Colchester Institute and VAT: when does Government funding become payment for a supply?

A guide

For the last decade, most education and non-for-profit bodies have treated Government funding as non-business grant income, leaving it comfortably outside the scope of VAT and largely uncontroversial.

However, the recent Court of Appeal decision in HMRC v Colchester Institute Corporation (CIC) will significantly alter this. The court confirmed that certain ESFA/DfE funding is in fact third-party consideration for the supply of education, which will thereby turn what was widely viewed as non-business grant into exempt business income.

The case itself concerns a further education college teaching 16–19 year olds, but its reasoning has wider implications across the sector. Although HMRC’s brief frames the decision in a further education context, the same principles could affect nurseries, independent schools, SEND providers and some charities where funding is linked to specific individuals, hours or places. It raises an important question: when is public funding genuinely a grant, and when is it really payment for a supply made to students, parents or service users?

In this article, our experts unpack what happened in the CIC case, why it matters, and what it could mean for affected organisations.

Why is the CIC case significant?

The Colchester Institute Corporation is a private further education college for 16-19 year olds. It receives:

Government funding (via ESFA/DfE) for eligible 16–19-year-old students.
Fees paid directly by parents for students who are not eligible for funding.

The college provides the same education and courses to all students, but the source of funding differs.

Historically, Government funding to Further Education (FE) entities and schools has been treated as non-business grant funding, outside the scope of VAT, particularly in cases where funding was viewed as general support for the institution’s activities.

However, The Institute took their case to the Court to argue for VAT exemption. While this may seem unusual from a practical point of view, as most bodies cannot recover VAT relating to non-business or business exempt supplies, the CIC’s reasoning was tied up with previous input tax it had claimed, and how that interacted with existing case law. For them, classifying funding as business exempt brought it within the scope of that case and improved their position.

The Court of Appeal’s decision

The Court of Appeal held that the ESFA/DfE funding in this case was not a non-business grant but third-party consideration for supplies of education to eligible students.

Or in other words, the funding is directly linked to the educational services provided, for instance:

The eligibility rules determine who is funded – this would not be the case with a general grant.
The money flows because particular students are taught.

Together, these factors meant the funding was treated as exempt business income rather than a non-business grant. As a Court of Appeal decision, the case also sets a precedent with implications beyond the organisation itself, forcing institutions to reconsider long‑held assumptions and ask: when does public funding stop being a grant and start being payment for a supply?

What is a non-business grant?

A non-business grant is funding received in situations where:

The recipient (often a charity or school) is not seeking to make a profit in relation to that income.
There is no strong or direct link between the amount of funding and services to specific individuals.
The funder is essentially supporting the organisation’s activities as a whole.

Example

A typical Primary School will receive funding from the DfE. This funding is for school’s activities as a whole, not for specific students’ education. It is therefore classified as general, non-business funding.

VAT treatment

A genuine grant (i.e. where no supply is made in return) will generally fall outside the scope of VAT.

Recovery of input VAT on related costs depends on whether those costs are incurred for business activities (e.g. making taxable supplies).

Where the funded activity is non‑business, input VAT is typically irrecoverable, except for bodies eligible for refund schemes such as local authorities (s33 VATA 1994) and academy trusts (s33B VATA 1994).

Unsure whether your funding is a non-business grant or consideration for a supply?

The distinction isn’t always straightforward and can depend on factors such as the purpose of the funding, the relationship between the parties and how any surplus is generated and used. If you’re reviewing a funding arrangement, our VAT specialists can help you assess the position and avoid unexpected VAT liabilities.

Get in touch

What is third‑party consideration?

Third‑party consideration arises where:

A third party (e.g. the Government) pays for a service supplied to someone else (e.g. a student).
The payment is specifically linked to identifiable services (often per head/per hour/per place).
There is a clear “direct link” between the funding and the supply.

Example

A nursery is being paid by the Government so that certain children can attend and receive a specific amount of education or care. The payment therefore exists because the child is attending and receiving that fixed service, not as a general donation.

VAT treatment

Third-party consideration means the organisation is making a business supply, which in education, is usually exempt. Exempt business status normally blocks recovery of the input VAT associated with that activity.

Why does this distinction matter?

Both non‑business grants and exempt business supplies can result in no VAT being charged on income. However, the categorisation does affect the following:

Whether input VAT can be recovered
Partial exemption calculations
Interaction with special reliefs (e.g. academies’ Section 33B, capital goods schemes)

The CIC case demonstrates that even where the immediate VAT recovery outcome may seem similar, the legal distinction between non‑business and exempt business can be critical once you consider the wider VAT framework and past/future capital projects.

Sectors that may need to review their funding treatment

Nurseries and early years providers

Nurseries are likely to be among the organisations most affected, as their funding models often create a direct link between the payment received and the care or education provided.

Nursery funding models usually involve the Government paying for a set number of “free” hours per eligible child, with parents paying for any additional hours or services. Under the Court of Appeal’s reasoning, those funded hours may amount to third-party consideration for a supply to the child or parent, rather than a general grant.

Independent schools and SEND/SEM providers

SEND/SEM funding is also at risk, specifically those schools which receive governmental or local authority funding for pupils, places or programmes, alongside parental fees. Where this is structured per child/per place, with clear eligibility conditions, the risk is that the funding will be treated as third‑party consideration.

Charities and other funded services

Charities and other publicly funded organisations may also need to consider the wider implications of the CIC case, although the position is more nuanced. Many charities already review contracts to assess whether funding relates to a supply for VAT purposes, but the case adds another layer of consideration.

Where funding has historically been treated as a grant, there may still be a risk that it could be viewed as third-party consideration if it is linked to a specific service for identifiable users. This does not mean every contract needs to be reviewed, but organisations should focus on arrangements where they are clearly delivering a service in return for funding.

Will academies need to review their funding treatment?

Academies are in a distinct VAT position because of their specific legal framework, including Section 33B of the VAT Act 1994, which allows them to recover VAT on non-business activities. As a result, we do not expect the CIC case to affect their core funding model.

If all an academy’s business activities were reclassified as business exempt, the legislation intended to equalise the VAT position of academies with local authority schools would become redundant. In that hypothetical case, the Government would likely need to amend the law to restore the intended VAT recovery, as doing otherwise would leave academies in a worse position.

For that reason, while academies should still consider specific activities such as nursery or post-16 provision, they are much less exposed to the eventual implications of this case.

Nuances and exceptions within academy trusts

The specific activities within academy trusts that could still be affected are:

Nursery provisions
Post-16 or other discrete funded programmes

In these cases, if funding is structured on a per-child/per-hour based (similar to mainstream nurseries and CIC), the risk of it being classed as third-party consideration is higher.

HMRC’s current guidance and the need for review

HMRC has issued a brief stating that FE funding should continue to be treated as non-business until further guidance is provided.

However, given the direction of the CIC case, some education providers may need to consider whether treating relevant Government funding as exempt, starting immediately, would be more appropriate for their circumstances. Also, any providers entering into capital projects such as building programmes may need to exercise some caution in light of this case, as it may impact the level (proportion) of activities categorised as either business or non-business. Professional advice should be sought to provide some clarity and perspective on any potential exposure.

Until further guidance is issued, this leaves a degree of uncertainty and makes it important for organisations to review whether their own funding arrangements could be affected.

What organisations should be doing now

Review funding contracts and documentation

The first practical steps organisations can take is to review their contracts and funding structures. Focusing on:

How the contracts stipulate what the money is for.
Whether funding is described as general support or as payment for specific services, places or hours.
Whether the wording creates a direct link between funding and particular children, students or service users.

For example:

If a contract says, “We’re funding you generally because we like what you’re doing,” this is more likely to support non‑business treatment.

If it says, “we’re paying you for X hours of provision for Y children,” then that looks much closer to third‑party consideration.

Identify where arrangements mirror CIC or nursery models

Institutions should identify funding streams that:

Are calculated per student, per child, per hour or per place.
Distinguish between eligible and non‑eligible individuals, with payment coming from government for some and from parents/others for the remainder.

These arrangements are the most likely to be recast as third‑party consideration if challenged.

Reassess VAT treatment and input tax recovery

If the reviewing process identifies funding streams that could potentially be impacted, we advise institutions to consider:

Whether continuing to treat the income as non‑business is defensible after the case.
The effect on input VAT recovery, partial exemption and capital projects of reclassifying it as exempt.

Our experts are already reviewing advice to treat relevant funding as exempt rather than non‑business, on a risk‑managed basis.

Prepare for HMRC scrutiny

In time, HMRC will be likely to review institution’s funding and VAT treatment. Undertaking internal reviews now, and documenting reasoning, could help demonstrate a considered, prudent, and compliant approach later.

Engage with specialist advisers

Given the potential VAT implications, organisations should seek specialist advice before making changes to their funding treatment. A review can help identify where arrangements may be affected, assess the impact on VAT recovery and build a stronger position if HMRC’s guidance develops further.

Closing thoughts

The CIC vs HMRC case verdict has revealed an important message: where public funding is directly linked to a specific service, it may require treatment as payment for that supply rather than a general grant. This will have consequences beyond further education, potentially impacting any kind of body that relies on public funding, including nurseries, independent schools, SEND providers, charities and academy trusts which have separately funded activities.

Organisations should use this period of uncertainty to review their funding arrangements, identify any direct links between payments and services, and consider the VAT impact of any change in treatment.

If you are unsure how the case could affect your organisation, our VAT specialists can help review your position and develop a practical, defensible approach. Fill in the form below to speak to an expert today.

We always recommend that you seek advice from a suitably qualified adviser before taking any action. The information in this article only serves as a guide and no responsibility for loss occasioned by any person acting or refraining from action as a result of this material can be accepted by the authors or the firm.

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