A recent VAT case, U-Drive Ltd (UDL) highlighted the rules applying when VAT is incurred in a situation where 3 parties are involved (a tripartite situation).
UDL supplies hire cars. Costs of insuring the hire vehicles with a third party insurer had risen and to mitigate this cost UDL set up captive insurance company, Parallel Insurances Services Limited (PISL). The arrangements between UDL and PISL meant that UDL had a financial interest in keeping the costs of claims down and as a result when a vehicle owned by a third party was damaged in a collision with a UDL hire car UDL would, where it was more cost effective, pay for that vehicle to be repaired, as an alternative to the third party making a claim against PISL.
In these circumstances UDL contracted with and paid the repairing garage for work carried out on the third party’s vehicle. The repairing garage invoiced UDL plus VAT. There was no contract for repair services between the vehicle owner and the garage.
UDL made a claim to recover VAT charged by garages in respect of repair services. HMRC rejected the claim on the basis that the repair services were supplied to the third party vehicle owner, not UDL, and only the recipient of a service is allowed to recover VAT charged by a supplier.
In considering the case the Upper Tribunal (UT) concluded that in the first instance the contractual position should be considered, but then it was necessary to decide if that analysis reflected the economic reality of the transaction.
In the UDL case the UT considered that the contractual position did not reflect the economic reality; UDL did not receive the supply of the repairs and, as a result, was not entitled to recover VAT incurred.
This case serves as a reminder to consider VAT recovery when a business pays a cost when arguably another person receives the benefit of the underlying goods or services. Errors often arise, particularly with legal costs. The leading case on this point, Airtours, considered advice from PWC paid for by Airtours but with PWC holding a contractual obligation to organisations from which Airtours was seeking finance. Airtours was considered relevant by the UTT in deciding the UDL case.
If a business is incurring costs in a tripartite situation it is worth seeking advice on VAT recovery as claims could be challenged and give rise to tax assessments and penalties.
There is a broader problem with cases like this insofar as:
- There was a business rationale for the arrangements in place (reducing costs); and
- The contractual relationships were crystal clear.
Therefore HMRC, because it did not believe the outcome to be “fair,” has, with the support of the courts, imposed an “economic reality” that bears no relationship to the contractual position. Furthermore, it has taken this approach rather than using other tools or changing the law. Essentially, this means that businesses cannot rely on the legal certainty of their contractual arrangements because at any time HMRC could seek, to ignore the contractual reality to impose a different economic reality. Of course, this will be a one way street because taxpayers can expect short shrift from HMRC if they argue in cases that might reduce tax payments that economic reality should trump unhelpful contractual arrangements. After all, as HMRC guidance says “HMRC must apply the law correctly, and the Commissioners cannot choose to move away from this position merely because the result seems unfair or unreasonable. To move away from the strict application of the law would be counter to the will of Parliament”.
Of course, HMRC would probably argue that in this case it has applied the law strictly (to the economic reality). However, this being the case it should be open to taxpayers to argue an economic reality position and, in our experience, this would not be accepted by HMRC. It will be interesting to see whether this decision is appealed and the outcome. However, perhaps more interesting in the long-term will be whether, in its enthusiasm to prevent outcomes it disapproves of, HMRC is opening a Pandora’s Box. The law of unintended consequences sometimes takes a long while to prove itself. There are lots of examples of HMRC adopting an apparently expedient “fix” to a perceived problem only to discover that there is a far higher price to pay in the long-term. However, it may be time for businesses to decide whether they are disadvantaged by their failure to apply “economic reality”. And, of course, these nebulous concepts make an already complicated tax system even more complicated since one person’s view of the economic reality may be completely different to another person’s view, although we can be quite confident that HMRC will work backwards from the answer it wants and claim that it cannot apply economic reality in cases that do not deliver this outcome (after all its hands are tied and it must apply the law strictly, however unfair the outcome might appear!).