The European Court of Justice has recently given its ruling in the Halifax case. It stated that:

• motive is irrelevant to whether transactions constitute supplies of goods or services or an economic activity for the purposes of the Sixth Directive;
• the Sixth Directive precludes the right of a taxable person to deduct input VAT where the transactions from which that right derives constitute an abusive practice; and
• where an abusive practice exists, the transactions involved must be reworked and the value-added tax (VAT) analysis applied to the effectively re-written transaction.

Facts of the case

Halifax is a partially exempt trader with an overall input VAT recovery rate of approximately 5%. It wished to build new call centres on various sites across the UK. Had it done so directly it would have suffered a significant amount of input VAT on the construction costs, which would have been largely irrecoverable.

In an attempt to solve this, it entered into a planning structure using three other companies associated with Halifax but outside the Halifax VAT group. One of these companies made a large pre-payment for construction services in a year in which it made only taxable supplies and was thus able to recover all the related input VAT. In the following VAT year, the company only made exempt supplies of land.

HMRC challenged the right to recover input tax in these circumstances and the matter was referred to the ECJ.

Findings of the ECJ

The ECJ considered that the purpose for which a transaction is carried out (specifically whether motivated by the obtaining of a tax advantage) is irrelevant for the purposes of determining whether or not there is a supply of goods, services or whether or not a transaction constitutes an economic activity. The ECJ considered that these terms are all objective in nature and apply without regard to the purposes or results of the transactions concerned. Imposing upon tax authorities an obligation to carry out enquiries to ascertain the intention of the taxable person in making such a supply would be contrary to the objectives of the common system of VAT of ensuring legal certainty and having regard to the objective nature of the relevant transaction.

The next question considered by the ECJ was whether the Sixth Directive should be interpreted as meaning that a taxable person has no right to deduct input VAT where the transactions on which that right is based constitute an "abusive practice".

The court found that the principle of European Community law which states that the law cannot be relied upon for abusive or fraudulent ends applies equally to the sphere of VAT.

However, in the VAT context, an abusive practice only exists if:

• the transactions concerned result in the accrual of a tax advantage, the grant of which would be contrary to the purpose of the Sixth Directive and the corresponding national legislation; and
• it is apparent from a number of factors that the aim of the transactions concerned is to obtain the tax advantage – the prohibition of abuse is not relevant where the economic activity carried out may have some explanation other than the mere attainment of tax advantages.

With regard to first point above, it was for the national court to verify whether an action constituting an abusive practice had taken place in a case before it. To allow a taxable person to deduct all input VAT, even though in their commercial operations, no transactions fell within the deduction rules of the Sixth Directive or the relevant national legislation enabling such a deduction, would be contrary to the principle of fiscal neutrality which forms the basis of the VAT regime.

With respect to the second point above, again, it is the responsibility of national courts to determine the real significance of the transactions concerned and whether or not they essentially seek to obtain a tax advantage, although in so doing the national court was entitled to take into account the purely artificial nature of the transactions and any links between the participants.

The ECJ said that, although the right of deduction provided by the Sixth Directive is an integral part of the VAT scheme, the right to deduction, once it has arisen, can only be retained in the absence of fraud or abuse. Where there exists an abusive practice the transaction essentially needs to be rewritten removing the transactions that constitute the abusive practice and VAT charged accordingly.

Therefore, on the facts of the case as reported, it would seem likely that Halifax has failed.

Matthew Desborough-Hurst (Matthew.Desborough-Hurst@herbertsmith.com), London