VAT Avoidance - When Is A Supply Not A Supply? -- I

VAT Avoidance - When Is A Supply Not A Supply? – I

Robert Venables QC explains how the VAT tribunal went sorely astray in its Halifax decision.

Question: 'When IS a supply not a taxable supply for VAT purposes?'
Answer: 'When it is made for the purpose of tax avoidance.'

The answer was given by His Honour Stephen Oliver QC, President of the VAT and Duties Tribunal, in a decision of the tribunal on 1 March 2001 in Halifax plc.

The United Kingdom tax world has been stunned by this decision, which rests on no United Kingdom or European Community authority, which, in my view, runs counter to the views of Lord Hoffmann, one of the most influential judges of the House of Lords and the Privy Council, and which appears to be inspired by a mistaken view of certain United Kingdom judicial decisions on direct taxation.

While the House of Lords has been very careful in MacNiven v Westmoreland [2001] STC 237 to cut back the scope of the Ramsay doctrine, the tribunal has rushed in to invent another judicial anti-avoidance doctrine. The Westmoreland limitations on Ramsay apparently need not now concern Customs in a VAT case before the tribunal. For, by a perverse application of Commissioners of Customs and Excise v Reed Personnel Services [1995] STC 588, the tribunal also found that Ramsay apart, one can re-characterise a supply made by A to B, in circumstances where B was to make an onward supply to C, as a supply directly from A to C!

Customs also advanced a thoroughly un-British argument based on an alleged European Community doctrine of 'abuse of rights', with which the tribunal did not deal substantively.

The tribunal expressed some interesting and, in my view erroneous, views, on the principle of fiscal neutrality in VAT, which I discuss in the fuller version of this article which is published in the current issue of the EC Tax Journal published by Key Haven.

In my respectful view, the decision is shot through with legal heresy and the sooner it is denounced by the courts, the better.

The facts

The diagram may make the case easier to understand.

Halifax plc makes largely exempt supplies. It was intending to refurbish various properties for its own use. If it simply refurbished the sites itself, it would have recovered only about five per cent of the input tax. A strategy was therefore devised whereby, taking the Halifax group as a whole, 100 per cent of the input tax could, it was considered, be recovered. This involved the use of three other English companies, Developments, Country Wide and Investments, of each of which Halifax was the 100 per cent parent. It is not clear whether they were created for the purposes of the scheme. Halifax, Developments and Country Wide each had separate VAT registrations. Investments had no VAT registration.

Halifax granted long leases of various sites to Developments for a premium. Developments funded the purchase price by issuing a debenture to Halifax. During Development's first 'partial exemption year' (year 1) it purported to make to Halifax taxable supplies of building services of small value. It also refurbished the properties, contracting for building services to be supplied by Country Wide, which in turn subcontracted to obtain such services from non-connected builders. It ensured that the properties were not 'capital goods'. In Development's second 'partial exemption year', it sold the properties to Investments. Investments then leased them to Halifax. Each of Developments, Country Wide and Investments were to make a profit from entering into the arrangements. Developments and Country Wide did indeed make such a profit.

Country Wide retained the services of various unconnected main contractors and professionals, to which the tribunal referred collectively as 'the arm's length builders'. A number of the relevant agreements were apparently accompanied by separate agreements to which Halifax was a party and under which the arm's length builder warranted to Halifax that he would carry out the duties and obligations on his part to be performed under and in connection with his appointment.

It was admitted that 'Halifax's sole purposes in arranging the insertion of [Developments] and [Country Wide] between itself and the arms' length construction contractors was to procure (in group terms) the recovery of substantially all the VAT on the construction works, when otherwise most of that VAT would have been irrecoverable'.

The strategy

The basis of the VAT strategy was that:

(a) Developments recovered all input tax on building services in year 1, because the only supplies it made in that year were standard rated, and that there was no clawback of such input tax as the result of later developments, in particular the subsequent sale of its interest in the properties.

(b) Developments charged no VAT on the sale to Investments in year 2 (because the supply was exempt).

(c) Investments charged no VAT to Halifax (because it made only exempt supplies).

The overall result, if the strategy was successful, was that VAT recovery, taking the group as a whole, was increased from five per cent to 100 per cent. Customs seem to have agreed with Halifax that, subject to the points argued before the tribunal, the strategy worked.

Contentions

Customs' case

Customs claimed that the result was:

• Developments made no supplies of construction works to Halifax;
• Developments obtained no supplies of construction works from Country Wide;
• on the proper analysis of the arrangements as a whole, Halifax received supplies from the arms' length builders and not from Developments and could recover only the normal partial exemption recovery percentage of the input tax.

The alternative bases for reaching this result were:

• a transaction entered into solely for the purposes of VAT avoidance was neither itself a 'supply' nor a step taken in the course of furtherance of an 'economic activity' as those terms in the Sixth Directive (and the equivalent terms in the VAT Act 1994) are properly to be interpreted;
• transactions entered into solely for the purpose of VAT avoidance should, in accordance with the general principle of European Community law preventing 'abuse of rights', be disregarded and, instead, the terms of the Sixth Directive (and, here, the provisions of the VAT Act 1994, which implement the Directive) be applied to the true nature of the transactions in issue.

The reality of the arrangements, whichever approach be adopted, was that the only true supplies of construction services were those provided by the arms' length builders, etc. and those supplies were made direct to Halifax.

The tribunal accepted the first and third of these bases. This meant that it was not necessary for it to adjudicate on the second.

Effects of decisions appealed against

The effect of the Commissioners' decisions, if correct, was:

• Developments made no supplies of construction works to Halifax;
• Developments obtained no supplies of construction works from Country Wide;
• Halifax incurred no input tax under its agreements with Developments;
• on the proper analysis of the arrangements as a whole, Halifax received supplies from the arm's length builders and not from Developments; it could recover the tax shown on the invoices applying its normal partial exemption recovery percentage.

The appellants' case

The case for the appellants, put positively, was that all the transactions forming part of the arrangements with which these appeals are concerned were genuine; they resulted in supplies that had genuinely been made. The supplies of the arm's length builders self-evidently served commercial purposes. So also did Country Wide's supplies of construction services and Investments supplies of construction services and land. Each of those two companies and Investments were to earn profits from their participation in the arrangements. Those factors formed part of the commercial considerations behind the arrangements. The appellants accepted that the arrangements had been structured so as to achieve an advantageous fiscal result. But, it was argued, the VAT system imposed a charge to tax on a transaction by transaction basis; genuine transactions such as these could not be disregarded for any reason.

The legal basis for the appellants' argument on the construction of the Sixth Directive was that a taxable person's purposes in entering into a transaction is immaterial to the question of whether that transaction amounts to a supply or whether the person in question has carried out an economic activity. The aim or purpose for which the transaction (or series of transactions) were carried out is not in point: if supplies are not genuine they can properly be disregarded for all VAT purposes; if, on the other hand, they have genuinely been made, they must be given their due tax consequences and if the authorities want to deny these, they must seek a change in the law.

'Tax avoidance'?

The tribunal relied on the decision of the European Court of Justice in Direct Cosmetics Ltd v Commissioners of Customs and Excise [1988] STC 540. In that case the question was whether the United Kingdom, having been authorised, pursuant to Article 27(1) of the Sixth Directive, to adopt a measure of national law derogating from Article 11A(1)(a) of the Directive, could apply that measure to, inter alios, a taxpayer who had been accepted as carrying on business without any intention to evade or to avoid VAT and whose method of trading had evolved solely on account of commercial considerations. The Court of Justice held it could.

The tribunal decided that the Direct Cosmetics decision was authority for the meaning of 'the concept of "tax avoidance" in the Sixth Directive'. Yet it is plainly an authority only on the interpretation of Article 27(1) and that interpretation is based on a purposive construction of that provision. It is enough for there to be an objective leakage of tax for Article 27 to come into play.

There is some doubt as to whether the tribunal in fact applied an objective test, in that it concluded, puzzlingly:

'Our task, therefore, is to identify what the solution was designed to achieve and to examine the steps taken in implementation of the solution and from those to conclude, one way or the other, whether those factors possess the inherently objective characteristics of tax avoidance.'

The tribunal went on to conclude that 'the scheme implementing the solution and every step and every transaction involved in it were "tax avoidance" in the sense contemplated by the Sixth Directive'. One bizarre piece of reasoning was 'if the scheme works it will "cause distortions of competition at National and Community level": see paragraph 23 of Direct Cosmetics. This follows from the fact that the Halifax's 'competitors who do not adopt an avoidance scheme having similar effect will be at a disadvantage in economic terms as compared with the Halifax'. Halifax's competitors were, of course, just as able to implement the scheme as was Halifax.

United Kingdom direct tax authorities

The tribunal's inspiration

While accepting that the transactions were genuine, the tribunal nevertheless rejected these submissions. It observed:

'Were this a matter of United Kingdom law alone, the transactions comprised in the Halifax's tax avoidance solution would not, we think, be classed as taxable supplies. This is because they would not have been made in the course or furtherance of the businesses of either [Developments] or [Country Wide]. The House of Lords in FA & AB Ltd v Lupton [1972] AC 634 concluded that if the sole object of a transaction was tax avoidance, it was not a trading transaction for purposes of tax on corporate profits. That was so even if, as here, there was a profit built into the scheme: see Thomson v Gurneville Securities [1972] AC 661. A similar robust approach would, we think, be applied where the issues concerned businesses as distinct from trades.'

Critique

This is a key passage as it reveals the 'inspiration' for the rule of European Community law which the tribunal considers it has discovered. The tribunal has, with respect, misunderstood the ratio decidendi of those cases and had overlooked later House of Lords authority which flatly rejects the view espoused by the tribunal. Moreover, even if its analysis of them were correct, it has overlooked the vital difference between a 'trade' in the context of taxes on income and a 'business' in the context of a tax on consumption.

The dividend stripping cases

The cases in question related to dividend stripping tax avoidance schemes. The tribunal chairman, Stephen Oliver QC, would have been well acquainted with these cases. He represented the tax avoider in FA & AB Ltd. With respect, the tribunal misunderstood the effect of these authorities. The point was that in the cases where the taxpayers lost, the shares were not acquired as trading stock in the course of the dealer's trade of dealing in securities. It is only losses made in the course of a trade which are deductible in computing trading profits. Now it is true that the only reason the dealer entered into these transactions was that they were part of a raid on the Revenue. But it was not that per se which meant that they were not transactions carried out in the course of the taxpayer's trade or that the shares were not trading stock. They were not carried out in the course of the taxpayer's trade because of their nature. Of course, their nature was determined by what were thought to be the necessary requirements for a successful fiscal raid. Hence, on the particular and highly unusual facts, there was a causal connection between their being tax motivated and their not being transactions carried out in the course of the taxpayer's trade of dealing in shares.

It is a logically unjustified leap to conclude, as did the tribunal: 'if the sole object of a transaction was tax avoidance, it was not a trading transaction for purposes of tax on corporate profits'. That this leap is impermissible is made abundantly clear even by the speeches in FA & AB Ltd itself! For example, Lord Morris of Borth-y-Guest said: 'If, therefore, as in my view is clear, the presence of a motive of securing tax recovery does not cause a trading transaction to cease to be one, then reliance on motive must disappear'.

Ensign Tankers

It is striking that the tribunal did not quote the House of Lords decision in Ensign Tankers (Leasing) Ltd v Stokes [1992] STC 226. The House of Lords reversed the decision of the Court of Appeal in Ensign Tankers. Lord Templeman roundly rejected the heresy, propagated by that Court, that a fiscal motive can turn a trading transaction into a non-trading transaction. In a later passage in his speech he said:

'Similarly, in the view of Sir Nicolas Browne-Wilkinson V-C ([1991] STC 136 at 149), the taxpayer is deprived of all the beneficial effects of the scheme if the scheme was entered into "essentially for the purpose of obtaining a fiscal advantage under the guise of a commercial transaction".

'In the view of Sir Nicolas Browne-Wilkinson V-C (at 147):

With respect, the position could hardly be clearer. The acquisition of the property, its refurbishment and its resale at an intended profit amount in law to a trade and those transactions were effected in the course of that trade. Hence, Developments was trading. Similarly, contracting to provide building services and providing those services through the agency of subcontractors to make an intended profit is trading. Consequently Country Wide was trading. It is immaterial in either case that the purpose of carrying on the trade was to help secure a tax advantage for another member of a company in the same group as the company carrying on the trade.

If only the tribunal had simply found the facts and applied the law in Halifax, as enjoined by the House of Lords, the decision would have been an uncontroversial one and this article would not have been written!

Trade and business

I have so far dealt with the question whether Developments and Country Wide were trading. In United Kingdom VAT law, the question was whether the supplies were made in the course or furtherance of a 'business'. The tribunal had added: 'A similar robust approach would, we think, be applied where the issues concerned businesses as distinct from trades'.

In my view, if the companies were carrying on a trade, they were also carrying on a business. While 'business' is not a technical term of United Kingdom law – it takes its colour from its context – it is clearly wider than 'trade'. In the United Kingdom VAT legislation, business is expressly defined to include a trade.

Even if the presence of a tax avoidance motive meant that the companies were not carrying on a trade, it by no means follows that they were not carrying on a business. Purpose is to an extent relevant in determining whether a person is carrying on a trade. For carrying on an activity in the hope or expectation of profit is the hallmark of a trade. It is the profit motive which determines the commercial nature of the profits and thus, in most systems, brings them within the charge to tax on income, which they would escape were they, say, casual profits arising from the purchase and sale of a capital asset by a private individual. What the United Kingdom direct tax authorities establish is that once that purpose is established, the trade does not cease to be a trade because there is some reason for carrying on the trade beyond the desire to earn profits. That reason might be the avoidance of taxation. The trade might be carried on in performance of a statutory duty. Or the trader might simply enjoy his work and have no need for the profits, which he donates to charity.

Value added tax, by contrast, is a tax on consumption which is only at a technical level levied on the person making the supply and is in reality levied on the recipient of the supply. The motive of the supplier in making the supply should thus in principle make no difference to the taxability of the supply.

Illegal activities

The tribunal relied on European Court of Justice cases which have established that 'Unlawful trading activities will be excluded [from the scope of VAT] so long as their exclusion will not produce unfair competition between unlawful and lawful activities in the same area of trade'. The tribunal then reasoned:

'The Halifax's tax avoidance scheme contains transactions that have no business purpose and which were inserted solely for tax avoidance reasons. To exclude these from the ranks of economic activities could not possibly create unfair competition. Indeed to allow them to qualify as economic activities would, as we observed in paragraph 42 above, put the Halifax at an unfair advantage over comparable financial institutions that did not adopt such schemes.'

The authorities establish that the exception to the rule that illegal supplies are not taxable supplies is where they would otherwise unfairly compete with lawful supplies. To conclude that a lawful supply ceases to be a taxable supply if either:

(a) its exclusion 'from the ranks of economic activities could not possibly create unfair competition'; or

(b) if its non-exclusion would confer on those who made such supplies an unfair advantage over comparable institutions which did not,

is in each a complete non sequitur.

Governmental functions

The tribunal then considered another category of non-supplies:

'Regulatory activities conducted by an outside body on behalf of the state are another example of activities excluded from the scope of economic activities. That was the effect of the decision of the House of Lords in Institute of Chartered Accountants in England and Wales v Commissioners of Customs and Excise [1999] STC 398.... This decision and the other cases cited in Lord Slynn's speech show that, in deciding whether an activity is an economic activity, it is, to use the words of the Advocate General (Lenz) in Wellcome Trust Ltd (C-15 5/94) [1996] STC 945.... the inherent nature of the activity itself that is the vital consideration.'

The tribunal concluded that 'the inherent nature of the transactions with which the present appeal is concerned is, taking those transactions collectively and individually, tax avoidance. There was no business purpose. Adapting the Sixth Directive terms, the Halifax's tax avoidance activities were, we think, "counter-economic activities"'.

The Chartered Accountants case is light years away from Halifax. It was clear that the functions in question were 'regulatory functions... essentially for the protection of members of the public' and that, although supplies were made for a consideration, they were not made in the course or furtherance of a 'business' or of an 'economic activity'. Their Lordships held that the Institute was carrying out what was 'essentially a function of the state'.

In Halifax, there was no question of Developments or Country Wide carrying on any governmental functions. If Institute of Chartered Accountants in England and Wales was relevant at all, it was surely to show how wide is the concept of 'economic activity' and the complete irrelevance of motive. It is, according to their Lordships, 'the inherent nature of the activity itself that is the vital consideration'. One can only gawp in disbelief at the tribunal's conclusion that 'the inherent nature of the transactions with which the present appeal is concerned is, taking those transactions collectively and individually, tax avoidance'. To call this conclusion 'perverse' would be an understatement. How on earth does one persuade a tribunal capable of such reasoning that when the European Court of Justice says that 'the activity is considered per se and without regard to its purpose or result', it means precisely that?

Robert Venables QC is a bencher of the Middle Temple and council member of The Chartered Institute of Taxation. Chambers: 24 Old Buildings, Lincoln's Inn, London WC2A 3UP, tel: 020 7242 2744.

The second part of this article, to appear in next week's issue of Taxation, will examine the decision in the light of European Directives and case law.

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