Appeal Number MAN/2007/0430

[2009] UKFTT 204 (TC)

TC00157

Appeal number MAN/2007/0430

VAT- input tax-attribution of inputs to supplies- advertising of sofas –whether directly linked to supply of insurance intermediation; head office and store expenses.

VAT- input tax- special method – whether special method allowed (pre 1992) or approved. Whether difference between approval and allowing.

FIRST-TIER TRIBUNAL

TAX CHAMBER

DFS FURNITURE COMPANY LIMITEDAppellant

- and -

THE COMMISSIONERS FOR HER MAJESTY’S

REVENUE AND CUSTOMS (VAT)Respondents

TRIBUNAL: CHARLES HELLIER (Tribunal Judge)

JOHN ROBINSON

Sitting in public in London on 11 to 16, 18 and 19 May 2009

Roderick Cordara QC and James Willan instructed by KPMG, for the Appellant

Owain Thomas instructed by the Solicitor for HM Revenue and Customs, for the Respondents

© CROWN COPYRIGHT 2009

1

REPORT OF DECISION

This is a report of the Decision of the tribunal. It differs from the Decision released to the parties in that certain passages of the Decision which contained commercially sensitive information have been replaced in this report by passages in square brackets.

Introduction

1. This is an appeal of two parts. The first part concerns whether advertising and certain other inputs were direct cost components of the Appellant’s supplies both of sofas and of insurance intermediary services. The second relates to whether or not the Respondents “approved” a special method for the apportionment of the Appellant’s non directly attributable VAT.
2. This is a decision in principle on these issues as they relate to appeals against assessments made on the Appellant, DFS.
3. DFS is a well known supplier of sofas. (In this decision we have used the term “sofas” to encompass the variety of types of upholstered sitting furniture which DFS supplies.) There will be few who have not seen its television and other adverts. But if you go to one of the Appellant’s stores and decide to buy a sofa then you may be offered, and you may agree to take, one of two types of insurance. The first type is anti stain insurance: that speaks for itself. The second is Personal Protection Insurance (PPI) and is only offered if you have bought a sofa on interest free credit terms: it is insurance against illness or unemployment which could affect your ability to repay the credit.About 20% of customers take anti stain insurance and about 30% take PPI.
4. DFS does not itself provide the insurance but arranges for the customer’s application to be accepted by a third party insurance company. Those insurance companies pay commission to DFS for the introduction of the customer to them. Thus if the result of your visit to a DFS store is that you take both a sofa and an insurance policy, DFS will have made two VATable supplies: a taxable supply of the sofa to you and an exempt supply of intermediation to the insurance company.
5. DFS incurs costs in its business on which it bears input VAT. That input VAT is recoverable (and offsetable against the output tax it has charged and owes HMRC) in accordance with rules in the relevant EC Directive (the relevant directive at the time was the Sixth Directive) and domestic legislation. Broadly, unless HMRC (we use HMRC to include the previous manifestation of the Respondents as the Commissioners of Customs and Excise) permit or direct a “special method”, the input tax is fully recoverable if the input is a direct cost component of a taxable supply, not recoverable at all if it is a direct cost component of an exempt supply, and if it is neither – if it is “residual” – will fall to be recovered in accordance with a fraction determined by the legislation.
6. There is no doubt that DFS’ costs of making or buying sofas are direct cost components of its taxable supply of the sofas. This appeal concerns other costs. In the first part of the appeal DFS argues that, in particular, its advertising costs (“think sofas: think DFS”) are a direct cost component only of its sales of sofas – that its advertising is directly used only in selling sofas and not in insurance intermediation. In the second part DFS argues that HMRC had approved a “special method” of VAT recovery which permitted almost all its input tax to be recovered (including all that on its advertising).
7. The law and the relevant facts in relation to each part are almost wholly distinct, and we shall therefore deal with the two parts separately.
8. We heard oral evidence from Mr Massey who joined DFS as its deputy managing director in 1988; Mr Barnes, who joined DFS as its Finance Director in 2003; Mr Todhunter, who joined DFS as its Company Secretary in 1983, was financial controller from 1988 to 2003 and remains with the company as company secretary; Mr Gibson, who was HMRC’s lead officer for DFS from 1996 until 2008; Mrs Harrison the officer of HMRC who from 2006 conducted the discussion with the company about partial exemption; and from Mr Hall, who had been an officer of HMRC between 1987 and 1997and gave evidence as to the practice and procedure of HMRC but had no direct involvement with DFS. We also had four bundles of copy documents. From that evidence we make the findings of fact in the first section of Part I of this decision, and the “Events since 1986” section in Part II, (together with any facts related above).

PART I : Attribution

Our findings of fact

1. During the period relevant to the appeal DFS operated about 77 retail stores. Through 73 of them it sold sofas and other upholstered furniture, and through four of them cabinet furniture. DFS’ sales were not made in this period through its website. Mr Massey told us that DFS had a telephone ordering service. On reviewing his evidence it was not clear to us that this was available or used during the period relevant to the appeal. We conclude that in that period telephone sales were not a significant part of DFS’ activity. .
2. DFS had three factories in the UK which manufactured sofas. Its own factories supplied 15-20% of the furniture it sold. The balance it bought from external manufacturers.
3. A typical showroom will display some 80 different models. Each model will be available in various forms: four, three and two seater sofas, sofa beds, chairs, footstools or corner units. And each will be available in three or four different coverings (fabric or leather) and each fabric in perhaps 60 different colours. Endless sofas.
4. DFS are and were a one product specialist upholstered furniture business. They aimed to be able to offer sofas to appeal to 80% of the market: as Mr Massey said, perhaps not to those who live in castles or cardboard boxes, but to all the rest of us. Endless sofas.
5. A sofa showroom is divided into 60 or 70 room sets each set displaying a different model. The displays will be complimented by table lamps or pictures. DFS do not aim to sell theses accessories, but if a customer buys a sofa and says “I want that lamp too”, the lamp will be sold.
6. The interactions between the sales staff and customers will vary in nature, but generally the customer’s first decision, after perhaps discussion about prices, styles and fabric and colours, and after perhaps more than one visit and more than one discussion, will be to decide upon the style and form of sofa he or she wants and to settle on the fabric and colour. At this stage the customer will generally sit down (probably on his or her choice of sofa) with the salesman and an order form. The salesman will start to fill in the order form with the details of the furniture being ordered. Around this time there may also be a discussion about extras such as cushions, the care of the sofa, care products warranties and anti stain insurance; and also about delivery dates and the method of payment.
7. The customer will generally be offered the choice of paying by cash immediately (or in part on delivery) or some form of interest free credit. Interest free credit is available on all goods if the customer is accepted by the relevant finance company: of those who seek credit [a very substantial proportion] are approved.
8. Whilst we believe that there will be times when anti stain insurance is discussed before a customer settles on his order, we believe it likely that in the substantial majority of cases anti stain insurance will be discussed after the customer has decided to buy, and a final decision as to whether to purchase the insurance will be taken only after the details of the furniture order have been entered on the order form (although normally the order form will be signed, and the customer formally committed, only once it is complete with an entry in relation to anti stain insurance – if it is being taken up.)
9. Likewise, although there may be cases in which PPI may be discussed before the decision to buy is made, we believe that in the substantial majority of cases it will be discussed and settled upon as part of the decision as to how payment will be made. PPI is relevant only if some sort of credit is taken. Mr Massey described the PPI decision as a final option at the end of the process. We accept this: the structure of the order form and the credit application would generally be followed by a salesman, and PPI comes on that form after matters such as the details of the sofas ordered; a salesman’s focus will be on securing the order for the furniture (for which he or she receives commission) before selling PPI (for which he or she receives less commission); whilst he or she is likely to refer to interest free credit in leading a customer to a purchase it is in our view less likely that the additional cost of PPI will be raised at an earlier stage.(Although we note again that the customer will sign an order incorporating sofa specifications and other matters such as PPI only at the end of the process.)
10. Salesmen receive commission on completed orders. They earn commission on the sale of furniture. [The commission varies with the type of sale.] They also earn commission on sales of PPI and anti stain insurance.
11. After completion of the order form and (in [those] cases where credit is taken) the credit details form, a copy is given to the customer and copies are retained for processing by DFS. There is an office area in the sales floor of most showrooms where processing takes place. Processing results, in the case of credit sales in the credit application being forwarded to the finance company, and in the case of cash sales, and credit approved orders, in instruction being sent for the manufacture of the sofas. Anti stain insurance and PPI acceptances will be recorded in DFS’ systems at this stage. Orders are fulfilled by the manufacture and delivery of sofas. They are not sold from stock.

Anti stain insurance

1. Anti stain insurance is not offered on leather sofas. 62% of sales are of leather sofas. So anti stain is potentially relevant only to 38% of sales. About 84% of those customers who buy fabric sofas take up the offer of anti stain insurance. Thus only about 32% of all customers take up the insurance. The decision to take up anti stain insurance is recorded by ticking a box on the order form.
2. DFS has offered anti stain insurance since 1997. On 29 September 1997 it entered into an agreement with the insurer Pinnacle Insurance limited and the claims handler and administrator, Guardsman UK limited. The agreement describes DFS’ wish to provide a scheme under which its customers will have the opportunity of purchasing anti stain insurance, and for the purposes of the scheme appoints Pinnacle and Guardsman. DFS is not expressly appointed agent of Pinnacle, but Pinnacle agrees to accept all insurance sales made under the scheme. Guardsman is appointed to deal with all claims handling. DFS is to collect the premium and account for it to Pinnacle. Insurance rates are to be agreed between DFS and Pinnacle, and Pinnacle agrees to pay DFS commission at rates to be agreed between them.
3. Since the inception of the agreement DFS has applied an anti stain chemical spray to those insured sofas suitable for spraying (not all fabric sofas are). The agreement does not expressly impose any obligation upon DFS to apply the spray, although there is a clause under which DFS agrees that the intellectual property rights in the Guardsman anti stain product will remain with Guardsman, and the terms and conditions of the insurance policy refer to the benefits of Guardsman’s fabric protector. Mr Massey said that DFS regarded itself as obliged to spray, and that Pinnacle worked on that basis too. We find that, by the time of the periods relevant to this appeal, DFS were contractually bound to apply the spray to all eligible sofas which were insured.
4. Where the anti stain spray is to be applied, it will, in the case of sofas manufactured by DFS be applied at its factory, and in the case of the sofas from third party suppliers, be applied at the stores before despatch. Each of the stores has a warehouse area into which deliveries of sofas are received and checked, and from which they are dispatched. There is a small area a few times the size of an average sofa in which the spraying is done and in which the relevant equipment is stored. It occupies a small fraction of the warehouse area.
5. The following table indicated the take up of anti stain insurance.

Furniture orders / Fabric: 38% / Leather: 62%
Anti stain take up / 84%:yes; 16% No / No insurance offered

1. Thus anti stain insurance is sold on about 32% of orders. Of that 32% about one third are sprayed in the factory, one third at the store, and one third are not suitable for spraying.

Interest free credit and PPI

1. PPI is relevant only where customers take credit. It provides insurance against disability, unemployment or death. DFS entered into agreements with a number of credit providers under which it agreed to provide to the credit provider applications for credit arising from particular stores. DFS was not expressly appointed to act as agent for the credit provider. On receipt of the application the credit provider would accept or decline to give credit to the customer. The customer would pay for the PPI as part of his or her monthly payment.
2. We did not see a copy of an agreement between DFS and a PPI provider, but we accept that DFS was entitled to receive and received commission from each insurer in respect of the insurance placed with it.
3. Interest free credit was available in the relevant period on “straight terms” - where monthly payments started immediately - or on deferred terms - where monthly payments started after an interval. In each case the customer became indebted to the credit provider for the amount of his or her sale and the credit provider made a payment to DFS. That payment would be made net of a subsidy borne by DFS to cover the cost of the credit – that subsidy would thus vary with interest rates and the term of the credit. This mode of payment gave rise to the Primback issues which we discuss in the second part of this decision.
4. [Special arrangements applied to those customers who elected for credit on deferred terms and then repaid their loan before the first interest payment became due.]
5. When a salesman had determined that a customer would buy on credit, he or she would discuss PPI with the customer. Since January 2005 DFS has been regulated by the FSA in respect of the sale of PPI and was required to make an assessment and recommendation. This was done by filling in part of the order form in which the age and employment status of the customer were detailed and a formal recommendation made as to suitability of the policy. Formal training is given to the salesmen in relation to the provision of advice on PPI.
6. The following table indicates the take up of PPI as a proportion of orders:

Cash Sales : [less than half of all sales] / Orders with Credit sought: [more than half of all sales]
Credit declined:
[small fraction] / No PPI: [more than 1/3 of all sales] / PPI: [less than ¼ of all sales]
Deferred: [majority of PPI] / Straight: [relatively small part of PPI]
[Settled early] / [Not settled early]

1. The following table indicates in broad terms the financial weight of DFS’ supplies of sofas and insurance intermediation. The figures in the later columns are taken from Mr Barnes’ evidence, and those in the first columns from documents in the bundle before us and relate to the 2007 year. We find that these were approximately the financial effects in the period of the appeal although there were variations from year to year. The figures are not intended to be precise findings of amounts, but rather indications of broad relative proportions (thus for example the exempt income is a total of 4.5% of all income in the table; in fact it varied between 3.8% and 7.6% in the period 2000 to 2008):

Total gross income / %age of total gross income / % of total gross margin / % of gross margin on orders with insurance
Sales of Sofas / £604m / 96% / 94% / 80%
PPI Commission / £10m / 1.5% / 1% / 4%
Anti stain commission / £19m / 3% / 5% / 16%

The final column indicates the split of the contribution to gross margin of the various components in the case of sales where some insurance is taken up. The penultimate column indicates the split of gross margin across all sales. We note the relative unimportance of insurance intermediation income.