Focus: Finance and Governance - Outlook - The tale behind the historic VAT ruling

Resources are scarce in most charities. Marginal resources are the fairest maidens of the charity sector - they deliver an unequal proportion of innovation, quality and additional services.

However, VAT deprives charities of marginal resources. Charities can't recover VAT paid to suppliers against VAT paid by customers to the charity because charities don't have paying customers - charities mainly give their resources away to the neediest in society, either directly or through the services they provide. The Children's Society loses about £750,000 to the VAT man each year because of this - that's a lot of maidens.

In reality, there are few service-providing charities that rely solely on donated income, other than the smallest. The trading elements of charitable activities include, for example, contracts to provide services for anything from environmental studies to training for unemployed youths.

As a result, charities such as the Children's Society can recover part of their VAT bill. HM Revenue & Customs took the view that fundraising costs - in recruiting regular donors, for example - related only to fundraising income. Because those donations do not act as a commercial transaction, HMRC argued that VAT paid to suppliers to carry out those activities could not be recovered.

At the VAT tribunal in 2004, HMRC won on this point. The Children's Society appealed to the High Court, and the appeal was heard in June. Meanwhile, the European Court, the highest appeal court there is for VAT matters, made a historic ruling in a case this May. It ruled that VAT on the costs of fundraising through an issue of shares would be recoverable to the extent that a business undertook sales on which VAT would be charged to customers. The rider was that the money raised had to be capable of being used for any purpose in the organisation.

The parallel with charities is clear. Where a charity raises money through fundraising, the nature of fundraising itself is not relevant to determining a charity's ability to reclaim at least some of the VAT on its fundraising costs. Instead, it is the proportion of the charity's income that charges VAT to customers that determines how much VAT can be recovered. This is subject to the rider that the fundraising income must be for general purposes.

This is what the High Court found in its ruling at the end of July. The Children's Society - and, in principle, any charity providing some services upon which VAT is charged - can recover a proportion of its general fundraising costs.

What most alarms charities is the prospect of HMRC seeking to appeal this decision. With the principles so clearly set out in Mr Justice Blackburne's judgement, and following on the heels of a case settled in VAT's supreme court, this would only be a delaying tactic.

With the Chancellor and the Treasury genuinely interested in the most disadvantaged in society, we hope that they will guide HMRC to the right decision.

- See News special, page 5.

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