Insights

Insurer Update: PESMs: are you applying yours correctly?

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Insurers should consider how their investments impact their VAT partial exemption calculations before HMRC beats them to it.

Insurers that incur third party investment management fees may be in danger. They could be open to scrutiny by HMRC. Those who have not given sufficient thought to how their investments impact their partial exemption calculations may face significant costs by way of assessments of VAT, penalties and interest.

On the other hand, there are also opportunities to increase input VAT recovery by carefully considering all possible approaches.

HMRC appears to be aware that a number of Lloyd’s syndicates are not correctly applying their partial exemption special method (PESM) for VAT. These should be reviewed regularly. But we understand that HMRC has seen PESM agreements that are dated many years in the past and has assessed syndicates that may have forgotten the rationale behind the agreements.

At the moment HMRC is looking specifically at syndicates with sectorised PESMs, but the issue applies to any insurer that pays third party investment management fees.

The Lloyd’s VAT arrangements

HMRC is mostly targeting agreements that are based on the Lloyd’s VAT arrangements (LVA) that have been in place for many years. Although the LVA do provide a basic PESM template that may be appropriate for many syndicates and other Lloyd’s participants, they don’t necessarily reflect the way the insurer calculates its recoverable VAT. So they may not provide a sufficiently clear direction as to how to calculate recoverable input VAT.

We are currently helping several Lloyd’s syndicates to recalculate their recoverable VAT for previous years. HMRC asked them to do the recalculation because they hadn’t correctly applied the method set out in the PESM – agreed between the syndicate and HMRC many years ago.

HMRC understandably believes there may be more syndicates that have made mistakes in their VAT returns for the same reason. HMRC has sent out questionnaires designed to bring to light similar errors.

Sectorised methods with an investment sector

From our observations, HMRC seems most interested in cases with two-sector PESMs, where sector one is based on underwriting income and sector two on investment income. These PESMs are often identical (or almost identical) to the template PESM provided in the LVA.

It is particularly in the investment sector that insurers and syndicates appear to have difficulties.

In many instances, HMRC is finding that the input VAT relating to the investment sector is being recovered using the recovery rate of the underwriting sector. While this may lead to an ‘under recovery’ of input VAT, HMRC has made it clear that the agreed PESM must be applied.

In other instances, HMRC disagrees that (or fails to understand how) the method used by the syndicate in its investment sector relates to the method as set out in the agreed PESM. If the PESM is based on the standard LVA wording, it may not be possible to apply the method precisely as agreed.

There are other cases where HMRC and the syndicate may both have lost critical parts of the PESM (some PESMs are over 20 years old). This may lead to a strange situation where HMRC is reminding the syndicate that it must follow the PESM, but neither party is certain precisely what was agreed.

Issues and opportunities

If an agreed PESM is incorrectly applied, or not applied at all, HMRC may consider clawing back overclaimed input VAT (plus interest) going back four years. HMRC may also levy careless error penalties of up to 30% of the VAT assessed.

Conversely, some syndicates may be leaving input VAT on the table and may be able to increase their input VAT recovery (retrospectively going back up to four years). There are two ways to do this: either by strictly following the approach set out in their agreed PESM or, if they don’t already have one, setting up a PESM which takes investments into account.

Wider application

The above is not only relevant to syndicates with sectorised PESMs. It also applies to insurers that sell securities as part of the regular management of their investment portfolio and pay third party investment management fees. This is true whether or not a syndicate (or other insurer) has agreed a PESM with HMRC.

This is because input VAT related to the sale of securities is a special case in partial exemption. The input VAT incurred on such activities must be ringfenced and apportioned according to use.

‘Use’ is not defined and there are, therefore, many different ‘use’ methodologies that are arguably ‘fair and reasonable’.

A keen HMRC VAT officer could, for example, impose significant financial costs and administrative burdens on a syndicate (or other insurer) that had not already thought about how its investments might affect its input VAT recovery calculations. On the other hand, more forward planning for the correct approach may significantly increase input VAT recovery levels.

All in all, we recommend that syndicates and other insurers consider this matter proactively before they are prompted to do so by HMRC.

To discuss any of the issues raised in this article, please contact Mark Ellis.