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Written by: David Wilson

David Wilson

Technical Associate Director

Could HMRC’s change in VAT treatment of PCP contracts be detrimental to UK car financing arrangements?

A change in policy announced by HMRC will mean that the VAT treatment of personal contract purchase (PCP) agreements will depend on the level at which the final optional payment is set and could influence how future vehicle financing deals are structured.

Under a typical PCP agreement, the customer makes a series of payments and can either make a substantial payment (the ‘balloon’ payment) at the end of the contract and keep the asset, e.g. a car, or return the car to the finance company with no further obligation. 

As a result of the 2017 European Court decision in Mercedes-Benz Financial Services UK [C 164/16](MBFS), HMRC’s revised policy is that with effect from no later than 1 June 2019, the correct treatment of PCP and similar contracts will depend on the level at which the final optional payment is set. 

Where the level of the final optional payment is set at or above the anticipated market value of the goods, this is a single supply of leasing services, with VAT due on the value of each instalment. By contrast, where the final option payment below is market value this is likely to be a supply of goods. In this situation, VAT will be due in full at the initial handover of the goods, with a separate periodic exempt supply of finance charges.

Note that, although ‘balloon payments’ are also payable under hire-purchase contracts, the final instalment under HP contracts are not ‘optional’ payments, meaning that HP contracts are therefore not generally affected by the MBFS ruling.

It is estimated that some 90 per cent of new car sales, totalling some £37 billion, are financed through PCP or similar types of contracts and there is little doubt that clarification of HMRC rules will be welcomed by finance houses.  

Businesses must adopt the correct treatment for all new contracts no later than 1 June 2019 and may need to address past treatments and correct any errors, including where appropriate, adjustment to input tax recovery. Given that HMRC has been aware of the European Court’s decision since October 2017, affording businesses three months to review and change procedures does seem an exceptionally short timeframe.

Given that PCP contracts typically run for a term of two, three or even four years, the challenge for finance houses will be to ascertain what the expected residual value of vehicles would be at the end of their contract term, to compare those residual values with the option payments offered on future contracts, and to have adequate systems and accounting records to ensure they have proof that the anticipated residual value is a credible assessment.

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