure they meet health and safety requirements which may be a prerequisite for any insurance. Some insurers provide this service externally to their clients.

Other inspections may be carried out to assess the value for internal risk assessment purposes before committing to providing insurance cover, or to meet health and safety requirements.

Support and head office functions

Regulated insurance companies can only provide insurance and closely related activities. That is why the insurance group will often have separate support and service functions. These will carry out the day-to-day running of the group.

Examples of these functions will be pension administration, HR, IT and infrastructure and legal services (at business level). These will likely incur the majority of costs for the group.

The head office is concerned with the setting of strategy for the group and driving the business forward. Examples of head office activities may include strategy, tax and finance, risk and compliance, legal services (for the group as a whole), and marketing (the whole group brand).

Branches and subsidiaries

Like most multinationals, large insurers may organise themselves into branches and subsidiaries across the territories they operate in.

A branch is part of the same legal entity or company. A subsidiary is a different legal entity or company that is controlled by its parent.

Types of insurance companies

Insurance companies can be broken down into 3 types:

• life — those companies authorised to write long-term business

• general — those companies authorised to write short-term business

• composite — those companies authorised for both long-term and general business

Composite companies were prohibited further in the Insurance Companies Act 1982. The risk they presented was that funds accumulated from long-term business would be used to pay general claims.

Existing composites were allowed to continue trading after 1982, and since 1 July 1995 composites have been allowed in a limited format (health). Some large groups of companies are referred to as composites because they have life and general insurance companies in the group.

Captives

These are insurance companies set up to insure all or part of the risks of their parent company.

Loss adjuster

Loss adjusters provide the specialist service of investigating and valuing a claim. The adjuster acts for the insurer.

Loss assessor

Loss assessors provide the same service as the adjuster but act for the insured.

The Corporation of Lloyd’s

Lloyd’s is not an insurance company. It is a society of members, both corporate and individual, who underwrite insurance in syndicates. It is a market where policyholders are insured at Lloyd’s by members of Lloyd’s and not by Lloyd’s itself. However, the market has a common brand and identity.

Members, whether individuals or corporate, group together to form syndicates in order to accept insurance risk.

Risks at Lloyd’s are placed through brokers who shop around for insurance on behalf of their clients, and the types of insurance that can be purchased have widened out from just marine insurance to virtually all types of general insurance and reinsurance and some life insurance.

Each syndicate has a managing agent, who is appointed to manage its affairs. Employees of the managing agent carry out the underwriting and other functions in relation to the insurance risks.

Individual members, and most smaller corporate members, including Scottish Limited Partnerships, have to appoint a members’ agent.

The Corporation of Lloyd’s carries out the functions of advancing and protecting the interests of Lloyd’s members in connection with their Lloyd’s business.

Further guidance regarding Lloyds can be found in HMRC Insurance guidance VATINS4000.

There are specific administrative arrangements for operating VAT within the Lloyd’s market which include rules for PE. These can be found within HMRC Partial Exemption Guidance PE5700. It was drawn up following an extensive review of the previous Lloyd’s VAT Arrangements, which dated back to 1985 and a period of review and consultation with the Lloyd’s market.

Insurance groups’ additional activities

Consulting

An example is the provision of advice and risk identification and mitigation strategies in order for a client to reduce their insurance costs.

Claims handling

Claims professionals work on behalf of insurance policyholders and the insurance companies, investigating claims, determining their extent and validity, and negotiating the claim on behalf of the insured. This service may also be provided to third parties outside of the insurer’s VAT group.

Loss adjusting

A service company may operate independently of insurance companies, its function being to mitigate loss and get businesses back up and running with the minimum amount of disruption. Such activities may also include looking into the circumstances surrounding a claim — establishing the cause of a fire, for example — before negotiating a fair sum to replace the loss or repair the damage.

Specified supplies

SI 1999/3121 (the Specified Supplies Order), allows for recovery of input tax on financial, insurance and insurance related services when:

• the recipient of the supply of finance, insurance or related services belongs outside of the UK

• related services are supplied in connection with a contract under which the insured party belongs outside the UK (even if the insured party is not the recipient of the supply of related services)

• the insurance being supplied is directly linked to the export of goods to a place outside the UK

• related services are supplied in connection with insurance directly linked to the export of goods outside the UK

Supplies that meet the above conditions are usually referred to as specified supplies.

Attribution of input tax

In the insurance sector, relatively few costs are either used wholly to make exempt supplies, or used wholly to make taxable supplies. The main exceptions where direct attribution is possible is for example where cost is incurred on property and some specific projects of one VAT liability. Claims–related costs are also regarded as directly attributable to the related supply of insurance (see the Deutsche Rück section in this guide).

As set out, regulations require direct attribution to be carried out before cost allocation to sectors. However, direct attribution at this stage can cause difficulties where tax departments are unaware of how particular costs are used and have a large number of such costs to review.

It has been agreed by HMRC and the ABI that, whilst direct attribution must still take place, it need not always be the first step, and could, for some costs, follow the allocation stage. In other words, methods could refer to direct attribution both pre- and post-allocation, so that costs are dealt with in the most appropriate way. The underlying principle is that the method must be both fair and reasonable.

Deutsche Rück

This concerned a contract of reinsurance. The taxpayer received a supply of legal services in order to quantify a claim made under that contract. The High Court decided that the expense concerned was a cost component of the reinsurance service.

When applying the Deutsche Rück principles to the supply of insurance, HMRC consider the expenses incurred settling a contract of insurance to be a cost component of the supply even though they are incurred long after the premium has been paid.

Sectors

Sectors are used within partial exemption to sub divide a special method calculation into different business areas. Rather than having a single calculation, a sectorised method enables each different parts of a business to adopt a separate calculation appropriate to its circumstances.

These individual calculations are then combined to determine the recoverable VAT for the business as a whole. The use of sectors improves accuracy and lessens the risk of distortion. However, adding sectors increases complexity and compliance cost. Furthermore, unless sectors are chosen objectively they risk undermining fairness and certainty.

HMRC encourages the use of sectors in large partly exempt businesses to lessen the risk of unfair VAT recovery (either too much or too little). Sectors are particularly important for diverse businesses, such as large insurers that undertake a range of activities for which different sets of costs are incurred.

HMRC consider that such businesses should benefit from sectorising their special methods based on the operational sub-divisions within their organisation (such as business units for which separate accounts are prepared), and then allocating costs between these sectors in line with their internal cost accounting procedures.

Sectors should arise naturally out of the way a business is organised and should not be an artificial creation just for the purposes of partial exemption.

As stated above, sectors ideally should be aligned to the business divisions. If separate records have to be created in order to operate a sector, it suggests that the sector is not a natural one but is being created solely for partial exemption.

Sectors should ideally follow the existing commercial divisions in the business. In many cases this is likely to mean sectors based on either individual companies or collective groups of companies with similar activities, although a business (and thus its natural sectors) can also be organised along the lines of:

• specific function

• geographic area

• product

• project

These are just illustrative examples. Regulatory requirements might create another natural division, particularly for insurance businesses.

In a few situations, where HMRC feel that a distortion could result, HMRC will use its powers which allow for the creation of separate sectors for distortive transactions, such as sales of securities, or supplies from overseas branches.

It is good practice to include a sector to deal with input tax that is not dealt with elsewhere in the method. This catch-all sector may also be used to deal with a new business organisation or activity that has yet to be addressed in the method.

It is good practice to include a use-based sector to include major projects such as corporate rebranding, major relocation of business, mergers and acquisitions that need to be notified to the Stock Exchange (restructuring or acquisition or disposal costs of businesses) and anything outside the usual run of business. The use basis also enables the insurer to contact HMRC to discuss and agree a suitable basis for apportionment, as and when the need arises.

It is good practice to define a sector in terms of the activity it covers, rather than the legal entity which carries it out. Another area where PESMs and the business organisations may not be fully aligned is the names given to PESM sectors.

A PESM is usually in place for a number of years, and as highlighted above, the business may reorganise, merge etc. Although convenient for the business, the business name may change over time, or activities within it may change or be discontinued. Therefore, HMRC consider it best practice to identify sectors by their activities.

The most common sectors within insurance businesses can include:

• general insurance (retail, commercial, Lloyd’s) which may also include claims handling and policy administration as part of insurance underwriting

• life and pensions and other long-term insurance

• reinsurance

• run-off

• writing international insurance business

• investments in securities

• investment property (own property portfolio)

• investment management

• consulting

• fund management (may be carried out internally or outsourced)

• investment products (open-ended investment companies, authorised unit trusts etc)

• brokerage

• engineering inspections

• head office, typically including:

  • marketing (brand)

  • legal services

  • strategy

  • risk and compliance

  • tax and finance

  • treasury

• support

For a small insurance company, a basic split would be:

(a) between underwriting premiums and commission income

(b) the premium business sub-divided into three: general insurance, life/other long-term business and reinsurance

(c) general insurance premium business subdivided into three:

• commercial business
• retail business
• Lloyd’s business

(d) investment business sub-divided between property and securities, with each of these subdivided between insurance company’s own investments and investments made for clients

The template below will help you record the relevant information about sectors and sub-sectors:

Example 4 template: multi pot method

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Allocation of residual input tax to sectors of business

Partial exemption seeks to identify VAT on costs that are used or intended to be used for making taxable supplies (and supplies that give a right of VAT recovery). Use means economic use, which is the business’ rationale for incurring a cost. A business may decide to allocate costs by reliance on its internal cost accounting systems, which are systems designed by the business to provide it with reliable information on its cost base.

A business is encouraged to rely on its internal cost accounting systems for partial exemption purposes because this is likely to represent the business’ best view on the economic use of its costs.

The benefits of using a cost accounting methodology can be:

• the business does not have to use a separate allocation system for its partial exemption method

• the allocation methodology will tend to follow the changing circumstances of the business without the need to amend the method

• the cost allocation system will be underpinned by accounting principles, and audited, possibly independently

• the business has other motivations aside from VAT to ensure that the allocation method reflects the use of costs

It is not HMRC’s intention to bind the business to a PESM that uses its cost accounting method where the result proves to be distortive or too complex. There has to be a degree of trade-off between accuracy and practicality, but HMRC would generally expect departures from the internal business model of apportioning costs to be for good reasons.

HMRC believes that the internal business organisation and cost accounting methodology usually provide a strong foundation from which to build a special method. However, the overriding principle must be simplicity and that any methodology should be fair and reasonable.

A typical special method that links to a cost accounting methodology usually involves 3 steps; the principle, the detail and the appropriateness; for example:

• principle: input tax is to be allocated between sectors on the basis of the management cost accounting system

• detail: input tax on costs relating to 2 or more business units is to be allocated between them in proportions determined by the management cost accounting system

• appropriateness: the cost accounting methodology shall be determined by internal management and cost accountants in accordance with generally accepted accounting principles, and it should ideally be judged on the extent it is used and relied upon for purposes other than just partial exemption and tax, and how effectively it is managed

There are however many different types of cost allocation and there are no widely recognised set of standards. To summarise, they can be based on:

In identifying a suitable allocation methodology, it is important to consider whether sectors are cost centres, profit centres or a combination of both. It is also important to understand the basis, and the extent to which, central costs (such as head office, IT and infrastructure costs) are reallocated to profit centres as these costs may represent significant expenditure which needs to be allocated to the income-earning sectors within the partial exemption method.

Head office departments may also make some supplies, for example within treasury, IT, catering, or from within the insurance company’s own property portfolio.

A cost allocation method based on marginal costs (which might be more relevant for decision making purposes) should be treated with caution. This is because partial exemption is concerned with full cost allocation; both variable and fixed costs.

Marginal costing can result in unfair recovery within the partial exemption method and is a relatively common source of dispute when businesses introduce new (typically exempt) activities the marginal cost of which is minimal.

There may be instances where a allocation methodology is insufficient or unsuitable to form the basis for a partial exemption method as it stands. In these instances, the insurer will need to suitably adapt the methodology for partial exemption. The most common methodologies are those based on headcount or floor space.

Headcount allocation

Headcount is often used as the underlining basis for cost accounting methodology. However, headcount can also be used independently of a cost accounting methodology as a proxy for use-based allocation. To ensure a consistent approach is taken when addressing full- and part-time working, many organisations will apply full-time methodology.

Also the definition needs to clearly state which staff are to be included and which staff are to be excluded. Income generating staff should be included. This should include front office, middle office and back office who are closely connected with generating the income.

The key issue is to ensure that there is a degree of parity between the staff included within the calculation. This may have to be achieved by the use of weighting. In addition, the system used within the calculation must be robust and verifiable.

Floor space allocation

This is usually appropriate where costs are related predominately to one building with business sectors occupying specific floor areas with communal areas being excluded.

Pro-rata calculations

Generally, output values is normally the starting point for a PESM, however if output values is unsuitable other calculations will need to be considered. Common pro-rata methods are:

General insurance (retail and commercial)

Output values (usually based on premiums).

Life and long-term insurance

Output values or volumes by location of insured (excludes income arising on assets and sale proceeds of assets).

Run-off

This will normally be a set rate based on the last 3 full underwriting years. Normally the PESM will state how the fixed rate is calculated.

Writing international insurance business

Output values or volumes by location of insured (usually premiums).

Investments in securities

Transactions (number or value).

Investment property

Output values (usually based on property rental income from opted and non-opted properties excluding value of capital sale of properties).

Investment management

Output values (usually fees).

Consulting

Output values.

Fund management

Output values (fees and commissions).

Brokerage

Output values.

Engineering inspections

Internal and output fee values.

Head office costs

Reallocation to income generating areas of business. Failing that aggregate output value of the whole group. Due to the complexity of agreeing a suitable calculation for this sector, some insurers have a use-based apportionment for this sector.

Inputs-based method

Reallocation on the basis of directly attributable costs. For example, if 70% of directly attributable costs relate to taxable supplies, so the same percentage of non-attributable costs may be regarded as attributable to taxable supplies.

Support functions may have a pro-rata based on values for example:

Marketing

Reallocation to income generating areas of business. Failing that aggregate output value of the whole group.

IT and infrastructure

Reallocation to income generating areas of business. Failing that aggregate output value of the whole group.

Pensions administration

Output values.

Overseas branches and or head offices

Regulation 103 allows recovery of input tax incurred by UK insurers in connection with their overseas branches and or their overseas head offices. However, the process of identifying supplies made by overseas branches and head offices to EU and non-EU counterparties where there are various branches and subsidiaries and the amount of input tax the UK insurers can recover may be difficult.

Notice 700/57 (Administrative agreements entered into with trade bodies) contains agreed methodologies for recovery of such input tax that insurers can apply for overseas branches. Insurers have also treated input tax used in relation to supplies made by non-EU branches as fully recoverable and treated input tax used in relation to supplies made by EU branches as fully irrecoverable, Insurers may still apply this easement.

If they want to move away from this methodology and other methodologies contained in Notice 700/5, they can propose other methodologies to identify recovery rates that determine the use of input tax in relation to the branch activities and also for their head office activities if applicable.

It should be noted that the above are examples and are in no way to be treated as prescriptive. Each sector needs to be looked at individually and treated as such accordingly.

With regard to Insurance Premium Tax (IPT) businesses can choose to either include or exclude the value of IPT within their calculation. If they chose to include the value of UK IPT in sector and or sub-sector allocations or apportionment calculations, they should include equivalent foreign taxes and any other duties or taxes charged or chargeable on insurance premiums.

If they chose to exclude the value of UK IPT then equivalent foreign taxes and any other duties or taxes charged or chargeable on insurance premiums should be excluded.

Run-off

Run-off describes the situation where an insurer wishes to close either the whole of its business, or a particular book of business.

The nature of insurance means that an insurer cannot close immediately; it has to remain open until it has settled its liabilities, especially with reference to claims. These may arise even after the policy has lapsed. For example, an industrial disease may only become apparent many years after the period covered by the insurance policy has ended, but nonetheless the claim may still be made under that policy.

Therefore, the first stage of run-off is normally the closure to new business. This means that the insurer can now concentrate on the insurance policies that are extant but it also means that the premium income drops immediately as the only premium being received is any additional premium, arising from changes to the extant policies leading in an increase to the original premium charged.

In addition, premium may also be returned to the insured, known as return premium, in respect of cancelled policies or changes in circumstance leading to a reduction to the original premium charged.

As additional premium and return premium is the only premium to be accounted for by the insurer, a values-based method can become, at the least distorted and at the worst unworkable, especially when negative percentages are calculated.

Therefore, the normal practice is for an insurer to apply to use a fixed percentage recovery based on the last 3 years of business. This can be rather more subjective than representative.

For example, in cases where the book has not been open for 3 years, or the book has changed in a short period of time, best judgment should be used to arrive at a fair and reasonable method.

Annual adjustment

An annual adjustment is a review carried out at the end of at the end of the business’ tax year (the longer period) revisiting the provisional quarterly attribution of input tax within a partial exemption method, taking into account any changes in use. It allows business to reconsider the use of goods and services in the tax year and for some, to revaluate the exempt input tax under the de minimis regime. Guidance for annual adjustments can be found within HMRC’s Partial exemption Guidance PE4100.

The key points to keep in mind are:

• apportionment calculations should be reworked using figures for the whole adjustment period using the method as prescribed by the partial exemption method used in the year
• exempt input tax must be reconsidered in relation to the de minimis rules
• the Commissioners have powers to allow businesses to account for the adjustment in a later prescribed accounting period where businesses can show that they have difficulty in using the first prescribed accounting period after the end of the tax year (application and approval should be in writing)

If during a longer period a business discovers that it has made an error in the completion of its returns (other than an input tax allocation or attribution error), it cannot use the annual adjustment to correct this retrospectively. All errors must be calculated in their correct periods and only those that are not capped can be posted.

Capital Goods Scheme

Generally the Capital Goods Scheme (CGS) applies to the acquisition of:

• computers (in excess of £50,000)
• buildings, and the refurbishment of buildings (with a capital value in excess of £250,000) made by a partially exempt business

Input tax is claimed on the purchase of the capital items as per the partial exemption method in place for the business at the time of acquisition. Adjustments are made over a period of time (5 or 10 intervals depending on the capital item.). If the extent to which the capital item is used in making taxable supplies increases or decreases when compared to the initial use, a CGS adjustment is required.

Further guidance on the mechanics of the CGS can be found within HMRC’s Partial exemption Guidance PE4800.

An example where the CGS can have implications is when an insurer undertakes a major refurbishment of its head office or other large building in its possession. If the refurbishment is over £250,000 it will fall within the remit of the CGS.

HMRC’s preference is for CGS adjustments to be carried out at sector level where the input tax was incurred. In some instance this may not be applicable, so a negotiated bespoke methodology may be required.

It is best practice to include within the PESM a catch-all appendix to deal with any Capital Goods item which cannot be assigned to a sector, and apportion on the basis of use.

Annex 1: the basic principles of partial exemption

Partial exemption is the set of rules for determining recoverable input tax (VAT on business costs) insofar as the costs are used or intended to be used in making taxable supplies and supplies that carry a right of deduction (collectively termed taxed supplies).

HMRC see use as economic use meaning the business purpose, planning and source of funding for the cost. ECJ cases provide an alternative description, namely that costs must have a direct and immediate link, so as to be a cost component, of the price.

In accordance with partial exemption guidance, a special method typically involves:

(i) Direct attribution to taxed supplies. Identify input tax on costs used wholly for making taxable supplies. This input tax is normally recoverable in full.

(ii) Direct attribution to exempt supplies. Identify input tax on costs used wholly for making exempt supplies. This input tax is normally irrecoverable.

(iii) Direct allocation to partial exemption ‘sectors’ (business sub-units described in the special method). Identify input tax on costs used wholly within a sector making both taxable and exempt supplies. This input tax is apportioned between taxable and exempt supplies by application of a pro-rata.

(iv) Allocation re shared costs. Identify input tax on costs used in two or more sectors making both taxable and exempt supplies. Allocate input tax to the sectors in line with cost-usage and apportion between taxable and exempt supplies in each sector.

(v) Allocation re overhead costs. Identify input tax on costs used across all sectors of the business making both taxable and exempt supplies. Allocate input tax to sectors in line with cost-usage and apportion between taxable and exempt supplies in each sector.

(vi) Reallocation re internal customers. Identify input tax on costs used in providing services between sectors. Allocate input tax in line with cost-usage and apportion between taxable and exempt supplies in the sector(s) using the costs concerned.

In most but not all cases, the first stage in partial exemption is direct attribution (see the Attribution of input tax in this guide). It deals with a category of cost described in management accounting as direct cost, namely costs economically identified with (caused by) a specific output unit (or supply for VAT purposes).

The second stage in partial exemption is allocation. Allocation deals with common costs that relate to various outputs or parts of the business. Allocation also deals with central costs (or overheads) that relate to the business as a whole, and to internal services between business units.

Apportionment, which is the final stage in partial exemption, divides input tax between taxed and exempt supplies by way of a pro-rata calculation, based for example on methods illustrated in the pro-rata calculation section in this guide.

It is important to note that VAT regulations and partial exemption methodology require input tax to be identified on invoices, normally at the invoice coding stage by posting invoices net with VAT taken to a separate VAT account. It is normally unacceptable to post invoices gross and then calculate input tax for VAT recovery purposes; even if the same calculations are then used to assign input tax to taxed and exempt outputs.

Allocation and apportionment is an approximation and it is meaningless to refer to a correct methodology although for partial exemption purposes, some methodologies are preferred whilst others are unsuitable.

A special method need only be fair and reasonable, namely:

• robust, in that it can cope with reasonably foreseeable changes in business

• unambiguous, in that it can deal, definitively with all input tax likely to be incurred

• operable, in that the business can apply it without undue difficulty

• auditable, in that HMRC can check it without undue difficulty

• fair, in that it reflects the economic use of costs in making taxable and exempt supplies

HMRC will only approve the use of a special method if the business declares that it has taken reasonable steps to ensure the method is fair and reasonable. HMRC cannot confirm that a special method is fair and reasonable but will make enquiries based on an assessment of risk, and will never knowingly approve an unfair or unreasonable special method.

Annex 2: why a partial exemption special method is usually suitable for an insurance business.

Insurance businesses make a mixture of exempt and taxable supplies and may also provide specified services to customers located outside of the EU which incur a right to recover input tax.

When determining how to calculate the recoverable elements of input tax, the starting point is with the standard partial exemption method, as defined within regulation 101 of the VAT Regulations 1995, but this will rarely be suitable.

The reason is that insurance companies make disposals of investments in securities and supplies from overseas branches which are both excluded from the standard method calculation based on values, with recovery being determined on the basis of use under regulation 101(8) of the VAT Regulations 1995 (as amended). In addition, they often make disposals of investment property which may lead to an over-ride calculation under regulation 107A to F.

Moreover, many insurance businesses are complex organisations that provide many different services of differing liabilities to customers, often in different countries, using costs form suppliers around the world in different proportions. In addition, certain costs may have little relation to the value of the supplies for which they are incurred.

For a business that carries out a number of different business activities, a one pot method is too simplistic and will not reflect the reality of the activities carried out or measure, with any accuracy, how the costs incurred are to be used. As a result, the standard method rarely produces a fair and reasonable result for insurance businesses.

Therefore, most insurance businesses will need to apply to HMRC for approval to use a PESM.

As larger and more complex organisations have very different activities that use costs in different ways, HMRC encourages them to propose sectorised methods because it is considered that they are more likely to be fair and reasonable than a simple method.

Annex 3: partial exemption special method examples for the insurance sector

How to use the PESM templates

Introduction

This guidance note should be read in conjunction with the special method templates below and in drafting partial exemption special methods. These method templates are issued with a health warning and should be tailored to reflect the individual circumstances of the business.

If you have any queries regarding the drafting of special methods please consult a member of the indirect Tax Avoidance and Partial Exemption team or one of the local regional partial exemption specialist officers. You should also refer to VAT Notice 706.

You will find templates and examples to help you at the end of this section.

Supplies and transactions

Supplies and transactions should be defined in a single pot method or in each sector in a sectorised method. The suggested definition of transactions comes with a health warning, and the terms transactions and supplies need to be defined clearly within each special method depending on what supplies are being made.

Suggested wording for determining the recovery of non-attributable input tax

The following methods of apportionment can be used to determine input tax recovery in sectors, sub-sectors and in single special methods. The methods of apportionment need to be defined clearly within each sector and sub-sector or within single pot methods and should state any weightings (if applicable), inclusions and or exclusions.

a) Single pot special methods for other methods of apportionment

Refer to the section on Attribution in the Example 1 template: single pot value methods. The following paragraphs refer to suggested wording based on the method of apportionment other than values or transactions:

Headcount

Divide the number of staff generating taxable income in the period by the total number of income-generating staff in the period.

Where income generating staff is used as a method of apportionment in special methods, this term must be defined clearly. Exclusions and or inclusions should also be stated.

Time spent

Divide the time spent on taxable transactions in the period by the total time spent on all transactions in the period.

The apportionments above can also be used in sectors for multi pot special methods.

b) Methods for allocation to sectors for multi pot special methods

Refer to the Exclusions section of Example 1 template: multi pot method which can be downloaded from this guide. This can be replaced with the following:

Values

Identify all supplies and imports you receive which are used, or to be used, both in making taxable and exempt supplies and which are not used, or to be used, exclusively within a single sector. The input tax thereon should be allocated to the fullest extent possible between the sectors on whose behalf the expense was incurred, in the ratio of the value of transactions in each sector as a percentage of the total value of transactions in the nominated sectors.

Headcount

Identify all supplies and imports you receive which are used, or to be used, both in making taxable and exempt supplies and which are not used, or to be used, exclusively within a single sector. The input tax thereon should be allocated to the fullest extent possible between the sectors on whose behalf the expense was incurred, in the ratio of the number of income generating staff employed in each sector as a percentage of the total number of income generating staff employed in the nominated sectors.

Transactions

Identify all supplies and imports you receive which are used, or to be used, both in making taxable and exempt supplies and which are not used, or to be used, exclusively within a single sector. The input tax thereon should be allocated to the fullest extent possible between the sectors on whose behalf the expense was incurred, in the ratio of the number of transactions in each sector as a percentage of the total number of transactions in the nominated sectors.

Time spent

Identify all supplies and imports you receive which are used, or to be used, both in making taxable and exempt supplies and which are not used, or to be used, exclusively within a single sector. The input tax thereon should be allocated to the fullest extent possible between the sectors on whose behalf the expense was incurred, in the ratio of time spent on transactions in each sector as a percentage of the total time spent on all transactions in the nominated sectors.

Cost accounting system

Identify all supplies and imports you receive which are used, or to be used, both in making taxable and exempt supplies and which are not used, or to be used, exclusively within a single sector. The input tax thereon should be allocated to the fullest extent possible between the sectors on whose behalf the expense was incurred, using the method by which the input is accounted for within your own cost accounting system.

c) Methods for allocation and apportionment for sectorised methods

Refer to the Example 1 template: multi pot method for method allocation. You can use some of the suggested wording as listed in (b) above.

Also refer to the Example 1 template: multi pot method for methods of apportionment. You can refer to some of the suggested wording as listed in (a) above.

Exclusions

You should insert appropriate exclusions, based on the method(s) to be used, that are likely to cause a distortion to the calculation, as applicable to the particular business.

Refer to the exclusions that relate to values depending on method of apportionment.

Contact officer

This paragraph should only be included where there is an allocated officer for the business.

These templates and the instructions on how to use them are used by HMRC officers when drafting PESMs that have been proposed by customers. The format for the templates is suggested and in no way binding.

To access the templates, click on the link and the template document will be downloaded.

Example 1 template: single pot value methods

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Example 2 template: single pot transactions method

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Example 3 template: single pot other method

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Example 5 template: sectorised method

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Appendix 1 template: definitions

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Appendix 2 template: sectors and sub-sectors

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