Expert view: VAT and government funding is far too important to get wrong

When a charity or not-for-profit organisation receives money from a government body or regional development agency, the tax treatment of the funding is often misunderstood.

This can result in the VAT being charged to the funding body. Very often, the funding body will leave it to the charity to decide the tax treatment, and the charity will charge VAT to the funding body in the mistaken belief it can recover VAT on expenditure associated with the programme as input tax.

However, this is not the right decision. First, the local authority is acting as an 'accountable body' to the ultimate funding body, which might be the Government or the European Commission. The local authority is not the service provider, but simply the conduit by which funds are made available to the charity.

Second, the charity is being funded by grant to deliver the service to the community. The charity is not providing the service to the local authority and cannot charge VAT to it.

Third, the charity's relationship is with the business customer and, providing the service is free at the point of delivery, the service is a non-business activity, which means VAT on expenditure is irrecoverable.

The relationship between funding and funded bodies as grant or contract is a matter of fact, not choice. In most cases, grant status must be applied to achieve maximum use of funds. It is often assumed that the local authority can recover any VAT charged by the charity and that because the charity recovers its VAT on expenditure, the whole relationship becomes VAT neutral. This is incorrect.

Because the charity is providing the service to the business, any tax charged does not 'belong' to the local authority and cannot be recovered by it. Because the funding is finite, approximately 15 per cent will be lost in irrecoverable VAT.

However, if the relationship is worked out correctly, the VAT liability will be reduced to approximately 5 per cent in most cases, releasing up to an additional 10 per cent of funds for service delivery.

It is up to the funding body and the funding recipient to implement the correct treatment and maximise the funds available. In a recent case in which a relationship similar to the one described above was treated as a contract, it was possible to negotiate retrospective grant treatment over three years with HM Revenue & Customs. Almost £1m was claimed back and up to £300,000 freed up each year that would have been lost in VAT. This is too important to get wrong.

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