Tax planning: a landmark judgment by the European Court of Justice has provided welcome guidance on the legality of VAT avoidance schemes.

Traditionally, many people have considered tax to be marginal to management accounting, but the problem with this approach is that the cost of getting tax planning wrong can often wipe out your company's profits. There aren't many firms that can afford to lose an unbudgeted 17.5 per cent standard rate of VAT straight off the bottom line. Fortunately, a recent decision by the European Court of Justice in a case involving the Halifax bank offers hope for business in finding the right balance between tax planning and not overpaying tax.

Over the past few years UK companies have been plagued by uncertainty about the correct approach to VAT planning, with the costs measured not only in overpaid tax but also in lost business. Two extreme outside pressures in particular have made life difficult for them. First, highly engineered tax schemes, which are being sold by dedicated marketing teams, are increasing in number. The problem is that many of these are off-the-peg financial products, which aren't tailored to fit the individual client's needs. A firm might not only fail to achieve savings if its tax scheme goes wrong; it can end up losing money. Second, the newly merged HM Revenue & Customs (HMRC) has mounted an aggressive campaign against all tax planning.

With the Treasury under pressure as a result of ever-increasing government spending, HMRC has gone on to the offensive to increase its takings. One of its key tactics, according to some observers, has been to foster a climate of uncertainty about the legality of tax planning. The result has been seen as a form of extortion to scare businesses into passively overpaying tax simply to be sure that they're within the law. In its attempt to stop tax planning and thereby increase its revenue, HMRC developed a doctrine based on what it said was the principle against the abuse of rights granted by the European law on VAT. Its theory was that, because the avoidance of tax was supposedly against European law, then any planning scheme designed to achieve that would be illegal, with the effect that particular transactions could be unpicked by HMRC at the cost of the businesses directly involved.

HMRC's attack on VAT planning had a dragnet effect on businesses all along the supply chain, creating widespread uncertainty among them. This happened because, unlike a direct levy on a business's own profits--corporation tax, for example VAT--is an indirect transaction-based tax. Fundamentally, VAT is a tax on sales, for which individual businesses then have to account, with the output tax of the seller then becoming the input tax of the purchaser. Each link in the chain adds value until the full and final tax falls as an irrecoverable cost to the final consumer (or exempt business).

HMRC's aggressive approach was challenged in a VAT appeal by the Halifax. The particular case arose because the Halifax wanted to build four new call centres, on which, as a bank, it would normally have been able to recoup only about five per cent of the VAT paid on the construction costs. (Input tax can only be set against output tax and most of the Halifax's sales are exempt from VAT as financial services.) The bank used a tax scheme with associated companies and a set series of transactions by which it was able to get back all of the input VAT on the building costs. HMRC opposed this, using its "abuse of rights" theory to claim that the transactions didn't count for claiming back input VAT.

Because HMRC's theory was not clear, the case was referred by the UK courts to the European Court of Justice as the ultimate arbiter for interpreting European law--in particular, the sixth VAT directive and, through that, UK VAT law. Two other cases on the same issue, involving the University of Huddersfield and Bupa, were also referred to the court (see panel above). It made its judgment broadly on three issues: whether transactions could be excluded from VAT, what counted as an abusive tax practice and the tax consequences in the event of an abuse.

First, the court totally rejected HMRC's contention that certain transactions completely fell outside VAT. It held that the correct legal position was that supplies of goods or services did count for VAT, even where their sole aim was to obtain a tax advantage, since the definition of taxable transactions for VAT had to be given a uniform meaning across the whole of Europe. The court decided that economic activities such as those in these three cases were objective in character and their purpose did not matter. Providing that the transactions satisfied objective criteria, they counted for VAT purposes. The fact that they were conducted for the sole purpose of gaining a tax advantage was irrelevant.

After pausing to criticise the unsatisfactory state of British VAT law that had given rise to the cases, the court went on to define what it termed abusive practices. These were not normal commercial operations but ones purely intended to gain a tax advantage wrongfully. The court stressed that the need for certainty in the law had to be strictly observed (by HMRC) so that businesses could know exactly what their fiscal burden would be. It went out of its way to reject the HMRC approach by asserting the law that a business's choice between taxable or exempt transactions could be based on a range of factors, including the tax consequences. The court specifically stated that:

* "Where the taxable person chooses one of two transactions, the sixth directive does not require him to choose the one that involves paying the highest amount of VAT."

* "Taxpayers may choose to structure their business so as to limit their tax liability."

The court held that an abusive tax practice existed only if two conditions were fulfilled. The first was that the transaction in question would give a tax advantage that was contrary to the purpose of the legislation. To allow a trader to deduct all the input VAT when their normal operations would have allowed them to deduct only part of it would be contrary to the purpose of the relevant laws. The second condition was that it had to be objectively clear that the essential aim of the transactions in question was to obtain a tax advantage. Significantly, the court stated that an abuse would not arise where the economic activity in question might have some other explanation apart from the intention of gaining a tax advantage.

The court held that, in cases where an abusive practice was found to exist, the transactions entered into had to be examined to establish the situation that would have prevailed but for the abusive practice. HMRC could, therefore, claw back input tax deducted where there was an abusive practice, but the sting in the tail was that this also meant that it couldn't keep the related output tax.

HMRC is putting on a brave face about this and it's trying to use the Halifax case against business to maximise its tax take, claiming that virtually any tax planning is an abusive practice. But, whatever spin it tries to put on the situation, it's clear that the Halifax judgment is a landmark decision for the rights of business. Importantly for taxpayers, as a European case it sets a precedent that HMRC cannot easily avoid by trying to change UK law.

What the Halifax judgment does is helpfully establish reasonable ground rules for tax planning to ensure that a company pays the correct amount of tax due in law. That means not falling for the extremes of either paying too little through the use of abusive tax practices or paying too much as a result of aggressive tax extortion, both of which are wrong.

THE UNIVERSITY OF HUDDERSFIELD AND BUPA CASES

The University of Huddersfield case also involved building works and a scheme designed to recover most of the input VAT where ordinarily only a part would have been recoverable. The European Court of Justice held that these transactions counted for VAT, even if they had been conducted purely for tax planning purposes.

In Bupa's case there had been an attempt to get round an intended future change to the taw on VAT on drugs and prostheses used in its hospitals. Bupa had set up an arrangement with associated companies to make prepayments for drugs and prostheses. The plan was to have the prepayments count for VAT purposes under the old favourable tax treatment for six to seven years after the change in the law.

The European Court of Justice had no need to use the abusive practice doctrine, but struck the scheme out by holding that its generalised and flexible lump-sum prepayments were too uncertain in law to count under the old rules.

Eamon Mc Nicholas ACMA (eamon@ eamonmcnicholas.com) is a tax barrister at 3 Temple Gardens Tax Chambers, London EC4 9AU (020 7583 6264). The views expressed in this article are general and should not be used as advice in specific cases.