To protect a Scheme’s – and employer’s – position we suggest that some protective action is now taken by Schemes. We consider you should take this up with your investment managers.

Current Practice

Pension Schemes have taken their guidance from VAT Notice 700/17 – essentially unchanged since 1996. Schemes don’t normally themselves have separate VAT registration but tend to add themselves to the employer’s “group registration” – a step which maximises VAT recovery (for the employer) at no risk or cost to the Scheme.

Under current interpretations, investment management expense is apportioned between VAT recoverable elements – a scheme management component, e.g. meetings, performance calculation, valuation preparation – and a pure investment component – e.g. commission, investment advice, tax reclaim, custodianship.

A split of 30% (scheme management component) : 70% (pure investment component) is conceded in paragraph 3.3 Notice 700/17, but schemes may try to justify different percentages if they wish.

The Case

At the end of June 2007, the European Court of Justice ruled in the case of JP Morgan Fleming Claverhouse Investment Trust v. HMRC (C-363/05) that the British Government had misinterpreted Article 135(1)(g) of VAT Directive 2006/112 introduced in 1990 to exempt unit trusts and OEICs from paying VAT on investment management charges.

On a reference from the (UK) VAT and Duties Tribunal, the ECJ ruled in this case that whilst there is a discretion afforded to member states under the Sixth Directive to determine which funds should be designated “special investment funds” for the purposes of qualifying for this VAT exemption, in exercising the discretion member states needed to have regard to the objective of the provision, that being to facilitate investment in securities for investors through investment undertakings. The ECJ considered that the British Government’s argument that closed ended investment funds and other investment trusts are not required to use external management, but can opt to manage themselves, was not a sufficient ground on which to argue that closed ended investment funds should not benefit from the VAT exemption.

The case now comes back to the (UK) VAT and Duties Tribunal to make a final decision based on the ECJ’s guidance.

The Opportunity

This case involved an investment trust and has still not had a final decision. Commentators consider however that it offers the chance for a similar argument to be raised for pension schemes – and either by concession or a fresh VAT and Duties Tribunal ruling obtain a similar VAT exemption on scheme investment management expense.

Who would Gain?

In an ongoing DB Scheme, of course, the employer would harvest the economic gain from a successful ruling or challenge. In a DC Scheme how to treat any VAT saving between employer and beneficiaries ought to be clarified by the Trustees.

The Reclaim Limit

There is a three year limitation window for retrospective VAT challenges, so the earlier protective action is taken the fuller the potential reclaim.

Meanwhile the structure of VAT makes it desirable that the existing, unchallenged, VAT treatment continue to be adhered to.

Who must spearhead?

If a challenge on these lines is correct, what has happened is that your investment manager has charged VAT (70% irrevocable) to your scheme/employer. Thus it is for them to make the protective challenge since – on this analysis – they have overcharged you. Naturally, they must make it clear to HM Revenue & Customs that they would pay the recovery to their (“overcharged”) customers.

To Join Litigation?

Whether the Scheme’s trustees should positively join litigation individually or collectively cannot be the subject of general advice. Feel free to take this up with us. The amounts involved, the employer’s attitude, and the traditional distaste of trustees for court cases are factors. The intertwining of Trustees, employer, and investment manager complicates things.

All in all, the investment management community is more cohesive than pension schemes and they are legally and practically the best parties to take this forward.