sarah cramerOn 11 March 2015, the Supreme Court  heard Pendragon plc & Ors v Commissioners for HM Revenue and Customs. The case concerns whether a VAT scheme employed by the respondents, involving VAT charged on the sale of second-hand cars, was “abusive” under the abuse of rights principle of European law.

Background and facts

Abuse of Rights principle

The CJEU decision in Halifax v HM Customs and Excise Comrs[1] established that the “abuse of rights” principle can apply to VAT cases, and laid down a two limb test for determining whether an abusive practice exists.

Firstly, an arrangement or scheme must result in a tax advantage that is contrary to the purpose of VAT harmonisation legislation contained in the Sixth Directive on VAT[2]. Secondly, considered objectively, it must be clear that an essential aim of the transaction or scheme is the procurement of that tax advantage. Obtaining such a tax advantage need not be the only aim of the transaction (as established in the subsequent CJEU decision in Ministero dell’Economia e delle Finanze v Part Service Srl[3]).

Where an abusive practice can be shown to exist, the transaction must be reformulated to disallow the effect of that practice for VAT purposes.

VAT on a profit margin basis

Article 26A of the Directive makes special provision for the sale of second-hand goods, under which VAT can be charged by reference to the profit margin of the seller rather than the full sale price of the goods. The UK domestic implementation of this provision[4], in relation to second-hand cars, permits a dealer to charge VAT on a profit margin basis provided certain conditions are met.

The Pendragon Scheme

One of the respondents, the Pendragon Group, specialises in selling new and used cars. The scheme in question related specifically to VAT on the sale of their “demonstrator” cars: new cars that had been used for test drives and as courtesy or hire cars.

The group is composed of the holding company Pendragon plc, multiple separate captive leasing companies and the dealerships that sell to ultimate customers (together, the joint respondents in this case). On the basis of tax advice from KPMG, the Pendragon Group entered into a chain of transactions through which new cars were purchased from the manufacturer, leased and then assigned between different Pendragon entities and a third party financial institution.

This sequence of transactions enabled the Pendragon Group to fulfil the conditions necessary in order to charge VAT on the ultimate sale of the “demonstrator” cars on a profit margin basis. Throughout the sequence, each Pendragon entity was either able to recover any paid input VAT or was not charged VAT at all.

HMRC contested the use of the profit margin scheme. It argued that, because of the structure put in place by Pendragon, the scheme constituted an abusive practice and so, reformulating the scheme in line with Halifax, VAT was due on the entire sale price of the “demonstrator” cars.

First Tier Tribunal and Upper Tribunal decisions

The Pendragon Group’s appeal was heard by the First Tier Tribunal, which allowed the appeal on that grounds that the scheme failed to satisfy either limb of the Halifax test and so could not be deemed abusive. Regarding the first limb, it determined that the transactions in the scheme were not contrary to purpose of the Directive. In relation to the second limb, it decided that the essential aim of the scheme had been commercial in nature, concerning the financing of “demonstrator” cars and not the procurement of a tax advantage.

The Upper Tribunal allowed the appeal by HMRC, overturning the FTT’s decision on the basis that the FTT had erred in law in failing to consider a number of factors in assessing the essential aim of the scheme. These factors included evidence given by the group’s finance director and by KPMG and information relating to the overall financial position of the group. The UT found that the scheme was abusive and accordingly reformulated the transactions for VAT purposes.

Court of Appeal decision

An appeal by Pendragon was heard by the Court of Appeal in 2013. The UT decision was overturned, with the Court of Appeal concluding that the FTT had not erred in law in deciding the scheme was not abusive. It was decided that the FTT had been correct in dismissing certain evidence which pertained to a subjective assessment of the scheme’s essential aim, as the second limb of Halifax required an objective assessment of the aim of the scheme, and not the actual intention of the parties.

Dismissing the factors that the UT had identified, the Court of Appeal maintained that KMPG’s characterisation of the scheme as “aggressive” was not relevant for the purposes of an objective consideration of the scheme’s essential aim. Equally irrelevant was the FTT’s failure to consider the scale of the tax advantage obtained or the group’s financial position in terms of short-term financing needs.

Supreme Court appeal

The Supreme Court judgment will provide clarification as to what constitutes an abusive practice for VAT purposes. In particular, it will clarify the circumstances in which a tax efficient commercial arrangement will be deemed abusive and provide further guidance around the factors to be considered in an objective assessment of the essential aim of a scheme under the second limb of the Halifax test.

[1] Halifax plc v Customs and Excise Comrs (C-255/02) [2006] STC 919

[2] Directive 77/388/EEC

[3] Ministero dell’Economia e delle Finanze v Part Service Srl  (C-425/06)

[4] VAT (Cars) Order 1992 (SI 1992/2832)