The debate on hire purchase VAT recovery takes an unexpected turn in Europe

The Volkswagen Financial Services (VWFS) case has been rumbling on since 2011. It considers the issue of how a business supplying vehicles on hire purchase (HP) should recover VAT on overhead costs, given that HP transactions result in a standard rated supply (of the vehicle) and an exempt supply of finance.

VWFS has previously argued for a transaction count method (i.e. each HP agreement comprises one taxable and one exempt supply which should be given equal weighting), whilst HMRC has argued for minimal VAT recovery (on the basis that the vehicle is sold at cost and all of the effort and profit is directed towards the exempt supply).

VWFS has fared well in the UK courts, but a referral to the Court of Justice of the European Union (CJEU) on how the partial exemption calculation could (or should) be performed has taken an unexpected turn. Most CJEU rulings are preceded by an opinion from the Advocate General (AG) which is intended to help guide the Court in its decision making.

The AG considers that the UK is incorrect in treating HP as two separate transactions - instead it should be classified as a single taxable supply. This would mean that:

• the amount of VAT charged to customers would increase, as the previously exempt element would become VATable; and
• the HP element of the business would become fully taxable and therefore entitled to full VAT recovery on overhead costs such as property and IT costs.

Consequently, the question of VAT recovery methods becomes irrelevant – for the future at least. Even if this was the case, the AG recognises that, as a matter of fact, HP businesses have made exempt supplies of finance for the past. However, the ruling gives very little analysis regarding how VAT recovery on overheads should be treated. In summary, it seems that the AG is suggesting that:

• HP businesses should have the option to go back and treat the HP sales as fully taxable – i.e. declaring the additional output VAT and with full input VAT recovery on overhead costs; or
• in the event that the exemption is maintained (and businesses are able to rely on the UK interpretation of the law from the past), then VAT recovery should be limited to reflect the fact that all overhead costs have been incorporated into the exempt supply of finance.

Although the opinion is surprising (as it answers questions that weren’t asked), two things should be borne in mind:

• the CJEU is not bound by the AG opinion and it is not uncommon for an alternative decision to be reached; and
• the Supreme Court will need to consider how it interprets the CJEU answers in the context of the VWFS case.

Therefore, the AG opinion could be cast aside by the CJEU or could be open to interpretation by the Supreme Court. However, if the AG opinion is followed, it is likely to mean huge change for the sector.