Readers will no doubt have read about the recent VAT case, Brabners v HMRC. Brabners is a north- west firm of lawyers, which was supported by the Law Society in an unsuccessful appeal against an HMRC VAT assessment.

The case primarily rested on whether electronic search fees were properly allocated as disbursements for VAT purposes or whether they should have been part of the service supplied by the law firm. At the time of writing, it is not known whether Brabners LLP will appeal the decision.

In this edition of COFA Corner, we look at the fundamentals of the key concepts of disbursements and the related VAT treatment, which arise from the Brabners case. We also consider any relevant actions the COFA can consider while awaiting any further outcome.

What are disbursements for VAT purposes?

From an HMRC perspective, for an item to be treated as a disbursement, it must satisfy the 8 'disbursement conditions' in VAT Notice 700 Paragraph 25.1. These are:

• You acted as the agent of your client when you paid the third party.
• Your client actually received and used the goods or services provided by the third party. This condition usually prevents the agent's own travelling and subsistence expenses, phone bills, postage, and other costs being treated as disbursements for VAT purposes.
• Your client was responsible for paying the third party. Examples include fees which are actually payable by your client for the purposes of their transaction, contract or legal action. These could be SDLT or other taxes, most court fees and Land Registry fees.
• Your client authorised you to make the payment on its behalf.
• Your client knew that the goods or services you paid for would be provided by a third party.
• Your outlay will be separately itemised when you invoice your client.
• You recover only the exact amount which you paid to the third party.
• The goods or services for which you paid are clearly additional to the supplies which you make to your client on your own account.

If these conditions are not met, the costs incurred are deemed to be a recharge as a supply of services.

There are some exceptions to the standard position outlined above. These include concessions on:

• Postal property searches, which would still appear to apply, although few postal searches are undertaken these days; (*)
• Counsel’s fees and most medical examination fees.

(*) There may not be any apparent difference in principle or practice between how postal and electronic searches are used or otherwise by law firms. However, HMRC have established a long-standing concession to allow postal search recharges to be treated as disbursements.

One of Brabners’ arguments was that the concession applying to postal searches should apply equally to electronic searches. That argument may still run further: the tribunal indicated this matter was outside the case it was considering and would be outside its jurisdiction. This might be the basis for some further appeal.

Disbursement or recharge: why is this important?

No input VAT charged on the initial cost

It appears that Brabners were not being charged any input VAT on the electronic searches which they usually obtained through Searchflow. Therefore, such amounts were passed onto clients as a disbursement without VAT.

In the Brabners case, HMRC’s contention was upheld that, when clients engage a lawyer in property transactional work, the solicitor is not “simply a conduit or post-box for search results.” The client has an expectation that lawyers will use their knowledge and experience to obtain such searches as are reasonably required and will use the results of these searches to advise their client on any issues arising.

Based on the statement above, the cost of the searches was deemed to be part of the service provided and therefore not a disbursement for VAT purposes. So output VAT needs to be added to the onward charge to the client, even though no input VAT is incurred on the original cost.

This practice and understanding have been routinely accepted and applied to items such as travel expenses and postage, where no input VAT is incurred.

However, the Brabners case has now brought into question the position relating to search fees: although they do not incur input VAT, they do commonly include Land Registry official copies.

This has certainly created the biggest concern in the industry. If the Brabners decision stands, will firms bear the costs of accounting retrospectively for VAT previously not charged to clients? This could be the situation and many practices are waiting with bated breath for further developments.

Input VAT charged on the initial cost

Where a law firm’s expenditure on behalf of its client has incurred input VAT, there is arguably a greatly reduced risk of redefining such a disbursement as a recharge.

For instance, it is commonplace for law firms to record the gross cost as a disbursement and then charge the client the gross cost without accounting for any VAT.

If HMRC did claim that a law firm should account to it for output VAT on the onward charges to clients, the firm would also have a claim to input tax to offset the liability.

If a law firm is currently charged input VAT, recovers it on the VAT return and only treats the net amount as a disbursement, the firm should already be charging and accounting to HMRC for output VAT, when it passes that charge onto the client.

Payments direct from the client account

If the Brabners decision stands and search fees are deemed part of the firm’s service and not disbursements, does this change the fact that these amounts can be paid direct from funds held in the client account for the client? This would appear to be the position under the SRA Accounts Rules 2011: again, it would require some thought about changing the related systems and procedures.

What action can COFAs and law firms take while awaiting further developments?

1. It would be beneficial to ascertain what searches or similar services are being obtained on which the law firm is not charged VAT. Do they amount to a significant annual value? That total figure gives an indication of a firm’s possible exposure.
2. Review the procedures applied to accounting for these costs and the VAT treatment. Where a practice is charged VAT and recovers it as input tax, the practice should only be treating the net figure as a disbursement. It should generally be applying output VAT to that net figure when charging the client.
3. Where a practice is charged VAT and does not recover the input tax, instead treating this gross figure as a disbursement chargeable to the client, it is beneficial to make clear on the client bill that it is the gross amount. In this way, a firm’s financial exposure should be minimal, even if challenged by HMRC.
4. If the postal search concession does not apply, it appears that firms should be charging output tax on any disbursements for property, people locators, solicitor or bank searches, checks or similar services, where they are used as part of the service or advice given to the client. Note that any input VAT charged on these can be recovered. This treatment results from the Brabners case and is subject to any appeal or new Law Society guidance.
5. Watch the Law Society website and other services for further developments.

First published in the Nov/Dec 2017 issue of Legal Abacus Magazine. COFA Corner is written by Jason Mitchell, Partner – Legal Sector Specialist at Francis Clark LLP

This publication is produced by Francis Clark LLP for information only and is not intended to constitute professional advice. Specific professional advice should be obtained before acting on any of the information contained herein. While Francis Clark LLP is confident of the accuracy of the information in this publication (as at the date of its production), no duty of care is assumed to any direct or indirect recipient of this publication and no liability is accepted for any omission or inaccuracy.