HMRC Bows To ECJ VAT Ruling

by Amanda Banks, Tax-News.com, London

11 August 2005

The UK's HM Revenue & Customs (HMRC) has announced changes to its policy on the recovery of VAT incurred on goods and services supplied to a business for mixed business and non-business use as a result of the ECJ's judgement on the 'P Charles, T S Charles-Tijmens' case.

The Court found that Member States cannot use the derogation under Article 6(2) of the Sixth VAT Directive to deny taxpayers the right to treat all VAT incurred as input tax when they purchase capital goods for mixed business and private use and allocate the goods wholly to their business. It means the UK legislation introduced in 2003 to prevent the Lennartz mechanism being used for certain construction services, combined with the UK rules for input tax deduction, is ultra vires.

HMRC says it accepts that, where businesses incur VAT on certain construction services or on purchasing land, buildings and civil engineering works for mixed business and non-business use, they can now rely on the direct effect of the Sixth VAT Directive to treat all VAT incurred as input tax and, subject to the normal rules, recover all the tax up front. They must then account for output tax on the non-business use over the economic lifetime of the asset.

The services concerned are those, which result in, or will result in, the construction of a new building or civil engineering work, or a major refurbishment or extension of an existing building.

There is no change to the way that partial exemption operates. If the asset is to be used for both taxable and exempt purposes, input tax can only be deducted in accordance with the partial exemption method in place for the business.

HMRC will challenge any attempts to exploit the Lennartz mechanism to obtain an unfair revenue advantage by introducing artificial arrangements.

In 1991, the ECJ decided in the case of Lennartz (C-97/90) that taxpayers making business and private use of goods had, in principle, a right to full and immediate deduction of VAT on their purchase. The private use of goods forming part of the assets of a business is treated as a taxable supply of services (under Article 6(2) of the Sixth VAT Directive) and so liable to output tax. In short, therefore, a business can reclaim the VAT in full "up front" and then account for the private use of the goods over their economic life (as opposed to apportioning the VAT incurred between business and private use). This is known as the "Lennartz mechanism".

In 2002, HMRC became aware that schemes were being proposed to exploit the Lennartz mechanism unfairly. Tax advisers were also increasingly interested in using the Lennartz mechanism for high value capital goods such as buildings purchased by charities and colleges for mainly non-business activities. And, the ECJ found in the case of Seeling (C-269/00) that the Lennartz mechanism could also be used for construction services, opening it up to those incurring
VAT on constructing buildings and not just taxpayers purchasing a major interest in a building.

In order to protect the revenue, changes were made in the Finance Act 2003 to paragraph 5(4A) to Schedule 4 of the VAT Act 1994. These changes provided that where land and buildings and civil engineering works used in the business were put to non-business use, this was not a supply of services for consideration. HMRC considered this meant that where such items were purchased for mixed business and non-business use, there was no right to recover VAT incurred to the extent it was attributable to the non-business use. In making these changes, the UK relied on the derogation in the second paragraph of Article 6(2) of the Sixth VAT Directive.

In the 'P Charles, T S Charles-Tijmens' ECJ case, the appellants purchased a holiday bungalow in the Netherlands intending to use it 87.5% for business rental and 12.5% for private purposes. The Dutch tax authorities accepted that there was an entitlement to deduct 87.5% of the VAT incurred but they denied a full deduction under Dutch law. The ECJ found for the appellants - counter to the Advocate General's opinion and to the arguments put forward by both the Commission and other Member States. The ECJ's judgment was that Member States cannot use the derogation under Article 6(2) of the Sixth VAT Directive to deny taxpayers the right to treat all VAT incurred as input tax when they purchase capital goods for mixed business and private use and allocate the goods wholly to their business.

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