VAT & Grant Funding: Is it still what you think it is?
Grant funding is normally outside the scope of VAT. That assumption runs through the finances of most charities in Scotland, it has held good for decades, and for a great many organisations it still holds today.
What has changed is the ground underneath it.
Outside the scope tends to get read as nothing to see here. On the income side that is right, since there is nothing to charge. On the cost side it is a leap, and it is the leap that does the damage, because it turns a VAT position into something nobody needs to look at.
When the assumption stops holding, one of three things follows. Some organisations find they have a problem, where income should have been taxable and was not, and the exposure runs backwards rather than forwards. Some find they have an opportunity, where becoming taxable unlocks recovery on VAT they have been absorbing for years. Some find they have both, and there the order in which you deal with them matters a great deal.
Decades of agreement, overturned
In March 2026 the Court of Appeal decided a case involving Colchester Institute, a further education college, and the money it received from government funding agencies. For as long as anyone could remember, the college, the wider sector and HM Revenue & Customs had all treated that money as grant funding and outside the scope of VAT. It was public funding, paid to an educational charity, to do what educational charities do. Nobody thought anyone was buying anything.
The Court disagreed. It held that the funding was payment for the education the college supplied to its students. What persuaded the judges was the funding agreements themselves. Eligible students, eligible courses, money calculated by formula against what was actually delivered, reporting obligations, and clawback if the college fell short. There was no invoice per student, no price list, and no contract between the funder and the student. The reciprocity was in the paperwork.
Here is the interesting part – it was the college arguing that this was not a grant! HMRC was the one insisting it was – they appealed, and they lost.
That tells you something about this area that no amount of guidance will. A large, well-advised organisation looked hard at its own position and decided that being inside the VAT system was worth fighting for.
What actually decides it
Strip away the technical language and two questions decide whether money is a grant or payment for a service.
- Is somebody getting something in return for the money?
- Is the money being paid in order to obtain that something?
For a charity leader the practical version is shorter still. Does your funding agreement tell you what you may spend the money on, or does it tell you what you have to deliver? Conditions about how money is accounted for, what it may be used for, and what reports go back to the funder are the ordinary furniture of grant making. Specified outputs, service standards, named beneficiaries, opening hours, volumes, and a right for the funder to hold you to any of it start to look like something else entirely.
What the arrangement is called makes no difference at all. A Scottish sports charity funded jointly by a city council and a university found that out the hard way some years ago. Its agreement was headed Annual Grant Funding, in those words. The tribunal looked past the heading to the obligations underneath, found the charity had committed to run a facility to the funders’ requirements with priority access for their users, and held the money was payment for services. The assessment was over £350,000.
Two charities, one question
Consider two advice organisations, both charities, both funded by their local council. Both operate under a service level agreement setting out what they do and when they are open.
The first is a citizens advice bureau in Wolverhampton. The second is a health and social care watchdog in Hampshire. One received a grant. The other was paid for a service. The difference was not the sector, the funder, or the existence of an agreement.
The bureau provided free advice to anyone in the area who walked through the door. The council had not asked it to deliver anything in particular, and the conditions attached to the money were about proper stewardship rather than performance. The tribunal concluded it was a grant.
The watchdog had won a competitive tender to carry out functions the council was legally required to arrange. It had to deliver defined services to a defined standard, and the council could hold it to that. The ultimate beneficiaries were local people, but the contract was with the council. The tribunal concluded that this was payment for a service.
The distinction is the one that matters most in practice. Were you supported to do your own work, or were you engaged to do somebody else’s?
How we got here
Two things have moved, and only one of them is about tax.
The first is procurement. Public funders came under sustained pressure to show what their money bought. Grants became tenders. Standing arrangements became service level agreements. Annual settlements became contracts with outputs attached. In a great many cases the service on the ground did not change, the organisation delivering it did not change, and the people receiving it noticed nothing at all. What changed was the process, and the documents it produced.
The process is what decides this.
Most of the time nobody in that new process is thinking about VAT. The funder is evidencing value for money to its own stakeholders. The charity is competing to keep income it has had for years, sometimes against nobody.
The trouble is that the features which satisfy a public sector audit are precisely the ones that turn a grant into payment for a service. A procurement exercise designed to demonstrate rigour produces, almost incidentally, a contract.
The second change is the tax side, and it runs in the same direction.
For years charities argued hard that they were not carrying on a business. That sounds counterintuitive until you remember what non-business status unlocks. Zero rating on the construction of new charitable buildings; reduced rate fuel and power; and relief from the Climate Change Levy. Two nursery charities took that argument to the High Court in the early 2000s and won, and by 2005 HMRC had formally accepted the position.
Then the courts moved. Over the following decade they stopped asking what an organisation was predominantly concerned with and started asking something colder. Is there a direct link between what is supplied and what is paid? Charitable purpose no longer mattered. Neither did profit motive, nor charging below cost. In June 2022 HMRC withdrew its earlier concession and confirmed the harder test.
Which way does it fall?
The risk in all of this sits behind you rather than in front of you. If income should have been taxable and was not, the exposure is historic, and where the failure is one of registration it can reach back considerably further than the four years most people assume. Penalties depend heavily on whether the organisation came forward or was found out.
The opportunity is real too, and it is routinely missed. A charity that has never been VAT registered has been absorbing VAT on everything it buys. Registration can turn a meaningful slice of that from dead cost into recoverable input tax. Where a funding agreement is silent on VAT or states that the price excludes it, the charge itself may pass to the funder rather than being swallowed by the charity.
The difference between those two outcomes usually comes down to who is paying you. Can your funder recover the VAT?
A local authority generally can recover all of its VAT, particularly across its non-business statutory activities. A government directorate or a health board can also recover its VAT, but only where the service falls within a defined list, which is a real test rather than a formality. An independent grant making trust or a lottery distributor usually cannot recover anything at all, which means VAT on that income is a genuine cost that somebody has to absorb.
The answer changes whether this conversation is about a threat or an opportunity.
Where an organisation has both, sequence matters. Going to HMRC with a registration you should have had years ago is a different conversation when you can also show what the Exchequer owes you on the other side of the ledger. Work out the whole position before you open it, rather than volunteering the liability and discovering the recovery afterwards.
What to do about it
Three things, none of which needs a VAT specialist to start.
- Identify which of your income streams came through a tender or a service level agreement rather than a grant application, and what they are worth. You cannot judge the size of this until you know how much of your income sits in that category.
- Find the advice your current position rests on. If your treatment of a major income stream depends on something an advisor said, or a letter from HMRC, make sure you can still produce it and that it still says what you remember it saying. I have seen an organisation rely for over a decade on a favourable HMRC reply that neither it nor HMRC could locate when it mattered.
- Establish your funder’s recovery position in writing early. That conversation is straightforward while the question is hypothetical. It becomes considerably harder once VAT is already on an invoice.
So the question I would put to anyone running a charity is a simple one. Pick up your largest funding agreement and read it properly. Does it tell you what you may spend the money on, or does it tell you what you have to deliver? If it is the second, your funding may already be something other than a grant, whatever the heading on the front page says.
This blog has been written by Greg McNally, Managing Partner of VITA. VITA offers CLS members a free VAT surgery. This is a short, focused conversation where they give you an honest picture of where you stand. No jargon, no obligation, and no invoice at the end of it. Please email events@charityleadership.scot for more information.