HMRC guidance on the direct necessary test for the VAT cost sharing exemption

HMRC has published Revenue and Customs Brief 10 (2018) which explains changes to HMRC’s policy following legal judgments and the impact on the test for directly necessary services, which enables cost sharing groups to ignore certain non-qualifying supplies for the CSE. The brief is reproduced below:

Purpose of this brief

This brief explains a further change to HMRC’s policy following legal judgments on the cost share exemption (CSE). Revenue and Customs Brief 3 (2018) detailed previous changes which have been added into guidance. Paragraph 5 of that brief explained that HMRC was still considering the impact of the judgments on: the test for directly necessary services which enables cost share group (CSGs) to ignore certain non-qualifying supplies for the CSE; the social housing sector. This brief is about HMRC’s conclusions on the test for directly necessary services. The review of the use of the CSE by social housing associations has not been completed, so there is no change to the guidance at this time.


The CSE allows persons who carry on activities covered by certain exemptions to join together to form a CSG so they can acquire services and recharge their members for their use of the services at cost without incurring any additional sticking VAT. This exemption allows small providers who cannot afford to acquire assets on their own account to benefit from the same overall VAT position as larger providers who can afford to purchase the assets themselves. The circumstances where the CSE applies are fully explained in the VAT Cost Sharing Exemption manual CSE 1010.

Luxembourg has a rule where residual costs used by a CSG could be treated as qualifying for exemption under the CSE if up to 30% of those costs were also used by the members to make taxable supplies. The UK has a similar test but with a lower percentage of 15%. This is referred to in this brief and the former guidance as the ‘directly necessary’ test. The Advocate General in Commission v Luxembourg (Case C-274/15) said that the CSEcould not be used for such costs and this was confirmed by the Court in its judgment. The current tests for directly relevant services are therefore withdrawn from 15 August 2018. This means some CSGs will have to register for VAT if they go above the current registration threshold, however they may not need to do this before 31 December 2018 because of the transitional arrangements in paragraph 5.

 Changes to HMRC’s policy

The Court in its judgment held that the CSE was not restricted to CSGs whose members exclusively carried on exempt or non-business activities. Services which are bought by the CSG for mixed use could qualify for the CSE, but only to the extent that they were directly necessary for exempt or non-business activities by the members of the CSG.

HMRC is therefore introducing guidance on a suitable apportionment calculation which may be used where it is practicable to do so, and the conditions for its use can be met. Apportionment of the recharge of costs by the CSG to its members will be allowed if the CSG can carry it out fairly and keep records necessary for HMRC to verify the calculation. Full details are in the updated VAT Cost Sharing Exemption manual pages CSE3850 to CSE 3895.

HMRC reserves the right to refuse the exemption:

  • if the records to justify the apportionment used have not been keep
  • in any case of avoidance or abuse

Transitional arrangements

CSGs that have correctly used the previous guidance can continue to use the previous tests for directly necessary services until 31 December 2018, to give them time to make sure the correct records are set up and kept. The previous tests are set out in the VAT Cost Sharing Exemption manual pages CSE3720 to CSE3840.

The transitional arrangements cannot be used or relied on in cases:

  • of tax avoidance
  • where there is likely to be a distortion of competition

Services invoiced or paid for before 31 December 2018 will only benefit from the transitional arrangements to the extent that they’re performed before that date (specifically the basic tax point under section 6(3) of the VAT Act 1994 will apply).

Where prepayment or invoices cover services to be performed both before and after that date, then a reasonable apportionment will be needed.

Action required

CSGs should read the updated guidance on directly necessary services and consider the impact of the changes to the rules. Contact HMRC if you need more information.