The Supreme Court heard the above case on 3 November 2016.  The parties are seeking clarity from the court on the underlying principle to be relied upon when deducting general costs of business overheads for the purposes of value added tax (VAT) calculations.


One of the core principles behind VAT has always been that it is a tax on consumption and, as such, those in the supply chain should be able Tom_Pritchard_ph[1]to pass the tax on (input tax is matched by output tax and thus the supplier is reimbursed) until it is ultimately borne by the end-user (as implemented by numerous EU VAT Directives and the VAT Act 1994).

However, not all goods and services are created equal.  Certain supplies are taxable (and thus capable of being reimbursed) and certain supplies are exempt (in which case the input tax is irrecoverable).  In reality, companies often supply both taxable and exempt goods and/or services, and expenses are not directly attributable to any particular supply (whether taxable or exempt).  Overhead costs are a typical example of such a cost.

In this case, Volkswagen Financial Services (UK) Limited (VWFS) is an ultimately wholly owned subsidiary of the Volkswagen Group.  The company exists solely to provide prospective buyers of the Volkswagen Group’s vehicles with a hire purchase financing option. Consequently, for VAT purposes, VWFS is treated as making two separate supplies: the taxable supply of the car (in respect of which VWFS must account for output tax on the price of the vehicle) and the exempt supply of finance.  The VAT incurred on the overheads of a typical hire purchase transaction is therefore attributable to both taxable and exempt supplies.

Given the complicated arithmetic inevitably involved in untangling what expenses can be deductible in the above scenario, HMRC used its statutory power to derogate from the standard method of apportioning expenses deductible for VAT purposes (where those expenses relate to both taxable and exempt supplies).

In 2000 HMRC thus agreed a ‘partial exempt special method’ (PESM) with VWFS for the valuation of residual input tax attributable to hire purchase transactions.  In 2007, VWFS proposed a new PESM with specific provisions relating to the hire purchase sector of the business, in which it proposed that the proportion of recoverable input tax would be quantified by reference to a ratio of the total number of taxable transactions to total transactions.  The new PESM was agreed except in relation to the hire purchase point, on which both parties differed in opinion.

The dispute follows because VWFS proceeded on the basis of its suggested valuation method (which was not agreed by HMRC) resulting in underpaid tax.

First-tier Tribunal (FtT)

The claim was first heard by the FtT, where in August 2011 HMRC argued that (absent a valid PESM agreement) since the price of the vehicle did not change between a financed or non-financed acquisition, the economic use of the overhead costs must lie solely with the exempt financing operation and that they therefore cannot be a cost component of the taxable supply of vehicles.

The principle of fiscal neutrality requires recovery of input tax to be limited to those cases in which the maker of the taxable supply passes on to the ultimate consumer the cost of the overheads as part of the price and with it the VAT on that increased price which it recovers by the deduction of input tax.

Nonetheless, the FtT found against HMRC when ruling that:

We have concluded that, in relation to overheads, there is no requirement that the input tax referable to those expenses should be reflected in the price of the products.”

Upper Tribunal

The Upper Tribunal then overturned the FtT’s decision citing an economic argument that, since VWFS made all of its profits from the exempt supply of finance rather than the taxable supply of vehicles, the costs were irrecoverable.

Court of Appeal

Both sets of reasoning seemed at odds with the standard method, espoused by the VAT Directives and VAT Act 1994, in which the attribution is fair and reasonable.  As such, VWFS appealed.

In considering the appeal, Lord Justice Patten examined many other apportionment methods that had been substantiated by ECJ case law:

  • The “direct and immediate link” test (C-4/94 BLP Group v Customs and Excise Commissioners [1995] STC 424). There must an objective assessment of the link between the goods and services subject to the input tax and the supply to which they relate.  Can the overhead costs be directly and immediately linked to the taxable supply of the car?
  • The “cost components” test (C-98/98 Midland Bank plc v Customs and Excise Commissioners [2000] STC 501). If the immediate link test is not met, can it be said that the costs are incurred at least in part in making the taxable supply, and as such be a cost component of the supplier’s business as a whole?
  • The “trader relief” principle. As stated in the Opinion of Advocate General Kokott in C-126/14 Sveda, “the deduction system is meant to relieve the trader entirely of the burden of the VAT payable or paid in the course of all his economic activities, because the common system of VAT is intended to tax only the consumer and not the taxable trader”.

Lord Justice Patten made quick work of the Upper Tribunal’s reasoning when concluding that the supply of the vehicle is inseparable from the financing.  In doing so Patten decided that the taxable supply was part of the economic activity of the taxable person, thus the use of overheads to fund that supply is, on Midland Bank reasoning, enough to establish a direct and immediate link.  A zero attribution was therefore unfair and the court was persuaded to endorse VWFS’s proposed PESM.

Supreme Court

The decision has led to a scenario in which HMRC stand to lose a significant amount of VAT revenue (as a greater amount is being recovered by the supplier).  Consequently, the Supreme Court will now be considering the Court of Appeal’s decision in order to reach a conclusion as to what constitutes a “fair and reasonable” apportionment of residual input tax in respect of costs incurred relating to general overheads in the context of hire purchase schemes which, for VAT purposes, are part-taxable and part-exempt.