HMRC v Volkswagen Financial Services (UK) Ltd

Factual and Procedural Background

This opinion concerns an appeal by the Appellant against a decision of the First-tier Tribunal ("FTT") which allowed the Respondent's appeal against a VAT assessment issued by the Appellant. The dispute centers on the Partial Exemption Special Method ("PESM") used by the Respondent, a finance company, to determine the proportion of residual input tax recoverable in relation to hire purchase ("HP") transactions involving motor vehicles. The residual input tax relates to overhead costs partially attributable to both taxable supplies (sale of vehicles) and exempt supplies (finance charges).

The Respondent operates its business by purchasing vehicles from dealers at cost and invoicing customers at cost with no markup, combined with financing charges that are partly exempt (mostly interest and acceptance fees) and partly taxable (such as option to purchase fees). The parties agreed to use a PESM dividing the business into sectors, with the dispute focusing on the retail sector's HP transactions.

The Appellant issued a VAT assessment in June 2008, upheld in September 2008, which the Respondent appealed to the FTT. The FTT allowed the appeal, endorsing the Respondent's method which apportions 50% of the residual input tax to taxable supplies. The Appellant sought and was granted permission to appeal to the Upper Tribunal.

Legal Issues Presented

1. Whether residual input tax on overheads attributable to hire purchase transactions can be recovered in proportion to taxable supplies of motor vehicles.
2. Whether the residual cost inputs have a direct and immediate link with, and are cost components of, the taxable supplies of motor vehicles.
3. Whether a methodology attributing 50% of residual input tax to taxable supplies is fair and reasonable under VAT law and regulations.

Arguments of the Parties

Appellant's Arguments

• The residual input tax attributable to exempt finance supplies should not be deductible as a matter of law.
• Allowing 50% deduction would contradict the principle of fiscal neutrality, potentially resulting in perpetual VAT recovery rather than payment.
• The cost component test requires that residual input costs be part of the price of taxable outputs; here, overheads are built into exempt finance charges, not the vehicle sale price.
• The vehicle sale is at cost with no markup, so the cost component capacity is exhausted by the vehicle purchase input tax.
• Preferred method apportions residual input tax based on values of taxable and exempt outputs excluding the vehicle sale price.

Respondent's Arguments

• The FTT was correct in its approach and findings.
• The direct and immediate link test and the cost component test are effectively the same.
• Residual input costs need not be incorporated into the price of a particular output to be deductible.
• The hire purchase transaction is indivisible, comprising taxable sale and exempt finance, both using the overheads.
• The residual input costs relate to one economic activity supplying vehicles and finance together.
• Without the vehicle supply, there would be no finance business; thus, overheads support both taxable and exempt supplies.

Table of Precedents Cited

Court's Reasoning and Analysis

The court began by reviewing the statutory framework, including the Principal Directive and the Value Added Tax Act 1994, which require that input tax is deductible only if the goods or services are used for taxable transactions. The court examined the twin tests established by the CJEU and domestic case law: whether residual input costs have a direct and immediate link with taxable supplies, or alternatively, whether they are cost components of the taxable part of the business as a whole.

The court found no absolute rule preventing deduction if residual input costs are incorporated only into exempt supplies. Instead, the tests must be applied objectively considering the economic reality of the business.

Applying these principles, the court disagreed with the FTT’s characterization that the Respondent was engaged in a combined business of selling vehicles and providing finance. Instead, the economic reality was that the Respondent operated a finance business providing credit to customers purchasing vehicles from dealers, with vehicle sales at cost and no mark-up or profit to the Respondent.

The court noted that the residual input costs were overheads typical of a finance business and were incorporated into the exempt finance charges, not the taxable vehicle sales. The vehicle sales had no economic impact on the Respondent’s finances, and no profit was made on vehicle sales. Therefore, the residual input costs lacked the required direct and immediate link with taxable supplies and were not cost components of the taxable part of the Respondent’s economic activity.

Consequently, the court concluded that the PESM attributing 50% of residual input tax to taxable supplies was not fair and reasonable. The court also considered and rejected the Respondent’s argument that the indivisibility of the HP transaction justified the apportionment.

The court declined to refer the matter to the CJEU, finding the case law sufficiently clear, and noted that the decision on the application of the tests is for the national court.

Holding and Implications

The court ALLOWED the Appellant's appeal and overturned the FTT's decision.

The direct consequence is that the Respondent’s Partial Exemption Special Method attributing 50% of residual input tax to taxable supplies of vehicles under hire purchase transactions is not fair and reasonable, and the Respondent is not entitled to recover input tax on overheads to that extent.

No broader precedent was set beyond the specific application of the statutory and case law principles to the facts of this case, emphasizing the importance of economic reality and the nature of the business in assessing VAT input tax deductibility.