What's new in VAT abuse?

Michael Conlon KC

Rebecca Murray

Speed read

In Newey, the Upper Tribunal considered the CJEU’s preliminary ruling in the case and concluded that it said ‘nothing new’. Warren J upheld the FTT’s decision in favour of the taxpayer. A week later, in Pendragon, the Supreme Court pronounced on the nature and application of the abuse principle in VAT cases. Undertaking a careful analysis of Halifax, the court found for HMRC. It seems likely that the decision in Pendragon will encourage HMRC and the tribunals to take a more critical view of VAT planning arrangements and be less easy to persuade of the existence of a commercial motive.

The Newey case

The controversial Newey case involved

a scheme to relieve a loan broking business of the burden of irrecoverable VAT on its UK advertising spend. Existing arrangements were restructured using the following steps:

The company Alabaster was established as a loan broker in Jersey (although beneficially owned by Mr Newey, a UK resident).
The services of UK advertisers were routed through Wallace Barnaby, also established in Jersey, which supplied them on to Alabaster.
Mr Newey in the UK acted as independent contractor for Alabaster in processing loan applications.
Alabaster contracted to supply intermediary services to the lenders. As before, all loan applicants and lenders were in the UK.

The intended VAT analysis was

that the supplies at steps (2) and (3) were outside the scope of VAT; and step (4) did not trigger the reverse charge because the services were exempt. Accordingly, neither Alabaster nor Mr Newey incurred any VAT on advertising. The issues were whether the contractual framework could be set aside and the arrangements recharacterised such that Mr Newey was treated as the recipient of Wallace Barnaby’s services; and/or whether the scheme was abusive.

Importantly, when the case was referred to the CJEU (see Newey (t/a Ocean Finance) v HMRC (C-653/11) [2013] STC 2432), the CJEU had stated (at para 52) that contractual terms are a factor to be taken into account, but are not decisive for the purpose of identifying the supplier and recipient of a supply of services. In particular, they may be disregarded where they do not reflect economic and commercial reality and are set up with the sole aim of obtaining a tax advantage. This was for the national court to determine, having regard to all the circumstances. The CJEU also observed ‘it is conceivable that the effective use and enjoyment of the services took place in the UK and that Mr Newey profited therefrom’.

Originally, the FTT had decided:

the choice of an offshore structure did not create a tax advantage which was contrary to the purpose of the VAT Directive;
Alabaster was a commercial undertaking and not a ‘brass plate’ company; and
Alabaster did not merely ‘rubber stamp’ decisions made about loan applications by Mr Newey.

Accordingly, so they held, Alabaster received the advertising services in Jersey. For reasons we consider later in this article, the Upper Tribunal felt bound by these findings (see [2015] UKUT 0300). The UT concluded that the scheme was not abusive.

The Pendragon case

The equally long running and controversial Pendragon case concerned a scheme aimed to exploit national VAT legislation which ‘de-supplied’ certain transactions and which provided a ‘margin scheme’ for the supply of certain second hand goods. If the planning scheme succeeded, it enabled a motor dealer to recover VAT in full on purchasing cars used temporarily as demonstrators; and to escape VAT when the cars were disposed of at nil or negative margins.

The FTT (see [2009] UKFTT 192 (TC)) took a similar line to the FTT in Newey. In essence:

the arrangements were effective under national legislation and any tax advantage obtained was not contrary to the VAT Directive; and
in any event, there was a commercial aim, namely financing the undertaking.

The Upper Tribunal reversed this and decided the scheme was abusive (see [2012] UKUT 90 (TC)). The Court of Appeal, relying mainly on Edwards v Bairstow [1956] AC 14] , restored the decision of the FTT (see [2014] STC 844).

The Supreme Court unanimously reversed the Court of Appeal (see HMRC v Pendragon plc [2015] UKSC 37). Lord Carnwath added some observations of his own on the correct approach in an appeal from the FTT. Key legislative provisions are ss 11 and 12 of the Tribunals, Courts and Enforcement Act 2007. An appeal lies only on a point of law. Where it is found that in making the decision the FTT erred in law, the UT may remit the decision with appropriate directions, or remake it. Where it adopts the latter course, it may make such findings of fact as it considers appropriate. In Pendragon, as in Newey, therefore, the interplay of law and fact were critical to the application of the abuse principle and to the outcome.

Lord Sumption, giving the judgment of the court, provides valuable guidance on the distinction between tax evasion and tax avoidance and the concept of abuse. The use of an artificial structure to produce a more favourable tax outcome than the commercially comparable ‘normal’ transaction frustrates the objective of the taxing provision without falling foul of its language. This arbitrarily depresses tax receipts and potentially distorts competition. Legal certainty is an important legal principle of UK and EU law, but artificiality must be tested against some standard of transactional normality.

The task of the courts, in applying the abuse principle, is to reconcile these competing considerations. A particular difficulty is the role of normal commercial operations and the existence of concurrent purposes. The court emphasised the twin tests, as adumbrated by the CJEU in Halifax plc v CCE (C-255/02) [2006] STC 919 (Halifax); both of these must be satisfied before an abusive practice can be found:

Halifax test 1 is that the transactions concerned result in the accrual of a tax advantage which would be contrary to the purpose of the VAT Directive or the national legislation implementing it.
Halifax test 2 is that, viewed objectively, the essential aim of the transactions is to obtain that tax advantage.

Thus, if the tax advantage is contemplated by the legislation as a permissible part of the VAT system, test 1 is failed. Test 2 is failed if the transactions have some commercial objective other than the obtaining of the improper tax advantage. A transaction which fails either test is not abusive.

A key point in Pendragon is that the contractual framework was not a sham and created legal effects. The steps of the scheme were as follows:

Pendragon purchased new cars and deducted input VAT in full because it sold the cars on to captive leasing companies (CLCs), on which it accounted to HMRC for output VAT.
The CLCs entered into hybrid leases with the dealership companies and deducted VAT in full. As these hybrid leases provided that title to the cars did not automatically pass to the dealers, they were treated as supplies of services, not of goods (VATA Sch 4 para 1).
The CLCs assigned their right and interest under the leases to SGJ, a bank established in Jersey.
SGJ transferred these assets to captive company 5, Pendragon Demonstrator Sales (PDS), as the transfer of a business as a going concern (TOGC).
PDS sold the cars to retail customers.

The intended VAT analysis of the scheme was that step (2) did not trigger an immediate liability to account for VAT on the full price of the cars (as would have been the case if the leases were normal hire purchase agreements). Step (3) was de-supplied by virtue of article 5(1) of the Value Added Tax (Special Provisions) Order, SI 1995/1268 (SPO). Step (4) was de-supplied by art 5(2) of the SPO as a TOGC. At step (5), as PDS had acquired the cars without VAT, the Value Added Tax (Cars) Order, SI 1992/3122, (the Cars Order) applied. PDS could therefore use the margin scheme and account for output VAT only on the margin (if any). It was common ground in the appeal that technically the scheme worked in accordance with national legislation.

Application of Halifax test 1

The Supreme Court identified the purpose of art 26a of the Sixth Directive (second hand schemes) as twofold:

The direct purpose of the margin scheme is to grant relief to traders that have acquired goods from a supplier which had no right to deduct input tax on their acquisition.
The indirect purpose of the margin scheme is thereby to avoid double taxation, since second hand goods may already have been the subject of a net VAT charge at some earlier stage in their history.

The taxpayer’s argument that the national legislation was more generous in scope and that it had not been circumvented by the scheme was rejected. The court held that although the SPO and the Cars Order did not exactly mirror art 26a, the national legislation was not aimless. It was part of the implementation of an EU VAT system and pursued the same objective as art 26a. VAT was a tax on consumption. In this case, the taxpayer had sought to exploit the system designed to prevent double taxation by navigating itself between the exemptions so as to pay no tax at all. Halifax test 1 was satisfied.

The essential aim of the scheme

The FTT had looked at the combined steps as a whole and decided that the transactions were justified by the desire to obtain finance and not simply to obtain a tax advantage; the real substance and significance of the transactions was the obtaining of finance. However, according to the Supreme Court, this approach was wrong in law because it approached matters at too high a level of generality.

The securing of finance through a bank, even an offshore bank, was a normal commercial operation. However, the FTT had failed to ask itself whether Pendragon’s commercial objectives explained the particular features of the transactions which produced the tax advantage, specifically steps (3) and (4).

This raised the issue of law inherent in Halifax test 2, namely the essential aim of the transaction. The correct approach was to look at each step in the scheme and also at the scheme as a whole. Although involvement of a company established outside the jurisdiction was within the realm of choice permitted by the VAT system (see HMRC v RBS Deutschland Holding GmbH (C-277/09) [2011] STC 345 (RBS)), it was still necessary to pose the question: did any particular step inserted into the structure have no purpose other than the obtaining of the improper tax advantage?

According to Lord Sumption, steps (3) and (4) manifestly had no commercial purpose as part of normal commercial operations and the FTT should have concluded that Halifax test 2 was satisfied. Recharacterisation simply involved stripping out the CLCs. If that was done, the dealership companies should have accounted for output VAT on the full consideration for which the cars were sold to SGJ. In that way, the improper tax advantage would be negated.

The relevance of Edwards v Bairstow

The Supreme Court’s decision in Pendragon does not appear to undermine the principle in Edwards v Bairstow. The primary facts found by the FTT were not challenged. The Court of Appeal based its decision (upholding the FTT) on the respect to be accorded to the specialist fact finding tribunal in evaluating the facts. In consequence, it upheld the FTT’s conclusion that there was a commercial motive behind the scheme, namely to obtain finance.

The Supreme Court sidesteps this by recognising the existence of a concurrent purpose. As Lord Sumption put it, it is difficult to conceive of a scheme, other than a fraudulent one, which achieves absolutely nothing but a tax advantage. In Halifax itself, the taxpayer undoubtedly had a commercial need to build the call centres on which it sought to avoid VAT. What matters, however, is whether there are special features of a scheme (such as artificially inserting an offshore company or a TOGC of the undertaking) which have no commercial rationale.

The FTT (and the Court of Appeal) misapplied the Halifax tests to the primary findings of fact. Lord Carnwath’s observations on the role of the UT in taking an ‘intrusive’ approach to a review of the facts found by the FTT, and the need to lay down consistent guidance in areas such as abuse, were made in passing; he himself observed (at para 50) that there were no significant issues of primary fact.

The differences between the two tribunals related to the understanding of the abuse principle, and their evaluation of the facts in the light of that understanding.

Is Newey correctly decided?

If Warren J had had the benefit of the Supreme Court decision in Pendragon, would he have allowed HMRC’s appeal against the taxpayer?

The Newey case is difficult because it involved not just the abuse principle, but also questions of the identity of the person making and receiving a supply. To some extent, the UT decision runs these questions together. The UT concludes that, in order to depart from the contractual framework, HMRC must show that there is abuse. This conclusion appears to be based on the CJEU’s preliminary ruling in Newey.

HMRC argued that there was a freestanding doctrine (falling short of the abuse principle) enabling HMRC or the courts to depart from the contractual framework in the interests of economic and commercial reality. This was rejected. This was, though, precisely the type of ‘structural’ attack by HMRC which sometimes found favour with the courts before the abuse principle was developed.

Examples of cases where, despite what was said in the contract, the characterisation of the transaction (including whether there was a single composite or multiple supply) are legion. It may be, therefore, that the UT’s conclusion on the definitive nature of the contract in the absence of abuse is open to question. This point was touched upon, of course, by the Supreme Court in HMRC v Secret Hotels2 Ltd [2014] UKSC 16, which cited the CJEU in Newey. However, in Secret Hotels2, the case was decided expressly on the basis that the taxpayers were intermediaries, which led to a different result under the VAT Directive.

The main focus of the UT decision in Newey is the attack by HMRC on the FTT’s findings relating to commercial purpose. The FTT rejected HMRC’s case that it was Mr Newey who was the prime mover in the loan broking business; who had the relationship with the lenders; and who used and enjoyed the advertising services. Much of the UT’s decision is devoted to analysing whether the FTT was justified in its evaluation.

In that regard, the UT decision follows the orthodox Edwards v Bairstow line. It can be discerned in several places, however, that the UT was not fully comfortable with the FTT’s evaluation. There is a sense that had the UT heard the case at first instance, its approach to the multi-factorial assessment (and hence the conclusions) might well have been different.

The real point of interest, however, lies in the application of the Halifax tests. The FTT in Newey was satisfied that the arrangements did not result in the accrual of a tax advantage which was contrary to the Directive. But can that stand in the light of the broad view of the VAT system taken by the Supreme Court in Pendragon? VAT is a tax on consumption. In Newey, the service of advertising in the UK media was purchased for the purpose of attracting UK customers to take out loans from UK lenders. The main activity of loan broking (which benefited from the advertising) was carried on by Mr Newey in the UK. As the CJEU seemed to hint, it was open to the national court to find that the advertising services were used in the UK.

And what of the commercial motives for the arrangements? The FTT accepted that Alabaster was a commercial enterprise legitimately established in Jersey. In terms of Pendragon, though, perhaps the correct question under Halifax test 2 should have been: given that previously there was a UK loan broking business which suffered VAT on advertising, was the establishment of the Jersey structure beneficially owned by Mr Newey a peculiar feature outside the normal commercial operations of his UK loan broking business? If so, was the essential aim to secure the tax advantage?

The case raises many interesting questions, not least the interface with cases on the freedom to use other jurisdictions to secure the optimum tax result (see RBS and Cadbury Schweppes plc v IRC (C-196/04) [2006] STC 1908). It would be surprising if HMRC simply accepts the UT’s decision and does not seek permission to appeal.

Action points for businesses and advisers

HMRC is likely to take great comfort from Pendragon and to attack existing and future VAT planning structures. The continued efficacy of offshore structures, as in Newey, must be in doubt. Unless schemes are immediately collapsed, affected businesses and their advisers should urgently consider the following factors:

Does the scheme seek the accrual of a tax advantage which is contrary to the VAT Directive or national implementing legislation? (Note that this can include cases where the national legislation does not precisely mirror the Directive, but nevertheless can be described as part of the EU VAT scheme.) Identify and justify any counterarguments.
Is the chosen structure one of a number of legitimate choices open to the taxpayer?
Do the contracts as drafted support the arrangements? Do they reflect economic and commercial reality? What are the arguments in support?
Can the arrangements be described as normal commercial operations? What is the comparable transaction?
Taken individually, are any steps wholly artificial? Taken as a whole, are the arrangements wholly artificial?
If there are any special or peculiar features (such as inserted steps), are these devoid of commercial purpose? Identify the arguments and evidence to support commerciality.
Finally, if the scheme was devised by a contractual counterparty, are there adequate indemnities in place to protect against a VAT liability resulting from a recharacterisation of the arrangements. (Remember that it is clear from Halifax that a recharacterisation should not lead to VAT being imposed as a penalty, especially on an innocent third party.)

It may be there is little that is new in the way the CJEU has enunciated the abuse principle. It seems likely, however, that the Supreme Court decision in Pendragon will encourage HMRC and the tribunals to take a more critical view of VAT planning arrangements and be less easy to persuade of the existence of a commercial motive. One may also expect a degree of mission creep in the willingness of the Upper Tribunal to take an intrusive approach to factual evaluation by the First-tier Tribunal.

Issue: 1268
Categories: Analysis , Anti-avoidance , International taxes , Litigation , Tax policy & administration , VAT

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