Customs & Excise v Southern Primary Housing Ltd.

Lord Justice Jacob:

1. This appeal by the Commissioners of Customs and Excise (“CCE”), with the permission of Carnwath LJ, is from a decision of Sir Donald Rattee of 13^th February 2003. He dismissed CCE’s appeal from the decision of the VAT Tribunal of 7^th August 2002.

2. The primary facts are not in dispute and are clearly set out in paragraphs 2 and 3 of the Tribunal’s decision. I summarise. There were three transactions:

(i) A purchase by the taxpayer of some land. VAT was paid on the price. (This was because the vendor had opted to tax the property under para. 2 of Sched. 10 of the VAT Act 1994).

(ii) A sale by the taxpayer of the land to a housing association (HA). VAT was not paid on this sale because it was an exempt transaction.

(iii) A development contract between the taxpayer and the HA under which the taxpayer was to build housing for the HA on the land. In the course of carrying out the work the taxpayer of course had to buy materials and contract for building services.

3. The taxpayer, in the normal way, paid VAT on the goods and services it used to carry out the building contract. That VAT is undoubtedly input tax which is deductible against the output tax consisting of the VAT charged on the price of the development contract. But what about the VAT paid on the purchase of the land? Is that recoverable against the building contract output tax? That is the question on this appeal.

4. The three transactions were commercially connected. The Tribunal described the relationship this way:

“5. In summary there was a conditional contract for the purchase of the land by the Appellant entered into on 11 February, and a conditional contract for the sale of the land entered into on 14 April, both conditional on planning permission. The condition in both contracts was waived once it became clear that planning permission would be granted and both were completed on 27 June. By the time of the land sale contract, the building contract works had been agreed down to the last detail and a letter of comfort written. While the building contract was signed later we find that there was a contract for the building work by 14 April; it is not unusual for building contracts to be signed after the work commences. The facts which we regard as important are that the input transaction is an acquisition of land, and the output transaction is a single transaction comprising a sale of land plus building contract. This single transaction was carried out by two simultaneous contracts each specifying a separate price and each having different VAT results but none of this detracts from the fact that commercially they are a single transaction in the sense that neither party contemplated one occurring without the other.”

5. The taxpayer contended that because of the commercial connection between the transactions, the input tax it paid on the land purchase is recoverable. Both the Tribunal and the Judge accepted that contention. CCE say that is wrong. They also contend that the case of CCE v Wiggett Construction [2001] STC 1263, which is essentially on all fours with this case, was wrongly decided.

6. The question turns on the application of Art. 17 of the VAT 6^th Directive (77/388/EEC, amended by 91/680/EEC) to these facts. So far as is material this provides:

“1. The right to deduct shall arise at the time when the deductible tax becomes chargeable.

2. In so far as the goods and services are used for the purposes of his taxable transactions, the taxable person shall be entitled to deduct from the tax which he is liable to pay:

(a) valued added tax due or paid within the territory of the country in respect of goods or services supplied or to be supplied to him by another taxable person;

5. As regards goods and services to be used by a taxable person both for transactions covered by paragraphs 2 and 3 in respect of which value added tax is deductible, and for transactions in respect of which valued added tax is not deductible, only such proportion of the valued added tax shall be deductible as is attributable to the former transactions”.

7. Also relevant is Art.2 of the First Directive (67/227/EEC):

“On each transaction, VAT, ….., shall be chargeable after deduction of the amount of VAT borne directly by the various cost components.”

8. It is common ground that a supply of land is, for the purposes of the present case, a supply of “goods” (see Art.5(3) of the 6^th Directive). Stated in the language of Art. 17(2) of that Directive the question is whether the land was “used for the purposes of the taxpayer’s taxable transaction”, namely the development contract.

9. The meaning of Art. 17(2) has been considered by the ECJ in three key cases, BLP Group v CCE Case C-4/94 [1995] STC 424, Midland Bank v CCE Case C-98/98 [2000] STC and Abbey National v CCE Case C-408/98 [20001] STC 297. I go to these cases before considering the problem here further.

10. In BLP the taxpayer company had paid input tax on the fees for professional services in connection with the sale of shares. The sale of the shares was itself an exempt transaction. The taxpayer wanted the money raised to pay off debts of its business. So, it argued, the professional services it had paid for were used for the purpose of its taxable transactions. The Court summarised the argument as follows:

“12. BLP considers that art 17(2)(a) of the Sixth Directive must be given a wide interpretation so as to include within its scope the VAT due or paid in respect of supplies of goods or services directly or indirectly linked to the taxable person’s taxable transactions, including exempt supplies of goods or services which are used for carrying out taxable transactions. In the present case, the services supplied in connection with the sale of the Berg shares were used for the purpose of raising the funds necessary for paying BLP’s debts, which derived precisely from the taxable transactions it had effected.”

11. The court records a further contention:

“Moreover, BLP submits that the services in question were used both for a transaction not giving the right to deduct, namely the sale of the shares, and for taxable transactions, namely those falling within the company’s objects. Art.19 of the Sixth Directive, on calculation of the proportion in the case of mixed transactions, therefore applies, and since the exempt transactions is an incidental financial transaction, in accordance with paragraph 2 of that article it should not be taken into consideration in calculating the proportion provided for in paragraph 1.”

12. The Court roundly rejected BLP’s case. It said:

“19. Paragraph 5 lays down the rules applicable to the right to deduct VAT where the VAT relates to goods or services used by the taxable person ‘both for transactions covered by paragraphs 2 and 3, in respect of which valued added tax is deductible, and for transaction in respect of which valued added tax is not deductible’. The use in that provision of the words ‘for transactions’ shows that to give the right to deduct under paragraph 2, the goods or services in question must have a direct and immediate link with the taxable transactions, and that the ultimate aim pursued by the taxable person is irrelevant in this respect.”

13. The “direct and immediate link with taxable transactions” is the test. The Court went on to say more:

“24. Moreover, if BLP’s interpretation were accepted, the authorities, when confronted with supplies which, as in the present case, are not objectively linked to taxable transactions, would have to carry out inquiries to determine the intention of the taxable person. Such an obligation would be contrary to the VAT system’s objectives of ensuring legal certainty and facilitating application of the tax by having regard, save in exceptional cases, to the objective character of the transaction in question.

14. The Court dealt with the problem of general overheads as follows:

“25. It is true that an undertaking whose activity is subject to VAT is entitled to deduct the tax on the services supplied by accountants or legal advisers for the taxable person’s taxable transactions and that if BLP had decided to take out a bank loan for the purpose of meeting the same requirements, it would have been entitled to deduct the VAT on the accountant’s services required for that purpose. However, that is a consequence of the fact that those services, whose costs form part of the undertaking’s overheads and hence of the cost components of the products, are used by the taxable person for taxable transactions.”

15. It added in part of the next paragraph:

“The principle of the neutrality of VAT, as defined in the case law of the court, does not have the scope attributed to it by BLP. That the common system of VAT ensures that all economic activities, whatever their purpose or results, are taxed in a wholly neutral way, presupposes that those activities are themselves subject to VAT.”

16. I turn to the next case, Midland Bank. The taxpayer had spent a great deal of money by way of lawyers’ fees in defending a claim of negligence said to have caused loss in connection with a takeover of one of the bank’s clients. Was the whole of the input tax on the lawyers’ fees attributable to the bank’s supply of services to the client in connection with the takeover? There was no doubt that part of the input tax would be deductible as a general overhead, but the bank wanted the lot. The Court held it could not have it.

17. The Court dealt with two questions. The first of these was:

“1. Is it necessary to establish a direct and immediate link between a particular input obtainable by a taxable person acting as such and a particular transaction or transactions made by that person in order to: (a) establish the existence of an entitlement to deduct tax charged in respect of the input; and (b) determine the extent of that entitlement?

18. In response the Court re-affirmed the BLP “direct and immediate link” test (para. 20). It added:

“22. However, as the court has also held, entitlement to deduct, once it has arisen, is retained even if the economic activity envisaged does not give rise to taxed transactions or the taxable person has been unable to use the goods or services which gave rise to a deduction in the context of taxable transactions by reason of circumstances beyond his control (see Intercommunale voor Zeewaterontzilting (in liq) v Belgium (Case C-110/94) [1996] STC 569 at 579, [1996] ECR I-857 at 877, paras 20 and 21 and Belgium v Ghent Coal Terminal NV (Case C-37/95 [1998] STC 260 at 273, [1998] ECR I-1 at 25, para 24).

23. It is clear from that case law, as an exception and in specific circumstances, the right to deduct exists even if a direct and immediate link between a particular input transaction and an output transaction or transactions giving rise to the right to deduct cannot be established.

24. The answer to the first question must therefore be that art 2 of the First Directive and art 17(2), (3) and (5) of the Sixth Directive must be interpreted as meaning that, in principle, the existence of a direct and immediate link between a particular input transaction and a particular output transaction or transactions giving rise to entitlement to deduct is necessary before the taxable person is entitled to deduct input VAT and in order to determine the extent of such entitlement.”

So the answer to questions 1(a) and 1(b) was “yes.”

19. The second question in Midland was:

“2. If the answer to (1)(a) or (b) is in the affirmative, what is the nature of the direct and immediate link and, in particular, in the case of a taxable person making both transactions in respect of which VAT is deductible and transactions in respect of which it is not: (a) is the test for determining the amount of input tax that is deductible any different as between art 17(2), (3) and (5) (and, if so, in which respects is it different); and (b) is such a person entitled to deduct all the input tax charged in respect of an input on the ground that the input was utilised as a consequence of making a transaction falling within arts 17(2) or (3), in particular art 17(3)(c)?”

20. The Court began by saying:

“25. In so far as the national court seeks, in the first part of the second question, clarification of the nature of the ‘direct and immediate link’, the Midland, the United Kingdom government and the Commission rightly agree that it would not be realistic to attempt to be more specific in that regard. In view of the diversity of commercial and professional transactions, it is impossible to give a more appropriate reply as to the method of determining in every case the necessary relationship which must exist between the input and output transactions in order for input VAT to become deductible. It is for the national courts to apply the ‘direct and immediate link’ test to the facts of each case before them and to take account of all the circumstances surrounding the transactions at issue.

26. So far as concerns question 2(a), the Midland, the United Kingdom government and the Commission also agree that a taxable person who makes transactions in respect of which VAT is deductible and transactions in respect of which it is not may nevertheless deduct the VAT charged on the goods or services acquired by him, provided that such goods or services have a direct and immediate link with the output transactions in respect of which VAT is deductible, without it being necessary to take into account art 17(2), (3) or (5) of the Sixth Directive. If that were not so, essentially identical facts would lead to different outcomes according to the provision governing the transactions carried out by the taxable person.”

21. The Court then referred to “the fundamental principle” that “VAT applies to each transaction by way of production or distribution after deduction of the VAT directly borne by the various cost components” (para. 29). It added, after referring to BLP again:

“the right to deduct the VAT charged on … goods or services presupposes that the expenditure incurred in obtaining them was part of the cost components of the taxable transactions. Such expenditure must therefore be part of the costs of the output transactions which utilise the goods and services acquired. That is why those cost components must generally have arisen before the taxable person carried out the taxable transactions to which they relate” (para. 30).

22. It then went on to deal with the taxpayer’s argument:

“31. It follows that, contrary to what the Midland claims, there is in general no direct and immediate link in the sense intended in BLP Group, between an output transaction and services used by a taxable person as a consequence of and following completion of the said transaction. Although the expenditure incurred in order to obtain the aforementioned services is the consequence of the output transaction, the fact remains that it is not generally part of the cost components of the output transaction, which art 2 of the First Directive none the less requires. Such services do not therefore have any direct and immediate link with the output transaction. On the other hand, the costs of those services are part of the taxable person’s general costs and are, as such, components of the price of an undertaking’s products. Such services therefore do have a direct and immediate link with the taxable person’s business as a whole, so that the right to deduct VAT falls within art 17(5) of the Sixth Directive and the VAT is, according to that provision, deductible only in part.

32. It could only be otherwise if the taxable person were able to prove that, exceptionally, the costs relating to the goods or services which he has utilised as a consequence of making a deductible transaction are part of the cost components of that transaction.”

23. Abbey National was another case about the input tax on professional fees. The taxpayer had sold a business of business leasing of premises. No VAT was payable on the sale because it was a transfer of a going concern. The dispute was whether the whole of the VAT on the professional fees incurred in connection with the sale or only an appropriate proportion could be deducted, the fees being treated as a general overhead. The taxpayer lost. Advocate General Jacobs said this at para.35

“The reference to cost components in BLP is a reminder of the basic principle set out in art 2 of the First Directive: ‘On each transaction, value added tax … shall be chargeable after deduction of the amount of value added tax borne directly by the various cost components.’ Thus, what matters is whether the taxed input is a cost component of a taxable output, not whether the most closely-linked transaction is itself taxable. As the Commission submitted at the hearing, the conclusion to be drawn from BLP Group plc v Customs and Excise Comrs is that the question to be asked is not what is the transaction with which the cost component has the most direct and immediate link but whether there is a sufficiently direct and immediate link with a taxable economic activity. Indeed, it may be stressed that in that case the court was concerned with supplies which were not objectively linked to taxable transactions (see [1995] STC 424 at 437, [1995] ECR I-983 at 1010, para 24). Nevertheless, it remains clear from BLP that the ‘chain-breaking effect’ which is an inherent feature of an exempt transaction will always prevent VAT incurred on supplies used for such a transaction from being deductible from VAT to be paid on a subsequent output supply of which the exempt transaction forms a cost component. The need for a ‘direct and immediate link’ thus does not refer exclusively to the very next link in the chain but serves to exclude situations where the chain has been broken by an exempt supply.”

24. And the Court said at para.33:

“First, it is clear from art 17(2) of the Sixth Directive that a taxable person may deduct only the VAT on the goods and services used for the purposes of his own taxable transactions. Second, in any event, the amount of VAT paid by the transfer on the costs incurred for the services acquired in order to carry out a transfer of a totality of assets or part thereof does not directly burden the various cost components of the transferee’s taxable transactions, as required by art 2 of the First Directive. Those costs do not form part of the costs of the output transactions which use the goods and services acquired.”

25. I now turn to the reasoning of the Tribunal and Sir Donald Rattee. The Tribunal reasoned thus (para.15):

“The Appellant never made a separate supply of land; it only made joint supplies of land and building services. Accordingly we consider that the land acquired was used for transactions in respect of which tax is both deductible and not deductible (in the words of the Sixth Directive) ….. There is a direct and immediate link to both transactions or supplies according to the objective character of the transaction which is the making of the two simultaneous supplies.”

The essence of this reasoning is to conflate all the transactions because of their commercial links.

26. Sir Donald Rattee took the same view. He said:

“As a matter of common sense, it seems to me impossible to conclude that the taxpayer did not use the land for the purpose of providing the building services, when it was the very land on which the building was to take place.”

And later, after referring to para. 25 of Midland Bank:

“The Tribunal in the present case, and the Tribunal in Wiggett took the same view that, looked at objectively, the facts as a whole showed conclusively that the sale of the land and the building contract were part of one overall commercial transaction. That seems to me to be a conclusion of fact that they were well entitled to make. They applied the direct and immediate link and the cost component tests to that factual situation, as the court in the Midland Bank case told them to do.”

27. Mrs Melanie Hall QC for CCE attacks these conclusions. Logically her first hurdle must be whether the “direct and immediate link with taxable transactions” test is purely one of fact and so not subject to appeal. Mr Barlow, for the taxpayer, contends that it is, that the Tribunal has determined as a matter of fact that there is such a link and that is an end of the matter. He refers to paragraph 25 of Midland Bank, as did Sir Donald Rattee.

28. I do not think that can be correct. It is for the Tribunal to determine the primary facts (i.e. as to the commercial transactions). That it has done here, and no one quarrels with its findings – which are set out immaculately and concisely. Whether or not those facts amount to a “use” within the meaning of Art 17(2) as interpreted by the court is a question of law arising on those primary facts. Mrs Hall gets over her first hurdle.

29. Next she contends that Sir Donald Rattee accurately posed the right question:

“whether there is a direct and immediate link between the input of the acquisition of the land and the building contract according to the objective nature of the transaction, the aim of the parties being irrelevant, and whether the former is a cost component of the latter.”

But, she contends, he, like the Tribunal, then fell into error, indeed into five errors. They wrongly:

(a) focused on the taxpayer’s overall commercial aim;

(b) treated the two separate supplies as if they were one;

(c) asserted that the question whether two supplies are commercially linked is the same as the question whether inputs are attributable to either or both supplies;

(d) applied a test of attribution for which there is no authority – namely whether the input enabled the taxpayer to make a taxable supply;

(e) failed to appreciate that the taxpayer’s use of the land was exhausted on its sale and the land could not thereafter be attributed to construction works carried out thereafter.

30. Mr Barlow submits there is no error here. There is no illegitimate focussing on the overall commercial aim. Art 17(2) requires one to ask whether the land purchased was “used for the purposes” of the development contract. That is not looking at the overall commercial aim. The passage in BLP (para.24) was directed to a different point – BLP’s argument that it was raising the money from the share sale which it intended to use for taxable transactions. In the present case the intention to use the land for the purposes of the building contract was not just a future intention to use the land for taxable purposes, it was essential for those taxable purposes.

31. I think Mr Barlow is right about this. This case does not turn on the overall commercial aim point.

32. But there is substance in Mrs Hall’s remaining points (which, by and large) are different ways of looking at the same question. I particularly consider that point (d) is right. The land purchase transaction was commercially necessary to make its performance commercially possible, but it was not a cost component of the contract itself in the same way as the costs of materials used. There is a link with the contract but the link was not direct and immediate. The development contract would not have been made but for the associated land purchase and sale. But “but for” is not the test and does not equate to the “direct and immediate link” and “cost component” test.

33. One can look at it another way. There is nothing about the development contract as such which makes the land purchase and sale essential. If the housing association had already owned the land or had bought it from some third party, the inputs of the development contract would have been just the costs of carrying it out. The fact that there were commercially linked land transactions does not mean that those transactions are directly linked to the costs of the development contract. One would not say that the cost of buying the land was a cost of the development contract itself. It follows that the input tax on that cost is not a cost of the contract.

34. Other guidance from the ECJ supports that conclusion. Thus in BLP para. 26 the Court reaffirmed the principle of neutrality – namely that “all economic activities, whatever their purpose or results, are taxed in a wholly neutral way”. That principle would be violated if this development contract were taxed differently from an exactly similar “freestanding” contract.

35. Again if one applies the “fundamental principle” that “VAT applies to each transaction by way of production or distribution of deduction of the VAT directly borne by the various cost components” (Midland para 29) one is driven to ask whether the land purchase price is a cost component of the development contract – which to my mind it is obviously not. And, if one adapts Midland para.30 to the case the test is whether the expenditure on the land purchase was part of the costs of the development contract which used the land acquired. It did not. The carrying out of the development was on the land acquired, but did not utilise the land, whose ownership was irrelevant. My common sense differs in this respect from Sir Donald Rattee’s.

36. Midland para. 31 is also in point – there the Court said that lawyers’ fees were not “generally part of the costs of the output transaction” and “therefore” did not have any direct and immediate link with the output transaction.” Again the Court is focussing on the objective, transaction-by-transaction nature of VAT law. The price of a land purchase is not “generally” part of the costs of a development contract and therefore does not have any direct and immediate link with it.

37. Turning back to the Tribunal, it concluded that there was a direct and immediate link between the land purchase and both the land sale and development contract, with both an exempt and a non-exempt transaction. VAT law does not work in such a generalised way. You have to look at transactions individually, component transaction by component transaction. They may be linked in the sense that one would not have happened without the other, but they remain distinct transactions nonetheless. Only if one transaction is merely ancillary to a main transaction can one disregard the distinct nature of each transaction (see Card Protection Plan v CCE Case C-349/96) [1999] STC 270, para. 29). If that were not so, the principle of neutrality would be violated. Moreover there would be intractable problems as to which input was being attributed to which part of the “overall transaction”. You may find, as here, taxable and exempt transactions all mixed up in the same “overall” transaction – which is illegitimate.

38. I conclude that the appeal should be allowed. But I would not wish to go unmentioned the high quality of advocacy we received from both Mrs Hall and Mr Barlow.

Lord Justice Mantell:

39. I agree.

Master of the Rolls:

40. I also agree.