VAT Insights - November 2022

To what extent can services which have been outsourced to a third party qualify for VAT exemption where the recipient of them is making exempt finance-related supplies? The answer to this question has always been somewhat problematic. It was one of the rocks on which the EU Commission’s early noughties attempt to modernise and standardise the VAT finance exemptions ultimately ran aground..

It is clear that outsourced services may fall within the exemption themselves - though this does require a careful analysis of the nature of the exemption and its application may differ in practice depending on the particular exemption relied upon. This means that the outsourced services must not be merely technical or clerical in nature. In this context, the decision of the FTT in eMerchantPay Limited is a helpful case demonstrating when VAT exempt intermediary services may be successfully outsourced and remain within the exemption.

As well as looking the eMerchantPay case, in this edition we also cover the following recent VAT developments:

• the VAT treatment of loan sub-participation arrangements;
• the application of the capital goods scheme rules where a taxpayer goes into liquidation and goods remain unsold;
• the necessary level of evidence needed for VAT reclaims in historical VAT cases;
• developments in relation to the VAT exemption for fund management services in both the Netherlands and Ireland; and
• VAT aspects of the recent Spanish Budget.

We produce more detailed reports on the most significant tax developments so if you scroll to the bottom, there's a list of the most important issues we have covered, with a link to our more detailed report.

If you are interested in finding out more about the below or have a specific indirect tax query, please don't hesitate to get in touch.

Outsourcing VAT exempt intermediary services

In the context of supplies of VAT exempt finance services, it is important that, to the extent possible, any related supplies do not attract VAT. The provider of financial services will typically not be able to recover any input VAT it is charged and will instead need to factor any irrecoverable input VAT into the charges it makes to its customers – potentially putting it at a disadvantage to competitors in the market.

Nevertheless, outsourcing has become increasingly commonplace, with businesses seeking to benefit from economies of scale and a lower cost base in different jurisdictions. Outsourcing services which are a component of a VAT exempt supply can give rise to irrecoverable VAT, however, thereby reducing or eroding entirely other economic benefits. It is unsurprising therefore that providers of exempt financial services such as eMerchantPay Limited seek to argue that the outsourced services they receive themselves fall within the scope of the VAT exemption.

In eMerchantPay Limited v HMRC [2022] UKFTT 334, the appellant, a UK company providing financial intermediation services in relation to merchants requiring credit card services, had no employees itself and outsourced essentially all of its services to another group company in Bulgaria (EMPO). This included underwriting and account management activities, including following up leads on potential clients, carrying out due diligence on them and processing applications. It has successfully argued that these services themselves were exempt from VAT. The FTT rejected the contention that EMPO was doing no more than carrying out “clerical formalities”. It was clear that EMPO did far more, including elements which were essential in bringing merchant acquirers together with merchants.

Read our full article here.

Loan sub-participation arrangements

The VAT finance exemptions set out in the 2006 VAT Directive (and in Schedule 9 Group 5 of VATA 1994) largely date back almost 50 years. The transactions that they apply to have, in some cases, changed out of all recognition to those envisaged at the time they were drafted. Capital markets transactions, in particular, have grown significantly in complexity during that period – and the existing rules, designed for a much simpler financial world, are (to put it mildly) creaking…

The EU Commission is currently carrying out a consultation on changes to the insurance and finance exemptions and this holds out some hope for modernisation of the rules at the EU level. But in the meantime, those rules have become difficult to apply to modern financial arrangements such as the loan sub-participation arrangements in the Polish case, O. Fundusz lnwestycyjny Zamknięty reprezentowany przez O (Case C-250/21).

The case concerned the correct VAT treatment of a sub-participation agreement. An investment fund paid an originating lender an amount and in return the lender agreed to pay to the fund the proceeds obtained by it under the original loans. This removed the cash flow and the risk from the originator’s balance sheet, but the originator remained legal owner. The fund contended that its supply was an exempt grant of credit, but Poland’s Minister for Finance issued a tax ruling that the fund’s services were subject to VAT. The fund appealed and the matter was referred to the CJEU.

Although the AG opined that the supply did not fall within the VAT exemption for the grant of credit, the CJEU has rejected that analysis. The Court considered that the supply consisted, essentially, in a payment of capital in return for remuneration and this was correctly analysed as a grant of credit. The fact that the sub-participant had no legal remedy against the originator in the event of default by the debtors and the fact that the debt securities remained legally owned by the originator did not affect the essential nature of the transaction, which consisted in financing the initial loans.

Perhaps just as interesting is the fact that the CJEU considered that, in making a payment to the originator for the right to receive proceeds from the original loans, the sub-participator was making a supply at all. The person making a payment and receiving “something” in return is usually simply the recipient of a supply, but here (as in the loan factoring arrangements in MKG (Case C-305/01)), things were not quite so simple. Though the subsequent case of GKFL (Case C-93/10) concerning the purchase of debts at a discount shows that the borderline between supply and non-supply can be quite subtle.

Read our full review here.

The VAT Capital Goods Scheme and liquidations

It is a fundamental principle of the VAT system that a taxpayer is entitled to recover input VAT incurred in connection with taxable supplies. That includes a right to recover input VAT in the situation where VAT is deducted initially on the basis of intended taxable supplies even where those supplies do not eventually take place. On the other hand, the capital goods scheme (CGS) contains provisions which require adjustment of input VAT deductions where the actual use of goods does not match the expected use (which determines the original basis for deduction). Which of these two rules took precedence was, in essence, the question for the court in UAB ‘Vittamed technologijos’ v Valstybinė mokesčių inspekcija (Case C-293/21).

UAB was engaged in technical scientific research and incurred costs and input VAT in acquiring goods and services for a project to develop a prototype of a medical device. The project was completed in December 2013, but no sales of the medical prototypes were ever made. As a result, UAB was placed into liquidation in 2015. Did the input VAT initially recovered by UAB remain deductible, or was it necessary to adjust it on the basis that it fell within the scope of the CGS?

The CJEU has held that the capital goods scheme provisions override the general principle that input VAT which is deducted initially on the basis of intended supplies remains deductible even where those supplies do not actually take place. In this case, it was clear that UAB no longer had any intention of using the capital goods for the purposes of making taxable supplies and therefore the adjustment mechanism in the CGS applied.

Of course, in many cases the placing of the taxable person concerned in liquidation nevertheless results in a taxed transaction being carried out by the sale of the relevant assets. But in this case, the assets remained unsold.

Read our full review here.

Historical VAT reclaims and appropriate evidence

The result of the attempt by the government in 1996 to reduce the time limit on VAT reclaims to three years and the subsequent decision of the ECJ in Marks & Spencer in 2003 that that attempt (without the benefit of a transitional period) was illegal are still being worked through over 20 years later. In fact, in the realm of input VAT claims (where there was originally no time limit), some claims date back as far as the commencement of VAT in the UK in the early 1970s! One such case is HMRC v NHS Lothian Health Board [2022] UKSC 28.

It is one thing, however, to have a right to a reclaim in principle, it is another to be able to prove the quantum of that claim going back 50 years! It was in this context that the Scottish Court of Session held that EU principles of effectiveness and proportionality require the UK tax tribunals to take a flexible approach to the requirement that a taxpayer must provide evidence of the amount of a VAT reclaim in such historical cases. However, the Supreme Court has now overturned that decision, holding that the obligation on the taxpayer to prove their claim (both in principle and quantum) remains paramount. The Court of Session had been wrong to suggest that the principle of effectiveness required that the quantification of a historic claim should be possible in all but exceptional circumstances.

In this case, the Health Board concerned had evidence of the fact that it undertook taxable activities in the years back to 1974 (and should have been able to claim some input VAT recovery), but could not show the level of taxable compared to exempt activities at the time. Nor had it shown that the relevant percentage for the first year it could meet that burden (2006/2007) was representative of earlier years. As such, HMRC had been correct to reject the claim.

There remain many unresolved cases of historical input VAT reclaims. Many are unresolved due to similar problems with proof and evidence. This decision will be disappointing to many of those taxpayers. However, the case leaves open the possibility that the principle of effectiveness or other EU principles may be of more assistance in cases (unlike this one) where HMRC practice or the UK VAT rules were at fault at the relevant time and led to the taxpayer’s lack of appropriate records.

Read our full review here.

The Netherlands: VAT exempt management of pension funds

A Dutch court has referred to the CJEU a number of important questions concerning the application of the VAT exemption for management services provided to pension funds. Management services will only qualify for exemption where the pension fund qualifies as a “special investment fund” and this in turn requires that the participants in the pension scheme should be subject to investment risk. It is in this context that a Dutch court has recently referred questions to the CJEU regarding the extent and nature of the investment risk that participants need to be subject to. This is an important case and Dutch pension funds potentially affected by this decision should consider what approach they should take pending its outcome.

See our full review here.

Ireland: VAT exempt management of Irish Section 110 companies

Under current Irish VAT law, the supply of management services to a Section 110 company by a designated management company is a VAT exempt activity. Finance Bill 2022, which was published by the Irish government on 20 October 2022, includes a provision which would remove the VAT exemption where the Section 110 company holds qualifying assets that consist of plant and machinery. It is important to note that the Finance Bill is expected to be subject to further debate and amendment before its expected December enactment, and industry is currently seeking clarification as to the scope and operation of this provision.

Spain: Budget changes

The Spanish draft Finance Bill contains a number of measures in relation to VAT including: (i) easing the requirements for VAT recovery in the case of bad debts, (ii) amendments to the reverse charge rule and, most importantly (iii) a limitation to the application of the special effective use and enjoyment rule. With regards to the latter, the changes imply the removal of the application of such rule to business to business (B2B) transactions, with a few exceptions (leasing of transport, financial and insurance services). The rule will be completely removed in relation to supplies of intermediation, telecommunications, radio and television broadcasting, and electronically supplied services.

For more details on the Spanish draft Finance Bill see our full article.

Other issues we have recently covered

HMRC guidelines for compliance
HMRC has published new online guidance on areas of tax compliance for businesses. The intention is that these pages will offer HMRC's view on complex, widely misunderstood or novel risks that can occur across tax regimes, including guidelines for employers, corporation tax and VAT. They will go beyond HMRC's view of the law (as set out in their Manuals) and address areas of compliance risk.

The EU Commission consults on its BEFIT proposal
The European Commission has published a call for evidence and public consultation on its proposal for the introduction of a common corporate tax system in the EU. The consultation is open for responses until 5 January 2023. This initiative aims to introduce a common set of rules for EU groups operating cross-border to calculate their taxable base, together with agreement on a method for allocating profits between EU countries based on a formula. The Commission argues that the proposal will reduce compliance costs by creating a coherent approach to corporate taxation in the EU, but the proposal and its predecessor (the common consolidated corporate tax base) have long been controversial and resisted by a number of Member States.

The OECD's Crypto-Asset Reporting Framework
On 10 October, the OECD published its Crypto-Asset Reporting Framework and amendments to the Common Reporting Standard, developed in response to a mandate from the G20. The Crypto-Asset Reporting Framework (CARF) was developed in the light of the rapid growth of the crypto-asset market and provides for the reporting of information on transactions in crypto-assets in a standardised manner, with a view to automatically exchanging such information with the jurisdictions of residence of taxpayers on an annual basis. The CARF, which runs to some 100 pages, will be presented to G20 Finance Ministers and Central Bank Governors for discussion at their next meeting on 12 and 13 October.

The latest UK fiscal event - taking back control?
An update on the emergency policy statement by the recently appointed Chancellor Jeremy Hunt on 17 October, at which he announced significant changes to the measures announced by his predecessor in the 'mini budget' on 23 September.

UK implementation of OECD Model reporting rules for digital platforms
The UK government has published for consultation draft regulations for implementing the OECD Model Reporting Rules for Digital Platforms in the UK with effect from 1 January 2024. The draft regulations follow on from the Summary of Responses to the 2021 consultation and are available for comment until 13 December 2022. The draft regulations rely heavily on and incorporate by reference much of the text of the Model Rules themselves, including many of the basic definitions, such as platform, platform operator and reportable seller.

OECD guidance on Advance Pricing Agreements
Monique van Herksen’s article for Bloomberg’s Tax Management International Journal discusses the recent guidelines from the Organisation for Economic Cooperation and Development (OECD) published in the Bilateral Advance Pricing Arrangement Manual (BAPAM) and intended to provide best practices to improve the effectiveness of the bilateral advance pricing agreement process.

Upcoming webinars

Tax controversy and transfer pricing webinar series

In these highly uncertain times, governments desperately need revenues to support their economies. Tax authorities' increased focus on audits is therefore a given, and we know transfer pricing is one of the most important areas that are investigated.

Join our new series of 30 minute webinars to help you and your business be alert and agile to proactively manage transfer pricing controversies. Read more and register here.

Contracts Masterclass series

Join us on 29 November to discuss the key tax considerations in preparing contracts, including allocating tax risk between contractual parties, best practice in relation to establishing the VAT position, recent updates in the VAT treatment for liquidated damages and transfer pricing considerations in an intra group context.

The event is part of our annual contract masterclass webinar series, designed to provide the most up to date guidance on contractual issues in English law. Read more and register here.