VAT and hire purchase transactions

The ECJ has, in providing guidance on the correct method for attributing residual VAT to hire purchase transactions, rejected the Advocate General’s suggestion that a hire purchase transaction should be treated as a single taxable supply for VAT purposes.

In delivering its judgment in the Volkswagen Financial Services hire purchase case, the ECJ has, for the second time in two days, ignored the recommendations of the AG: HMRC v Volkswagen Financial Services (UK) Ltd (Case C 153/17) (ECJ, 18/10/2018). The ECJ did not accept the AG’s opinion that the UK’s treatment of hire purchase transactions was incorrect and should be regarded as a single taxable supply. Instead, the ECJ has provided guidance on the correct approach to the attribution of input VAT to the separate supplies of exempt finance and taxable goods, holding that the fact that Volkswagen Financial Services (VWFS) did not in fact pass on its costs in the price charged for the vehicles did not mean that no part of the input VAT was attributable to that element. Any method of apportionment prescribed by the UK therefore must take into account the value of the vehicles provided under the HP contract.

Providers of hire purchase will be relieved that the ECJ has not endorsed the AG’s approach, which would have resulted in such output VAT being charged on the full consideration for such transactions. However, uncertainty remains over what method of attributing residual input VAT to such transactions may ultimately be the most appropriate.

Background

VWFS is a company which is part of the Volkswagen group and which offers various types of contract under which persons can acquire ownership or use of a VW vehicle. In relation to hire purchase transactions, VWFS purchases a car from a dealership and then provides those cars to customers under a hire purchase arrangement charging a price for the vehicle (the same price paid by VWFS to the dealership) and a finance charge. The UK treats those two aspects of the hire purchase as separate supplies: a taxable supply of goods and an exempt supply of credit.

The dispute concerned the recovery of the input VAT incurred by VWFS. Input VAT on the purchase of the vehicles from dealers was fully recovered by VWFS against the output VAT accounted for on the taxable sale of the vehicle. However, the dispute arose in relation to the recovery of input VAT incurred by VWFS on general overheads in running its business. VWFS argued that the proportion of the input VAT recoverable on overheads should be based on the number of exempt and taxable transactions carried out, with each hire purchase transaction counting as two transactions. On this basis, half of the residual input VAT would be recoverable.

HM Revenue and Customs (HMRC), on the other hand, argued, in essence, that the residual input VAT was a cost component of the exempt transactions alone. In particular, VWFS sold on the cars to customers at the same price as they acquired them from dealers, such that the overhead costs were not incorporated into the price of the taxable supplies.

The dispute as to the correct approach to deduction of input VAT on overheads made its way up to the Supreme Court which decided to refer to the ECJ the question (in essence) whether a taxable person who undertakes connected taxable and exempt transactions has the right to deduct input VAT incurred indissociably for the purposes of both of those transactions on general overheads, despite the fact that the costs giving rise to the input VAT are not incorporated into the price of the taxable transactions at all.

Decision of the ECJ

The ECJ first considered the question whether the HP transactions concerned were correctly viewed as separate supplies of goods and finance. On this point, the AG had opined that neither the obtaining of credit nor the purchase of a vehicle constitutes an end in itself for a lessee under a hire purchase agreement. “That lessee is seeking to use the vehicle under conditions which are specific to a hire purchase agreement and which would not be satisfied by any other method of acquiring the vehicle.” Instead, correctly analysed, a hire purchase agreement amounts to a single taxable supply of services according to the AG.

The ECJ has rejected that argument. In principle, the question whether a transaction consists of independent services or a single service for VAT purposes is a question for the national court to determine based on the characteristics of the particular transaction. Neither the referring court nor the UK Government had argued that a hire purchase arrangement should be seen as a single supply. There was nothing in the order for reference or the observations submitted to the court to show that the characterisation of a hire purchase contract as two separate supplies was not consistent with the relevant principles set out by the court. Accordingly, the ECJ did not follow the approach suggested by the AG in this case.

How then to determine the correct approach to the attribution of residual VAT in circumstances where (i) the supplier clearly made both exempt and taxable supplies as part of its business, but (ii) as a matter of practice, that residual VAT was all born as a cost component of only the exempt supplies (as that element alone bore the mark up on cost)?

The ECJ noted that it is a fundamental principle of the VAT system that a person is entitled to deduct input VAT to the extent that that input VAT is attributable to taxable activities. In this case, it was clear that the general costs incurred “have a direct and immediate link with the activities of VWFS as a whole”. In that situation, the court held that “the fact that VWFS decided to include those costs not in the price of the taxable transactions, but solely in the price of the exempt transactions, can have no effect whatsoever on such a finding of fact”.

In essence, the ECJ has said that the “cost component” approach in this situation does not depend on the actual extent to which the taxpayer has added the costs to its outputs. To the extent that the cost were “in fact incurred, at least to a certain extent, for the purposes of the supply of vehicles, which are taxable transactions, those costs are, as such, components of the price of those transactions”.

Having decided that the residual costs must, to some extent, be attributed to the taxable supplies of vehicles, it was next necessary for the court to determine the correct basis for doing so. The primary basis set out in the VAT Directives is one based on turnover and the court noted that if HMRC wished to apply a different basis in this case (based on use), then that basis would need to “guarantee a more precise result” from an attribution of VAT perspective. This was a question for the national courts to decide, in principle. However, the court noted that any such method “cannot be regarded as objectively reflecting the actual share of the expenditure resulting from the acquisition of mixed use goods and services” if it failed to take “account of an actual and non-negligible allocation of a share of the general costs to transactions giving rise to a right to deduct”. Any such method would not be capable of ensuring a more precise apportionment than that which would arise from the application of the turnover-based allocation.

Comment

The decision of the court in this case may prove important more widely in the context of input VAT recovery. The development of the “cost component” approach to input VAT recovery has been notable over recent years. However, the ECJ may have indicated the limits to its application - at least in relation to cases involving residual VAT on general overheads - by rejecting any requirement for a literal or direct fiscal allocation of costs. Based on the price recharged for the vehicles by VWFS, it was clear that none of the additional overheads were actually priced into the charge for the vehicle. Nevertheless, the ECJ has held that this does not prevent those overheads being a cost component of all the supplies made by VWFS generally. Commercially and economically, it was clear that those overheads were born by the business as a whole and that business included the on-sale of the vehicles.

It remains unclear, however, whether this more general approach to the “cost component” analysis of VAT recovery is limited to cases of general overheads and residual VAT or may be applied more widely by the courts to situations involving direct attribution too.

More immediately, providers of hire purchase arrangements will be relieved that the ECJ has departed from the AG’s opinion, which would have required output VAT to be charged on the full consideration under hire purchase arrangements, including any finance element.

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