VAT and third party consideration

This article first appeared in the October 2016 edition of Butterworths Journal of International Banking & Financial Law.

It is a common feature of commercial transactions for those involved to seek a third party to provide an essential service to allow the transaction to reach fruition. Often the parties will enter into a tripartite contract with the third party, but only one of the parties will agree to bear the cost of obtaining that service. From a commercial perspective this raises few difficulties. For VAT purposes it raises a thorny issue which has led to much long and protracted litigation. The issue with such arrangements is whether the party paying the cost can recover the VAT charged on the cost of obtaining the service. If the services are “supplied” to the person who pays, the VAT will generally be recoverable as input tax. If the person who pays is simply meeting the cost of the person to whom the supply is actually made (in VAT terms providing third party consideration) then the VAT cannot be recovered by either party.

The Airtours case

The latest case to deal with the VAT issue of third party consideration (Airtours Holidays Transport Ltd v The Commissioners for Her Majesty’s Revenue & Customs) highlights this arcane distinction that has led to a sharp disagreement in the Supreme Court as to how this distinction should be addressed.

Airtours Holiday Transport Limited was in financial difficulty and needed to agree a rescue package with its banks if they were to continue to provide (Airtours) with finance. As part of the process of arranging that package it was decided that PwC should be engaged to provide a report on the financial viability, which included carrying out a strategic review of Airtours’ business and restructuring proposals.

An engagement letter was entered into between PwC, the banks and Airtours. The engagement letter provided that: PwC was retained by the banks and that PwC’s reports and letters were for the sole use of the banks (to whom PwC assumed a duty of care). The report was to be provided to the banks but with a copy also being sent to Airtours, although information which the banks considered confidential would be omitted from the copy. Airtours was responsible for PwC’s fees and expenses but the invoices would be sent to Airtours with copies to the banks. Airtours agreed to indemnify PwC against claims brought by any third party. In turn Airtours agreed that it would provide PWC with access to its papers and its directors would assist PWC in preparing the report. There was an agreed timetable for the report to be delivered.

Airtours’ argument fell into two parts. First it had a contractual right to require PWC to prepare the report in accordance with the timetable and it took on responsibilities in assisting PWC to prepare the report. Second it obtained the benefit of the report because obtaining the report was vital to saving its business by securing the continual provision of finance from the banks. It had a role in the decision-making process as to who was appointed to carry out the review of the plans for the business. HM Revenue & Customs accepted that Airtours had paid for the services and that it was a party to the engagement letter with PwC, but argued that the supply was to the banks, and not to Airtours. Accordingly, Airtours was not entitled to recover the input tax incurred in relation to those supplies.

Similar cases

The question of who a supply is made to was first considered against the tragic loss of the Herald of Free Enterprise in the North Sea. Following the disaster both the ferry company and the master were prosecuted for manslaughter. The ferry company instructed lawyers to act on behalf of the master because they were concerned that the master should be represented by high quality counsel. The case focussed on the contractual arrangements and came to the conclusion that as the ferry company had contracted with legal advisers to represent the master there was a supply of services to the ferry company and it could recover the VAT charged in respect of the services.

Following that decision the issue was considered again in Customs and Excise Commissioners v Redrow Group plc [1999] STC 161 (Redrow). In Redrow, a house builder (Redrow) agreed to pay the estate agent fees in respect of the sale of properties owned by individuals who subsequently bought a Redrow home. Redrow sought to deduct the input tax charged on the fees. HMRC refused the claim on the basis that the supplies were made to the homeowners and not to Redrow. The case reached the House of Lords, where Lord Millett said: ‘Once the taxpayer has identified the payment the question to be asked is: did he obtain anything – anything at all – used or to be used for the purposes of his business in return for that payment?’.

This seems to be a sensible analysis; if a taxable person is paying for something for the purpose of his business, then he should be in a position to obtain credit for any input tax in the same way as any other business expenditure would give rise to a credit.

Following the decision in Redrow the issue was considered again by the Supreme Court in a case involving the Nectar points scheme commonly used in the retail sector. That case refined the comments of Lord Millet. The starting point was to consider the contractual position but that had also to be considered against a sensitive analysis of the economic and commercial realities of the parties’ commercial relationships. What appears to be clear from all these decisions is that the court will not undertake an analysis of the extent to which the parties would benefit or benefit most from a particular supply of services.

A number of issues arise in determining VAT consequences of inter-related supplies in three party situations. As a matter of UK VAT law, a supply cannot normally be made other than for a consideration (s 5(2) Value Added Tax Act 1994). From the perspective of the supplier Art 73 2006/112/EC (VAT Directive) states that the taxable amount for VAT consists of:

‘everything which constitutes consideration obtained or to be obtained by the supplier, in return from the customer or a third party’.

This raises the question, is someone a “customer” or a “third party”. There is also a need to identify the recipient for the purpose of establishing the entitlement to input tax recovery:

‘in so far as the goods and services are to be used for the purposes of the taxed transactions of a taxable person, the taxable person … shall be entitled … to deduct … the VAT due … in respect of supplies to him of goods or services…’ Article 168 VAT Directive.

If you look at the position of the person paying, then the decision in Redrow sets out the principle that if that person has something done for him in return for that payment, then they have the right to deduct the input tax incurred if it is used for the person’s taxable activities.

Interpretation of the terms

In Airtours the majority view placed the interpretation of the contract squarely at the centre of the issue. Whilst it was clear that regard must be had to the economic realities of the transaction, the contract was the starting point because it was where the parties had set out their respective obligations.

In this case the majority view was that properly construed the contract did not entitle Airtours to require PWC to provide its services to them. The majority recognised that in some instances it may be the case that the contractual arrangements do not reflect the economic and commercial realities of the parties’ positions and in those cases the contractual analysis may be displaced. In effect the economic and commercial analysis resulted in a cross check against the contractual analysis for those exceptional cases where the contract does not reflect commercial reality.

The minority view disagreed on almost all of these conclusions. The contractual analysis is a starting point but has to be set in the context of commercial reality and in any event the majority had misconstrued the contract. Airtours did have a right to have PWC provide their services and in particular in accordance with the timetable set out in the engagement letter.

Where does this leave us?

It seems clear that the contractual terms are at the heart of the analysis. This means that it is important to draft contracts precisely. However, whilst focussing on the VAT issues in the drafting of contracts may achieve a better result for the tax-payer, the outcome will also depend on the commercial reality of the arrangement entered into by the parties.

There is flexibility in the way contracts are shaped which can affect the VAT analysis but the parties cannot make up an artificial and unrealistic story and expect that to change the VAT treatment.

Another cautionary lesson is to be careful how you describe the parties in a tripartite contract. Much of the difficulty in Airtours arose because the engagement letter used the terms we and you. In a tripartite contract that raised almost insurmountable difficulties as to whether “you” meant Airtours, the banks or both of them. At all levels the courts had to reach a conclusion about that and perhaps unsurprisingly came to the conclusion that sometimes it meant the other and sometimes both. The important lesson is that VAT needs to be considered carefully when drafting contracts particularly in a tripartite situation.