Robert Tsang and Ian Reid of Arthur Andersen examine the Royal and Sun Alliance Group plc High Court and Halifax plc Tribunal decisions.
Robert Tsang is a partner at Arthur Andersen, and the head of the firm’s indirect tax litigation practice. Ian Reid is a principal with Arthur Andersen, based in their Manchester office where he heads up the VAT department there
Published in the January 2001 issue of "Tax Adviser"
It was supposed to be a simple tax. Look at the burgeoning list of cases dealing with VAT, and you will wonder whatever happened to those good intentions. The two cases examined in this article are, we believe, examples of contrasting approaches to making sense of the myriad of rules governing a taxpayer’s right to input tax recovery on business expenditure. Both concerned regulation 109 of the VAT Regulations 1995: the regulation deals with the situation where a taxpayer did not initially reclaim an amount of input tax because they intended to use the inputs in making exempt supplies at some point in the future, but where that intention was not fulfilled and they instead used the inputs to make taxable supplies. In such circumstances the regulation allows the taxpayer to revisit the original attribution of the input tax and reclaim an appropriate sum from Customs. But how does this work in practice?
Royal and Sun Alliance Group plc (RSA) was the representative member of a VAT group whose subsidiaries held leases in five properties ranging in length from 15 to 25 years. In each instance RSA’s superior landlord had exercised its option to tax the rents. The group originally took the leases for the purposes of its insurance business, but then decided at various times respectively in the early 1990s that the properties were no longer required, and tried to sub-let them instead. In November 1995, RSA exercised the option to tax the sub-lettings. For subsequent VAT accounting periods, RSA claimed and had been allowed credit for the input tax payable by it as part of the rents to the landlords of the five properties.
On the basis of regulation 109, RSA then claimed repayment of input tax incurred on rents and service charges in respect of the five leasehold properties in the periods when they were vacant up to the making of the election to waive exemption in November 1995, on the basis that the VAT incurred related directly to taxable supplies in respect of the opted sub-leases. Customs disagreed with this analysis and refused the repayment request; the VAT Tribunal (decision 16148) agreed with the Commissioners. The High Court overturned the Tribunal’s decision, accepting that the inputs had been used to make taxable supplies and that the conditions of regulation 109 had been satisfied.
Contrast the Halifax case (Tribunal decision 16697), where the company attempted to use regulation 109 to reclaim input tax it had originally disallowed itself when purchasing stationery. When Halifax originally purchased the stationery, it intended to use it to make both taxable supplies and exempt supplies. As a consequence, Halifax included the associated input tax in the residual part of its partial exemption calculations. Some of the stationery subsequently became redundant and was disposed of by way of a taxable supply. Halifax argued that regulation 109 was applicable to the stationery disposed of in this way, since it had been used to make taxable supplies rather than both taxable and exempt supplies as originally intended. The Tribunal rejected Halifax’s argument on the basis that the company had not been able to demonstrate that the inputs in question had only been used to make taxable supplies.
Differences in approach?
In the RSA case, the court concluded that the inputs were attributable to taxable supplies once the options to tax had been exercised because, applying principles established by earlier ECJ cases, there was a direct and immediate link between the inputs and the taxable supplies, and the inputs were cost components of the taxable supplies.
Park J concluded that there was a direct and immediate link because the sub-leases were granted out of the superior leases. The latter gave rise to the inputs in question, and it was necessary for RSA to pay for those inputs in order to keep the superior leases in existence. The rents were cost components of the taxable supplies because by paying them RSA had complied with its obligations to its landlords and preserved the leases “against the risk of forfeiture”.
Customs had argued that the inputs had been ‘consumed’ or ‘exhausted’ by the time RSA opted to tax the properties and that they could not therefore have been used to make any subsequent taxable supplies. The judge’s view was that inputs could not have been consumed or used up because RSA had not been successful in granting sub-leases – in other words, for VAT purposes, an input can only have been used (or consumed) if there has been a related output supply. He accepted the theoretical point that inputs can sometimes be transient in nature, in that they exist only for a limited period and cannot therefore be used in making outputs after that period has expired. He did not however accept that the inputs in this case were of that nature: each superior lease represented a single supply rather than a succession of supplies corresponding to the quarterly rental payments. Therefore each superior lease was one supply that provided RSA with an asset which they would continue to own unless it was surrendered or forfeited due to failure to pay the rent. Those assets could not therefore have been used up in earlier periods since they would continue to exist for the remainder of the lease periods.
The court was therefore able to conclude that, once the elections had been made, the inputs did become cost components of an intended taxable supply and that there was a direct and immediate link between them and the intended outputs. The conditions concerning the operation of regulation 109 were therefore satisfied and RSA was entitled to reclaim the VAT it had originally disallowed itself.
In the Halifax case Customs’ argument was that the taxable disposal of some of the stationery was consistent with the original attribution which had anticipated that some of the stationery would be used to make taxable supplies; it did not matter that the nature of the taxable supplies was different from the type of taxable supply originally envisaged. The Tribunal concluded that regulation 109 can only take effect if all of the goods or services comprised in a particular supply are used to make taxable supplies. It rejected Halifax’s contention that each item of stationery represented a separate supply: placing an order with a supplier for a specific supply of stationery gave rise to a single supply. Halifax was not however able to demonstrate that all the stationery comprised in a given supply (by the Tribunal’s definition) had been disposed of and the Tribunal concluded that they were not therefore able to make an adjustment under the terms of the regulation.
Analysis and commentary
A couple of points are worth making:
Consumption of inputs
In RSA, Park J comments that the inputs cannot have been consumed in the earlier periods because no output supplies had been made in those periods. Looking at this there must be occasions when goods or services are used up when simply attempting to make a supply. Let us suppose that RSA had taken out a newspaper advertisement in an attempt to find tenants for the properties. By its very nature a newspaper advertisement only has a short effective life, perhaps a week or two. Therefore, had RSA incurred such inputs in the relevant periods, they would have been used up in attempting to make exempt supplies; in the case the judge acknowledges that there could theoretically be such ‘transient’ inputs, but has no difficulty reconciling this with his earlier assertion that inputs can only be used up if outputs have been made.
Fortunately this difficulty surrounding the question of consumption would seem to be limited to services since, in practice, it should be readily ascertainable whether goods have been used up.
Single or multiple supplies
In RSA the service charges associated with the rents were not held to be separate supplies because they were payable under the terms of the leases. The court concluded that the relevant amounts should therefore be construed as additional rent payments. This analysis is consistent with both the land law position and Customs’ historic view on the VAT treatment of such charges.
Park J also held that the grant of each lease was a single supply. This was principally on the basis that the grant of a lease is, in commercial and legal terms, a single transaction. He also considered the VAT regulations that deem that the grant of a lease shall be treated as separately and successively supplied at the earlier of the rent beig paid or a VAT invoice being issued. The judge concluded that the regulations do not deem there to be a number of supplies where, in the absence of the regulations, there would only be one supply, based on an analysis of the relevant primary legislation (s.6 VATA 1994) which provides for regulations to be made dealing with the time of supply, but not the nature of a supply. Those rules were not therefore inconsistent with the judge’s view that the grant of a lease is a single supply for VAT purposes. When one looks at the relevant regulations (85 and 90) the judge’s conclusion is, on first hearing, somewhat surprising since the regulations prescribe that each rent payment shall be treated as a separate supply. His approach of considering the scope of the enabling section is, however, based on an established rule of interpretation and is supported by case law.
In the Halifax case the single versus multiple supply argument was also important. Halifax could only invoke regulation 109 if they could show that all of the inputs in question had been used to make taxable supplies rather than both taxable and exempt supplies. The Tribunal concluded that Halifax needed to do this on a supply by supply basis. The chairman therefore had to determine whether each order for stationery placed by Halifax resulted in a single supply, or whether each individual piece of stationery represented a single supply, thereby giving rise to multiple supplies from each order. The Tribunal considered a number of cases dealing with the question of mixed versus composite supplies but found these cases of limited assistance. The chairman concluded it would be artificial to treat each piece of stationery as a single supply. He held that each order was a ‘composite and cohesive whole’ and therefore gave rise to a single supply. It was his view that this was a matter which could be decided by the UK courts and that it was not necessary to refer the matter to the ECJ. These are perhaps somewhat contentious conclusions given that there is very little case law on the question of single versus multiple supplies. The Sixth Directive provides little if any guidance on this matter and in the writers’ view this is a matter which the ECJ will need to consider at some point in the future.
It is worth mentioning one further point in relation to the single supply question. It is interesting to compare the Tribunal’s view that the whole of a supply must be used for a different purpose in order for regulation 109 to bite with the judgement in the RSA case. In RSA, the court held that each superior lease was a single supply, but the end result was that some of the input tax associated with each supply (lease) was treated as residual (the input tax paid on the rent during the periods when RSA occupied the buildings for the purposes of its own business) and, following the adjustments under regulation 109, the remainder of the input tax was treated as fully recoverable. Consequently, only part of each input supply was subject to adjustment under Reg 109.
Intention to use – an alternative analysis?
One of the planks of RSA’s case was that it had not initially reclaimed the input tax on the rent because it intended to use the inputs to make exempt supplies. How does this stack up against the commercial reality that it might or might not opt to tax the leases? The court accepted RSA’s analysis, on the practical basis that this is a sensible conclusion to draw when reading regulations 102 and 109 together.
We wonder however whether this was the only approach the courts could take. Regulation 101(2) requires the taxpayer to identify input tax that is to be used in the following ways:-
(i) for making taxable supplies,
(ii) for making exempt supplies,
(iii) for making both exempt and taxable supplies.
At the time it incurred the inputs in question, RSA arguably could not definitively say that it intended to use those inputs in any of the three ways mentioned above. In other words, it was unable to attribute the inputs by reference to regulation 101(2) and, as a consequence, there was no basis for it to reclaim those inputs at that time. This is clearly not the same as saying it attributed the inputs tax to category (ii) above.
If this analysis is correct, then regulation 109 becomes irrelevant because it only applies where the taxpayer originally intended to use the goods or services in making either exempt supplies, or both taxable and exempt supplies. If regulation 109 did not apply to RSA’s inputs, is there any mechanism by which the company might recover the VAT on the inputs? The answer is perhaps provided by moving forward in time to the point where RSA opted to tax the properties. At that stage RSA was able, for the first time, to put the inputs it had been incurring into one of the three categories referred to above, i.e. it was then able to say that it intended to use the inputs to make taxable supplies.
One would expect that RSA should then be able to recover the input tax. There is, however, a problem. Regulation 29 says that input tax must be reclaimed in the VAT accounting period in which the VAT became chargeable, save as the commissioners otherwise allow. RSA would therefore need the Commissioners’ approval to belatedly reclaim the input tax. The right to deduct is, though, a fundamental principle of the tax, to which the Commissioners would in our view have to give due regard, and to uphold. Park J in fact referred to this right and quoted from the Belgian State v Ghent Coal Terminal (C-37/95)  BTC 5, 121:
‘…the court has stated repeatedly that the deduction system is meant to relieve the trader entirely of the burden of the VAT payable in the course of all his economic activities.’
Given that Park J concluded that the inputs in question were used to make taxable supplies, Customs could not properly refuse RSA permission to recover the input tax. Whichever way the analysis is cut, in our view the answer is the same: once a direct link to taxable supplies is made, the associated input tax is recoverable. Payback time indeed, just in time for the holiday season…
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January 2001 by