The European Court of Justice (ECJ) decision in Halifax plc v Customs & Excise Commissioners of 21 February regarding the application of the abuse-of-rights doctrine to value added tax (VAT) planning has gone some way to address the long-running but unresolved issue of whether VAT legislation applies differently to transactions motivated solely or partially by VAT avoidance. The ECJ’s judgment, however, raises many more unanswered questions as to the extent and the limits within which VAT planning can operate.
The case concerned a scheme designed to reduce the VAT burden of Halifax plc on its construction of a number of call centres. Halifax entered into a series of transactions so that the supplies of construction services were made to various of its wholly owned subsidiaries which, on a literal interpretation of the relevant VAT legislation, would be able to recover VAT on those construction costs in full. Had Halifax itself directly engaged the independent contractors, it would only have been able to recover 5 per cent of the VAT on those construction costs because it is a financial institution which makes VAT exempt supplies. Therefore, it is restricted in its ability to reclaim its VAT costs.
The UK tax authorities rejected the claims for input tax recovery by the subsidiary companies on the basis that the transactions were a scheme designed solely for VAT avoidance. On an appeal by Halifax to the UK VAT Tribunal, the tribunal referred the matter to the European Court of Justice (ECJ) for guidance on the interpretation of the relevant provisions of the EC VAT legislation in question.
The ECJ held that what constitutes a taxable supply of goods or services should be determined according to objective criteria without regard to the purpose or results of the transaction. Accordingly, the transactions at issue were taxable supplies for VAT purposes and could not be disregarded (despite the UK VAT Tribunal’s finding that tax avoidance was the sole motive for entering the transactions).
The ECJ went on to state that EC law could not be relied on for abusive or fraudulent ends and, accordingly, EC law could not be extended to cover “abusive practices”, ie, “transactions carried out not in the context of normal commercial operations, but solely for the purpose of wrongfully obtaining advantages provided for by Community law”. However, the ECJ held that this anti-abuse principle was still subject to two qualifications: first, a requirement for legal certainty in the application of European Community (EC) law (hence the need for objective and not subjective criteria in determining its application); second, evidence that a person is permitted to structure their business in a way so as to limit their tax liability and is not required to take a course of action which involves paying the highest amount of VAT.
Accordingly, in light of these considerations (legal certainty and the ability to choose to mitigate tax), the ECJ stated that an “abusive practice” can be found to exist only if the following two-part test is satisfied. First, the transactions concerned, on a formal application of the relevant legislative provisions, result in the accrual of a tax advantage “the grant of which would be contrary to the purposes of those provisions”. Secondly, 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. No “abusive practice” can be found to exist where the transaction may have some motive other than the mere attainment of a tax advantage.
For the purposes of the second part of the test, the ECJ stated that, in determining the real substance and significance of the transactions, the courts of individual member states may consider objective factors, such as the purely artificial nature of those transactions and the legal, economic and/or personal links among operators involved in the tax avoidance scheme.
If an abusive practice exists, the ECJ held that the transactions involved must be redefined so as to re-establish the situation that “would have prevailed in the absence of transactions constituting that abusive practice”. Appropriate adjustments to the VAT payable should then be made on the basis of the re-characterisation, but no further penalty should be imposed on the taxpayer. The ECJ explained that it is for the member states to lay down conditions under which the tax authorities may recover VAT in the event that an abusive practice is found to exist, but they must do so in a manner which is proportionate to the aim of preventing fraud and abuse which would not undermine the fiscal neutrality of VAT.
In the context of a claim for input tax deduction, the existence of an abusive practice gives rise to an obligation on the taxpayer to repay the input tax recovered and receive credit for any output tax paid.
The case will now be referred back to the UK VAT Tribunal to decide the case in accordance with the ECJ judgment.
Effect on UK Law
The taxpayer can take comfort from the fact that the abuse-of-rights doctrine will only apply to unravel VAT planning where the sole aim of entering a transaction is tax avoidance. Where there is also a commercial rationale for entering the transactions, taxpayers can structure their affairs so as to mitigate their VAT liability. How substantial the non-tax motive must be in order for the VAT planning to remain effective is a question the ECJ’s judgment left unanswered.
Difficulties will arise in applying the two-part test because the ECJ did not define several concepts:
- How is the purpose behind the relevant VAT legislation determined?
- What is a “normal commercial operation”?
- How is “tax advantage” to be defined?
- What does the “aim” of the transaction mean?
- Does “tax advantage” include transactions structured to obtain a greater net liability overall?
- In determining the aim of a transaction, can the subjective intentions of the taxpayer be taken into account despite the ECJ’s insistence that only objective criteria should be relevant?
- If an abusive practice is found to exist, how are transactions to be re-characterised (there may be a number of different possible permutations)?
- Does the ECJ’s reasoning leave open the possibility that the abuse-of-rights doctrine can be invoked by tax authorities to attack planning for direct tax, as well as indirect tax, purposes?
The answers to these questions, and so the extent of the application of the abuse-of-rights doctrine to VAT planning, will have to be determined in future cases and references to the ECJ; this will be a very slow process. However, the ECJ clearly emphasised in its judgment that the development and application of the doctrine must have due regard for (and will thus be limited by) the need for legal certainty, the ability of the taxpayer to mitigate its VAT liability, immunity from penalty and proportionality of conditions laid down by the tax authorities of the member states.
Following this case, in order for VAT planning to be effective, relevant transactions should have a commercial (as well as a tax) motive, and transactions must not be artificial. In its judgment the ECJ gave no guidance as to how substantial the commercial reason for a transaction must be in order to avoid the application of the abuse-of-rights doctrine. However, the UK tax authorities have stated that if they found that any aspect of a transaction lacked a “substantial and real commercial purpose”, they would seek to apply the principle of abuse established in the Halifax judgment.
Therefore, it is advisable to make a contemporaneous written record of the commerciality and substance of each transaction, which can be used to demonstrate this to the tax authorities in any future negotiations or dispute.
It may also be worth documenting possible alternative methods of undertaking the transaction in question which it is thought would be less vulnerable to challenge (and would be the next best alternative tax efficient outcome for the taxpayer). Although the courts in each member state can apply the ECJ guidance in Halifax and re-characterise as they see fit, given that this would be a contemporaneous record, it should carry some weight with the court and may assist the taxpayer in arguing for its preferred re-characterisation.