VAT Briefing

Compiled by Graham Elliott of haysmacintyre
Eighth Directive refunds

Where companies incur costs in a European Union state in which they make no supplies, they may sometimes claim a refund of VAT on those costs. Where they are based in another member state, this refund is made under the Eighth Directive. A typical scenario is where the company operating in one member state has a representative office in another, and incurs VAT on maintaining the office.

It was possible for some partially-exempt businesses to make a full recovery of VAT under these Eighth Directive procedures. But that was anomalous, and it later became clear that VAT ought to be apportioned if the taxpayer was partially exempt in his own state. The practical issue is how the apportionment has to be carried out where the rules of apportionment and the question of whether a supply is exempt or taxable differ from state to state.

The European Court of Justice considered this point in Taschi PDI Siena. This was an Italian bank that operated exclusively in Italy. It had a representative office in France. The French authorities sought to refuse to make any refund of VAT on the basis that they could not apportion the VAT accurately. The French courts rejected this in principle, but still left the question of how the calculation of input tax recovery would be made. The question was should the rules that applied in Italy be imposed on the VAT authorities in France, or should those that applied in France override the Italian ones? So, if the supply were taxable in Italy, but exempt in France, would it be regarded as being exempt for the purposes of a refund, or taxable? And, insofar as there are differences in the prescribed partial exemption apportionment methodology, would the Italian rules, or the French ones, prevail?

The European Court of Justice has decided that both sets of rules for both states must be looked at. VAT can only be recovered insofar as taxable transactions are actually made in the member state of establishment. However, what must also be checked is whether the state in which the refund is claimed would also allow such services to be taxable. If they would be exempt in the refund state, then a refund cannot apply by virtue of those services. If, on the other hand, they would be taxable in the refund state but exempt in the establishment state, then they must be treated as exempt because they do not qualify as taxable services in both states.

Furthermore, it is the state of refund whose partial exemption regulations will apply to the refunds, in order to ensure that overseas traders are not given different treatment from home traders. Where certain classes of expenditure are generically non-deductible under the refund state's system (such as, for example, hotel expenditure in France), then it remains non-deductible even though it might have been deductible in the state of establishment.

This decision may seem very logical, but it also appears to ignore the possibility of a company with operating units in a variety of states, and where a representative office in one state has a relationship with supplies that are made in several states. It seems to say that an entity must look at the VAT treatment of every supply in all of the states it operates in, and then compare it to the VAT rules in the state of refund. Such a scenario is a virtual nightmare. Yet there must be many partially-exempt organisations that operate globally and have operations in many EU states. This decision, although there may be some logic in it, seems extremely impractical and may well be impossible to administer on the ground.

Adoption services

Charities' adoption services often involve placing a particular child with a potential adopter. Charities tend to regard such activities as exempt from VAT under item 9 of the welfare provisions, which allow exemption for activities involving the protection of children.

The VAT tribunal has cast doubt on this exemption, albeit for a very specific type of adoption service, as provided by Parents and Children Together (17283). In this case, the charity charged fees to the prospective adopters. The essence of the service was assessing whether the adopter would pass the rigorous tests of suitability. The services included a certain amount of help with enhancing the likelihood of success. Most customers were based abroad.

The tribunal said that this was not a service of 'protecting children' since the children were not the clients, nor were the clients people who had any responsibility towards any particular child. In essence, the service helped adults to become adopters rather than assisted a particular child. The fact that the two must go hand in hand, and that a child's prospect for adoption must be enhanced by encouraging adopters, was not a direct enough effect for the tribunal to take the view that the exemption should apply here.

Pheasants: sport or food?

The supply of animals that are edible is generally zero-rated as a supply of food. The supply of the right to shoot or trap such animals is stan-dard-rated as a sporting right. Questions do sometimes arise about whether the supply has been one or other of these.

In the case of N C D Carter (17288), Customs took the view that selling pheasants to people who intended to shoot them was a standard-rated supply of the right to participate in the sport. The tribunal, however, agreed with the appellant that this was a zero-rated supply of food. When the pheasants were sold to the customers, they were generally not delivered, but released into an area in which they could be hunted.

They were intended to be sold at an age at which they were unsuitable to be hunted, but they would be available for hunting later. In the meantime, they could fly away, be poached, or be taken by foxes. There was no guarantee of their safety, and it was the customer's responsibility to arrange for them to be fed and looked after in preparation for the sporting activity. The customer specifically had the right to take the pheasants away at any time, although in practice this is not what happened.

Customs focused on the fact that the same supplier also sold pheasants at £3 each to the local market for immediate delivery, but sold the pheasants to the hunters for £5. The extra £2, it argued, was the premium value for the sporting rights. But the tribunal found that the actual right to shoot the birds had to be granted by other parties as well, and the only right the appellant was exercising was access to the land to shoot the pheasants that had already been sold.

The appellant's purpose in selling the pheasants at an earlier date was to ensure income in the non-hunting season so that his income stream was spread. The difference in price was said to be that these keen hunters would normally have to pay far more than £5 a pheasant if they were buying them in the context of a right to hunt. Therefore they were prepared to pay a little extra over the food price of the pheasants for these arrangements.

The tribunal took the view that, at the time of supply, the pheasants were being sold simply as they stood, and the appellant gave a free right over the land at a later stage so that the purchasers could shoot them if they so desired.

It added that, if the charge per pheasant were nearer £15, it would have considered the idea that there were sporting rights inherent in the payment. But the relatively low charge of £5 a bird suggested that the hunting rights could not be regarded as being included.

This is an interesting point of view, but it may prove to be the Achilles heel of this particular decision if Customs appeals to the High Court.

Meanwhile, Customs is likely to regard the decision as one that turns on the special facts of the case. It seems unlikely that very many establishments dealing in hunting rights over pheasants would choose to sell them at £5 a head, out of the hunting season, when they might fetch anything between £10 and £15 during the hunting season.

VAT grouping and international services

Before the legislation changed, it was theoretically possible to export qualifying services to a company based outside the European Union, but which was part of a UK VAT group registration, for these services to be outside the scope of VAT. It was also possible for the other members of the VAT group to suffer no VAT on a recharge by the group member, because of the VAT group registration rules concerning the disapplication of VAT on charges within a group. Or that was the legal advice that Customs must have received, since it made arrangements for the law to be changed to stop this perceived abuse in 1997.

An important tribunal case, BUPA (17286), related to this planning scheme and therefore to the previous legislation. So it should be stressed that the scheme in question is not available any longer, but Customs attempted to attack the arrangements BUPA put in place. This raises interesting points about general VAT legislation.

BUPA arranged to purchase advertising services from a UK-based agency via two companies based in Guernsey. One of them was a member of BUPA's UK VAT group, and it purchased its services from another separate company, which in turn had obtained outside scope advertising services from a UK-based advertising agency.

There was no doubt that this arrangement had been put in place purely to avoid VAT. Indeed, an indemnity had to be given to the UK advertising agency against the possibility that Customs would attack its supplies' liability.

Customs sought to attack this scheme on the basis that the Guernsey-based companies were almost a sham and had no true involvement in the activity. Therefore they had to be regarded as superfluous for VAT purposes, or if they were not entirely superfluous, they had no more than a paper-shuffling involvement with the supply. This was not enough to make the supply applicable to Guernsey. A second argument was that the Guernsey-based member of the VAT group could not be both in Guernsey and a UK VAT group member at the same time. That was an inconsistent standpoint, Customs said, and should be struck out.

On the basis of the facts, the tribunal had little choice but to find in the appellant's favour.

Although the Guernsey companies' involvement was very much at an administrative level, and included nothing by way of a creative side or the true control of the contract, it was not a sham. The tribunal found that the function, however ephemeral, was actually being performed. Equally, there was no suggestion that a company had to be regarded as belonging in the UK simply because it was part of a UK VAT group. It may have its registered office in the UK, but it may have its actual place of activity elsewhere, in which case it would be regarded as being based outside the UK for VAT purposes. Accordingly, Customs' argument failed.

Although this decision was released on 11 June, the hearing took place in early October 2000. Therefore there is no mention of the Halifax decision or contrivance in the VAT planning arrangements, although passing reference is made to Furniss v Dawson. As a consequence, it seems likely that Customs will take the matter to appeal with a Halifax slant.

The only fact reported in the present case with that slant is that the Guernsey companies' various administrative activities may be regarded as worthwhile because they provided a second and third check on very large sums of money being paid ultimately to the advertising agents. Whether that is considered to be a good enough reason for allowing that the transactions transcend the Halifax principle, even though they were undoubtedly entered into for avoidance purposes, remains to be seen, but seems doubtful. It is likely, however, that the Halifax appeal itself will go ahead before the present case is appealed.

Accounting for non-business VAT

In principle, VAT cannot be recovered on expenditure relating to non-business activities. VAT on such expenditure is not classified as input tax. Where expenditure is wholly used for non-business purposes, the rule is that none of the VAT on it can be recovered.

There are two potential approaches where VAT is incurred on expenditure that is used part-ly for business purposes and partly for non-business purposes. The more usual approach is to apportion such VAT on the basis of the purchase's expected use. However, that expectation is often proved not to be fulfilled in practice, and it can often be difficult to make any form of accurate estimate of the percentage use of the purchase for non-business purposes.

Non-business VAT is, furthermore, not adjusted by such things as annual adjustments and capital goods scheme adjustments, unless that is specifically arranged between the taxpayer and Customs. The alternative approach is for a full deduction to be made, and for a balancing output tax charge to arise on the periodic value of the non-business use of the assets that the business allows. That is the so-called Lennartz principle, following the European Court of Justice case of that name concerning the private use of motor vehicles.

The Stoke-on-Trent Citizens' Advice Bureau (17296) has taken a Lennartz point with regard to refurbishment work on one of its properties. The bureau is partly non-business, but it argued that it should have a full deduction of VAT on the refurbishment work, followed by an agreed output tax declaration to take account of the non-business activity. This has a beneficial cash flow effect, since immediate deduction is made but the VAT on the non-business use can be spread over the asset's lifetime.

There was common agreement between the appellant and the respondent that the Lennartz principle could only apply to goods and not to a purchase of services. The tribunal chairman queried that point, but since it was a matter of agreement between the various parties, he proceeded on that basis.

The appellant therefore argued that the refurbishment of the property was the purchase of goods, since the property refurbishment costs were capitalised in the accounts, and once the services had been rendered they were transformed into goods by virtue of being incorporated into goods. But the tribunal could not see how an activity that was classifiable as services at the time of purchase could become goods simply because of an accounting treatment or their incorporation into what were existing goods. The appeal was rejected.

As the tribunal chairman said, whether the Lennartz principle applies to services is a question for another day. But the case acts as a reminder that the principle has potential application to purchases, particularly by charities, which may put them to a mixed business and non-business use.

The need to account for regular output tax declarations is potentially onerous in an administrative sense, and provides no more than a cash flow advantage. Indeed, it could conceivably provide a VAT disadvantage if the output tax declarations exceeded the amount of input tax originally claimed, although in theory that should not happen. However, Customs is likely to object strenuously where organisations, whose business use is more or less incidental, make a full deduction of VAT where the non-business use predominates. This case may ignite interest in the Lennartz principle as an alternative to the much more common apportionment approach. In that case it may very well be followed by other cases exploring the Lennartz parameters in greater depth.

Barter transactions

Transactions need not be paid for in money in order to attract VAT. The barter of goods or services in exchange for each other attracts VAT as though they were cash. The question this raises is how to value a barter on both sides.

The European Court of Justice recently heard such a case. Bertelsmann AG rewarded existing members of its book club by sending them a free book for introducing new members.

Books are zero-rated in the UK, but are positive rated in other parts of Europe.

Bertelsmann AG duly accounted for VAT on the book's value at cost price, on the basis that it had bartered the book in exchange for introductory services. The German VAT authorities took the view that the cost valuation should include the cost of posting the goods to the members. The ECJ agreed. The entire cost of rewarding the members for their services of introduction ought to be taken into account when valuing the supply, and that would have to include the transport costs.

There does not appear to have been a specific mention of an allocation of overhead expenditure and other incidental costs, which will have contributed to the cost of the exercise. However, the case does appear to give grounds for taking into account all the costs incurred in rewarding services by way of other services or goods.

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