Grant or payment for services? Why getting this right really matters

When money comes into a charity or other not‑for‑profit organisations, it’s easy to focus on what it’s called. If it is labelled a “grant”, many organisations assume the VAT position is simple, i.e. VAT free, and move on.

In reality, the position is often much more complicated and requires careful consideration as it could in fact be a contract for services.

How funding is treated for VAT purposes can lead to late VAT registration, underpayment of VAT on the income and it will also directly affect how much VAT on expenditure the organisation can recover. If the charity has a mix of business and non‑business (e.g. grant only funded) activities, it will need to adopt a business/non‑business method to restrict non-business related VAT on expenditure, and the way funding is treated will feed into that calculation. It can also affect the accuracy of partial exemption calculations where the organisation fails to spot that a “grant” is in fact a contract for either taxable or possibly exempt services. Getting the treatment of grants versus services right can have a material impact on its VAT position.

A complex area – not a simple yes or no

Establishing whether funding is a grant or consideration for services is often a tricky area. Funding agreements are increasing in detail and can look more commercial than they may actually be, from a VAT perspective. They often include specific activities, spending conditions, reporting requirements, and timescales. This makes analysis tougher because these agreements can start to look very similar to contracts for goods or services. From HMRC’s perspective, their starting point for any enquiry or review is often to ask for copies of contracts or agreements.

If the wording points towards goods or services being provided in return for payment, that can quickly lead to questions about how much VAT an organisation is paying. In many cases, those questions could be avoided if the agreement were worded more clearly and reflected the true nature of the payment. Two arrangements that look similar on the surface can have very different VAT outcome once HMRC look at the detail.

There is no single rule that determines whether a payment is a grant for VAT purposes. It took HMRC years to issue guidance on the subject and it remains a complex area of VAT, and tribunal cases considering these issues regularly run to dozens of pages. Decisions are based on a detailed review of the facts, the wording of the agreements and how the arrangements work in practice. For that reason, the charity needs to look at the overall picture and apply a two‑stage test, supported by case law. The outcome depends on weighing up a range of factors, rather than applying a simple “checklist”.

We have pulled together some of HMRC’s key indicators below to help explain their approach. HMRC’s current approach is to apply a two-stage test, and they no longer rely solely on the old “business test” derived from the cases of Lord Fisher and Morrison’s Academy. The indicators from those cases can still provide helpful context when analysing the overall position though. In practice, both need to be kept in mind, which is why we have included some detail on these below. 

• If both stages are answered “yes”, the income is likely to be business income. 
• If either stage is answered “no”, it is more likely to be non‑business.

Stage One: “The activity results in a supply of goods or services for consideration”

Here, HMRC will usually start by looking at whether there is a legal relationship between the parties. This does not have to be a formal commercial contract, but there will normally be some form of agreement setting out what the organisation is expected to do and what funding it will receive. The key question is whether the organisation is obliged to carry out particular activities, deliver services or achieve specified outcomes. The more specific and detailed those obligations are, the more likely HMRC are to see a supply. This might include clearly defined outputs, timetables, service standards, or detailed reporting focused on delivery.

It is important to remember that “consideration” does not necessarily just mean cash. It can be payment in money or in kind; so there does not necessarily need to be an exchange of cash at all, the consideration could be the provision of goods or services in return.

If HMRC conclude there is not a supply, the payment is outside the scope of VAT and the analysis stops here. If there is a supply, you need to consider the Stage Two Test.

Stage Two: “The supply is made for the purpose of obtaining income therefrom (remuneration)”

HMRC then move to the second stage and ask “why” the supply is being made. Here, HMRC look at whether the activity is carried out with the intention of obtaining income or payment. Profit is not required. Even where funding simply helps keep an activity going or reimburses costs, it can still count as remuneration for VAT purposes.

If HMRC conclude the supply is not made for the purposes of obtaining income, the payment is outside the scope of VAT.

The “old” Lord Fisher and Morrison’s Academy test

Before HMRC adopted their current two‑stage test, much of the VAT analysis for charities focused on whether an activity was a business activity, based on principles from the Lord Fisher and Morrison’s Academy cases. While HMRC no longer rely solely on this approach, these cases are still relevant. In short, these cases looked at whether an activity had the characteristics of a “business”. Factors considered included whether the activity was carried out with a degree of seriousness and continuity, whether supplies were made in return for payment, and whether those supplies were of a kind typically provided by commercial organisations. No single factor was decisive. Instead, the courts looked at the overall picture to decide whether the activity amounted to an economic activity for VAT purposes. In practice, these indicators can still be helpful. They sit alongside HMRC’s two‑stage test and help inform whether an arrangement feels more like grant‑funded charitable activity or the provision of goods or services in return for payment.

HMRC’s indicators of when there is or is not a supply

HMRC’s VAT manuals also provide a range of indicators that help distinguish between funding that is outside the scope of VAT (such as grants) and payments that are consideration for a supply. These indicators are drawn from case law and are intended to be weighed together. Where HMRC are more likely to see a supply, the arrangement usually looks contractual. This includes situations where the funder initiates the agreement, directly benefits from the activity, and has a high level of control over what is delivered. Detailed specifications, performance targets, links between payment levels and outputs, enforceable rights if funding is withdrawn, and treatment of the income as trading all point towards there being a supply for VAT purposes.

By contrast, HMRC are more likely to accept that there is no supply where funding is freely given to support an organisation’s own aims. Common features include funding awarded through a grant application process, benefits flowing mainly to third‑party beneficiaries rather than the funder, limited control over delivery, and monitoring focused on proper use of funds rather than performance. The absence of legal rights if funding stops, treatment of income as non‑trading, and the presence of clawback clauses to recover unused funds also support the view that the payment is outside the scope of VAT.

These indicators do not decide the answer on their own. HMRC and the courts will look at how the arrangement works in real life, not just what the agreement says. That’s why it’s important to use clear wording and review funding arrangements from time to time.

Getting comfortable with the position

Many real‑world funding arrangements sit somewhere in between a genuine grant and a clear contract for goods or services. Small differences in wording or how an agreement operates can have a big impact on the VAT outcome and on VAT recovery. Reviewing funding terms early and making sure the agreement matches what is intended in practice, can help reduce VAT risk and avoid difficult conversations with HMRC later.  

We regularly help charities and not‑for‑profit organisations review funding arrangements, understand HMRC’s approach and assess the impact on VAT recovery. If you’d like to talk through your funding arrangements or sense‑check the VAT position, please do get in touch. We’d be very happy to help!