The case was taken to the CJEU by HMRC from the Court of Appeal. It concerned the VAT treatment of a specific motor vehicle finance agreement called ‘Agility’ which MBFS offered to customers who are undecided as to whether they want to own the car or want to keep open the option of whether to purchase or not.

The Agility agreement is marketed as an hire purchase contract, but offers lower monthly payments than a typical hire agreement and does not cover the full value of the vehicle. It allows the customer to lease the vehicle for a prescribed period, after which the customer can purchase it subject to payment of a final 'optional purchase payment'. Around half of all customers take advantage of the option to purchase, according to the Court of Appeal.

MBFS considers that Agility is a rental agreement with an option to purchase and therefore, treated its supplies as services for VAT purposes.

CJEU case law has established that lease agreements should, as a rule, be treated as supplies of services. However, HMRC argued that the Agility agreement should be treated as a supply of goods. Its view is that this is in keeping with the wording of the VAT Directive, which provides that a contract where ‘in the normal course of events, ownership is to pass at the latest upon payment of the final instalment’ is a supply of goods.

The judge in the MBFS case took the view that ‘legal certainty requires that lease agreements should be regarded as supplies of goods for the purpose of levying VAT only when it can be assumed with certainty that in the normal course of events, at the latest by the end of the agreement term, ownership of the subject matter of the leasing agreement will be transferred to the lessee.’

The CJEU noted that the label attached to a specific agreement for the hiring of a motor vehicle with an option to purchase (e.g. ‘finance lease’ or ‘hire purchase’) is not determinative as to whether the supply is one of goods or services.

The court went on to set the tests to determine whether a supply falls to be treated as goods under Article 14(2)(b) of the VAT directive as being: the contract must include a clause expressly relating to the transfer of ownership of the goods; and objectively assessed, ownership of the goods will pass automatically through the normal performance, over the full term, of the contract.

In a contract where the first of the above tests is met but where the transfer of ownership of the goods is not automatic and is one of a number of options available to the customer (other options being for example to return the goods or extend the hire period), the second test above will not be met. Thus the contract will not fall within Article 14(2)(b).

However, as an exception to this in regard to the second test, the contract will fall within Article 14(2)(b), where the contractual instalments correspond to the market value of the goods including financing; and the customer will not be required to pay a substantial additional fee in order to exercise the option to purchase.

This decision can create a significant cash flow advantage of not having to account for output VAT upfront, but when instalments are paid.

In commentary on the CJEU’s ruling, KPMG said: ‘In KPMG’s view the application of the CJEU’s guidance when applied to MBFS’s Agility agreements will mean that these contracts should be classified as falling outside Article 14(2)(b) and therefore treated as services.

‘Hire purchase contracts are a common method of financing the purchase of new and used cars in the UK. Therefore, this case potentially has wide ramifications for the automotive retail and finance sectors.’

Stuart Walsh, VAT expert and partner with law firm Pinsent Masons agreed, describing it as ‘a pleasing judgment for taxpayers and welcome news for the car industry at a time of uncertainty.’  He pointed out that the judgment said an option to purchase should only be treated as a 'supply of goods' for VAT purposes if exercising that option is the lessee's ‘only economically rational choice’

‘As the Agility product requires the purchaser to make a payment of around 40% of the total price, then exercising the purchase option is certainly not the customer's only rational choice.

‘It will be left for taxpayers, authorities and the courts to determine whether the exercise of the option requires a “substantial” payment to be made by the customer. In the Agility case, it seems clear that 40% of the total value must qualify as being substantial. However, could the same be said for a product requiring 20% of the total value to be paid?’ Walsh said.

As a result of the judgment, it was likely that VAT would have been overpaid. Customers and car manufacturers ‘will be keen to recover this overpaid tax’, Walsh said.

Case C‑164/16, Commissioners for Her Majesty’s Revenue & Customs v. Mercedes-Benz Financial Services UK Ltd is here.

Report by Pat Sweet