If you are setting up or buying into a VAT planning scheme (or you have done so in the past), then a recent decision of the Upper Tribunal (Tax & Chancery Chamber) (UT) might lead you to question the wisdom of that decision. Even though a strict, formalistic interpretation of VAT law might give you the result you were hoping for, where VAT planning involves an 'abuse of rights' it will be overturned by the courts.
In this case, the taxpayer was found to have abused its rights, and the UT - looking at what would have happened had the planning not been implemented - disallowed the vast majority of input VAT for which the taxpayer claimed credit.
Our tax experts analyse the decision and its implications for future tax planning.
In HMRC v University of Huddersfield Higher Education Corporation (2014), the university (H) owned a derelict mill. It intended to convert the mill for its own use. If VAT on conversion services was attributable directly to H's general use, then (because it provided mainly exempt education services) little of its input tax would be recoverable. If, on the other hand, H could arrange matters such that the same input tax was attributed to H's supply of taxable goods and services, then all input tax would be recoverable.
Following advice from a well-known accountancy firm:
- H set up a trust (T) with £10 capital. It could have set up a subsidiary company with £10 share capital - but this would not have been sufficient to circumvent some specific UK VAT anti-avoidance legislation. H appointed the trustees of T, and H was a beneficiary.
- H contracted with a wholly-owned subsidiary (S) outside its own VAT group to provide construction services to convert the mill, and was charged £3,500,000 plus VAT. S sub-contracted the work to an unconnected third party construction company, and was charged £3,500,000 plus VAT. There was no intention that S would make a profit.
- H opted to tax the mill, and granted a 20 year lease to T at an initial rent of £12.50pa plus VAT (increased to £400,000pa plus VAT on completion of the conversion works).
- T granted an underlease back to H at an initial rent of £13 pa plus VAT (increased to £415,000pa plus VAT on completion of the conversion works).
H reclaimed VAT of more than £612,000 incurred on the conversion works, on the basis (it claimed) that its input VAT was directly and immediately attributable to the taxable supply of its lease to T. HMRC denied H's ability to recover the £612,000 as it did not regard the input tax as being incurred for the purposes of that supply.
It was found as a matter of fact that:
- The sole reason for the creation and use of T was to facilitate VAT planning, and that the sole purpose of the lease and underlease was also to facilitate VAT planning. It was a purely artificial structure.
- It was H's intention to obtain an absolute VAT saving by collapsing the arrangements after two or three years, or break the leases in accordance with their terms. In this way, a VAT deferral
An abuse of rights?
For all its artificiality, was the VAT scheme used by H an abuse of its VAT rights? If it was, then the UT was entitled to re-define the transactions in a manner that did not abuse those rights, and to apply VAT to the redefined transaction accordingly.
In Halifax plc and others v Commissioners of Customs and Excise (2006), the Court of Justice had laid down two conditions which must be satisfied for an abuse of rights attack to be successful.
- First, the relevant transactions (notwithstanding formal application of VAT law) must result in the accrual of a tax advantage, the grant of which would be contrary to the purpose of those laws.
- Second, it must be apparent from a number of objective factors that the essential aim of the transactions in question
H conceded that there was sufficient evidence that the essential aim of its transactions was to obtain a tax advantage, and so the second condition was satisfied. The UT focused, therefore, on the first condition: Did a tax advantage accrue to H, and was the grant of that advantage contrary to EU law?
- Did a tax advantage accrue to H? Yes, said the UT. The tax advantage was, as a result of the planning, an ability to claim that input tax on the conversion works was directly and immediately linked to the taxable grant of the lease to T (rather than to H's general exempt supplies). As such, H could recover all its input tax on conversion (rather than just a small proportion of it).
- Was its grant contrary to VAT law? Yes, said the UT.
- Those making exempt supplies cannot be permitted to recover input tax on supplies that are (in reality) directly and immediately linked to exempt supplies. The planning was an artificial attempt to create a taxable supply which did not have any function other than to enable the deduction of input tax. It would be contrary to EU VAT law to allow H to rely on its lease to T as a taxable supply.
- A second argument - that the use of T (rather than a company) was a technical device to undermine the purpose of a domestic UK VAT anti-avoidance provision and so should be seen as an abuse of rights - was rejected as taking the 'abuse of rights' principle too far. If the UK legislation failed to achieve its purpose by defining connected persons narrowly (and so failing to capture a trust arrangement), then the UT was uncomfortable in ruling that it was a function of the abuse of rights doctrine to correct that failure.
Redefining relevant transactions
Having found an abuse of rights, how would the UT redefine the VAT situation to re-establish the position that would have prevailed in the absence of the abuse? Halifax makes clear that there should be no penalty on H. The result of any re-definition must be that H is obliged to repay all or part of the VAT (artificially) claimed as input VAT; but it should be given credit, for example, for any output tax for which it (artificially) accounted under the arrangements.
The UT decided to disregard the lease and underlease. In so doing, the £612,000 input tax was said to be directly and immediately attributable to H's general purposes. This meant that most of H's claim was disallowed - but it was entitled to recover some of the £612,000 input tax under the partial exemption rules as they applied to it.
The UT rejected a re-definition that simply disregarded the option to tax (and so kept in place the leases). This was because the UT was concerned that HMRC might then have argued that the £612,000 input tax was directly attributable to exempt supplies of land - so allowing no VAT recovery at all by H. The UT considered that would not be the correct approach.
This is a well-written and well thought-out decision. Some points are left open, and further consideration by a higher court would be helpful.
The case reinforces the tax planning principle that formalistic compliance with UK VAT law is not sufficient for successful VAT planning; but that "artificiality" (by itself) is not sufficient for an abuse of rights attack.
Opportunities remain for VAT planning.
- Planning to defer a VAT liability is entirely legitimate, and is not susceptible to an abuse of rights attack (see HMRC v Weald Leasing Limited (2010)). H may well have been successful, therefore, had it used the planning merely to defer VAT (rather than intending to generate an absolute saving). The arrangements that were put in place to collapse the leases were fatal to H's case.
- A genuine commercial rationale for the restructuring of a transaction will defeat an abuse of rights attack - one does not have to arrange one's affairs so as to maximise VAT costs. If H had been letting the mill to third parties or if it had been using the mill exclusively for its own taxable purposes, then it would have been entitled to opt to tax and recover input VAT on the conversion works.
- There are limits to the court's willingness to use the abuse of rights principle. It should not be used to plug the gaps left by deficiencies in UK law.
VAT rules on options to tax, and the circumstances in which such an option can be rendered ineffective, have been overhauled over the fifteen years since H reclaimed its input tax credit. It is likely that these revised rules would have disapplied H's option to tax in this case.
Taxpayers always need to be wary of implementing or buying VAT planning schemes, and of being too ambitious if they do so. With the correct holistic approach, taxpayers need not be fearful of VAT planning provided that is tailored to their individual needs and driven by underlying commercial common sense.