EU court must rule on 'fair and reasonable' apportionment of input tax recovery

Taxpayer Volkswagen Financial Services (VWFS) is a member of the Volkswagen Group, and is used to provide hire purchase (HP) finance for the sale of vehicles manufactured by the group. It has been in dispute with HM Revenue and Customs (HMRC) over the proportion of input tax paid on general business overheads, not directly attributable to particular supplies, it is entitled to recover.

The business model is, briefly, as follows. When a customer wishes to purchase a car on HP, VWFS first purchases the car from the dealer and then supplies it to the end consumer on credit terms. The car is supplied to the customer at the same value for which VWFS acquired it from the dealer.

HMRC's position is that all business overheads are attributable to the exempt supplies of financial services to customers, meaning that none of the income tax is recoverable. This position is based upon the argument that none of the residual, or non attributable, input tax incurred by VWFS is a cost component of the supply of the car by VWFS to the customer. Instead it is included in the price of the credit and, as such, not recoverable.

VWFS has claimed that it should be entitled to recover a proportion of the income tax attributable to the part of the HP transaction that involves the taxable supply of a vehicle to the customer, it is not necessary to follow a cost component analysis for residual input tax.

Under article 173 of the EU's Principle VAT Directive, a UK taxpayer can enter into a 'partial exemption special method' (PESM) with HMRC allowing it to recover a predetermined proportion of input tax attributable to taxable supplies. The Supreme Court's questions to the CJEU include whether a taxpayer has the right to deduct any input tax in this scenario and whether it can be "legitimate in principle" to ignore the value of the taxable supplies of cars for the purpose of setting up a PESM.

The Supreme Court was, however, able to dispose of a secondary issue raised by HMRC, which had claimed that the first-tier tribunal (FTT) had not properly considered an alternative method of calculating the deductible proportion of input tax.

Giving the unanimous judgment of the court, Lord Carnwath quoted from the text of the FTT's ruling in the case, in which it said that "what amounts to a fair and reasonable attribution, such as ease of audit and operation" were not at issue.

"The dispute is not on the weighting, but on whether any part of the residual input tax should be attributed at all to the taxable supply of the vehicle," the FTT said at the time.

"In my view, this issue does not require examination of general questions about the tribunal's role," Lord Carnwath said in his judgment.

"One of the strengths of the new tribunal system is the flexibility of its procedures, which need to be and can be adapted to a wide range of types of case and of litigant. In some areas, particularly those involving litigants in person, a more inquisitorial role may be appropriate. However, when the tribunal as here is dealing with substantial litigants, represented by experienced counsel, it is entitled to assume that the parties will have identified with some care what they regard as relevant issues for decision," he said.

"HMRC continues to stick by its cost component analysis at all costs, despite this approach being roundly rejected by the Court of Appeal," said tax expert Darren Mellor-Clark of Pinsent Masons, the law firm behind Out-Law.com.

"It will be interesting to observe how the CJEU deals with this question. In particular, will the court remark upon the incongruity in HMRC's acceptance that the costs are residual, and thus are not used exclusively for making taxable or exempt supplies but is still arguing that the costs in question are a cost component of finance element of the HP transaction," he said.

"Given time delays, it may also be the case that judgment is delivered as one of the first major VAT references from the UK once it has left the EU," he said.