Legalflyer

Issue 4

July 2009

Plane taking off

Contacts

Introduction

Welcome to our Summer edition of Legalflyer where we once again review a series of topical issues for the aviation industry.

Our first article from our climate change group in the banking department, looks at the timetable for implementation of the EU  Emissions Trading Scheme (EU ETS) and what steps the industry needs to be taking in preparation for 2012. This article follows on from a recent EU ETS aviation seminar hosted by Norton Rose LLP , London.

The second article from our dispute resolution team looks at a recent Court of Appeal decision which calls into question the effectiveness of boilerplate non-waiver clauses and the guidance this provides for lessors in relation to defaulting lessees.

Our third article, the first of a two part series, considers the challenges presented to airlines by cross border competition and antitrust regulations. This first part focuses on the key differences between compliance policies for low cost carriers and traditional carriers before outlining the main features of a compliance policy for the latter.

The fourth article from our tax department looks at potential changes in UK   VAT  zero-rating for aircraft in order to comply with the EU VAT directive. The fifth and final article is an update from our competition and EC department on the BAA  break-up and the impact of the recent judicial review application.

As always, I hope that you will find our articles to be of interest and I would be delighted if readers could provide any comments on the content, or suggestions for future editions of Legalflyer, by using the comments box which can be accessed through this hyperlink. Likewise please feel free to pass on the details of colleagues who may wish to receive Legalflyer.

Editor

Patrick Farrell, Partner
Norton Rose LLP, London

Ready for takeoff?

Aircraft operators and regulators rush to prepare for aviation’s entrance into the EU  Emissions Trading Scheme

From 1 January 2012, for the first time in history, aircraft operators departing or arriving from an EU airport will have to monitor, report and verify their emissions, and surrender an equivalent number of emission allowances to account for such emissions.

After over a decade of consideration by the International Civil Aviation Organization on how to reduce emissions from aviation, a lack of action led the EU to press ahead with its own plans to include aviation within its cap-and-trade scheme, the EU emissions trading scheme (EU ETS). The EU Directive including aviation in the EU ETS entered into force on 2 February 2009 (the Aviation Directive). This article provides a short outline of the major regulatory requirements that a company to which the Aviation Directive applies must undertake and should serve as a useful reminder of the compliance schedule within the UK.

Cap-and-trade

In the first compliance year of 2012, the ‘cap’ on emissions is set at 97 per cent of ‘historical aviation emissions’ (an average of emissions from EU aviation over the years 2004, 2005 and 2006), a figure which the Aviation Directive requires the European Commission to determine by 2 August 2009. For subsequent years, the cap is set at 95 per cent of this figure.

While many aircraft operators are less than enthusiastic about the inclusion of aviation in the EU ETS and the costs associated with compliance within their companies, they should at the same time bear in mind the potential for trading. To begin with, aircraft operators are eligible to receive 85 per cent of their emission allowances free and may buy further allowances at auction. The Aviation Directive creates a new kind of allowance, an aviation EU emissions allowance, which is fully fungible for trading purposes; however, only aircraft operators are permitted to use them for compliance. In addition to aviation emissions allowances, aircraft operators are permitted to use regular EU allowances as well as up to 15 per cent of Certified Emission Reductions and Emission Reduction Units from project activities. This reduces to only 1.5 per cent from 2013.

Which Member State will an aircraft operator need to report to?

The European Commission has published a draft list of aircraft operators under the EU ETS and the Member States that should regulate them (Administering Member State). Consultation on this list by the Commission ended on 31 March 2009 and publication of a final list of aircraft operators is expected imminently.

The Commission’s list of operators was based on information held in Eurocontrol’s Office database on flights undertaken by aircraft operators in EU airspace during the 2006-2008 period. Aircraft operators which possess an EU Operating Licence have been assigned to the Member State that issued that licence and all other operators have been assigned to the Member State to which the greatest proportion of CO2  emissions is attributable. Future changes in routes, for example, in the EU should have a minimal impact on the Administering Member State to which an aircraft operator is designated in the future, as aircraft operators will only be reassigned if, during the first two years of a trading scheme period, the operator has no attributable emissions from flights to or from its Administering Member State.

Emissions monitoring plan and benchmarking plan

Each aircraft operator must submit to the competent authority in its Administering Member State a monitoring plan outlining how reportable annual C02 emissions will be determined. The content of the monitoring plan should set out the procedures that will be in place by 1 January 2010 to report such emissions.

Additionally, aircraft operators that want to apply for free allowances must submit to the competent authority in their Administering Member State a monitoring plan which outlines how they will determine their tonne-kilometre data in 2010. This report is of particular importance as it will serve as a benchmark for the allocation of allowances from 2012 - 2020. This information will also be passed to the Commission for review.

Once the plans described above have been approved by the competent authority, aircraft operators must begin, on 1 January 2010, to monitor their emissions and tonne-kilometre data, where relevant. The monitoring and reporting must be carried out in accordance with the systems and processes set out in each of their respective approved monitoring plans, taking into account the European Commission’s Monitoring and Reporting Guidelines.

Following the first monitoring year, aircraft operators must submit their first year’s emissions and benchmarking reports on or before 31 March 2011. Before the reports are submitted to the relevant national authority, an independent verifier must certify that they are accurate. Different Member States may apply different sanctions to ensure compliance with these requirements (the Aviation Directive only stipulates that Member States must implement “effective, proportionate and dissuasive” national penalties).

The view from the UK

The UK , as Europe’s major hub for air transport, will regulate the largest number of aircraft operators of any EU Member State. According to the provisional list provided by the European Commission in February, just over 2,700 aircraft operators were due to be regulated, of which 780 were due to be regulated by the UK.

The transposition process from EU to UK law is being managed jointly by the Department for Transport and the Department for Energy and Climate Change. In a consultation paper on the UK’s transposition of the Aviation Directive published in March 2009, the UK warned aircraft operators that failure to submit an emissions monitoring plan might result in a fine. More importantly, failure to submit a benchmarking plan on time may result in aircraft operators receiving no free emissions allowances from 2012 until 2020.

According to the consultation, the deadline to submit both the emissions monitoring and benchmarking plans was originally set for 31 August this year. Furthermore, relevant UK regulations were due to be tabled in the House of Commons on 3 July and enter into law on 3 August. However the government has now missed its deadline for publication of the regulations and has not publicly indicated when they will be published. More pertinent to aircraft operators, at the time of writing, according to sources, it appears that the 31 August 2009 deadline has been pushed back following a decision from the UK authorities to postpone the implementation of the programme until the European Commision publishes its definitive list of aircraft operators.

Next steps

The inclusion of aviation in the EU ETS is moving apace, with even the EU seeming to struggle to keep up. Aircraft operators will need to be aware of the fast approaching deadlines for compliance and any developments in the time schedule that may affect them. Despite the possibility of further delays, aircraft operators should at this stage have their compliance strategies well under way as there is little margin for error or omission. With the potential for fines and, importantly, missing out on free allowances for eight compliance years, proper preparation and planning will be rewarded.

Andrew Hedges is a partner, Tim Baines an associate and Georgina Shelley a paralegal in the Climate Change Group, the Banking Department, Norton Rose LLP, London.

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Preserving termination rights under non-waiver clauses

Tele2 International Card Company SA, KUB 2 Technology Limited (formerly known as C3 Calling Card Company (Ireland) Limited), KUB 7 Technology Limited (formerly known as Calling Card Company (UK) Limited) v Post Office Limited

Summary

In the above case the Court of Appeal held that the Respondent was not entitled to terminate an agreement between the parties despite the Appellants’ failure to provide the parent company guarantees required under the agreement. The Respondent’s continued performance of the agreement, notwithstanding that the guarantees were outstanding for over 11 months, constituted an affirmation of the agreement by election, regardless of the non-waiver and termination provisions in the agreement on which the Respondent sought to rely.

This decision calls into question the effectiveness of boilerplate non-waiver clauses. It illustrates the need for parties to consider their positions carefully when exercising termination rights under contracts and highlights the importance not only of reserving rights conferred on parties under a contract but also of ensuring that such rights are exercised correctly.

The agreement

The parties entered into an agreement in 2001 whereby the Appellant group of companies agreed to make and supply phone cards and phone card services to the Respondent for sale and promotion in all Post Office branches nationwide (the Agreement).

Under the Agreement the Appellants were required to provide the Respondent with parent company guarantees for the calendar year from January 2001 within 20 days of the date of execution of the Agreement. These guarantees were required in order that each company would have sufficient capital to continue to perform its obligations under the Agreement. Each subsequent parent company guarantee was to be provided by each Appellant company to the Respondent seven days prior to the commencement of each calendar year (i.e. by the end of 24 December each year). At the time of entering into the Agreement, the parent company guarantees were important to the Respondent as it had concerns over the financial viability of the Appellant companies.

In addition to including a standard termination provision that the Agreement was terminable by either party upon 24 months’ written notice, the Agreement provided that either party was entitled to terminate the Agreement at any time by giving three months’ written notice to the other in the event that the other party was in material breach of any of its obligations under the Agreement.

Finally, clause 16 of the Agreement contained the following boilerplate non-waiver clause:

“In no event shall any delay, neglect or forbearance on the part of any party in enforcing (in whole or in part) any provision of this Agreement be or be deemed to be a waiver thereof or a waiver of any other provision or shall in any way prejudice any right of that party under this Agreement.”

The dispute

By September 2004 the Respondent had become dissatisfied with the Appellants’ service and from late summer the Respondent began selling and promoting a competitor’s phone cards in Post Office branches.

Following legal advice, on 1 December 2004 the Respondent sent a written notice of termination to the Appellants effective from 31 March 2005, stating that the Appellants’ failure to provide the parent company guarantees for 2004 (the due date for which was 24 December 2003) was a material breach of the Agreement. This was notwithstanding the fact that the parent company guarantees had, at this point, been outstanding for over 11 months.

Following the Respondent’s purported termination, the Appellants commenced proceedings claiming wrongful termination of the Agreement. The Appellants alleged that the Respondent’s delay of 11 months in issuing the termination notice and its subsequent performance of the Agreement constituted an affirmation of the Agreement by election. As such, it was the Appellants’ case that the Respondent was not entitled to issue the termination notice and that the notice was therefore a wrongful anticipatory renunciation of the Agreement.

The Respondent stated that it was entitled to terminate the Agreement as it considered that the Appellants’ failure to provide the necessary parent company guarantees constituted a material breach of the terms of the Agreement.

In any event the Respondent sought to rely on the terms of the non-waiver clause, stating that any delay on its part to issue the termination notice could not be used to found an affirmation of the Agreement by election, as any delay on its part to issue the termination notice could not prejudice its position or entitlement to rely on the terms of the Agreement.

First instance decision

At first instance, it was held that the Appellants’ failure to provide the parent company guarantees did constitute a material breach of the Agreement which entitled the Respondent to terminate; further, the non-waiver clause prevented the Respondent from losing its right to terminate the Agreement. The court did however grant that, but for the non-waiver clause, the Respondent’s right to terminate would not have arisen.

The appeal

The Court of Appeal overturned this decision and held that the Respondent was not entitled to terminate the Agreement. The Respondent had in fact elected to affirm the Agreement by continuing to perform its part of the Agreement and also by permitting the Appellants to perform their obligations under the Agreement from 25 December 2003 to 1 December 2004, during which time the Respondent was well aware that it was entitled to terminate.

In addition, the existence of the non-waiver clause did not prevent the Appellants from relying on the doctrine of affirmation of a contract by election - a party’s right to affirm an Agreement by election is not compromised or in any way affected by the provisions of a non-waiver clause. As such, the Respondent remained entitled to affirm the contract by election, and as a matter of fact it did so.

As a result the Respondent’s termination notice was not valid and constituted an anticipatory renunciation of the Agreement. The Respondent’s refusal to perform the Agreement after 31 March 2005 was an actual repudiation of the Agreement and the Appellants were entitled to damages.

Comment

The Court appears to have taken an unsympathetic view of the overall conduct of the Respondent in the lead up to its purported termination of the Agreement and its subsequent failure to perform and, while this case was not dealing with an aviation-specific dispute, the Court of Appeal’s decision is significant and provides useful guidance for lessors in relation to defaulting lessees.

This case clearly illustrates the point that, despite the fact that a contract may contain non-waiver clauses, the court will look closely at the subsequent conduct of the parties and will not apply a strict construction to contractual terms in a vacuum.

A written agreement can be amended by email exchanges or even an oral agreement between the parties, particularly if the parties then act upon and in accordance with that amendment. The court will not look kindly on parties who later seek to ignore such amendments or to rely on boilerplate clauses notwithstanding a long period of inaction following the occurrence of a breach which might have given rise to rights under the agreement prior to its amendment.

Further, if a lessee is in breach and the lessor fails to protect its position as soon as it becomes aware of the lessee’s default, the lessor could find itself in a position where it may be prevented from relying on a non-waiver clause in the lease; and such a delay in taking action could constitute an acceptance by the lessor of the lessee’s default.

In order to avoid a situation like this from arising, it is very important that lessors put lessees on notice of their default or pending default as soon as possible and that they reserve all their rights to take further appropriate action against the lessee, using standard reservation of rights wording.

Patrick Farrell is a partner and Emma Humphries is an associate in the Dispute Resolution department, Norton Rose LLP , London.

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Competition compliance policies for airlines

The past two years have seen many established names in the aviation industry blemished by convictions for cartel activities around the world: in the United States alone, fifteen airlines were fined in excess of US$  1.5 billion by the Department of Justice for price-fixing. Competition authorities in other American countries but also in Europe, Asia-Pacific and Africa are reported to be investigating similar conduct. Many carriers currently face private antitrust (competition) claims for millions of US  dollars in damages in the UK , Canada, the United States and Australia. In several countries individuals can also face personal sanctions such as prison sentences and fines for competition law infringements - for example, a Qantas executive was recently sentenced to six months imprisonment in the US and four British Airways executives are facing a UK criminal trial early next year with the possibility of up to five years’ imprisonment if found guilty.

These cases show that corporate competition compliance policies limited to general compliance statements and good intentions are not enough to protect an airline from antitrust liability. Effective corporate compliance requires a compliance culture at all levels of the organisation and specific commercial and legal management processes tailored to a carrier’s business. However, complying with competition and antitrust regulation remains a particular challenge for companies with operations in many different jurisdictions, at a time where more than 100 countries have adopted competition law rules.

This article begins a two-part series that explores how airlines can use competition compliance solutions to their commercial benefit. In this first part we look at the main differences between compliance policies for low cost carriers and traditional carriers, before outlining the main features of a compliance policy for the latter. In the next edition we will consider in more detail the features of a compliance policy for a low cost carrier.

Compliance policies generally

Expectations and benefits

Compliance policies typically serve two primary functions: to prevent or minimise the risk of competition law infringements in the future, and to detect any current or historic infringements to allow remedial action to be taken. While not prescriptive, competition authorities have provided some general guidance on what they expect to find in a competition compliance policy:

  • clearly established compliance standards;
  • an effective governance and enforcement structure with ultimate responsibility resting on senior executives;
  • effective communication of standards and procedures and regular staff training;
  • appropriate disciplinary mechanisms in cases of breach; and
  • appropriate remedial action when a violation is detected to prevent re-occurrence.

Adoption of a compliance policy that fits these requirements will however be of little benefit if its implementation is ineffective. If the policy allows the early detection of possible competition law infringements, which are reported to relevant competition authorities as part of leniency or amnesty programmes, the company (and its employees and directors) may benefit from the mitigation or avoidance of any sanction. However, if the policy is ineffective and does not prevent competition law infringements, regulators will rarely mitigate the penalty imposed on account of the company having adopted a compliance policy. On the contrary, competition authorities and courts sometimes rely on the existence of a compliance policy to show that the individuals concerned knew or should have known that they were committing a competition law infringement. However, this should not discourage a company from implementing a compliance policy as if a company is found to have infringed competition law and does not have a compliance policy in place, it will often be forced to adopt one subject to judicial or regulatory supervision, so making administration of the policy more costly.

There is therefore very little choice but to commit the necessary resources to introduce a competition compliance policy and to ensure that it is effective.

A competition compliance policy is a business management tool: it must fit a company’s business and governance culture

Every business is different. The success of a compliance policy depends on how well it is adjusted to a company’s culture, operations and business environment. The latter is of some significance in the airline industry: the end of antitrust exemptions for the traditional IATA  tariff setting mechanisms, together with the increase in competition regulatory oversight of the industry, have prompted airlines to adopt comprehensive compliance policies. While the contents and structure of an airline’s compliance policy will vary, there are four pillars that are common: compliance standards; scope and governance; training and communication; and audit.

Competition compliance tools are not significantly different from other corporate management policies. A competition compliance policy can be modelled on other policies dealing with delegation of powers which establish responsibility for signing contracts or for authorising expenses. It is well understood that only a limited number of staff members should have the authority to commit the company’s financial resources. Similarly, a competition compliance policy is based on the premise that most employees should not be involved in discussing competitively sensitive matters with third parties. Only a limited number of personnel with the appropriate training and knowledge should be entrusted with the management of such sensitive matters.

Low cost carriers and traditional carriers have different business models

In our experience the different business models of low cost and traditional “hub and spoke” carriers require a different approach to competition compliance. The following table illustrates the main differences.

 Traditional carriersLow cost carriers
Interline relationships Typically rely on IATA membership and interline agreements to generate part of their revenues.

Compliance policy needs to address negotiation of interline agreements and information exchanges with interline partners.
Typically not engaged in interline relationships

Compliance policy can be more strict about contacts with competing airlines as there is less justification for information exchanges in the absence of an interline business relationship.
Joint ventures and codeshares Typically enter into joint ventures for a great variety of purposes: distribution (e.g. GDS ), maintenance, catering, joint operation of routes, joint purchasing, etc. Also frequently conclude codeshare agreements.

Compliance programme should provide for adequate information barriers in competitor contacts, in order to guard against exchange of sensitive business information.
Less likely to form joint ventures or codeshares with competitors, which reduces the scope for legitimate contacts with competitors.

Compliance policy may therefore be very strict on competitor interaction.
Cargo activities Freight operation due to “hub and spoke” model.

Compliance policy should address cargo activities, reflecting the differences between cargo and passenger service (e.g. markets are typically broadly defined on the cargo side).
Limited freight operations.
Sales and distribution Rely both on their direct sales platform and on third parties (agents, consolidators, general sales agents, tour operators, and other airlines) to sell their seat inventory or freight capacity.

Compliance policy should consider both vertical and horizontal relationshipss, as well as the importance of not using third parties as conduits for communication with competitors.
Mostly use direct sales model, but act as distributors for other travel-related products.

Compliance policy should focus on the airline’s position as a seller and as a distributor.
Dominance issues Core activity is typically the transport service, with ancillary activities (ground handling, maintenance, tour operator services, catering, etc) meant to bring additional revenues and achieve economies of scope.

Compliance policy mainly concerns conduct in (i) the sale of passenger tickets in a given geographical area, (ii) the air transport service between an origin and destination, and (iii) purchasing markets at certain airports.
Often derive substantial revenues from the sale of other services either during the trip or at the time of the booking.

Compliance policy should not only cover the three traditional air transport services ((i) the sale of passenger tickets in a given geographical area, (ii) the air transport service between an origin and destination, and (iii) purchasing markets at certain airports), but also other services.
Multi-jurisdictional dimension Typically derive the bulk of their profits from long haul travel and have sales or representative offices in destinations where they operate.

Compliance policy needs to be adjusted to jurisdiction-specific aspects of competition law and must account for the minimal management structure of small operations in many countries.
Typically operate short to medium haul flights, with centralised management functions and very limited or no market-facing operations at the various destinations.

Compliance policy likely to consider competition rules of only one or a few jurisdictions, with governance structures focused on headquarters-based staff.
State Aid (in Europe) Normally do not face state aid issues as part of their regular business operations, apart from the operation of specific routes pursuant to public service obligations.


State aid issues may arise for national carriers in difficulty, while EU  anti-subsidy rules may be relevant for non-EU carriers.

Often depend on advantages granted by public or semi-public authorities to operate from a given airport.

Compliance policy needs to address state aid issues in many aspects of their business development.
Using competition law to combat anti-competitive practices As incumbent operator in most of its activities, less likely to be target of exclusionary behaviour.
However, recent investigations highlight how easily anti-competitive practices can arise.

Compliance policies need to focus on management of this risk and allow rapid implementation of remedial strategies where appropriate.
Frequently face situations as a new entrant where competition law might be used to attack behaviour of incumbent operator or airport.

Compliance policy needs to focus on making personnel aware of these opportunities.

A compliance policy for the “hub and spoke” model

Having regard to their “hub and spoke” business model, the following outlines the main issues relevant to the design of an effective competition law compliance programme for traditional carriers.

Compliance standards

There is no reason to depart from the traditional management model of delegation of authority: there should be a general set of behavioural standards applicable to everyone with commercial responsibility in the company, with specific guidelines that create safe harbours for a limited number of staff members.

General competition law compliance policy

The general policy will contain a list of prohibitions applicable to all staff with some limited safe harbours for interline relationships and some general recommended best practices.

Specific policies and safe harbours

The contents of specific policies will depend on a variety of factors:

  1. Is the airline part of an alliance? If yes, provide for alliance-specific rules applicable to the airline’s alliance team.
  2. Does the airline benefit from antitrust immunity or a similar exemption for any part of its business? If yes, provide for specific rules applicable to relevant personnel.
  3. Is the airline active in jurisdictions with different approaches to competition law enforcement? If yes, consider country-specific variations to the policy.
  4. Does the airline operate from congested airports? If yes, consider specific rules for staff in charge of slot management.
  5. Is the airline involved in joint ventures? If yes, consider whether appropriate safeguards and information barriers must be part of the compliance policy.

The need for specific policies will depend on answers to the above questions and on business needs. Specific policies may include some of the following examples.

Relationship with legal requirements

The main purpose of the policy is to manage competition law risk. Accordingly, its content will be based upon the applicable legislation, but more importantly will reflect best practices adopted by the company to deliver business solutions that are both commercially sound and legally compliant.

Scope and governance mechanisms

There is little argument that flight deck and cabin crew as well as junior check-in and airport staff need not be subject to an airline’s competition compliance policy. Most, if not all, other members of staff above a certain level of seniority will fall within the scope of the general compliance policy. Specific guidelines with safe harbours will apply to senior management, certain cargo staff, certain passenger revenue management staff, individuals in charge of aeropolitical affairs, procurement staff, etc. There may also be a need for different compliance procedures and policies at outports and at headquarters, depending on the scope of operations at each airport.

In terms of governance, the airline’s Chief Compliance Officer should be entrusted with organising internal functions to assist staff in applying the competition compliance policy and promoting a compliance culture within the organisation. The policy should be endorsed at Board level and benefit from strong support from senior management. It should also clearly identify what staff can do alone and where they need to involve legal or compliance staff.

A delicate part of the policy will be the management of disciplinary action. This is an essential part of an effective competition compliance policy. Breaches should not remain unsanctioned. As airline staff will be subject to different sets of employment laws and regulations in the various countries where the airline operates, it is often best to refer to existing disciplinary procedures as opposed to creating ad hoc processes to sanction breaches of the competition compliance policy.

Training and communication

Proper internal communication is vital to ensure that a compliance policy is effective.

The first step in ensuring effective communication is to produce content that airline staff can relate to. We would suggest the following steps in designing an effective programme:

  • favour business language with clear examples rather than lengthy descriptions of the legal framework;
  • provide management solutions for the reader, such as when to end a discussion, when to put a negotiation on hold, who to contact for assistance, etc;
  • inform staff personally via email from the airline’s CEO or the Chief Compliance Officer or otherwise of any new major compliance policies;
  • include antitrust compliance training in staff induction processes; and
  • organise regular refresher training.

Audit

The audit of corporate compliance procedures can be a complex affair. The work of a company’s financial audit team will typically involve the review of some typical transactions, of whether internal control mechanisms and accounting procedures are complied with, and of whether reporting systems are effectively used. Auditing a competition compliance policy will involve similar steps. However, checking whether a department or a port has complied with internal reporting rules and made the appropriate competition compliance checks will not always lead to a true and fair view of the state of compliance within an organisation.

In this respect, competition compliance is similar to anti-corruption rules: it is the undocumented part of an airline’s commercial life which is likely to raise the most risks. Auditing the effectiveness of a competition compliance policy therefore often requires the use of techniques that are not part of the traditional audit repertoire, such as surprise audit visits, review of a team’s full electronic and hard copy archives and detailed staff interviews.

The second part of this article in the next edition of LegalFlyer will outline the main features of a compliance policy for low cost carriers.

Marc Waha is a partner in the Competition department, Norton Rose Hong Kong.

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Possible change in UK VAT zero-rating for aircraft

The EU  has just issued a formal notice to the UK  requesting it to change the way it has enacted domestic VAT  law relating to the transfer of aircraft and aircraft parts. Although the UK may argue that its approach is justified, it is possible that UK law may change in the very near future to be more in line with the rest of Europe.

In recent years, the UK has often been a jurisdiction of choice for transferring aircraft and aircraft engines. This is largely due to the UK’s more practical interpretation of the aviation exemption in the EU VAT directive which avoids some of the difficulties that have arisen in other EU jurisdictions who have incorporated the original wording in the VAT directive wholesale.

The directive exempts supplies of aircraft and parts that are “used by airlines operating for reward chiefly on international routes”. The ECJ  has ruled that, even if a specific aircraft is used chiefly on domestic routes, this does not matter for the VAT exemption so long as the airline itself is chiefly international. However, if implemented in this form, this wording does give rise to difficulties of interpretation, such as whether one should look at the buyer or seller in determining whether the sale involves an international airline, and whether that test should be applied to the user of the aircraft rather than the legal owner where, for example, the seller is a lessor.

The UK has incorporated the VAT directive into UK law in more practical style, deeming that the supply of any aircraft with a take off weight over 8,000kg which is not designed for use for recreation or pleasure would satisfy the condition to be zero-rated for UK VAT purposes. It can be seen that this test is much easier to apply, relating as it does to the type of aircraft rather than the nature of the transacting parties and hence it is much easier to form a firm view as to the VAT treatment.

In either case, the exemption applies to parts as well as to aircraft. Often, in this context, the strict wording of the VAT directive has created even more difficulties in relation to engines than aircraft as it is difficult for a seller to be comfortable that an engine it is selling is going to be used by an airline satisfying the relevant conditions to be an “international” airline, particularly where the engine joins a pool.

The European Commission has announced that it has sent the UK a reasoned opinion as to why the UK’s implementation of the VAT directive infringes the directive and giving the UK two months to change its rules. If the UK fails to do this, the Commission may take the government to the European Court of Justice to defend the current rules. This process may take time, but there is always the possibility that the UK may change its domestic rules at some point rather than go through proceedings in the ECJ.

Airlines that have previously transferred aircraft or parts in the UK should not panic. Historic transfers should be protected by the principles of EU law that allow a citizen to rely on the flawed domestic law in these circumstances. This principle should continue to apply until such time as the law is changed, although when arranging transfers, it will be necessary to be aware of the possibility of a sudden change in UK VAT law.

It is very rare for transfers of commercial aircraft and parts to be anything other than VAT-neutral because, even if the exemption does not apply, the purchaser is normally in a position to be able to recover the VAT charged. Further, since aircraft are such mobile assets, sales generally do not take place in “unfriendly” jurisdictions. Bearing this in mind, it is somewhat disappointing that the Commission has focused on a minor discrepancy in the way the UK has implemented the VAT directive. True, it is possible to think of a circumstance where VAT would be chargeable in the UK on the sale of an aircraft that would be exempt elsewhere in the EU (and vice versa) but, from a commercial point of view, the certainty provided by the UK regime might be thought preferable to an absolutely even playing field across the EU in circumstances where the need to pay VAT often does not arise at all.

Matthew Hodkin is a partner in the Tax department, Norton Rose LLP , London.

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BAA update – Judicial Review application threatens to delay sale process

Observers who have been monitoring the enforced break-up of BAA  following the final decision of the Competition Commission (CC) in March have had a particular interest in the timetable that BAA will be forced to adhere to disposing of Gatwick, Stansted and either of Edinburgh or Glasgow airports. Given the current financial climate it is not surprising that BAA has sought to delay this process by launching a Judicial Review (JR) of the CC’s decision on 18 May.

JR actions in competition cases are heard before the Competition Appeal Tribunal (CAT), which aims to hear all cases within nine months. In this case a final judgment is therefore expected around early spring 2010. What is potentially more significant is whether or not the CAT is minded to grant BAA interim relief which would suspend the sale timetable imposed by the CC.

The starting point is that the airports are to be sold in sequence, beginning with Gatwick then Stansted, followed by either Edinburgh or Glasgow. The sale of Gatwick, was initiated by BAA in September 2008. A deadline of 19 March 2011 has been imposed for the sale of all three airports. BAA has also been issued deadlines by which each of the individual sales must be completed, although the precise dates have not been published so as not to prejudice a fair and effective sales process. Reported problems for BAA in agreeing a price with the preferred bidder for the Gatwick sale threaten further delays - and possibly an enforced fire-sale under a Divestiture Trustee (although note that BAA had committed to this sale prior to the CC’s final decision, and so it was not expected that BAA would seek to delay this pending the outcome of the JR process).

The CAT’s decision on making an interim order will be crucial to BAA’s strategy as, in the absence of interim relief, BAA will need to assess the risk of not proceeding with the Stansted and Scottish sales against the likelihood of winning the appeal and potentially gaining a significant extension to the timetable. It would be surprising if BAA were to take the risk of delaying the auction process for Stansted and the Scottish airport until after resolution of the JR proceedings.

The decision on whether or not to make any interim order will be based on the CAT, balancing on the one hand the public interest and impact on competition if the order is made (i.e. the detriment to passengers of BAA’s continuing ownership) against, on the other, the effect on BAA of the order not being granted (i.e. the loss that will be suffered as a result of forcing through the sales within two years). To date there has been no confirmation of when such a decision will be made, and it was not discussed at the Case Management Conference on 1 July.

In terms of the substance of the application, BAA is claiming that the final report of the CC was affected by apparent bias due to links between a member of the CC panel and the Manchester Airport consortium bidding for Gatwick. In addition, BAA claims that the CC has not acted proportionately by failing to take into account the adverse financial impact of requiring it to sell the airports within two years in the current financial and economic circumstances.

BAA’s chances of success in the ultimate JR hearing appear slim. For the CAT to support the bias finding on the facts would set a very difficult precedent for regulatory authorities, while the estimation of the potential detriment to consumers of the ongoing monopoly situation is likely to be considered to outweigh any detriment to BAA in terms of the achievable sale price. Ryanair’s successful application to intervene is only likely to mean the airline and consumer detriment points are amplified at the final hearing. For the same reasons, BAA may be disappointed in its attempts to buy time for the auction process by the application for an interim order, although its arguments are stronger in this respect.

Ian Giles is a senior associate and Caroline Thomas is an associate in the Competition and EC  department, Norton Rose LLP , London.

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