Demonstrator car VAT scheme was abusive, Supreme Court has ruled

Normally when a car distributor buys new cars for use as demonstrators it will pay VAT on the full sale price and then recover the input tax. The scheme, devised by KPMG, exploited three exceptions to the normal incidence of VAT so that Pendragon would only have to account for VAT in respect of the difference between the wholesale purchase price and the retail sale price of its demonstrator cars.

Under the scheme, in 2000 and 2001 Pendragon bought cars from a wholesaler then sold them to four captive leasing companies which immediately leased the cars to Pendragon dealerships and then assigned the leases and their title in the cars to an offshore bank. Some 30 to 45 days later the offshore bank transferred as a going concern the lease agreements and title in the cars to Captive Co 5. The demonstrator cars were sold to customers by the dealerships, acting as agents for Captive Co 5. Customers paid VAT only on Captive Co 5’s profit on the sale, rather than on the total sale price, under the 'profit margin' scheme, which is available under UK law where goods are acquired as part of a business transferred as a going concern.

HMRC accepted that the scheme technically worked, as the conditions for exemption from VAT and for the margin scheme were satisfied. However, it argued that the scheme breached the EU law principle of abuse of law and so the VAT advantages could be denied.

Giving the leading judgment in the Supreme Court Lord Sumption said the principle of abuse of rights "confines the exercise of legal rights to the purpose for which they exist, and precludes their use for a collateral purpose".

In 2006, in a case concerning a scheme implemented by Halifax, the bank, for claiming input tax on the construction costs of four call centres, the Court of Justice of the European Union (CJEU) said two conditions had to be satisfied for the abuse of rights principle to apply. The CJEU said that the first condition was that the transactions concerned, notwithstanding the formal application of the EU and domestic legislation "result in the accrual of a tax advantage the grant of which would be contrary to the purpose of those provisions" The second condition set down by the CJEU in the Halifax case was that "it must also be apparent from a number of objective factors that the essential aim of the transactions concerned is to obtain a tax advantage."

Deciding that the first test was satisfied in relation to the scheme devised by KPMG and used by Pendragon, Lord Sumption said the direct purpose of the margin scheme was to grant relief to traders who had acquired goods from a supplier who had no right to deduct input tax in respect of their own acquisition of them and the indirect purpose of the scheme was to avoid double taxation. He said that the KPMG scheme was abusive as "a system designed to prevent double taxation on the consideration for goods has been exploited so as to prevent any taxation on the consideration at all."

In relation to the second test, Lord Sumption said that the application of the abuse of law principle to tax avoidance schemes "calls for a difficult balance to be drawn" as schemes are rarely directed exclusively to tax avoidance and generally have some concurrent commercial purpose. He said the question was "whether the commercial objective is enough to explain the particular features of the contractual arrangements which produce the tax advantage".

The judge said that the selection as the funding bank of an offshore institution which was not a taxable person "cannot in itself be regarded as objectionable". However, it was essential to the scheme that Captive Co 5 acquired the cars as part of a business as a going concern, and for that to be possible, it was essential that the transferor of the business had acquired the cars by assignment. He said these steps were "manifestly included" not for the purpose of facilitating the obtaining of credit from the offshore bank "but for the sole purpose of legally recharacterising a transfer of cars without incurring net liability on the price". The Supreme Court therefore said that the second Halifax test was also satisfied.

The Court said that the transactions should be redefined by stripping out the five captive companies, so that the dealerships would be accountable for VAT on the full second-hand price of the cars.

Darren Mellor Clark a VAT expert at Pinsent Masons, the law firm behind Out-law.com said “This case appears to constitute further indication that, in tax, there is the same dynamic of inherent obsolescence as is to be found in technology and the proponents of Moore’s Law. The scheme relates to transactions conducted in 2000 and 2001 and then evaluates those via the considerations and context of 2015. It appears that 'old technology' is unlikely to be acceptable to today’s Supreme Court. Their Lordships appear to caution users of arrangements with legitimate commercial purpose if that purpose supports accrual of a tax advantage as its key aim.”

The First Tier Tribunal had originally held that the scheme was not abusive. However, the Upper Tier Tribunal had disagreed and substituted its own finding on the facts that the scheme was abusive. The Court of Appeal said that the Upper Tribunal had exceeded its proper appellate role by substituting its own decision for the decision of the First Tier Tribunal based on an evaluation of competing factors.

Lord Sumption said that "unless vitiated by some error of principle a decision [of the First Tier Tribunal] based on the evaluation of competing factors will generally be respected". However, in his opinion, the Upper Tribunal was entitled to intervene in this case because the First Tier Tribunal had erred in law. Lord Carnwath added that the Tribunals, Courts and Enforcement Act 2007 now provides that, where the Upper Tribunal finds that the First Tier Tribunal has erred in law, it may itself remake the decision, including by making further findings of fact. He said it was appropriate for the Upper Tribunal to do so in this case in order to give guidance on the abuse principle. He said it was the Upper Tribunal decision rather than that of the First Tier Tribunal which should have been the main focus of the Court of Appeal’s consideration.

Earlier this month the Upper Tribunal upheld a decision of the First Tier Tribunal relating to loan broker Ocean Finance that HMRC should not look beyond the contractual arrangements that govern a company's structure when establishing liability for VAT unless those arrangements do not reflect "economic and commercial reality".