Revenue and Customs v Pendragon plc & Ors [2015] UKSC 37

The Pendragon Group used a KPMG-designed VAT scheme involving demonstrator cars, exploiting exemptions to recover input tax while paying output tax only on profit margins. The Supreme Court held the scheme was an abuse of law and allowed HMRC's appeal.

Facts

The Pendragon Group, Europe’s largest car sales group, implemented a tax avoidance scheme designed and marketed by KPMG in late 2000 and early 2001 concerning demonstrator cars used by retail distributors for test drives. The scheme aimed to enable group companies to recover input tax paid on new cars acquired from manufacturers, while avoiding output tax on the eventual second-hand sale to consumers.

The scheme exploited three exceptions to normal VAT incidence: (i) the ‘de-supply’ of assignments of hire-purchase rights to financial institutions under article 5(4) of the Value Added Tax (Special Provisions) Order 1995; (ii) the ‘de-supply’ of transfers of a business as a going concern under article 5(1); and (iii) the margin scheme for second-hand goods under article 8 of the Value Added Tax (Cars) Order 1992, implementing article 26a of the Sixth Directive.

The scheme involved five prearranged steps: (1) Pendragon plc sold new cars to Captive Leasing Companies (CLCs); (2) the CLCs leased the cars to Pendragon dealerships under hybrid HP/lease agreements; (3) the CLCs assigned the leases and title to SG Hambros Bank and Trust (Jersey) Ltd (‘SGJ’), an offshore bank, for approximately £20m, treated as ‘de-supplied’; (4) some 30-45 days later, SGJ transferred the leasing business as a going concern to Captive Co 5; and (5) Captive Co 5 sold the cars to consumers via the dealerships, applying the margin scheme so that VAT was payable only on the profit margin.

Issues

The principal issue was whether the KPMG scheme constituted an abuse of law under EU VAT jurisprudence, even though it technically satisfied all statutory conditions. Specifically, the court had to apply the two-stage test established in Halifax plc v Customs and Excise Commissioners (Case C-255/02): (i) whether the transactions, despite formal compliance with the legislation, resulted in a tax advantage contrary to the purpose of the relevant provisions; and (ii) whether it was apparent from objective factors that the essential aim of the transactions was to obtain that tax advantage.

A secondary issue, addressed by Lord Carnwath, concerned the proper role of the Upper Tribunal when reviewing decisions of the First Tier Tribunal under sections 11-12 of the Tribunals, Courts and Enforcement Act 2007.

Arguments

HMRC (Appellant)

HMRC argued that the scheme defeated the purpose of the margin scheme, which is designed to prevent double taxation by allowing relief where goods have previously suffered a non-recoverable charge to VAT. Here, the input tax had been fully recovered, so no net charge to VAT was ever suffered. The artificial interposition of the CLCs and Captive Co 5, and the routing through an offshore bank, had no commercial rationale other than securing the tax advantage.

Pendragon (Respondents)

Pendragon argued that the margin scheme legislation was not solely directed at avoiding double taxation, since it captured cases where VAT had never been charged. They submitted that the application of the margin scheme to ‘de-supplied’ transactions under article 8(2)(c) and (d) of the Cars Order was a domestic concession not derived from EU law, so the EU principle of abuse of law could not apply. They contended the scheme had genuine commercial purposes: diversifying credit sources by adding Société Générale as a funder and obtaining secured finance for carrying costs.

Judgment

The Supreme Court unanimously allowed HMRC’s appeal. Lord Sumption gave the leading judgment (with whom Lord Neuberger, Lord Reed, Lord Carnwath and Lord Hodge agreed).

The principle of abuse of law

Lord Sumption reviewed the EU jurisprudence, particularly Emsland-Stärke, Halifax, Part Service, Weald Leasing and RBS Deutschland. He observed that abuse of law confines the exercise of legal rights to the purpose for which they exist. The ‘normality’ of a transaction is relevant to the first Halifax test; sourcing goods from a jurisdiction with a more favourable VAT regime is not in itself abusive. Where there are concurrent commercial and fiscal purposes, the question is whether the commercial objective explains the particular features producing the tax advantage. Both the scheme as a whole and its individual components must be analysed.

First Halifax test: contrary to purpose

The court held that the underlying purpose of the margin scheme, derived from the recitals to Council Directive 94/5/EC, was the avoidance of double taxation and distortion of competition. Although the scheme captured some cases where VAT had never been charged (an element of ‘overkill’), this reflected the practical difficulty of designing a workable regime, not a different policy. For used cars almost all will originally have suffered a full charge to VAT.

Pendragon’s argument that article 8(2)(c) and (d) of the Cars Order represented domestic concessions outside EU law was rejected. Following Weald Leasing and the Court of Appeal’s decision in WHA Ltd, the abuse of law principle applies to national VAT legislation enacted to implement a Directive, even where the implementation imperfectly transposes it. The Pendragon scheme enabled cars to be sold under the margin scheme where VAT had not only been charged but fully recovered, so no net VAT was suffered. This was contrary to the EU policy underlying the margin scheme.

Second Halifax test: essential aim

While selection of an offshore bank was not in itself abusive, the particular method by which SGJ was brought into the chain – via the interposition of the CLCs at Steps 2 and 3 and Captive Co 5 at Step 4 – was an unnecessary and artificial structure. The economic substance was an ordinary sale and lease-back, but two special features were essential only to the tax efficacy: interposing a Captive Leasing Company as lessor, and using Captive Co 5 to take a ‘going concern’ transfer of the leasing business. Neither feature had any commercial rationale other than the tax advantage.

The First Tier Tribunal had erred in law by approaching the question at too high a level of generality. It identified general commercial objectives but failed to ask whether those objectives explained the particular features producing the tax advantage. Had it done so, it would have been bound to conclude they had no other rationale.

Redefinition

The transactions were redefined notionally to strip out the CLCs and Captive Co 5. It was to be assumed that Pendragon plc sold the cars to the dealerships, which sold them to SGJ, took them back on a 45-day lease, and then resold them as used cars to consumers. On this footing, article 8(2) of the Cars Order would not apply and the dealerships were accountable for VAT on the full second-hand sale price.

Role of the Upper Tribunal

Lord Carnwath added observations on the Upper Tribunal’s enhanced jurisdiction under the Tribunals, Courts and Enforcement Act 2007. Where the Upper Tribunal finds an error of law, it may remake the decision and make its own findings of fact under section 12(4). As a specialist appellate tribunal, an important function is to develop structured guidance on central concepts such as ‘abuse of law’. The Court of Appeal had been wrong to focus principally on whether the Upper Tribunal had exceeded its proper appellate role; the correct task was to assess the merits of the Upper Tribunal’s reasoning on its own terms.

Implications

The decision is significant in clarifying how the EU principle of abuse of law applies to elaborate VAT avoidance schemes. Several important points emerge from the reasoning:

First, the abuse of law principle applies to provisions of national VAT legislation enacted to implement a Directive, even where particular provisions go beyond what the Directive strictly requires. The principle cannot be circumvented by identifying steps that rely on domestic, rather than EU, legislative choices.

Second, in cases of concurrent commercial and fiscal purposes, the inquiry must focus on whether the commercial objectives explain the particular contractual features producing the tax advantage. A tribunal that identifies general commercial purposes without analysing the specific artificial features risks falling into legal error.

Third, the choice of an offshore counterparty or the selection of a tax-efficient jurisdiction is not in itself abusive; what matters is whether the structure used to involve that counterparty is artificial.

Fourth, Lord Carnwath’s observations reinforce the role of the Upper Tribunal as a specialist body capable of remaking decisions and giving authoritative guidance on principles of general application. The distinction between law and fact is often unproductive in such contexts.

The decision matters particularly to advisers designing or reviewing VAT-driven structures, to HMRC in challenging such schemes, and to the tribunals tasked with applying the Halifax tests. It illustrates the limits placed by EU law on taxpayer choice, particularly where multi-step arrangements engineer a result inconsistent with the purpose of relieving provisions such as the margin scheme.

Verdict: Appeal allowed. The KPMG scheme constituted an abuse of law under both limbs of the Halifax test. The transactions were to be redefined so as to strip out the artificial intermediary entities, with the dealership companies accountable for VAT on the full second-hand sale price.

Source: Revenue and Customs v Pendragon plc & Ors [2015] UKSC 37