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HMRC's Mixed Supply Rules Would confuse even the brightest of minds George W Bush

The phrase ‘opening up a can of worms’ is frequently heard in relation to the wonderful world of tax, and the rules surrounding it.  Unfortunately, opening a can of worms, appears to be exactly what HMRC are planning to do, in their current examination of the rules on how VAT is accounted for on mixed supplies.

What are mixed supplies?

In essence, for the purposes of VAT, a mixed supply is a number of goods or services, that attract different rates of VAT, which are bundled together and sold for a single price to a customer.

The problems start if any of the goods or services are considered ‘incidental’ to the main supply, as they are ignored for tax purposes. So, to demonstrate this, I’ll give you a couple of examples:

Mixed Supply Example 1: if you buy a standard rated fridge from Currys costing £499 that includes a zero-rated instruction manual on how to operate the machine with a value of £5, you ignore the leaflet’s value as it is incidental to the overall price of the ‘bundle’ and pay 20% VAT on the entire price.

Mixed Supply Example 2: Online booksellers Lovetoread offer a monthly subscription service for £17.50, and include a small free gift, such as an ornate bookmark or a protective book cover, with a typical value of £2.50. The booksellers decided that the gift was ‘incidental’ and zero-rated the entire cost of the subscription.

In example (1) the manual is only worth 1% of the total cost, but in example (2) the ’free’ gift is worth nearly 15% of the total cost. Are they both correct in their interpretation of what can be considered ‘incidental’? As an expert on VAT I would argue that Currys are correct, but that Lovetoread are pushing their luck somewhat.

Unfortunately, there aren’t any written rules on what percentage of the value of a bundle is incidental; with the onus on the trader to decide on a ‘fair reasonable’ apportionment. Ultimately HMRC are the sole arbitrator in these situations, which is probably why so many of these cases end up at a Tax Tribunal.

A worked example of a mixed supply

In this example a small limited company called Dolphin Watch Ltd, has a simple business model. Customers enjoy a four-hour sea trip to watch dolphins, during which a meal and drinks are provided for a single price of £50. The four-hour sailing trip is zero rated as a supply of transport, but the food and drink, being a supply of catering, is standard rated at 20% VAT. So, the problem for Dolphin Watch Ltd is how much of the £50 is subject to 20% VAT and how much is zero-rated? HMRC-VAT currently advise that the company can apportion output tax using any method which they consider to be ‘fair and reasonable’. In law no particular method is prescribed, but HMRC is now proposing to change that situation.

HMRC are proposing three alternatives mixed supply rules:

Option A – When supplies can be purchased separately: Dolphin Watch Ltd could give customers the chance to only pay for a boat ride, charging say £35, or just enjoy a meal and no ride – charging say £25. In this situation, the 20% output tax payable on the combined package can be calculated by using the ratio of the separate prices resulting in £3.47 VAT being due (£50 x £25/£60 x 1/6 = £3.47).

HMRC opening up a VAT can of mixed supply wormsHMRC’s intention is to “mandate this method of apportionment” if separate prices are charged for the individual supplies.

Option B – When only some supplies can be used separately: If Dolphin Watch Ltd gives customers the chance to enjoy a boat ride without food, charging £30, but not the option of a meal without the ride. This would make commercial sense – the boat makes more profit when it is moving. In this scenario the output tax is £3.33 (£50 selling price – £30 value for ride = £20 for meal x 1/6 = £3.33).

HMRC’s proposal is to mandate this method, as long as the cost of Dolphin Watch Ltd providing the meal is less than £25. If it exceeds this amount, ie cost is greater than revenue, then the cost price is used instead.

Option C – Single package only supplied: If Dolphin Watch Ltd only offers the combined trip & meal package, at present it can calculate its output tax using any method that gives a fair result. So, for example, if the going rate for a four-hour boat ride is £35, this figure can be used as the zero-rated element of the package. A bit hit and miss, perhaps, but an easy method of calculation.

HMRC proposal is that the ‘use of cost will be mandatory’ – ie apportionment must be made according to the cost of providing each separate supply within the bundle. Oh deary, deary me!!

I just can’t see how Dolphin Watch can accurately apportion costs in this scenario, it will be a nightmare. What are the costs associated with the boat ride – depreciation of the boat? Fuel and repair costs? The wages of the seaman who steers the boat? And what about the cost of the meal – depreciation of the tables and chairs where customers eat their meal? The wages of the chef? Do the deckhands double as waiters to serve the meal? Answers on a postcard, please.

Potential tax avoidance

The simple solution for Dolphin Watch Ltd with scenarios B & C, would be to introduce separate pricing if the HMRC proposals become law, so only scenario A applies. Unfortunately, this potentially opens the door for blatant tax avoidance unless the legislation brings in anti-avoidance measures.

For example, if Dolphin Watch Ltd advertises a meal only option of £40, and a ride only option of £60, then no customers will ever book these options if the combined price is £50 for both of them. But as far as VAT is concerned, output tax under HMRC’s mandated proposals will be £40/£100 x £40 x 1/6 = £2.67. This is a worse deal for HMRC than at present as output tax can be apportioned with any method as long as it is ‘fair and reasonable.’

Tax Accountant’s Comment

As the closing date for feedback to the HMRC consultation on its proposals was on 30th April. I personally hope that the issue will be forgotten as quickly as the recent proposals for a European football league. So instead of opening up a can of worms, perhaps they should opt for letting sleeping dogs lie instead.