Since the judgment of the European Court of Justice (ECJ) in Halifax[1], the taxpayer and HM Revenue & Customs have adopted different interpretations of the abuse test in relation to VAT. The ECJ case of The Commissioners for Her Majesty's Revenue & Customs v Weald Leasing Limited[2] further considers and develops the application of the abusive practice test in relation to VAT.

Weald Leasing

Weald Leasing concerned a deliberate attempt by a taxpayer to circumvent the ability of HMRC to make a direction under paragraph 1 of Schedule 6 to the Value Added Tax Act 1994 (VATA).

Relevant subsidiaries within the Churchill group of companies (Churchill Management Limited (CML) and Churchill Accident Repair Centre Limited (CARC)) were heavily exempt and were only in a position to recover 1% of VAT incurred on the acquisition of the assets in question were they to purchase them direct.

Also within the Churchill corporate group was a company named Weald Leasing Limited (Weald). Instead of CML and CARC purchasing the assets in question outright, Weald effected the purchase. It then leased the assets to Suas Limited (SUAS), plus VAT. It should be noted that SUAS was not part of the Churchill corporate group and was technically not connected. This on the face of it enabled Weald to recover the VAT it incurred on the cost of the assets. SUAS then entered into a contractual arrangement with CML and CARC under which it would sub-lease to each of those entities the assets it initially purchased from Weald.

As a consequence of the above transactions Weald sought to recover 100% of the input tax incurred by it on the assets in question. SUAS did likewise. CML and CARC on the other hand restricted their ability to recover the input tax charged to each of them by SUAS by reference to the nature of their heavily exempt business. However, for them the advantage existed in the form of drip-feeding the irrecoverable input tax over the course of the lease with SUAS, as opposed to incurring it up-front.

HMRC sought to prevent Weald from recovering the input tax incurred by it on the purchase of the assets, and assessed.

Whilst re-stating the general principle of abuse set out by it in at paragraph 69 of Halifax, the ECJ emphasised that the Directive does not require a taxpayer who has a choice of transactions "to choose the one that involves paying the higher amount of tax" (paragraph 27). Importantly, it went on to state, at paragraph 33, that recourse to a leasing transaction as opposed to purchasing an asset outright "does not, in itself, constitute a tax advantage the grant of which would be contrary to the purpose of [the Directive]".

At paragraph 34 the ECJ went further to state that a taxable person "cannot be criticised" for choosing a leasing transaction and thereby "spreading the payment" of irrecoverable VAT as opposed to purchasing the asset in question outright "provided that the VAT on the leasing transaction is duly and fully paid".

Neither CML nor CARC had sought to recover more input tax than they were entitled to. However, the ECJ made it clear that the UK courts will now have to consider whether the terms of the leasing transactions in question were contrary to the purpose of the Directive. It stated that this would be the case "if the rentals were set at levels which were unusually low or did not reflect any economic reality".

If the terms of the sub-lease from SUAS to each of CML and CARC were less than market value then they would be unable to issue a determination under paragraph 1 of Schedule 6 VATA. This, in turn, would mean that although CML and CARC would be restricting their input tax recovery the fiscal burden of so doing would be lower than if HMRC were able to issue a market value direction under Schedule 6. This was the crux of the issue for HMRC as it potentially, therefore, gave rise to a fiscal advantage.

However, Weald argued that Halifax could not apply to such an advantage, the reason being that paragraph 1 of Schedule 6 was introduced as a derogation under Article 27 of the Sixth VAT Directive and forms part of VATA - it was not, therefore a community rule for the purposes of the abuse test. The ECJ disagreed with this and held, at paragraph 45, that the leasing transactions in issue would not give rise to a tax advantage if the terms of the lease setting the rental amounts were arm's length and the involvement of SUAS did not prevent HMRC from making a market value direction under paragraph 1 of Schedule 6 VATA.

In addition to its statement in paragraph 45, the ECJ stated that the fact that CML and CARC did not normally enter into leasing transactions was irrelevant and that the finding of an abusive practice is to be inferred not from the commercial operations of the taxpayer in question but from the object and effect of the transactions in question (paragraph 44).

The ECJ therefore held that the arrangements would not give rise to an abusive practice unless the terms of leases to CML/CARC were not at arm's length and/or the involvement of SUAS prevented HMRC from making a direction under paragraph 1 of Schedule 6 VATA.

Comment

Weald Leasing involved a series of transactions taking place between entities that were ostensibly not connected. The intention behind Weald Leasing was that HRMC would be prevented from making a direction under paragraph 1 of Schedule 6 VATA. It should be remembered that paragraph 1 of Schedule 6 is a derogation under what was Article 27 of the Sixth Directive, which was therefore implemented to prevent evasion or avoidance.

It is interesting to note that the ECJ said that the existence of an abusive practice is not to be defined by reference to the commercial operations of the entity in question usually engaged in. It may be that if the ECJ took into account the fact that SUAS and CML/CARC did not ordinarily enter into leasing transactions that fact would inevitably influence any decision that an abusive practice took place in Weald Leasing. This would have meant that the ECJ would not have been able to state that a decision by an entity to lease assets as opposed to purchasing them outright is on the face of it acceptable. Given that one of the stated aims of the VAT Directive is to avoid distortions of competition (e.g. recitals 4 and 7 of the Principal VAT Directive), as a point of principle VAT considerations should not influence business decisions (e.g. Intercommunale voor Zeewaterontzilting v. Belgian State (Case C-110/94) at paragraph 16).The abuse in Weald Leasing is therefore putting CML/CARC in the position where their irrecoverable input tax is lower than it would be if the rental payments charged to them were at market value.

What can be taken away from Weald Leasing is that the ECJ has reinforced what it said at paragraph 73 in Halifax in that a taxpayer is generally free to structure his affairs in a VAT-efficient manner. This is nothing new, and a boundary does of course still exist between acceptable and unacceptable behaviour, but the ECJ has arguably provided more certainty to the taxpayer as to where it is to be found.