The European Court of Justice (ECJ) (Grand Chamber) ruled that Directive 77/388 (‘the sixth directive’) precluded any right of a taxable person to deduct input VAT where the transactions from which that right derived constituted an abusive practice. An abusive practice existed where the transactions concerned, notwithstanding formal application of the conditions laid down by the relevant provisions of the sixth directive and of national legislation transposing it, resulted in the accrual of a tax advantage, the grant of which would be contrary to the purpose of those provisions. It should also be apparent from a number of objective factors that the essential aim of the transactions concerned was to obtain a tax advantage.

Where an abusive practice was found to exist, the transactions involved had to be redefined so as to reestablish the situation that would have prevailed in the absence of the transactions constituting that abusive practice.

Facts

A bank (‘Halifax’) made mainly exempt supplies for VAT purposes so that its ability to recover input tax on supplies was restricted by the rules relating to partial exemption. Halifax had two wholly-owned subsidiaries which were registered separately for VAT (‘LPDS’ and ‘CWPI’) and to reduce the amount of VAT that it would ultimately pay, Halifax arranged to enter into transactions whereby the subsidiaries would incur input tax on the building works in connection with the construction of four call centres on sites which it owned. Customs subsequently refused input tax claims by LPDS and CWPI because, on a proper analysis of the transactions as a whole, the building services were supplied to Halifax and the sole reason for entering into the transactions with the subsidiaries was to avoid or mitigate the VAT liability of the Halifax group. Therefore the transactions in question were neither supplies nor made in furtherance of an economic activity.

The three companies appealed to the VAT tribunal arguing that the subsidiaries were entitled to an input tax repayment because the transactions gave rise to genuine supplies and had a business purpose, as well as a tax avoidance purpose, since both LPDS and CWPI earned profits from participation in the transactions. The VAT tribunal held that Customs were not required to allow the input tax repayment claim unless Halifax and its subsidiaries entered into the arrangement for a business purpose other than tax avoidance. In this case the only purpose of the arrangement was tax avoidance since there was no additional benefit to the subsidiaries ([2001] BVC 2,240; Decision No. 17,124). The High Court allowed the companies’ appeal and remitted the case to the tribunal on the basis that there was a real doubt whether it had asked and answered the right question ([2002] BTC 5,286).

The tribunal gave a direction that further submissions should be made with reference to the evidence of the witnesses already given to the tribunal and to determine three questions: whether the sole purpose of LPDS and CWPI in entering into the transactions was VAT avoidance; whether the tribunal wished to reconsider its finding that if the scheme had worked it would cause distortions of competition at national and Community levels; and whether the tribunal wished to reconsider its finding that the arrangements were designed to enable LPDS to on-sell and assign the lease in question to another connected company (HPIL) forthwith and, if so, the consequences of that consideration.

The tribunal held that those features were not essential to its conclusions, but were directed at the question of whether the objective characteristics of the arrangements had led to the conclusion that the transactions amounted to supplies carried out in the course of economic activities without regard to the subjective intentions behind those activities. In the tribunal's view the appeals raised questions that should be referred to the ECJ for preliminary rulings ([2003] BVC 4,012; Decision No. 17,721).

Issues

Whether transactions of the kind at issue in the main proceedings constituted supplies of goods or supplies of services and an economic activity within the meaning of art. 2(1), 4(1), (2), 5(1) and 6(1) of the sixth directive, when they were effected for the sole purpose of obtaining a tax advantage, without any other economic aim; whether the directive should be interpreted as meaning that a taxable person had no right to deduct VAT where the transactions on which that right was based constituted an abusive practice; and under what conditions VAT might be recovered where an abusive practice had been found to exist.

Decision

The ECJ (Grand Chamber) (ruling accordingly) said that the problems raised by the case appeared, at least in part, to stem from national rules which allowed a taxable person who undertook at the same time taxed and untaxed transactions, or only untaxed transactions, to transfer leases of immovable property to another entity under its control, which was entitled to opt for taxation of the letting of that property and deduct the total input VAT paid on construction or renovation costs.

Community law could not be relied on for abusive or fraudulent ends. The application of Community legislation could not be extended to cover abusive practices by economic operators, i.e. 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. The principle of prohibiting abusive practices also applied to the sphere of VAT. Preventing possible tax evasion, avoidance and abuse was an objective recognised and encouraged by the sixth directive. An analysis of the definitions of taxable person and economic activities showed that the scope of the term activities was very wide, and that the term was objective, in the sense that the activity was considered per se without regard to its purpose or results. An obligation on the tax authorities to carry out inquiries to determine the intention of the taxable person would be contrary to the objectives of the common system of VAT of ensuring legal certainty and facilitating the application of VAT by having regard, save in exceptional circumstances, to the objective character of the transaction in question.

It followed that transactions of the kind at issue in the main proceedings constituted supplies of goods or services and an economic activity within the meaning of art. 2(1), 4(1), (2), 5(1) and 6(1) of the sixth directive provided that they satisfied the objective criteria on which those concepts were based, even where they were carried out with the sole aim of obtaining a tax advantage, without any other economic objective. To allow taxable persons to deduct all input VAT even though, in the context of their normal commercial operations, no transactions conforming with the deduction rules of the directive or of the national legislation transposing it would have enabled them to deduct such VAT, or would have allowed them to deduct only a part, would be contrary to the principle and purpose of fiscal neutrality. Accordingly, the sixth directive had to be interpreted as precluding any right of a taxable person to deduct input VAT where the transactions from which that right derived constituted an abusive practice.

No provision of the sixth directive dealt with the recovery of VAT. It merely defined, in art. 20, the conditions which must be complied with in order that deduction of input taxes might be adjusted at the level of the person to whom goods or services had been provided. It was therefore, as a rule, for the member states to lay down the conditions under which the tax authorities might recover VAT after the event, while remaining within the limits imposed by Community law.

However the measures which the member states might adopt under art. 22(8) of the sixth directive in order to ensure the correct levying and collection of the tax and for the prevention of fraud must not go further than was necessary to attain such objectives. They might not therefore be used in such a way that they would have the effect of undermining the fundamental neutrality of VAT in Community law.

It should also be borne in mind that a finding of abusive practice must not lead to a penalty, for which a clear and unambiguous legal basis would be necessary, but rather to an obligation to repay, simply as a consequence of that finding, which rendered undue all or part of the deductions of input VAT. In that regard, the tax authorities were entitled to demand, with retroactive effect, repayment of the amounts deducted in relation to each transaction whenever they found that the right to deduct had been exercised abusively. However they also had to subtract therefrom any tax charged on an output transaction for which the taxable person was artificially liable under a scheme for reduction of the tax burden and, if appropriate, to reimburse any excess.

Similarly, a taxable person who, in the absence of transactions constituting an abusive practice, would have benefited from the first transaction not constituting such a practice, should be allowed to deduct, under the deduction rules of the sixth directive, the VAT on that input transaction.

European Court of Justice (Grand Chamber). Judgment delivered 21 February 2006.