Adviser Q&A: The Court of Appeal decision in Pendragon

Why does this decision matter?

The recent case of Pendragon PLC v HMRC [2013] EWCA Civ 868 in the Court of Appeal might have cast some much needed clarity on the scope of the EU principle of abuse of rights in the context of VAT. However, the case was resolved on the procedural issue that the decision of the First-tier Tribunal could not be challenged on Edwards v Bairstow [1956] AC 14 grounds. It is a salutary reminder to taxpayer and tax authority alike of the critical importance of the First-tier Tribunal decision in the resolution of tax disputes.

What were the facts in the case?

Pendragon is a dealer in motor vehicles which implemented a complicated arrangement for the financing and sale of its demonstrator cars. The arrangement involved five steps. When Pendragon bought new cars from manufacturers to be used as demonstrators, it first sold the cars to a captive leasing company in Jersey. These were taxable supplies by Pendragon on which it charged VAT, and that enabled it to recover the VAT it had been charged by the manufacturer. The leasing company leased the cars to dealerships, which had an option to buy exercisable seven days after the end of the lease period. These hybrid HP contracts were taxable supplies of services subject to VAT (and not supplies of goods, because of the delay before the option to buy could be exercised). The VAT was recoverable by the dealerships. The leasing companies then sold the cars and the benefit of the hybrid HP contracts to a Jersey-based bank for the value of the payments due for a substantial sum. This was not a supply for VAT purposes. The Jersey bank then sold its business and title to the cars to another Jersey captive. This transaction was outside the scope of VAT as a transfer of a going concern. Finally, the last Jersey captive sold the cars to consumers under the second-hand goods scheme, applying VAT only to its margin.

The arrangement had two effects. It delivered Pendragon a large VAT advantage, because it recovered the VAT on the cost of new cars but charged its retail customers only a small amount of VAT under the margin scheme. The second effect, unrelated to VAT, was that it enabled the group to raise finance via the assignment to the Jersey bank.

It was accepted that the arrangement achieved its intended result based on the legislation, but was challenged by HMRC on the basis that it was an abuse of law. To establish that, HMRC had to show that the sole or essential purpose of the arrangement was to obtain a tax advantage which was contrary to the purpose of the legislation.

What was decided on the abuse of law point?

The Court of Appeal did provide some helpful commentary on this issue; it rejected HMRC’s contention that a quantitative balance had to be struck between the value of the tax advantage and the value of any other advantages obtained. The test was whether there was a substantial purpose to the arrangement, in addition to any purpose of obtaining a tax advantage. That test, it seems, should not be resolved by a simplistic quantitative analysis.

What was decided on the procedural issues?

The First-tier Tribunal held that HMRC had failed to establish either of the limbs for the application of the abuse of law doctrine to counteract the effect of the scheme. HMRC successfully overturned that decision in the Upper Tribunal, and so the case came to the Court of Appeal where the decision turned solely on one question: could the decision of the First-tier Tribunal, which was that the essential aim of the transaction was to obtain finance, be overturned?

The Court of Appeal refused to re-open this question. It noted the question as to the essential aim of a transaction is partly one of fact and partly one of law. The First-tier Tribunal had correctly stated the law in its judgment and, to overturn its decision, HMRC had to show that, when it applied the law to the facts, it had found the evaluative determination it made was one no reasonable tribunal could have reached. The court could intervene in those circumstances, because it would be clear the tribunal had misunderstood the law. After a painstaking review of the First-tier Tribunal’s decision, the Court of Appeal concluded the tribunal’s determination was reasonable. The court noted that had the Upper Tribunal been sitting as the First-tier, it might well have reached the opposite conclusion – that the essential aim of the transaction was to achieve a tax advantage – and that could also have been a reasonable decision.

Any further thoughts?

It is somewhat disquieting that the result of a tax dispute could turn on a lottery as to the composition of the tribunal. However, that is part of the risk for both parties in pursuing litigation. This makes a good case for pursuing all routes to resolution, including techniques such as mediation, before submitting the issue to the tribunal for judgment.