Lease Funding and VAT

In a standard operational lease, part of the lease instalments relates to the financing costs incurred by the lessor. As the lease instalments in their entirety are subject to value added tax (VAT), tax is also due on this financing component. Lessees that do not have the right to deduct VAT have looked for ways to avoid paying VAT on the financing component. A feasible structure appeared to be a lease/financing scheme in which the lessee issues an interest-free loan to the lessor. Using this interest-free loan for its investments, the lessor no longer incurs financing costs. Without any financing costs, the lease instalments could be lower, leading to less VAT being due. VAT savings thus appeared to be within reach.

In the Netherlands the use of lease/financing schemes led to a conflict between VAT experts. One side was convinced that the provision of an interest-free loan actually constituted a payment in kind for the lease, and VAT was thus due on the value of the loan. Understandably, the Dutch VAT authorities adhered to this view. The other side saw no payment in kind: VAT was due only on the lease instalments. Recently, the Dutch Supreme Court(1) ended the dispute by issuing a clear decision on the question of whether VAT was due. After analyzing the facts the court clearly sanctioned the use of lease/financing schemes to limit VAT. According to the court the provision of an interest-free loan was not a payment in kind for the lease. As a result, the loan was not subject to VAT.

The Lease Structure

The case presented to the Dutch Supreme Court was relatively simple. A leasing company let cars to various lessees. During these (operational) leases the lessor remained the full owner at all times; the lessee could not acquire the car. For the purposes of Dutch VAT, each lease was considered a supply of a service. Cars were not rented out only to lessees who could deduct VAT, but also to lessees who could not recover the VAT on the lease instalments. In the case at hand, cars were rented out to an entrepreneur performing VAT-exempt activities. For this group of lessees, a special scheme was introduced. Under this scheme the lessee and the lessor concluded not only an operational lease agreement, but also a separate loan agreement. The amount lent by the lessee equalled the purchase price of the subjects of the lease. The loan had another special feature: it was interest free. Further, the loan tracked the book value of the leased car, a diminishing value corresponded to a lower loan amount. The special scheme thus resulted in the lessee effectively assuming the car's financing. The lessor could avail itself of 'free' money for its investments and incurred no financing cost, thus leading to lower lease instalments.

The Dutch VAT inspector qualified the interest-free loan as payment in kind for the lease of the car. In its view the lessor received payment partially in cash (the lease instalments) and partially in kind (the interest-free loan). As with all payments in kind, VAT should have been paid on the value of the remuneration in kind. For the lessor that value equalled the amount of interest charged on a comparable interest-bearing loan. Accordingly, the inspector levied an additional VAT assessment for that amount.

The lessor successfully challenged the VAT assessment before the Amsterdam Tax Court, which annulled a previous decision made by the Dutch Supreme Court with respect to a comparable lease/financing scheme.(2) The VAT inspector appealed the case to the Dutch Supreme Court, which upheld the tax court's decision, thereby sanctioning the use of VAT-saving lease/financing schemes.

In its judgment the Dutch Supreme Court introduced a new VAT doctrine: the 'means' doctrine. This doctrine addresses the situation where a customer provides its supplier with certain means, which the supplier can use only for its services towards that customer. Means thus supplied do not constitute a payment for the services and cannot be considered a payment in kind. The provision of the means takes place outside the scope of VAT.

The Means Doctrine in Practice

The means doctrine can be demonstrated as follows. Imagine a taxi driver with engine trouble. If the driver wants his car to be repaired he must take it to a service station and actually 'hand over' the car to a car repairman. No one would consider this temporary provision of the car as a payment in kind for the repair work to be carried out, since the garage receives the car for a certain period of time, but cannot freely make use of it. The car can be 'used' only in order to carry out the repair services. The car is thus a means for the requested services. The provision of the car takes place outside the scope of VAT.

Another example would be a situation in which someone provides a tailor with a piece of cloth in order to make a new suit. Handing over the fabric does not constitute a payment for the tailoring services to be performed. The tailor does not derive any profit from the piece of fabric, since it will be processed into the ordered clothing in its entirety. The raw material provided by the customer, the piece of cloth, is thus a means that remains outside the scope of VAT.

Money as Means

In its judgment the Dutch Supreme Court acknowledged that an amount of money could also be used as means. In certain situations, similar to the examples used above, handing over money does not constitute a payment.

According to the Supreme Court, the lessor used the interest-free loan to finance the lease subjects. The loan was used solely to perform services for the lessee (ie, the lease of a car). Under these circumstances the loan did not constitute a payment for the lease. Instead, the loan was simply the provision of means outside the scope of VAT. Following this reasoning, the court concluded that the interest-free loan was not a payment for the lease. The Amsterdam Tax Court's original decision was therefore upheld: the lease/financing structure was not subject to additional VAT.

Sacrifices Made by the Lessee

During the proceedings before the Supreme Court the Dutch state secretary of finance emphasized the expenses incurred by the lessee. According to the state secretary, the lessee could not dispose of a certain amount of money for a certain period of time. As a result, the lessee possibly lost interest income. The 'sacrifice' thus made constituted a payment for the lease and should have been subject to VAT. Many Dutch VAT experts sympathized with this point of view. However, the Supreme Court did not. In the court's view the lost interest income constituted costs directly incurred by the lessee. The court saw no direct link between those costs and the provision of a car under the lease. The sacrifice thus made by the lessee was therefore not a remuneration for the lease.

This point can be clarified by returning to the example of the taxi driver and his broken-down car. The taxi driver cannot generate income as long as his vehicle is in the garage for repairs. However, the income thus sacrificed does not constitute a remuneration for the repair work. The garage does not profit in any way from the income lost by the driver. The missed income is an (extra) expense incurred by the driver, which has no direct link to the repairs performed. Of course, no VAT is due on this sacrificed income.

The Timing of the Transactions

In the lease/financing structure reviewed by the Dutch Supreme Court, the timing of transactions was important. The lessor had acquired the cars before obtaining the lessee's interest-free loan. Strictly speaking, the loan therefore could not be used to finance the cars as they had already been financed. The lessor could use the money for other purposes. The loan was nonetheless a payment in kind. In his opinion for the Dutch Supreme Court, the solicitor general supported an economic approach. In his view, a historical connection between the loan and the investment made by the lessor was not required. A linking of the loan to the book value and lifespan of the car sufficed. A loan granted after the lessor purchased the car altered the way in which the car was financed. Such a loan did not differ significantly from a loan granted before the purchase of the cars. The Supreme Court apparently agreed with the solicitor general's view. As a result, it seems that a VAT-saving lease/financing structure can be implemented at any time, as long as the loan is linked to the book value and economic lifespan of the lease's subject.

The European Court of Justice's View

The question arises as to whether the means doctrine of the Dutch Supreme Court is in accordance with the provisions of the Sixth Directive.(3) Unfortunately, the Sixth Directive does not seem to give clear guidance on the position of such means provided by a customer. However, European Court of Justice (ECJ) case law seems to favour the Dutch approach.

In the First National Case(4) the First National Bank of Chicago carried out a wide variety of banking activities, including foreign exchange dealings. In this respect, the bank purchased and sold currencies. The spread between the purchase price and the sale price of the currencies constituted profit for the bank.

During proceedings before the UK High Court of Justice, two questions were referred to the ECJ. First, do such foreign exchange transactions constitute the supply of goods or services for consideration? Second, if there has been a supply of goods or services for consideration, what it the nature of the consideration in relation to such transactions?

The ECJ's answer to the first question was affirmative; the exchange transactions constituted a supply of services that was subject to VAT. Looking for the taxable amount, the court considered the following:

"While they are subject to a supply, the currencies transferred to a trader by his counter party in the course of a foreign exchange transaction cannot be regarded as constituting remuneration for the service of exchanging currencies for other currencies or consequently as constituting consideration for that service."

According to the court, determining the consideration for these services came down to determining what the bank received on foreign exchange transactions (ie, the remuneration on foreign exchange transactions that the bank could actually take for itself). Apparently, all other amounts that the bank received were considered means and thus outside the scope of VAT. The only relevant amount was the amount that the bank kept (ie, the net results of its transactions over a given period of time).

The ECJ also considered its previous decision in the Glawe Case,(5) which revolved around the VAT position of slot machines. Should VAT be calculated on all money inserted or on the net result of the machine after deduction of prizes paid out? The court held that tax was due only on the net result. The only relevant amount was the amount of money present in the slot machine "at the end of the day". The rest of the money inserted was considered means, without VAT implications. This money was used to provide a service to the customer: paying out prizes.

This case law appears to supports the means doctrine employed by the Dutch Supreme Court. What is relevant is what a taxpayer can keep for itself, not what it receives from its customer.

Comment

Under an operational lease VAT savings can be achieved by extending the lease with an interest-free loan from the lessee. By financing the subjects of the lease with such a loan, the lessor can calculate lower lease instalments. The lessee thus avoids paying VAT on a financing component. Such lease/financing structures have clearly been sanctioned by the Dutch Supreme Court. The ECJ appears to have followed the same reasoning. Perhaps such structures can now be used throughout the European Union.

For further information on this topic please contact Redmar Wolf at Baker & McKenzie, Amsterdam by telephone (+31 20 5517555) or by fax (+31 20 626 79 49) or by email ([email protected]).

Endnotes

(1) Decision 35.311 of March 28 2001.

(2) Dutch Supreme Court judgment 31443 of October 2 1996.

(3) Sixth Council Directive (77/388/EEC) of May 17 1977 with respect to the Harmonization of the Laws of Member States Relating to Turnover Taxes.

(4) The Commissioners of Customs and Excise v First National Bank of Chicago (Case C-172/96).

(5) Glawe v Finanzamt Hamburg-Brambeck-Uhlenhorst (Case C-38/93).