The European Court of Justice (‘ECJ’) ruled that under art. 20(3) of Directive 77/388 (‘the sixth directive’) where a 999-year lease over capital goods was granted to a person against the payment of a substantial premium and the freehold reversion in that property was transferred three days later to another person at a much lower price, and where those two transactions were inextricably linked, and consisted of a first exempt transaction and a second taxable transaction, and if those transactions, owing to the transfer of the right to dispose of those capital goods as owner, constituted supplies within art. 5(1), the goods in question were regarded, until the expiry of the period of adjustment, as used in partly taxable and partly exempt business activities in proportion to the respective values of the two transactions.

Facts

In 1994 a building was constructed by a university but as it made predominantly exempt supplies of education it was unable to reclaim the VAT incurred on the construction costs. Following completion, the university entered into a sale and leaseback arrangement under which it sold the freehold of the building to the taxpayer as a standard-rated supply of a new commercial building in the sum of £6.5m plus VAT. In return, the taxpayer elected to waive exemption in respect of the property and granted a lease to the university for 20 years and six months. As a result, the university was able to reclaim VAT on the construction costs, but became liable for VAT on the rent charged by the taxpayer.

In 1996, the university entered into a second planning scheme involving the grant by the taxpayer of an exempt 999-year lease to an unregistered subsidiary of the university at a premium of £6.4m, followed shortly after by the taxable transfer of the freehold reversion to the university for £1,000 plus VAT. Following the sale, the taxpayer cancelled its VAT registration. In its final return, the taxpayer made an adjustment pursuant to reg. 115(2) of the Value Added Tax Regulations 1995 (SI 1995/2518) on the basis that it had made exempt supplies for only three days out of 365 in the adjustment period. However, Customs considered that the taxpayer should have made a final adjustment under reg. 115(3) to reflect the supply of the whole interest in the building in the form of an exempt 999-year lease. Later, Customs reconsidered their position and contended that the supply of the whole interest in the building comprised both the grant of the 999-year lease and the taxable transfer of the freehold reversion.

Customs regarded the taxpayer's grant of the 999-year lease as the supply of its whole interest in the building for the purposes of reg. 115(3) and said that the subsequent taxable disposal of the freehold reversion was insignificant and should be ignored. Alternatively, the taxpayer had supplied the whole of its interest by way of two supplies, one taxable and one exempt, and that, in those circumstances, reg. 115(3) required an apportionment in the calculation of the final adjustment to be carried out upon disposal of the capital item. Even if the legislation did not specifically prescribe an apportionment, it should be construed as implying an apportionment. The first contention would give rise to a liability of the taxpayer to Customs of £796,250, the second of £796,090. The taxpayer disagreed. It claimed that it had disposed of its whole interest in the building by the transfer alone so that its liability to Customs under reg. 115(3) did not exceed £943.93.

The tribunal ([2002] BVC 2,117) rejected the taxpayer's contention and the first claim by Customs. They concluded that the reversionary lease and the transfer were pre-ordained in that there was no likelihood that the transfer would not be concluded once the reversionary lease had been granted. In those circumstances, they considered that the proper application of reg. 115(3) required an apportionment between them. On that basis they confirmed the liability of the taxpayer to Customs as £796,090. The taxpayer appealed against that decision. There was no cross-appeal by Customs from the tribunal's rejection of the argument that the transfer should be ignored on the basis that it was de minimis. The High Court ([2003] EWHC 44 (Ch)) made a reference to the ECJ for a preliminary ruling on the proper interpretation and application of art. 20(3) in relation to immovable property.

Issue

Whether under art. 20(3), until the expiry of the period of adjustment, the goods should be treated as if they had been applied for business activities which were presumed to be fully taxable or fully exempt, or partly taxable and partly exempt in the proportion of the respective values of the two transactions to which those goods were subject.

Decision

The ECJ (ruling accordingly) said that art. 20 laid down a special system of adjustment for capital goods. Article 20(3) governed the particular case of the supply of capital goods before the end of the period of adjustment. In that case, the annual adjustment was replaced by a single adjustment, based on the presumed use of the capital goods in question for the period still to run. Under that provision, the deductibility of the input VAT depended on whether the supply made was or was not subject to VAT. It was clear from the wording of art. 5(1) of the sixth directive that ‘supply of goods’ did not refer to the transfer of ownership in accordance with the procedures prescribed by the applicable national law but covered any transfer of tangible property by one party which empowered the other party actually to dispose of it as if he were the owner of the property. In that context, it was for the national court to determine in each individual case, on the basis of the facts of the case, whether a given transaction in respect of property resulted in the transfer of the right to dispose of the property as owner within the meaning of art. 5(1).

It followed that both the first transaction, the grant of the 999-year lease, and the second transaction, the transfer of the freehold reversion, could constitute a ‘supply’ within the meaning of the sixth directive. If each of those transactions constituted a supply, it had to be determined which of them must be taken into account for the purposes of the adjustment required by art. 20(3) or, if appropriate, the extent to which each of them must be taken into account for that purpose. Under art. 20(3), in the case of supply during the period of adjustment capital goods were to be regarded as if they had still been applied for business use by the taxable person until the expiry of the period of adjustment. Such business activities were presumed to be fully taxed in cases where the supply of the goods concerned was taxed and they were presumed to be fully exempt where the supply of those goods was exempt. However, it could not be deduced from the wording of art. 20(3) that, in a situation in which ‘the case of supply’ consisted of two closely and inextricably linked transactions, each of which could in itself be regarded as a supply, only one of those transactions must be taken into consideration for the purposes of the adjustment required by that provision. The system of deductions and adjustments provided for in art. 17–20 of the sixth directive was intended to establish a close and direct relationship between the right to deduct input VAT and the use of the goods and services concerned for taxable transactions. In the specific circumstances of this case, taking into account each of the two supplies in question in proportion to their respective values was likely to attain that objective most satisfactorily. There could be no objection to that interpretation because no apportionment mechanism was expressly provided for in art. 20(3), whereas other provisions of the directive, particularly art. 17(5),provided explicitly for such a mechanism. The adjustment rules relating to capital goods, of which art. 20(3) formed part, had to be interpreted in the light of their objective, which was to ensure that deductions of input VAT closely reflected the use of durable inputs for the purposes of taxable transactions. A proportional approach was required even in circumstances where the wording of the relevant provision of the sixth directive did not provide for it expressly.

European Court of Justice (Third Chamber). Judgment delivered 15 December 2005.