Tax Planning: A Landmark Judgment by the European Court of Justice Has Provided Welcome Guidance on the Legality of VAT Avoidance Schemes

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Traditionally, many people have considered tax to be marginal to management accounting, but the problem with this approach is that the cost of getting tax planning wrong can often wipe out your company's profits. There aren't many firms that can afford to lose an unbudgeted 17.5 per cent standard rate of VAT straight off the bottom line. Fortunately, a recent decision by the European Court of Justice in a case involving the Halifax bank offers hope for business in finding the right balance between tax planning and not overpaying tax.

Over the past few years UK companies have been plagued by uncertainty about the correct approach to VAT planning, with the costs measured not only in overpaid tax but also in lost business. Two extreme outside pressures in particular have made life difficult for them. First, highly engineered tax schemes, which are being sold by dedicated marketing teams, are increasing in number. The problem is that many of these are off-the-peg financial products, which aren't tailored to fit the individual client's needs. A firm might not only fail to achieve savings if its tax scheme goes wrong; it can end up losing money. Second, the newly merged HM Revenue & Customs (HMRC) has mounted an aggressive campaign against all tax planning.

With the Treasury under pressure as a result of ever-increasing government spending, HMRC has gone on to the offensive to increase its takings. One of its key tactics, according to some observers, has been to foster a climate of uncertainty about the legality of tax planning. The result has been seen as a form of extortion to scare businesses into passively overpaying tax simply to be sure that they're within the law. In its attempt to stop tax planning and thereby increase its revenue, HMRC developed a doctrine based on what it said was the principle against the abuse of rights granted by the European law on VAT. Its theory was that, because the avoidance of tax was supposedly against European law, then any planning scheme designed to achieve that would be illegal, with the effect that particular transactions could be unpicked by HMRC at the cost of the businesses directly involved.

HMRC's attack on VAT planning had a dragnet effect on businesses all along the supply chain, creating widespread uncertainty among them. This happened because, unlike a direct levy on a business's own profits--corporation tax, for example VAT--is an indirect transaction-based tax. Fundamentally, VAT is a tax on sales, for which individual businesses then have to account, with the output tax of the seller then becoming the input tax of the purchaser. Each link in the chain adds value until the full and final tax falls as an irrecoverable cost to the final consumer (or exempt business).

HMRC's aggressive approach was challenged in a VAT appeal by the Halifax. The particular case arose because the Halifax wanted to build four new call centres, on which, as a bank, it would normally have been able to recoup only about five per cent of the VAT paid on the construction costs. (Input tax can only be set against output tax and most of the Halifax's sales are exempt from VAT as financial services.) The bank used a tax scheme with associated companies and a set series of transactions by which it was able to get back all of the input VAT on the building costs. HMRC opposed this, using its "abuse of rights" theory to claim that the transactions didn't count for claiming back input VAT.

Because HMRC's theory was not clear, the case was referred by the UK courts to the European Court of Justice as the ultimate arbiter for interpreting European law--in particular, the sixth VAT directive and, through that, UK VAT law. Two other cases on the same issue, involving the University of Huddersfield and Bupa, were also referred to the court (see panel above). It made its judgment broadly on three issues: whether transactions could be excluded from VAT, what counted as an abusive tax practice and the tax consequences in the event of an abuse. …