HMRC v Colchester Institute: What the Court of Appeal Decision Means for FE Colleges

On 27 March 2026, the Court of Appeal handed down its judgment in HMRC v Colchester Institute Corporation [2026] EWCA Civ 363. Colchester won. HMRC's appeal was dismissed unanimously.

HMRC now has until 24 April to decide whether to seek permission to appeal to the Supreme Court. If it does not, this six-year dispute is over. If it does, the sector faces another 12 to 18 months of uncertainty.

The question at the heart of the case

The dispute is about the VAT treatment of government funding received by FE colleges from ESFA (and its predecessor agencies, the EFA and SFA).

HMRC's long-held position was that this funding is a grant. Under that treatment, the education colleges deliver using this funding is a non-business activity, outside the scope of VAT. That classification gave colleges access to two valuable reliefs: zero-rating on new construction under VATA 1994 Schedule 8 Group 5, and the 5% reduced rate on fuel and power.

Colchester Institute argued the opposite. It said the funding was consideration for an exempt supply of education services to students, not a grant. The practical effect of that argument was to bring the education into the scope of VAT as an exempt business activity.

Why would a college want its income treated as exempt rather than non-business? Because of the Lennartz mechanism. In 2008, Colchester recovered over £2.25m in input VAT on a capital project by treating its activities as partly taxable. When it later stopped making the corresponding output tax payments, HMRC issued assessments. The entire dispute flows from that starting point.

What the Court of Appeal decided

Lord Justice Foxton, with whom Lord Justice Arnold and Lady Justice Asplin agreed, dismissed both grounds of HMRC's appeal.

On the first ground, HMRC argued the Upper Tribunal had misapplied the CJEU's decision in Rayon d'Or. The Court of Appeal rejected this, though it acknowledged the Upper Tribunal's characterisation of the case went further than necessary.

On the second ground, HMRC challenged the finding that a direct link existed between the funding and the supply of education. This was the substantive argument and the one the sector was watching most closely.

The Court of Appeal held that the wording of the funding agreements was the right starting point. Clause 4.1 of the EFA agreement stated that funding was paid "in consideration of" Colchester's performance of its obligations. The SFA's Financial Memorandum stated that funding was paid "for learning provision." The court found that these terms, combined with the formula-based funding model tied to student numbers and lagged learner data, the clawback provisions for underperformance, and the fact that Colchester issued receipts to all students (with funded students receiving a fee waiver), pointed clearly towards consideration for a supply rather than a general institutional grant.

The absence of a direct contractual relationship between the funding agencies and individual students was not fatal. The court confirmed that settled EU case law permits third-party consideration to establish the required direct link.

Why this matters for the sector

The implications fall into five areas.

Capital projects and zero-rating. If ESFA funding is consideration for an exempt supply, colleges are no longer making non-business supplies. That removes the basis for claiming zero-rating on new construction as a relevant charitable purpose building. Any college with a live capital project that has claimed or expects to claim zero-rating under Group 5 should be quantifying the exposure now. For a typical new-build teaching block, the difference between zero-rated and standard-rated construction is 20% of the contract value.

Energy costs. The 5% reduced rate on fuel and power for charitable non-business use sits on the same non-business classification. A Colchester outcome removes it. Depending on the college's energy consumption, this could add tens of thousands to annual running costs.

Input VAT on revenue expenditure. This is where the picture is less dramatic than it looks. Under the pre-Colchester treatment, input VAT on education costs is blocked because the activity is non-business. Under the Colchester treatment, it is still blocked because the supply is exempt. The block simply changes category. There is no material VAT recovery improvement on day-to-day spending under either outcome. In fact, a Colchester win may worsen partial exemption recovery rates on overhead costs by enlarging the exempt denominator in the residual method calculation.

Private school VAT interaction. Since January 2025, the supply of private school education has been subject to VAT at 20%. If ESFA-funded college education is now an exempt business supply, the dividing line between exempt college education and taxable private education becomes a live question that the sector has not yet fully worked through.

Colleges that already adopted Colchester. Approximately 20 to 30 colleges followed the Upper Tribunal decision and changed their VAT treatment after 2020. Four of them (Colchester, Portsmouth, Cornwall, Derby) secured rebates totalling over £2.8m. If HMRC does not appeal to the Supreme Court, those colleges' positions are vindicated on the historic claims but face the same forward-looking exposure on reliefs.

What finance directors should do now

Before 24 April. Watch for HMRC's decision on a Supreme Court application. FE Week and the GOV.UK VAT appeals list are the two sources that will report it first.

Regardless of HMRC's next move. Map your current and planned capital projects against the two scenarios. For each project, quantify the VAT cost difference between zero-rated (non-business) and standard-rated (exempt business) treatment. That is the contingency number your board needs.

If HMRC does not appeal. Expect updated Revenue & Customs guidance within 60 to 90 days, replacing or supplementing RC Brief 8/2021. Do not change your VAT treatment until that guidance is published. HMRC will need to set a transition timeline, and early movers risk getting it wrong.

If HMRC does appeal. The status quo holds. Continue on HMRC's non-business treatment. The Supreme Court hearing, if permission is granted, is unlikely before mid-2027.

Review your partial exemption method. If Colchester stands, every college that uses the standard method will need to negotiate a special method with HMRC that properly reflects the new split between exempt ESFA-funded education and any remaining non-business activities. Start that conversation with your VAT adviser now rather than waiting for the deadline.

The bigger picture

The sector's core VAT problem is not solved by this case. FE colleges bear an estimated £200m a year in irrecoverable input VAT that schools and academies, covered by the Section 33 refund mechanism, do not. Whether that irrecoverable VAT is blocked as non-business or as exempt makes no practical difference to the bottom line.

What would make a difference is extending Section 33 to FE corporations. The Large College Group has argued for exactly this, and the LSE Consulting report commissioned to support that case describes it as a necessary policy correction rather than a fiscal favour.

Colchester resolves a legal question. It does not resolve a funding one.