In this case the Court was asked to decide whether the taxpayers were entitled to sell cars and account for VAT on the basis of the margin of profit or if they were obliged to account for VAT on the full selling price, irrespective of whether a profit was made.

Background

The companies were car dealerships in the same group, and, in October 2000, were made aware by their accountants of ‘tax efficient demonstrator finance’ arrangements. It was commonly understood that these arrangements constituted a margin scheme under Article 26(a) of the Sixth Directive, Article 8 of the Value Added Tax (Cars) Order 1992 and Article 5 of the Value Added Tax (Special Provisions) Order 1995.

Under the scheme, agreements were entered into between various companies and the taxpayers’ captive leasing companies. The aim of the arrangements was to obtain a particular VAT treatment, namely to limit the VAT accountable on the disposal of demonstrator cars to the value of the margin achieved rather than the full selling price.

The companies contended that there was no abuse of law or rights under the principle established in the case Halifax plc v C & E Commrs, as all that was involved in their case was the obtaining of finance. They argued that the test laid down in Halifax was not satisfied since the scheme was not contrary to the purpose of the Sixth directive and the essential aim of the transactions was not to obtain a tax advantage, but to finance the business.

The companies further argued that a VAT advantage might have been achieved by allowing VAT to be accounted for on the profit margin of the vehicles but that there was no obligation on taxpayers to structure their business in the most VAT disadvantageous way.

HMRC disagreed and took the view that this was a case of abuse, such that the taxpayers could not take advantage of the margin scheme nor of any other benefits attributable to the implementation of an abusive scheme. HMRC further argued that the arrangements fell within EU law's overarching general anti-avoidance principle that a person could not rely on EU law for an abusive purpose.

The First-tier Tribunal (“FTT”) allowed the taxpayers’ appeal on the basis that the engagement by the taxpayers of accountants to advise on a scheme intended to limit their tax liability did not of itself make what was done abusive or contrary to the purposes of the Sixth Directive.

Furthermore, because what was done was done in a tax-efficient manner did not make the essential aim of the scheme to obtain a tax advantage. The Tribunal's view was that the essential aim of the scheme was to obtain finance, not an abusive VAT advantage, and that the taxpayer chose its business structure in a way that would minimise its VAT liability. Furthermore, since second-hand goods were being sold it was right that the margin scheme should apply. HMRC appealed against this decision.

Decision

The Upper Tribunal (“UT”) (Tax and Chancery Chamber) allowed HMRC's appeal in full and considered two issues in the course of making their decision:

1. Whether accrual of a tax advantage was contrary to the purpose of the legislation

The scheme enabled the companies to sell demonstrator cars in circumstances where they did not charge VAT on the full amount of the consideration for the sale of these to consumers and therefore VAT was charged on the much smaller sum, represented by the profit margin on sale. That result would apply where there had not been an earlier sale to a consumer where VAT on the full sale price had been charged and where there was no risk of double taxation.

It was clear from the second, third and fifth recitals in the preamble to Council Directive 94/5 (which introduced Article 26(a) of the Sixth Directive) that the policy behind Article 26(a) was the avoidance of double taxation and the distortion of competition. However, the mere fact that goods were second-hand goods (as defined) did not mean that the margin scheme should be applied to them (various cases were considered).

The accrual of the tax advantage claimed by the taxpayers was contrary to the purpose of Article 26(a) and it was not needed to prevent double taxation. Furthermore, if the taxpayer was able to benefit from the tax advantage which it claimed, that would distort competition by placing it in a position where it reduced the amount of VAT which it had to charge and account for, as compared with other car dealers who charged and accounted for VAT on the full amount receivable for the sale of the demonstrator car.

That conclusion did not mean that the national provisions were ultra vires and merely meant that the application of the national provisions in the circumstances of this particular case were abusive. The national provisions were being used by the taxpayer companies for the essential aim of obtaining a tax advantage contrary to the purpose of the European and compatible national provisions.

2. Whether the essential aim of scheme was to obtain tax advantage

The second question under the Halifax test involved the court or tribunal determining what was ‘the essential aim’ of the transaction in question, considering objective factors and commercial reality.

In this case, it was important to assess both the tax and the commercial consequences of the transactions. The transactions concerned motor vehicles with a value of approximately £20m and an applicable rate of VAT of 17.5%. If the motor vehicles were sold whereby VAT at 17.5% was chargeable on the total consideration for the supply of the vehicles, the resulting output VAT would be £3.5m.

If the margin scheme applied to the sale of £20m worth of vehicles, then the amount of VAT chargeable would depend on the profit margin on the vehicles. Therefore, there was an overwhelming case for saying that, objectively assessed, the essential aim of the transaction was to gain a considerable tax advantage, even though it also provided short term finance.

The UT held that the ultimate decision of the FTT was plainly wrong and that it had committed an error of law in reaching that conclusion. The transactions involved an abuse of law and had to be redefined and taxed accordingly.

The UT decided that the margin scheme involving demonstrator cars purchased by car dealerships, objectively assessed, had the essential aim of obtaining a tax advantage and involved an abuse of law contrary to the Sixth VAT directive and the related national provisions previously mentioned.

The full text of the case is available at http://www.tribunals.gov.uk/financeandtax/Documents/decisions/HMRC_v_Pendragon.pdf