Narrow, functional interpretation of VAT finance exemption necessary

The Supreme Court has confirmed that the VAT finance exemption for payments and transfers must be given a narrow interpretation, requiring the relevant services to have the effect of both transferring funds and changing the legal and financial situation of the relevant parties: Target Group Ltd v HMRC [2023] UKSC 35. It is not sufficient to fall within the scope of the exemption that a person gives instructions to a financial institution to make a payment or transfer, even if it is necessary and even if that payment occurs automatically as a result of that instruction. In so doing, the Court has held that the earlier Court of Appeal decision in FDR was wrongly decided.

As a result, the Court has confirmed that the composite supplies by a loan servicer to a bank in this case did not fall within the exemption for transactions concerning payments or transfers.

Background

Target provided loan servicing for a bank, Shawbrook, covering the lifecycle of loans to the bank's customers other than the making of the initial advance. Target established loan accounts using its own systems, communicated with borrowers as an undisclosed agent of the bank, and dealt with payments by borrowers and all administrative issues that arose during the life of the loan. The terms of the loans, including interest rates, were set by the bank and Target had very limited discretion in dealing with customers. Also, although Target was involved in dealing with arrears, any enforcement action was a decision for the bank. It was accepted that the activities amounted to a single composite supply for VAT purposes.

Target claimed that its supplies were exempt from VAT pursuant to the Principal VAT Directive Article 135(1)(d) either as transactions...concerning payments, transfers, debts, but excluding debt collection. Alternatively, its supplies were exempt as services concerning current accounts within Article 131(1)(d).  

HMRC rejected these arguments, considering that the supplies were either standard rated debt collection in line with the CJEU decision in AXA or, if the wider elements of the supply meant that the composite supply was not simply "debt collection", then it amounted to a supply of standard rated credit management services.

The First-tier Tribunal (FTT) held that, although the supplies by Target could, in principle, fall within the exemption for payments and transfers, overall the service amounted to one that was predominantly a supply of debt collection services and as such fell outside the scope of the exemption following the CJEU decision in AXA.

The FTT decision was handed down before the CJEU decision in DPAS (Case C-5/17) [2018] STC 1615 and when the case was appealed to the Upper Tribunal (UT), the UT held that the subsequent CJEU decision made it clear that the supplies by Target did not fall within the scope of the exemption for payments and transfers. The UT also  held that Target's inputting of accounting entries in the loan account did not fall within the exemption as it did not change any party's legal and financial position.

The Court of Appeal rejected Target's appeal. In particular, DPAS made it clear that "actual execution is necessary to qualify as a transaction concerning transfer or payment, and the mere giving of an instruction is not sufficient in itself, even if the instruction is or order is indispensable to the transaction taking effect, and even if the instruction triggers an entirely automatic process leading to payment". In agreement with the lower tribunals, the Court of Appeal also rejected the alternative argument that the supplies were exempt as transactions concerning current accounts. In agreement with the FTT and the UT, the Court considered that a fundamental characteristic of a current account was that a customer is able to deposit and withdraw funds in varying amounts and, in the case of a current account, the account holder can pay amounts to third parties. The loan accounts operated by Target were not "current accounts".

Target appealed to the Supreme Court contending that its services fell within the scope of Article 135(1)(d) either:

• by giving instructions which automatically and inevitably resulted in payment from the borrower's bank accounts to Shawbrook's bank accounts via BACS; and/or
• by the inputting of entries into the borrower's loan accounts with Shawbrook.

In particular, Target contended that the approach of the Court of Appeal in C&E Comrs v FDR Limited [2000] STC 672 that services which involve giving instructions which will automatically and inevitably result in a payment being made fall within the article 135(1)(d) exemption remained correct. Later CJEU case law, including DPAS, had re-affirmed the correctness of the long-established principles set out in SDC. The Court of Appeal had been wrong to interpret DPAS as departing from the law set out in SDC, as interpreted in FDR, and thereby to disturb the settled state of the law.

Decision of the Supreme Court

To determine the correct approach, the Supreme Court considered the history of the jurisprudence in this area.

Looking at the CJEU decision in Sparekassernes Datacenter (SDC) v Skatteministeriet (Case C-2/95) [1997] STC 932, the Supreme Court noted that this determined that, "viewed broadly" and as "a distinct whole", to be exempt the services must (i) have the effect of transferring funds and (ii) change the legal and financial situation. What remained arguably unclear was whether the services must in themselves have that effect and make that change (the narrow interpretation) or whether it was sufficient for them to have that causal effect (the wider interpretation).

Following the decision in SDC, the issue was considered in the UK Court of Appeal decision in FDR. In that case, HMRC argued that the transfers were not within the exemption because, following SDC, a transaction concerning a transfer required the execution of the transfer rather than merely an instruction to do so - ie the narrow interpretation. The Court of Appeal rejected this argument. It held that it was sufficient if the services had the automatic and inevitable effect of executing a transfer.

However, the later case law of the CJEU, including, in particular, Bookit Ltd v HMRC (Case C-607/14) and National Exhibition Centre Ltd v HMRC (Case C-130/15) [2016] STC 2132 and especially DPAS, had made it absolutely clear that the narrow interpretation is the correct one.

"The narrow interpretation means that the services must in themselves have the effect of transferring funds and changing the legal and financial situation. It is not enough to give instructions to do so thereby triggering a transfer or payment. It is not enough to perform a service which is essential to the carrying out of the transfer or payment, nor one which automatically and inevitably leads to transfer or payment. It is necessary to be involved in the carrying out or execution of the transfer or payment - its "materialisation". This requires functional participation and performance. Causation is insufficient, however inevitable the consequences."

In addition, the Court noted that this approach was consistent with the need to interpret the exemption strictly, the fact that its subject matter is financial transactions and its rationale of covering cases where it is not possible to identify the tax base.

As a result of this decision, the Court went on to confirm that "it is now apparent that domestic law took a wrong turn in FDR and the Court of Appeal's conclusion ... in that case must be overruled".

What of the argument that the making of accounting entries in loan books was sufficient to bring Target within the scope of the exemption? In relation to this issue, Target argued that the making of accounting entries is the standard modern means of effecting movements of value. Further, as a matter of EU law and English law unilateral accounting entries may be sufficient to effect a transfer or payment. In the present case, Target's role included the authorised debiting and crediting of the borrower loan accounts with Shawbrook and this involved making changes to the legal and financial situation of the parties and so fell within the article 135(1)(d) exemption.

The Supreme Court recognised that accounting entries may be sufficient to effect the necessary transfer of funds and change the legal and financial position of the parties. That had been recognised by the CJEU in its judgment in ATP PensionService A/S v Skatteministeriet (Case C-464), [2014] STC 2145, which was a useful illustration of how the exemption may apply to non-financial institutions. However, the Supreme Court noted that this was clearly distinguishable from the present case. On the CJEU's analysis, the account entries made in that case did change the legal and financial situation by transforming a right held by a worker against his employer into one held in relation to a pension fund.

In this case, the FTT's factual findings where that the ledger entries were in relation to "expected" payments which were assumed to be made, which, therefore, could not and did not legally change anything. The loan account was no more than a ledger, recording the effect of payments made by customers to Shawbrook but not effecting such payments.

Comment

The decision is further confirmation that a functional approach to the VAT exemption for payments or transfers is necessary. In particular, the giving of instructions by a person to a financial institution to make a payment or transfer is insufficient, even if it is necessary and even if that payment occurs automatically as a result of that instruction. It remains that case that it is the underlying financial institution that is making the payment or transfer that effects the necessary change in the legal situation. As such, earlier significant cases must all now be read in the light of DPAS.

In many cases this will mean that it is only the services provided by a bank or similar financial institution which will be exempt, but that is not necessarily so, as is illustrated by the ATP case.

The decision itself is not a surprising outcome - it is widely accepted that loan servicing no longer constitutes exempt payment services. Nevertheless, in practice, much loan servicing will still qualify for exemption from VAT as it often falls within the scope of "management of credit by the person granting it". Based on published HMRC guidance, this applies where the originator of the loan (or a company in its VAT group) continues to service loans after their sale to a third party or finance vehicle, or where the servicer (or a company in its VAT group) acquires/holds bare legal title to the loans it services.