Ahead of the upcoming general election, a major feature of Labour’s revenue-raising programme is the now confirmed manifesto proposal to remove independent schools from the VAT exemption for education, and introduce VAT on school fees for private education (and other closely related supplies).
At present, education fees are exempt from VAT. But Labour has pledged to remove independent schools from the exemption which will mean that 20% VAT would be payable on top of current school fees, and other closely related supplies.
However, there may be some unintended Inheritance Tax (IHT) and Income Tax consequences of this policy where fees are not funded by the child’s parents. These should be considered prior to payment.
Here we look at the VAT, IHT and Income Tax consequences such a change might have on parents and those who pay school fees.
VAT consequences for individuals
In the event that this proposal becomes legislation, parents will be expected to pay an additional 20% (as is the current standard rate of VAT) on top of their child’s private education fees (and closely related supplies). This will understandably be a substantial increase in cost for the majority of those who pay the school fees on the child’s behalf.
What services will VAT be applied on?
As mentioned above, the current VAT exemption for education also applies to services that are considered to be ‘closely related’ to education such as (but not limited to) school trips, school transport, accommodation and provision of meals.
There is potential for some of the ‘closely’ related services to continue to not attract any VAT, as there are other reliefs such as zero-rating for pupil transport and exemption for welfare services (e.g. after school care).
Each independent school will need to assess their income streams and determine what supplies will be affected, and how best to manage the application of VAT to reduce the burden on parents where possible.
Will parents be expected to pay the full amount of VAT?
This will depend on the school.
Independent schools will have to become registered for VAT following this legislation, so there will be a possibility for schools to recover VAT on capital and running costs. In turn, this could allow independent schools to absorb some of the VAT cost to be passed on to parents. Based on our understanding from working closely with private education clients, we understand that some schools are seeking to absorb some of the VAT cost and therefore the increase in fees will not likely be as high as 20%.
What if parents are based overseas?
VAT will be applicable on all education fees regardless of where the parents are located.
There will be cases where a pupil’s fees are paid by parents/guardians who are located outside of the UK, which may lead some to assume that no VAT would be applicable in these circumstances. However, based on the general rule for supplies of services, the supply of education will be by a business to a consumer, so the place of supply will be the supplier’s location. The school will be based in the UK, so VAT will apply.
What if the education fees were paid by a third party entity?
In some instances parents may seek to have the increased fees covered by a third party entity (e.g. an associated company or Trust). However, from a VAT perspective it is not essential to the VAT liability of the supply who pays for the supply. What is more relevant is who the supply is made by and to whom. Education fees paid for by a third party but ultimately provided to the child will still be considered to be a supply for VAT purposes and will attract VAT.
In addition, as the supply would be being made to the child, the parents or associated third parties would not be eligible to reclaim the VAT costs with a valid VAT registration, as the supply could not be said to being made to anyone but the child.
What about fees paid in advance?
There has been some discussion about whether this would be an opportunity for parents to pay in advance prior to the legislation coming into force.
We are aware that some schools have been discussing and moving forward with payment in advance schemes to capture school fees for more than one term in advance to avoid having to charge VAT on fees. We have been urging caution on this, because there is potential for any payments of school fees made prior to any formal introduction of the legislation to still fall within the scope of VAT if the final provisions were to include anti-forestalling legislation.
We have been advising clients to consider this and highlight to parents that should any fees paid in advance fall within the scope of VAT, the school may be required to charge the applicable VAT to the parents at a later date, if required.
It will be the responsibility of the school to issue communications to parents regarding any applicable pay in advance schemes, and also advise on the VAT implications of any payments made in relation to this.
What are the potential IHT consequences of paying school fees in advance?
Where private school fees are funded by any other individual than the child’s parents, this would be a gift for IHT purposes.
If a grandparent, for example, usually settles the cost of their grandchildren’s private education, such gifts may be considered to be “Gifts out of surplus income” and exempt from IHT if the following criteria are met:
- The gifts are made regularly i.e. monthly, yearly etc; and
- The gifts are made from their post-tax annual income and not from capital funds e.g. the payment is not funded from the sale of shares; and
- The gifts do not affect their quality of life i.e. they can continue to meet their normal living expenses after making these gifts.
However, if the grandparent now decides to pay the remaining school fees as a lump sum to mitigate a large VAT liability, the gift would no longer be considered a “Gift out of surplus income” assuming not enough surplus income is available to meet the gift.
The gift would instead be considered a Potentially Exempt Transfer (PET) for IHT purposes. If the grandparent does not survive 7 years from the date of gift, the gift may be subject to IHT on their death.
Where school fees are paid via a payment in advance scheme and VAT is subsequently required to be paid at a later date, the settlement of the VAT payable would be treated as a PET where this expenditure does not qualify under the “Gifts out of surplus” exemption.
Further details on the IHT consequences of PETs can be found in our separate blog: Gifting money and inheritance tax (IHT): the rules – CT.
What are the tax consequences where a trust distribution is used to pay school fees?
At present, children and/or their parents may be in receipt of a trust distribution, with the funds thereafter used to settle private school fees.
Such distributions are likely to be very tax efficient as, dependant on the recipients’ marginal income tax rates, they may be able to reclaim a large proportion of the income tax credit attached to the distribution.
Should the trustees decide to pay a larger trust distribution to facilitate the pre-payment of school fees, where there is sufficient income available, this could have unintended income tax consequences for the recipient and the trust itself.
Dependant on the recipient’s other income and marginal rate of income tax, a larger income distribution may result in additional income tax being payable by the recipient, rather than a repayment being due.
If the trust also does not have a sufficient balance in the trust tax pool to cover the tax credits applied to trust distributions, any shortfall would be payable by the trustees in the tax year of distribution.
Dependant on the level of funds required, the trustees may need to consider capital distributions, rather than income, to facilitate the required payments to beneficiaries. However, the IHT and Capital Gains Tax consequences of doing so will need to be considered prior to any payments being made.
Questions
If you have any queries or would like more information on IHT or Income Tax consequences of pre-paying school fees, please contact our Personal Tax Team.
If you have any VAT queries, please email our specialist VAT team or call our VAT Director, Iain Masterton on 0131 558 5800.
