I've worked either for local authorities or with them for over 40 years. I joined East Hertfordshire District Council straight after my A-levels in the mid-80s, as a clerical assistant in the accountancy section, having found the job in the local paper. For the past 30 years or so I've specialised in VAT, and I'm also the author of the Town and Parish Councils VAT Guide.
Recently, I had the pleasure of speaking at a Scribe Academy webinar about VAT on capital projects, focusing on community facilities. Before getting into any project, it helps to understand the basics, so this post covers what VAT is and how it works, when councils can claim VAT back, and how VAT-exempt activities can limit that recovery through partial exemption.
In a second post, I put all of this into practice with a worked example: building a new community centre.
1. When Does VAT Apply?
The five conditions
VAT is only charged when all five of these conditions are met:
- Someone supplies goods or services.
- They receive something in return. We call this "consideration", and it covers payment in money and payment in kind, such as a barter of goods or services in return.
- The supply is part of a business activity. It needs a degree of regularity or scale before it is accepted as a business activity.
- The supplier is a "taxable person". They are either VAT registered or should be.
- The supply takes place within the UK. It's a UK tax.
If any of those conditions are missing, the transaction falls outside the scope of VAT.
Are councils taxable persons?
Yes, if they make taxable business supplies. But not when they act as public authorities under a special legal regime. That's an important sentence, and the concept is key for local authority VAT.
A council acts under a special legal regime when either a targeted piece of legislation compels it to do something, or, if it only empowers it, the legislation places conditions on the council that a private sector supplier of a similar service simply wouldn't have to meet. There must also be no significant competition for that service. If all those conditions are met, the activity is outside the scope of VAT, even if you charge for it.
There are lots of things councils do statutorily. But there are other things you do by choice, and there you are in competition with other potential providers, so the normal VAT rules apply.
2. How VAT Works for Councils
Output VAT and input VAT
- Output VAT is the VAT you collect, as a tax collector for the Treasury, on the taxable supplies you make. Only VAT-registered councils will have output VAT to account for.
- Input VAT is the VAT you pay on the goods and services you buy in. As councils, you generally have the ability to recover it, either on a VAT return if you're registered, or on a VAT126 form if you're not.
In a chain of VAT-registered businesses making taxable supplies, each charges VAT on its sales and recovers the VAT on its purchases, paying HMRC only the difference. The principle is that the final consumer, the person who can't recover it, bears the cost. The important underlying message is that not every organisation can recover all the VAT it pays. Councils have a more far-reaching and generous VAT recovery power than almost anyone else, but it isn't unlimited.
Three categories of activity
Everything a council does falls into one of three broad groups:
- Non-business (outside the scope of VAT). Activities funded by your precept, loans, grants or donations at no direct charge, such as public toilets, and many statutory services where you can charge but you're acting under special legal powers, such as allotments, burials and leisure facilities. No VAT is charged on this income.
- Exempt business activities. These are business supplies but specifically exempted in VAT law. There's no VAT on the income, but potentially restricted VAT recovery. For councils, the most common is land: everything from the freehold sale, or lease of a property, to lettings and room hire. Education provided for a fee also has its own exemption.
- Taxable business activities. Pretty much everything else. If you're charging for something, it isn't under a special legal regime and you can't find it listed as exempt, it's taxable. Then there's a process of elimination: there's a defined list of zero-rated supplies (such as books and some basic food items) and a defined list at the reduced 5% rate (such as electricity and gas for domestic or charitable use). If it's in neither, the standard 20% applies.
So, start with the question: are we charging someone for this? If so, expect it to be standard-rated, unless you can show it's non-business, exempt, zero-rated or reduced-rated.
What changes when a council registers for VAT?
Councils must register if they make taxable supplies. Councils aren't subject to the normal registration threshold. Technically you should register for any level of taxable activity, but in practice HMRC would expect a council to register once the VAT due on those activities reaches £1,000 a year. That's £6,000 of taxable income.
- Charge VAT on non-business and exempt income? Unregistered: No. Registered: No.
- Charge VAT on taxable business income? Unregistered: No. Registered: Yes.
- Claim back VAT on non-business costs? Unregistered: Yes. Registered: Yes.
- Claim back VAT on exempt costs, within the partial exemption limit? Unregistered: Yes. Registered: Yes.
- Claim back VAT on exempt costs, above the limit? Unregistered: No. Registered: No.
- Claim back VAT on taxable business costs? Unregistered: No. Registered: Yes.
- Which form? Unregistered: VAT126. Registered: VAT return.
That last "No" matters: the VAT126 form can't be used to recover VAT that relates to a taxable activity. Only formal registration does that.
3. What You Need to Claim VAT Back
Beyond the legal right to recover VAT, there are four practical boxes to tick. The council must:
- Place the order for the goods or services.
- Receive the goods or services. Together, those two make it clear it's your VAT, not somebody else's.
- Hold a valid VAT invoice addressed to the council.
- Pay from its own funds, or funds it controls.
Tick those four and you're entitled to recover the VAT. Then there's the housekeeping: HMRC may ask for proof when they visit, which could be years later, so keep your VAT records for at least six years. That's six actual years, not six financial years, so we tend to say six years plus the current year. They can be kept electronically.
4. Partial Exemption: The Cliff Edge
Partial exemption is the single, consistently present risk to a council's ability to recover VAT.
How it works
During the year, you recover VAT as you spend it, including VAT on costs linked to exempt activities. The partial exemption calculation is then done in arrears, once the accounts are closed, to prove you are entitled to keep it. You can keep the VAT on exempt costs if it is:
- less than 5% of all the VAT you recovered from HMRC in the year, or
- less than £7,500,
whichever is higher. For most local councils it's the £7,500 limit that counts. The 5% test only really comes into play once you're incurring around £150,000 of VAT a year, which means spending well over £750,000 on taxable goods and services.
HMRC also allows for a seven-year average. If you breach the limit in one year but it's a one-off, and your average over the period stays below the limit, HMRC will overlook the breach.
The three steps
At year-end you:
- Identify the VAT on costs used only for exempt activities, including exempt supplies you intend to make. A capital project is the classic case: you're incurring lots of expenditure now, and the exempt lettings come later.
- Work out the exempt share of VAT on costs that support several activities, such as overheads, on a fair and reasonable basis, cost centre by cost centre.
- Add them together and compare the total with the limit.
Why it's a cliff edge
You don't just lose the VAT above £7,500. Once you've breached the limit, the whole amount becomes repayable to HMRC. And because the test is done in arrears, you might not realise you're going to breach it, and you might not have budgeted for the repayment.
So, monitor your partial exemption position regularly. Know which activities create the risk, and focus particularly on building works and land and property projects that are likely to result in you letting a building to the public for a charge. The earlier you raise a possible VAT recovery risk, the more likely there's a solution that will protect you. The single biggest lesson is: ask about VAT as early as you possibly can.
Key Takeaways for Clerks and RFOs
- Know which of your activities are non-business, exempt or taxable. The category decides whether you charge VAT and whether you can recover it.
- If you're charging for something, assume it's taxable at the standard rate until you can show it's non-business, exempt, zero-rated or reduced-rated.
- The VAT126 form can't recover VAT on taxable activities. Only formal registration does that, and HMRC would expect you to register once the VAT due reaches £1,000 a year.
- Tick the four boxes: place the order, receive the goods or services, hold a VAT invoice addressed to the council, pay from your own funds. Keep records for six years plus the current year.
- Monitor partial exemption during the year, not just at year-end. Breach the £7,500 limit and the whole amount is repayable.
- Ask about VAT early, especially for building works and projects that will lead to lettings.
Final Thoughts
Councils have more generous VAT recovery powers than almost anyone else, but they aren't unlimited, and the biggest risk, partial exemption, only shows itself after the year has closed. The earlier you raise the question, the more options you have. Not asking the question will almost certainly cost you; the answer often doesn't. To see how this plays out on a realistic project, read the second post: a worked example of building a new community centre.
If you have a question, email helpline@pstax.co.uk with details of your project and we'll give you our initial thoughts on the VAT issues and risks, with a more detailed review available under consultancy terms if needed. If you're an SLCC member, VAT questions to the SLCC advice line come straight through to us as part of your subscription.
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About the Author
Richard Strevens is Associate Director and Divisional Lead for Indirect Taxes at PSTAX. He has worked for or with local authorities for over 40 years, specialising in VAT for the past 30, and is the author of the Town and Parish Council VAT Guide.
PSTAX is a specialist public sector tax consultancy, part of the Dains group: pstax.co.uk
