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To cap it all ...

18 April 2007 / Graham Brearley
Issue: 4104 / Categories: Comment & Analysis , VAT
The three-year cap on VAT claims is causing problems 11 years on since it was introduced. GRAHAM BREARLEY explores a recent leading case on the subject.

Key points * The Marks & Spencer teacakes case has been referred to the ECJ again. * Is policy surrounding the zero rate governed solely by domestic law? * The zero rate must be operated in accordance with the Sixth Directive. * How the term 'taxable transaction' affects the zero rate.

IT IS ALMOST 11 years since the Government introduced the so-called 'three-year cap' on a taxpayer's ability to reclaim overpaid VAT. The leading case, Marks & Spencer plc v CCE [2005] STC 1254, has recently been re-referred back to the European Court of Justice for further clarification and it is therefore likely to be some considerable time before the matter is finally resolved.
In its initial judgment in the case, and in full agreement with the Advocate General's opinion, the European Court of Justice ruled that:

'While national legislation reducing the period within which repayment of sums collected in breach of Community law may be sought is not incompatible with the principle of effectiveness, it is subject to the condition not only that the new limitation period is reasonable but also that the new legislation includes transitional arrangements allowing an adequate period after the enactment of the legislation for lodging the claims for repayment which persons were entitled to submit under the original legislation. Such transitional arrangements are necessary where the immediate application to those claims of a limitation period shorter than that which was previously in force would have the effect of retroactively depriving some individuals of their right to repayment, or of allowing them too short a period for asserting that right.'

This led to the court to conclude that:

'Accordingly, legislation such as that at issue in the main proceedings, the retroactive effect of which deprives individuals of any possibility of exercising a right which they previously enjoyed with regard to repayment of VAT collected in breach of provisions of the Sixth Directive with direct effect must be held to be incompatible with the principle of effectiveness.'

Definitive ruling

It seems to me that this ruling is about as definitive as it can be. In very simple terms, the judgment means that the UK's retrospective application of the limitation period offends the Community principle of effectiveness because it sought to prevent a taxpayer from exercising rights he enjoyed under the preceding law. It seems equally clear that the statute which sought to introduce the measure into UK law, i.e. FA 1997, s 47 which amended VATA 1994, s 80(4), contained no such transitional arrangements.
Although subject to appeals to the House of Lords, subsequent cases, Fleming t/a Bodycraft v CCE [2006] STC 864 and Conde Nast Publications  v CCE [2006] STC 1721, heard at the Court of Appeal have also established that, in the absence of any written words within the body of the statute, the court cannot, through adopting the principle of conforming interpretation, imply a transitional arrangement either.
As a consequence, provided that VAT has been collected in breach of a directly effective provision of the Sixth Directive, it seems quite clear that the measure introducing the cap into UK domestic law was and continues to be defective. If the UK wishes to correct that defect, it must re-enact the legislation in a way which complies with the principle of effectiveness, that is, it must take effect from a current date and must contain statutory provision for a reasonable and prospective transitional arrangement.

The teacakes claim

As far as the M&S case is concerned, one of the questions which remains to be resolved is the question of whether VAT has been collected in breach of a directly effective provision of the Sixth Directive. It had been thought that this question had already been resolved by the European Court of Justice in its original 2002 judgment especially in light of the Advocate General's opinion when he said:

'It is manifestly clear from the documents before the court that, in regard to both teacakes and gift vouchers after August 1992, the Commissioners applied national tax legislation in a manner inconsistent with the directive.'

However, in an unanimous judgment despite this clear wording, in view of the fact that the first Court of Appeal's question to the European Court of Justice did not even raise the teacakes issue, and, as it was not specifically referred to in the court's full judgment either, the House of Lords has decided that the matter is unclear and has, therefore, reluctantly decided to refer a number of further questions to the court. It has taken well over a year for the questions to be formulated and agreed by the parties and, at the time of writing, the European Court of Justice has not yet listed the case for a hearing. It may well be 2009 before the matter is settled.
Of the questions referred, the House of Lords' first question is crucial to Marks & Spencer. Quite simply, it asks the ECJ to rule on whether a trader has a directly enforceable Community law right to be taxed at the zero rate in circumstances where, as in the UK, the Member State has maintained in its domestic VAT legislation an exemption with refund for certain supplies.
Leaving aside the separate arguments relating to unjust enrichment (which is the subject matter of other referred questions), if the answer to that question is 'yes', it seems clear that, in relation to the teacakes claim, the cap cannot be effective. If the answer is 'no', there is no breach of a directly effective provision of the Sixth Directive and, as a result, no community law rights have been breached and the cap is effective.

The arguments

Customs argue that the imposition of a VAT zero rate is a matter governed solely by domestic law and that, as such, there is no directly enforceable Community law right. On the face of it, Lord Hoffmann agrees. He says quite clearly that, in his judgment, 'the UK has chosen as a matter of domestic law, to exercise this power [to impose a zero rate]. But does this mean that Marks & Spencer has a Community right to be zero rated? I should have thought not'.
Marks & Spencer contend that by virtue of Article 12(1) of the Sixth Directive, the rate in force at the time of the chargeable event, and thus the rate determined in accordance with the directive and not domestic law, was the zero rate. In relation to this contention, Lord Hoffmann said:

'I do not accept this submission. Article 12(1) is concerned with timing, not with the rate which may be charged. In any case, Article 12(1) can have no application to transactions on which no tax is imposed, whether they are exempt in the narrower UK sense or zero rated, that is to say, exempt with refund of tax previously paid.'

Lord Hoffmann cited Ideal Tourisme SA V Belgium (C-36/99) [2001] STC 1386 as the authority for that view but, with respect, that case had nothing to do with determining the applicable rate. The case concerned the interpretation of Article 12(3) (not Article 12(1)) and examined the matter of whether the Belgian state's application of exemption to supplies of international air transport and its application of a rate of 6% to international coach transport contravened the community principles of equal treatment and non-discrimination. The ECJ found that in accordance with Article 28(3)(b), the Belgian state was entitled to continue to apply exemptions which were provided for in their legislation before the entry into force of the Sixth Directive. However, in terms of coach transport, the Belgian state was entitled to limit the exemption (which it had clearly chosen to do). In essence, exemptions can be withdrawn, but not introduced or re-introduced after having been withdrawn.

Not a question of entitlement

Lord Hoffmann seems to have missed the point here. Marks & Spencer has nothing to do with whether the UK is entitled to retain the exemption, as it clearly is, but it is to do with whether the imposition of a rate of tax to a particular transaction by a Member State exercising a discretion allowed by Community law, confers a Community law right on the taxpayer to be taxed at that rate. Marks & Spencer is not arguing that the UK's application of zero rating to supplies of teacakes is incorrect, but that by having chosen to zero rate supplies of food and, having chosen to maintain that rate (by virtue of Article 28(2)(a)), Article 12(1) must then determine that that rate is applicable to the particular transactions, i.e. the applicable rate must be that in force at the time of the transaction.
By comparison, Article 12(3) also provides a discretion to Member States to fix the standard rate of VAT provided that this is not below 15%. If a Member State chooses to impose a standard rate of 17.5%, that is a matter of domestic law. Once the standard rate is fixed in the Member State, it seems clear that if a Member State were to then impose a different rate from that in force, this would constitute a breach of Article 12(1).
Similarly, Lord Hoffmann's suggestion, that Article 12(1) is only concerned with timing and not with the rate which may be charged, is puzzling. Article 12 of the Directive falls under Title IX which is clearly entitled 'Rates'. Article 12(1) states that 'the rate applicable to taxable transactions shall be that in force at the time of the chargeable event'. Other provisions of the directive, notably Article 10, are concerned with timing. In a sense, Title IX would better describe the articles if it had been entitled 'Rate applicable to transactions'.

Zero rate at the UK's discretion

The UK's decision to maintain the zero rate (exemption with credit) was solely a matter for its discretion but, crucially, once it had exercised that discretion it must apply the rate it has chosen in strict compliance with the directive. In other words, provided the conditions laid down in Article 28(2)(a) were, and continue to be satisfied, the UK's decision to maintain exemption with refund is a matter of domestic law. However, having exercised that discretion, the UK is then bound by the directive and has no power to derogate from Article 12(1). In the great scheme of things, the only discretion available to the UK under domestic law in this regard is the discretion to maintain the zero rate. Everything else that follows must surely be in accordance with the directive.
Does this therefore create a directly enforceable right for the transactions in question to be taxed at the zero rate? On the face of it, Article 12(1) is unconditional, clear and precise such that the two tests in Becker v Finanzamt Munster-Immenstadt (Case 8/81) [1982] ECR 53 are both met. Marks & Spencer should therefore be reasonably confident that it can rely on Article 12(1) to determine the applicable rate to the sale of teacakes and, as a consequence, it must therefore have a directly enforceable Community law right and its claim for overpaid VAT must succeed (subject to the unjust enrichment arguments).

Taxable transactions

However, nothing is ever that easy and I have one nagging doubt on this point. This centres around the use of the expression 'taxable transactions' in the wording of Article 12(1). The article refers to 'the rate applicable to taxable transactions' (not to exempt transactions).
On the one hand, in the UK, zero-rated (exempt with credit) transactions are treated for VAT purposes as taxable transactions, albeit the rate of tax applied is zero. Indeed, when a UK business makes zero-rated supplies, these are included in its calculation of taxable turnover or income and a business becomes liable to register for UK VAT if its taxable turnover, including zero-rated turnover, exceeds the UK's VAT registration threshold.
On the other hand, the directive refers to transactions that are exempt from VAT albeit that some transactions are exempt with an entitlement to a refund of the tax paid at the preceding stage. Nowhere in the directive are such transactions ever referred to as taxable transactions; they are always referred to as exempt transactions.
Interestingly, the European Commission has made a distinction between transactions that are exempt with no right of recovery under the core provisions of Article 13, and exempt transactions that do carry a right of recovery. See European Commission v Federal Republic of Germany [1996] STC 843: 'exemptions, strictly interpreted, are not exemptions accompanied by reimbursement of the tax paid at the previous stage'. I am not suggesting that such a distinction carries any weight, but rather that, in the circumstances it is noteworthy that the distinction is made at all.
Whether the European Court of Justice will adopt the UK's definition of taxable transactions, which includes supplies that are exempt with credit, or prefer the directive's terminology, such that exempt transactions with credit for tax paid at the previous stage can never be termed taxable transactions, is of paramount importance not only to Marks & Spencer, but also to thousands of other potential claimants.
Whatever the outcome, it will have taken the best part of 12 years for the matter to be resolved. Even when the legal issues have been determined, if Customs lose the arguments, it is likely to take a further couple of years for them to make the necessary repayments.                   

11 years on …

In the days of the final throes of the last Tory Government, Ken Clarke assured the House of Commons during the 1996 Budget debate (Hansard, 3 December 1996, column 899) that, 'Lawyers may challenge the measures if they wish, but we are satisfied that we are within the law'. I am sure he never expected that the lawyers would still be challenging them in 2007.                                       
Graham C Brearley LLB (Hons) is senior VAT manager with Grant Thornton UK LLP. The views expressed in this article are the author's own and not necessarily the views of the firm.

Issue: 4104 / Categories: Comment & Analysis , VAT
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