Loan servicing not exempt from VAT

The First-tier Tribunal has held that supplies by a business administering a loan portfolio for a bank were not exempt from VAT as the supplies fell within the exception for “debt collection”.

The First-tier Tribunal has held that composite supplies by a loan servicer to a bank fell within the debt collection exception to the VAT finance exemptions and were therefore standard-rated: Target Group Limited v HMRC [2018] UKFTT 226. Despite considering that the supplies provided by the administrator of a loan in maintaining the sole record of a customer’s loan account might, in principle, fall within the exemption for transactions concerning payments or transfers, overall the service, looked at objectively from the recipient’s perspective, amounted to one that was predominantly a supply of debt collection services.

Whilst the individual taxpayer in this case failed to fall within the exemption, the decision of the FTT that the exemption for transactions concerning payments or transfers can extend to a person running a loan account book and making accounting entries may be helpful in other cases and may indicate that the narrow approach in Bookit and NEC is best restricted to cases where there is simply a demand or request for payment amounting to an exchange of information.

Background

Target provided loan servicing for a bank, covering the lifecycle of loans to the bank's customers other than the making of the initial advance. Target established loan accounts using its own systems, communicated with borrowers as an undisclosed agent of the bank, and dealt with payments by borrowers and all administrative issues that arise during the life of the loan. The terms of the loans, including interest rates, were set by the bank and Target had very limited discretion in dealing with customers. Also, although Target was involved in dealing with arrears, any enforcement action was a decision for the bank. It was accepted that the activities amounted to a single composite supply for VAT purposes.

Target claimed that its supplies were exempt from VAT pursuant to the Principal VAT Directive Article 135(1)(d) either as:

  • transactions… concerning… payments, transfers, or
  • the operation of any current … account.

HMRC rejected this considering that the supplies were either standard rated debt collection in line with the ECJ decision in AXA or, if the wider elements of the supply meant that the composite supply was not simply “debt collection”, then it amounted to a supply of standard rated credit management services.

FTT decision

The FTT first analysed the correct approach to the classification of a single, complex supply. The tribunal considered that “the starting point is to identify the individual elements of a single complex supply. Whether that supply falls to be treated as exempt will generally (but not necessarily exclusively) be determined by reference to predominance, but this might either be a single predominant element or in some cases a combination of elements. The test is an objective one, from the perspective of a typical consumer, and based on the contract and the economic realities”. It was not simply a case of looking at the individual elements and deciding if any of those might qualify for exemption, as argued by HMRC.

Turning to the question whether the supply included transactions concerning payments or transfers, Target, represented by Roderick Cordara QC, stressed that the loan accounts were controlled and maintained it and provided the sole record of the position between the bank and its customers. The key was Target’s authority to effect changes to the parties’ legal and financial situations by crediting and debiting entries to those accounts. The FTT agreed that, despite the recent decisions in Bookit and NEC, that activities of Target fulfilled the specific, essential functions of payments or transfers, going beyond a mere physical or technical supply.

“In particular, Target is responsible for matching payments made into… bank accounts to individual loan accounts and crediting them accordingly. It also debits those accounts with the principal amount due, as well as interest and any fees. There is no other record of these amounts or the precise level of indebtedness outstanding at any time. Target has responsibility extending beyond technical aspects to the creation of credit and debit entries. Importantly, ATP demonstrates that the concept of transfer does not require any physical transfer of funds: accounting entries are sufficient.”

The situation was different to those in Bookit and NEC where there was “simply a demand or request for payment, or in essence an exchange of information between a trader and a merchant acquirer”. In addition, in the current case, “Target itself uses the BACS and CHAPS payment systems, rather than effectively instructing or requesting a financial institution to do so”, when making transfers to and from the bank’s accounts.

However, the FTT rejected any argument that the supplies might fall within the exemption for the operation of a current account. The FTT considered that the term “current account” does not have a specific legal meaning but instead takes its meaning from the commercial world. On that basis, a banker would clearly take the view that the accounts in this case were not current accounts, but loan accounts. In particular, whilst modern current accounts can have a wide variety of features, including a loan in the form of an overdraft, an “important element of the functionality is that there is free ability on the part of the customer to vary the amount owed to it up and down”. That was missing here.

Turning to the debt collection carve out, the FTT pointed out that whilst the exemptions from VAT must be interpreted narrowly in principle, the exception to the exemptions must be interpreted broadly. This approach applied to the exception for debt collection. Once it was accepted (in line with AXA) that debt collection includes collecting amounts as they fall due, then it followed that the payments and transfers processed by Target in this case was best described as “debt collection”. Target relied heavily on the earlier Court of Appeal decision in EDS. However, the FTT distinguished that case on the basis that, although the focus was equally on the “payments or transfers” exemption, it involved “loan arrangement and execution services”.

In this context, whilst the exemption for management of credit in Article 135(1)(b) was touched upon in the decision, it was agreed that this exemption (which is limited to the management of credit by the person granting it) was not be available on the facts.

What then was the appropriate description of the single supply provided by Target to the bank? This required “identifying the predominant element or elements of the supply based on the contractual arrangements and the economic realities”. In order for that supply to be exempt, that description must fall within the exemption for “payments or transfers” without being excluded by being “debt collection”. In the view of the FTT, the essence of what was being acquired by the bank, its main objective, was the collection of debts as they fell due, covering interest, principal and charges. The extent of any additional services provided by Target (such as creation of accounts, dealing with queries, provision of statements etc) did not affect the predominant nature of the supply as one of debt collection. As such, the supplies by Target to the bank were excluded from exemption since they were, properly described, “debt collection”.

Comment

The decision itself is not in any way a surprising outcome – it is widely accepted that loan servicing no longer constitutes exempt payment services. Nevertheless, in practice, much loan servicing will still qualify for exemption from VAT as it often falls within the scope of “management of credit by the person granting it”. This applies where the originator of the loan (or a company in its VAT group) continues to service loans after their sale to a third party or finance vehicle, or where the servicer (or a company in its VAT group) acquires/holds bare legal title to the loans it services.

Nevertheless, the decision may, in fact, be somewhat helpful to those outsourcing payment handling services more generally, in highlighting that exemption may still be available to non-financial institutions in some circumstances, especially where they are responsible for recording and handling “transfers” via book entries.

Equally, the current case should be contrasted with the earlier decision in EDS where the court held that “loan arrangement and execution services” fell within the “payments or transfers” exemption. In that case, the taxpayer was responsible not only for dealing with payments as they fell due but also for releasing the initial loan funds to the borrower. This may point to a significant difference which may assist other loan administration services to remain exempt. However, it should be remembered that the EDS decision predates both the AXA decision on debt collection and the more restrictive decisions in Bookit and NEC on the payments or transfers exemption and it should, therefore, be approached with a degree of caution.

Finally, whilst it was accepted there was a single composite supply in this case, with different structuring, it might have been possible to create a better argument for a mixed supply in respect of which an element was exempt - for example, if there had been a separate charge for payment services which operated independently of the loan servicing fee.

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