The ECJ has given its decision in the case of JP Morgan Fleming Claverhouse Investment Trust plc v Commissioners of HM Revenue and Customs (Case C-363/05), a test case brought alongside the Association of Investment Trust Companies (now the Association of Investment Companies).
The issue under consideration is the extent of the VAT exemption for "management of special investment funds as defined by Member States" conferred by Article 13B(d)(6) of the EC Sixth Directive. The UK purports to implement this exemption in domestic VAT law in the VAT Act 1994 (Items 9 and 10, Group 5, Schedule 9), which applies to open-ended collective investment schemes such as authorised unit trusts ("AUTs") and OEICs, but not to closed-ended entities such as investment trusts. The taxpayer is an investment trust company ("ITC") receiving management services from a third party, which are currently treated as chargeable to VAT. It is therefore incurring substantially irrecoverable VAT on receipt of those management services.
The four issues referred to the ECJ were as follows:
- Are the words "special investment funds" in Article 13B(d)(6) of the Sixth Directive capable of including closed-ended investment funds, such as ITCs?
- If the answer to 1 is yes, does the phrase "as defined by Member States" in Article 13B(d)(6): -
- allow Member States to select certain of the "special investment funds" within their jurisdiction to benefit from the VAT exemption for management services and exclude others from the exemption?; or
- mean that Member States are to identify those funds within their jurisdiction that fall within the definition of "special investment funds" on the basis that the benefit of the exemption should extend to all such funds?
If the answer to 2 is that Member States can select which "special investment funds" benefit from the exemption, how do the principles of fiscal neutrality, equal treatment and the prevention of distortion of competition affect the exercise of that discretion?
Does Article 13B(d)(6) have direct effect (ie, can taxpayers rely directly upon its provisions before domestic courts or does it require further implementation in domestic law by Member States)?
Decision of the ECJ
The Sixth Directive contains no definition of "special investment fund". The Abbey National case (Case C-169/04) (a case with the same presiding Advocate General) stressed that the scope of the Sixth Directive exemption did not depend on the legal form of the fund in question. So whereas ITCs have legal form and are closed-ended, they can still be "special investment funds" for the purposes of the exemption. It was not relevant for the ECJ that closed-ended investment vehicles were not subject to the UCITS Directive (85/611/EEC), as this was adopted after the Sixth Directive. At the time the Sixth Directive was adopted, EC terminology in the field of special investment funds was not harmonised.
Hence, in the ECJ's view, the definition of special investment funds in Article 13B(d)(6) is capable of encompassing ITCs.
Issues 2 and 3
The second and third issues were considered together. The ECJ considered that the discretion afforded to Member States did not enable them to select which types of fund should benefit from the exemption and which should not. Rather, Member States have only the power to define the funds located on their territory that meet the definition of "special investment funds". Furthermore, in exercising that power, Member States must respect the purpose of the exemption in Article 13B(d)(6) and the principle of fiscal neutrality of the VAT system. The purpose of the exemption, the ECJ observed, is to facilitate investment in securities by means of investment undertakings by excluding the cost of VAT. The principle of fiscal neutrality means that economic operators carrying out the same transactions should not be treated differently in relation to the levying of VAT.
The ECJ held that any application of national legislation that excludes the management of special closed-ended investment funds from the VAT exemption is contrary to the objective of the exemption and to the principle of fiscal neutrality in circumstances where the funds in question are collective investment undertakings that allow investors to invest in securities and where those funds are in competition with other types of fund that benefit from the exemption from VAT.
The ECJ stated that:
"according to the statements put before the court, the management of ITCs falls within the objective of the Sixth Directive and ITCs constitute investment funds comparable to AUTs and OEICs which fall within the definition of 'special investment funds'. In those circumstances, the exclusion of ITCs from the exemption provided for by Article 13B(d)(6) does not appear justified in the light of the objective of that provision and the principle of fiscal neutrality."
Issue 4 The ECJ considered that Article 13B(d)(6) has direct effect, being sufficiently precise and unconditional and could therefore be relied on by a taxable person before a national court in order to challenge the application of national legislation alleged to be incompatible with it.
The matter will now be referred back to the UK VAT and Duties Tribunal, who will be required to decide whether the exemption provided in UK VAT law is contrary to the principles in the EC Sixth Directive, and hence whether ITCs should be entitled to the same exemption from VAT as open-ended vehicles such as AUTs and OEICs in the UK. However, the ECJ's strong statement that distinguishing ITCs from such open-ended vehicles does not appear to be justified in light of the EC Directive means that the most likely outcome is now that the VAT exemption for management services should apply equally to ITCs.
On the assumption that the VAT and Duties Tribunal reach this conclusion, managers will broadly be able to bring claims against HM Revenue & Customs ("HMRC") for refunds of VAT wrongly accounted for in relation to ITC management fees. A statutory limit is imposed by UK VAT law on claims for refunds of VAT accounted for in error, restricting such refunds to VAT paid in the three years prior to the refund claim in question (although the question of whether this three year restriction may be valid as regards VAT that may have been accounted for prior to the introduction of the limit in 1997 is shortly to be considered by the House of Lords in the related cases of Michael Fleming v. CRC and Condé Nast Publications Ltd v. CRC).
The ramifications of this decision for individual ITCs and their managers may depend on any action taken to date in anticipation of the ECJ's judgment. ITCs and managers may have formulated arrangements to enshrine the procedures that will be followed, both in advance of the judgment and following a successful judgment. The nature of any such arrangements will obviously differ on a case by case basis, but may include, among others, provision for managers to submit "protective claims" to HMRC for refunds of VAT accounted for in the three years prior to the date of those protective claims. In general terms, managers will be obliged by law to pay any sums refunded from HMRC in relation to VAT paid in error, but the amount of the refund will be limited to the sum actually accounted for by the managers to HMRC (which will be net of creditable VAT incurred by the manager on its own purchases).
There is also, therefore, the possibility of a shortfall in amounts refunded by HMRC as compared to VAT actually paid by the ITCs to their managers with their fees in the past. There are complex principles of contract law underpinning the treatment of VAT sums paid wrongly by ITCs to managers under the terms of their management agreements, and the above mentioned arrangements may include provision as to the extent of the refund and terms for repayments from managers.
Pending a ruling from the VAT and Duties Tribunal in line with the ECJ's judgment in Claverhouse, it is strongly recommended that any ITCs and their managers who have not yet engaged in relation to the question of recovering VAT paid and accounted for on management fees historically do so now and seek professional advice where necessary.
The nature of the ECJ's judgment, that Member States do not have freedom to choose what type of investment fund benefits from the VAT exemption, leaves open the possibility that other forms of vehicle may seek to argue that their management expenses should attract the same benefit. It can be strongly inferred from the judgment that Member States should not distinguish in implementing Article 13B(d)(6) between one type of collective investment undertaking that allows investors to invest in securities and another, where the undertakings are in competition.
Questions therefore remain as to whether other forms of common investment entity, such as pension and endowment funds, could now claim that the UK is not justified in denying them an exemption from VAT on their fund management expenses.