Abbey National PLC v The Commissioners of Customs and Excise [2003] UKVAT V18236 (17 July 2003)

[Home] [Databases] [World Law] [Multidatabase Search] [Help] [Feedback]

United Kingdom VAT & Duties Tribunals Decisions

You are here: BAILII >> Databases >> United Kingdom VAT & Duties Tribunals Decisions >> Abbey National PLC v The Commissioners of Customs and Excise [2003] UKVAT V18236 (17 July 2003)
URL: http://www.bailii.org/uk/cases/UKVAT/2003/V18236.html
Cite as: [2003] UKVAT V18236

[New search] [Printable RTF version] [Help]

18236

VAT bad debt relief – conditional sale agreement – allocation of instalment payments between goods and credit charge in the case of a mixed or composite supply – whether allocation made by terms of agreement – no – whether allocation to be made in accordance with taxpayer's accounting treatment – no – whether statutory method of apportionment contrary to Sixth VAT Directive and Community law – no – VAT Act 1994 section 36 – VAT Regulations 1995 regulations 170 and 170A – Sixth VAT Directive Article 11 C (1) – appeal dismissed

LONDON TRIBUNAL CENTRE

ABBEY NATIONAL PLC Appellant

- and -

THE COMMISSIONERS OF CUSTOMS AND EXCISE Respondents

Tribunal: Mr A E SADLER (Chairman)

Mr K C MANTERFIELD, FCA

Sitting in public in London 12, 13 and 14 May 2003

Dr David Southern of Counsel, instructed by the Corporate Solicitor of Abbey National plc, for the Appellant

Mr Kenneth Parker, QC and Mr Timothy Ward of Counsel, instructed by the Solicitor for the Customs & Excise, for the Respondents

DECISION

The appeal and the issues in summary

The appeal of Abbey National plc ("the Appellant") relates to a decision of the Commissioners contained in a letter dated 3 August 2000, in which the Commissioners stated their intention of raising an assessment for VAT of £91,439 for the Appellant's VAT quarterly accounting period ended 30 June 2000. By their letter dated 11 November 2002 the Commissioners reduced the assessment to £18,096, and it is this reduced assessment which is the subject of this appeal. We were informed that a second appeal, against a substantially larger sum assessed, and which turns on the same issue as this appeal, has been stood over pending our decision in this case.

The Appellant, as well as being the parent company of the well-known banking and financial services group, is the representative member of the VAT group which at all material times included its wholly-owned indirect subsidiary company, Wagon Finance Limited ("Wagon Finance"). The appeal relates entirely to the business of Wagon Finance and to transactions to which it was a party in the period 1 July 1995 to 31 December 1998. Throughout that period Wagon Finance carried on a business which consisted primarily of the provision of finance for the purchase of vehicles (for the most part motor-cars) by private individuals on credit terms, usually in the form of conditional sale agreements. Some of Wagon Finance's customers defaulted under their agreements, failing to pay all the instalments due, and giving rise to a bad debt for Wagon Finance. As described below, under the VAT treatment applicable to instalment credit finance transactions (where there is a taxable supply of goods and also an exempt supply of credit), such default gives rise to an entitlement for Wagon Finance (or, strictly, the Appellant) to claim bad debt relief for VAT purposes in respect of the VAT which it has paid to the Commissioners in relation to the supply of the goods but which it has failed to recover from the customer because the customer has so defaulted.

The issue between the parties in this appeal relates to the way in which, in these circumstances, and for the purposes of VAT, the aggregate amount received under a conditional sale agreement at the time of default should be allocated between the goods element and the credit element so as to determine the amount of VAT which (because it relates to the goods element) can be regarded as recovered from the customer and (in consequence) the balance which should be regarded as not so recovered by reason of the customer's default: it is this unrecovered balance for which the Appellant can make a claim from the Commissioners under the VAT bad debt relief provisions.

In summary, the Commissioners argue that there is specific legislation which applies to determine for VAT purposes, in these circumstances of a "mixed" supply of goods (taxable) and credit (exempt), the allocation of instalments received as between the goods element and the credit element and the consequent amount which (because it relates to the goods element) is to be treated as unrecovered VAT for which relief is available. (There is a complication in this appeal, explained below, in that the Commissioners have applied the legislation on a concessionary basis and the law has since been changed to reflect this concessionary basis.) The Appellant argues that such legislation (even as applied by concession) does not apply in its terms to Wagon Finance's circumstances, and that such legislation is in any event inconsistent with the over-riding terms of the Sixth Directive on VAT – instead the allocation for VAT purposes of instalments received as between the goods element and the credit element should be determined by reference to implicit terms in the relevant instalment credit finance agreements and the accounting entries which Wagon Finance is compelled by relevant accounting standards to make when it accounts for those instalments.

The Appellant argues that instalment payments received under the instalment credit finance agreements Wagon Finance enters into should be allocated between the goods element (principal or credit balance) and the credit element (interest or finance charge) on an amortisation, or sum of digits, basis where the constant rate of interest implicit in the agreement is applied to a reducing balance of principal so that the principal is reduced to zero at the end of the term of the agreement. The Commissioners argue that the relevant VAT legislation applies so that instalment payments received must be allocated between the goods element and the credit element by straight-line apportionment, each payment over the life of the agreement being so allocated in the proportions of the total cost of the goods and the total credit (interest element) cost.

If the allocation of instalments received as between goods and credit is made on the basis for which the Appellant contends, then at the point when the customer defaults less has been allocated to the goods element than is the case if the legislative system of allocation (for which the Commissioners contend) applies. The result is that the amount of VAT regarded as unrecovered by reason of the bad debt (and therefore eligible for VAT bad debt relief) is greater applying the Appellant's basis of allocation than is the case if the Commissioners' basis of allocation is applied – the difference between the two amounts of VAT regarded as unrecovered as a result of applying the different bases of allocation gives the amount which is assessed and against which the Appellant appeals.

The VAT context and legislation

As stated, Wagon Finance enters into transactions whereby it sells goods (mostly motor-cars) to its customers on instalment credit finance terms, usually by conditional sale agreements (the relevant terms of these agreements, and the relevant statutory framework which applies under the consumer credit legislation to most of the transactions entered into by Wagon Finance, is discussed below). The essence of the arrangement is that the car is sold on deferred payment terms, with Wagon Finance extending credit to the customer, and the total amount paid by the customer by instalment payments reflects both the price of the car and the credit which Wagon Finance has made available.

It is necessary to understand first the VAT treatment of a sale made on instalment credit finance terms. Such a sale is regarded for VAT purposes as a supply of goods (the car) and also a supply of services (the provision of credit). In the present case the supply of goods is a taxable supply at the standard rate and the supply of services is an exempt supply (if the car is second-hand, special rules may apply to determine the extent of the standard-rated supply, but nothing turns on that in this appeal). The conditional sale agreement will specify an amount which is the "total cash price of goods" (that is, the price which would be paid if the car were sold for immediate cash settlement of the price), and it is common ground that the VAT payable in respect of the sale of the car is fixed by reference to that amount. The balance of the amount paid under the conditional sale agreement (identified in the agreement as the "total charge for credit") is regarded for VAT purposes as the consideration given for the provision of credit for which no VAT is chargeable as it is an exempt supply of services.

When Wagon Finance sells a car under a conditional sale agreement it must charge the customer VAT on the supply of goods (by reference to the total cash price) and account to the Commissioners for that VAT. The VAT legislation relating to the time of supply requires Wagon Finance to account for the whole of that VAT when possession of the car passes to the customer – effectively this will be when the customer drives the car away having signed his conditional sale agreement and paid whatever deposit is required under that agreement. Wagon Finance is out of pocket at this point, since it must make immediate payment of all the VAT chargeable on the sale of the car, but it will receive payment for the car (including recovery of the VAT which it has already accounted for) by instalments over the lifetime of the conditional sale agreement.

If the conditional sale agreement runs its full course, all instalments will be paid, and Wagon Finance will recover all the VAT chargeable (and which it has accounted for) on the sale of the car. If, however, the customer defaults and Wagon Finance is unable to recover outstanding instalments, the VAT bad debt relief provisions take effect so that (in broad effect) Wagon Finance is able to reclaim from the Commissioners that portion of VAT it has accounted for on the sale of the car but which it has failed to recover from the customer because of his default.

The principle is clear, but the difficulty arises when (as with a conditional sale agreement or other form of sale on instalment credit finance terms) there is a "mixed" or "composite" supply, that is, a taxable supply alongside an exempt supply, and where payments made are consideration for both supplies. When the customer defaults, what amounts respectively are to be regarded as having been paid for the taxable supply on the one hand and for the exempt supply on the other?

The Sixth VAT Directive sets out the general rules which Member States are required to implement by domestic legislation. Article 11 A (1)(a) provides the general rule which governs the amount on which VAT is chargeable:-

The taxable amount shall be:

(a) in respect of supplies of goods and services other than those referred to in (b), (c) and (d) below, everything which constitutes the consideration which has been or is to be obtained by the supplier from the purchaser, the customer or a third party for such supplies including subsidies directly linked to the price of such supplies…

Article 11 C (1) deals with cases where adjustment is required to the taxable amount:-

In the case of cancellation, refusal or total or partial non-payment, or where the price is reduced after the supply takes place, the taxable amount shall be reduced accordingly under conditions which shall be determined by the member states.

However, in the case of total or partial non-payment, member states may derogate from this rule.

Thus it is a requirement of the Sixth Directive that the taxable amount must be reduced in the case of bad debts (that is, where there is "total or partial non-payment"), but subject to the right of a Member State to derogate from this rule.

The domestic legislation enacted by the UK to deal with bad debt relief is to be found in section 36 of the Value Added Tax Act 1994 and regulation 170 of the Value Added Tax Regulations SI 1995/2518. For the purposes of this appeal the relevant parts of the legislation are as follows:-

Bad debts

(1) Subsection (2) below applies where –

(a) a person has supplied goods or services and has accounted for an paid VAT on the supply,

(b) the whole or any part of the consideration for the supply has been written off in his accounts as a bad debt, and

(c) a period of 6 months (beginning with the date of the supply) has elapsed.

(2) Subject to the following provisions of this section and to regulations under it the person shall be entitled, on making a claim to the Commissioners, to a refund of the amount of VAT chargeable by reference to the outstanding amount.

(3) In subsection (2) above "the outstanding amount" means –

(a) if at the time of the claim no part of the consideration written off in the claimant's accounts as a bad debt has been received, an amount equal to the amount of the consideration so written off;

(b) if at that time any part of the consideration so written off has been received, an amount by which that part is exceeded by the amount of the consideration written off;

and in this subsection "received" means received either by the claimant or by a person to whom has been assigned a right to receive the whole or any part of the consideration written off.

…

(5) Regulations under this section may –

…

(f) include such supplementary, incidental, consequential or transitional provisions as appear to the Commissioners to be necessary or expedient for the purposes of this section;

…

(6) The provisions which may be included in regulations by virtue of subsection (5)(f) above may include rules for ascertaining –

(a) whether, when and to what extent consideration is to be taken to have been written off in accounts as a bad debt;

(b) whether anything received is to be taken as received by way of consideration for a particular supply;

(c) whether, and to what extent, anything received is to be taken as received by way of consideration written off in accounts as a bad debt.

….

Regulation 170 (Attribution of payments) of the VAT Regulations 1995 is as follows:-

170 - (1)Where –

(a) the claimant made more than one supply (whether taxable or otherwise) to the purchaser, and

(b) a payment is received in relation to those supplies,

the payment shall be attributed to each such supply in accordance with the rules set out in paragraphs (2) and (3) below.

(2) The payment shall be attributed to the supply which is the earliest in time and, if not wholly attributed to that supply, thereafter to supplies in the order of the dates on which they were made, except that attribution under this paragraph shall not be made to any supply if the payment was allocated to that supply by the purchaser at the time of payment and the consideration for that supply was paid in full.

(3) Where –

(a) the earliest supply and other supplies to which the whole of the payment could be attributed under this regulation occur on one day, or

(b) the supplies to which the balance of the payment could be attributed under this regulation occur on one day,

the payment shall be attributed to those supplies by multiplying, for each such supply, the payment received by a fraction of which the numerator is the outstanding consideration for that supply and the denominator is the total outstanding consideration for those supplies.

For reasons which will become apparent, it is also helpful to set out the provisions of regulation 170A of the Value Added Tax Regulations. Regulation 170A has effect from 1 January 2003, and therefore is not in its terms applicable to this appeal. Regulation 170 is, as from 1 January 2003, subject to regulation 170A:

170A – (1) Where-

(a) the claimant made a supply of goods and, in connection with that supply, a supply of credit;

(b) those supplies were made under a hire purchase, conditional sale or credit sale agreement; and

(c) a payment is received in relation to those supplies (other than a payment of an amount upon which interest is not charged),

the payment shall be attributed to each supply in accordance with the rules set out in paragraph (2) below.

(2) The payment shall be attributed –

(a) as to the amount obtained by multiplying it by the fraction A/B to the supply of credit; and

(b) as to the balance, to the supply of goods,

where –

A is the total of the interest on the credit provided under the agreement under which the supplies are made (determined as at the date of the making of the agreement); and

B is the total amount payable under the agreement, less any amount upon which interest is not charged.

(3) Where an agreement provides for variation of the rate of interest after the date of the making of the agreement then, for the purposes of the calculation in paragraph (2) above, it shall be assumed that the rate is not varied.

It will be seen that the scheme of the UK legislation is as follows:-

1 Section 36 entitles the taxpayer to claim a refund of VAT which has been paid on a supply of goods or services where the whole or part of the consideration for the supply has been written off in the taxpayer's accounts as a bad debt.

2 The refund is to be calculated by reference to the "outstanding amount": that is the amount written off as a bad debt (less the amount (if any) which, although written off, has been received).

3 Where, as in the case of the Appellant, the person claiming bad debt relief has made more than one supply to the defaulting purchaser (in this case, a taxable supply and an exempt supply) and there has been some payment in relation to those supplies, there has to be attribution of the payment received to each supply.

4 The general attribution rule is that payments are attributed in time order, that is, first to the supply which is the earliest in time, and after that has been treated as paid for in full, the balance of the payments (if there is such a balance) is attributed to the next in time supply, and so on. This "first in time" attribution is displaced where the purchaser has allocated the payment to a particular supply and the consideration for that supply was paid in full.

5 If the various supplies to which the payment could be attributed occur on the same day, the payment is attributed to each supply on a straight-line apportionment basis by reference to the outstanding consideration for the supply as a proportion of the total outstanding consideration for all supplies.

6 Where regulation 170A applies (that is, in the case of conditional sale agreements and other instalment credit finance arrangements), the straight-line apportionment applies regardless of whether the exempt and taxable supplies are first made on the same day. The straight-line apportionment is made by reference to the proportion of the total credit charge at the outset of the agreement to the total amount payable under the agreement (less any amount on which interest is not charged, such as an initial deposit).

In the case of conditional sale agreements these provisions can work in a particular way (which, the Commissioners were prepared to concede when introducing the concession referred to below, might produce an unfair result): as mentioned, in the case of such agreements there is a taxable supply of the goods and an exempt supply of credit, so that payments made must be attributed to those respective supplies. Under the VAT rules relating to the time of supply of goods and services (not in dispute in this appeal), in the case of the supply of goods, the time of supply is the date when possession of the goods passes to the purchaser (or when the VAT invoice is issued, if earlier); in the case of the supply of the services (the credit), since the credit is supplied over the period of the agreement, there is a separate and successive supply each time a payment is received, and the supply is treated as taking place only to the extent covered by the payment. Since, therefore, the taxable supply of goods takes place before any supply of credit takes place (and not on the same day), the Commissioners have previously proceeded on the basis that regulation 170(2) applies, so that payments are attributed first to the supply of goods, and only after payment in full for the goods can any balance be attributed to the exempt supply of credit, with a consequent reduction in (or perhaps elimination of) the amount outstanding for which VAT bad debt relief can be claimed in respect of the supply of the goods. The initial decision of the Commissioners against which the Appellant appealed applied regulation 170(2), to this effect.

In December 2001 the Commissioners announced that, as a matter of concession, regulation 170(2) would no longer be applied in the case of supplies under hire-purchase or conditional sale agreements: instead, taxpayers were given the right to allocate payments between the goods and the credit supplies by applying the straight-line apportionment as provided in regulation 170(3), notwithstanding that the supply of goods and the supply of credit did not occur on the same day according to the time of supply rules. The initial decision of the Commissioners in relation to the Appellant was amended so as to apply regulation 170(3) to the circumstances of the Appellant in this concessionary way. This significantly improved the position for the Appellant by reducing the amount paid by the defaulting purchaser which fell to be allocated to the taxable supply of goods, and consequently increasing the amount for which VAT bad debt relief could be claimed in respect of the supply of the goods. Nevertheless, the Appellant argued that a different method of allocation should apply, based on the contractual terms and the accounting treatment of payments received, which increased still further the amount qualifying for VAT bad debt relief. The Appellant therefore continued its appeal.

New provisions were introduced with effect from 1 January 2003 as regulation 170A which puts on a statutory footing the straight-line apportionment concessionary treatment extended by the Commissioners to suppliers of goods under instalment credit finance agreements.

In this appeal the Commissioners were prepared to argue their case by reference to the concession they had announced (with a straight-line method of allocating payments received between the credit and the goods in the proportions of the total cost of credit (interest element) and the total cost of the goods, following regulation 170(3) and foreshadowing regulation 170A), rather than relying on the application of regulation 170(2), which was the basis of the initial decision giving rise to the appeal. Whilst it is convenient to characterise the approach of the Commissioners to the key issue of allocation of payments as being the "statutory formula" (as opposed to the "accounts/contracts formula" for which the Appellant contends), that approach as it relates to the circumstances of this appeal is concessionary.

Evidence and findings of fact

For the Appellant we heard evidence from Mr. K. W. Horlock, and Ms D.E. Roberts from Wagon Finance, and Dr. R. Barnes who appeared as an expert witness for the Appellant. For the Commissioners we had evidence in the witness statement of Mr. P. J. Leung and the witness statement of Mr. P. Hannick, both officers of the Commissioners.

Mr. Horlock was actively engaged in the management of the business of Wagon Finance during the period relevant to the appeal. His evidence related to the nature of that business and the instalment credit finance agreements which it entered into with its customers. We were shown examples of conditional sale agreements entered into by Wagon Finance. We find the following facts from Mr. Horlock's evidence (from his witness statement and from his cross-examination by Mr. Parker for the Commissioners and from the sample agreements referred to by Mr. Horlock):-

1 Wagon Finance specialises in the provision of finance for the purchase of new and second-hand cars and motorcycles. It raises its funds for its business solely by borrowing from its parent company, paying interest on the borrowed funds, and entering into financing transactions with its customers on a basis intended to result in a specified net percentage return on the credit advanced to those customers and an overall specified return on shareholder funds invested in the business.

2 Wagon Finance provides finance to customers exclusively by means of conditional sale agreements. A customer approaches, say, a car dealer wishing to purchase a car and requiring finance to make that purchase. If Wagon Finance agrees to finance the purchase of the car, Wagon Finance purchases the car from the dealer for the price which the customer has agreed to pay for the car (less any deposit paid by the customer), and immediately resells the car to the customer on the terms of a conditional sale agreement. Wagon Finance makes no profit from the purchase and re-sale of the car as such – its profit is made from the provision of the finance extended to the customer over the life of the conditional sale agreement. Wagon Finance pays the car dealer a commission for the business introduced.

3 The terms of the conditional sale agreement require the customer to pay fixed amount instalments (usually monthly) over the period of the agreement, and on payment of the final instalment the title to the car is transferred from Wagon Finance to the customer.

4 Most, but not all, of the conditional sale agreements which Wagon Finance enters into are "regulated agreements" within the terms of the Consumer Credit Act 1974. The terms of the agreements must therefore comply with the detailed legislation in and derived from this Act, which regulates all the material terms of conditional sale agreements. In Wagon Finance's practice, the form of conditional sale agreements used for car sales which (because the price exceeds the statutory maximum) are outside the consumer credit legislation will nevertheless follow in all material respects the form of the "regulated agreements".

5 Regulated agreements must specify the total cash price of the car (part of which may be paid by initial deposit or part exchange); the amount of credit provided (in effect the credit extended by Wagon Finance for the total cash price of the car less any deposit); the total charge for credit (i.e. the aggregate amount of "interest" over the life of the agreement); the total amount payable by instalments (the amount of credit plus the total charge for credit); the number of instalments and their frequency; and the amount of each instalment. The agreement must also state the "annual percentage rate of charge" ("APR"), which is the total charge for credit expressed as an annualised percentage interest rate applied to the amount of credit provided – the implicit annual rate of interest paid by the customer on the credit advanced to him by Wagon Finance over the life of the agreement.

6 Wagon Finance enters into three broad types of conditional sale agreement: full repayment contracts (where the total amount payable is repaid by a fixed number of equal instalments); dealer subsidy contracts (where, again the total amount is repaid by a fixed number of equal instalments, but the total charge for credit under the agreement is a reduced amount (with a consequent reduction in the APR) because the car dealer (by way of sales promotion) is prepared to meet part of the cost of credit by making a subsidy payment to Wagon Finance at the outset of the agreement); and personal contract plans (where the final instalment is a "balloon" payment of a substantial amount reflecting the anticipated residual value of the car at the end of the agreement period – all prior instalments are reduced accordingly). A personal contract plan may be combined with a dealer subsidy contract.

7 In the case of regulated agreements, the consumer credit legislation gives certain statutory rights to a customer and these must be specified in the terms of the conditional sale agreement. These rights limit the entitlement of Wagon Finance to repossess cars on default by a purchaser. The purchaser may also terminate the agreement without further liability if he has paid (or pays on termination) half the total instalments and returns the car. Subject to these statutory rights, if a purchaser wishes to terminate the agreement and retain the car, or if a purchaser defaults in performance of his contractual terms, he is required to pay the balance of unpaid instalments (less the trade value of the car as reduced by sale costs if it is recovered by Wagon Finance), but Wagon Finance is then required to give a rebate of credit charges calculated by a statutory formula (so that, where the credit is repayable by equal instalments at equal intervals, as in full repayment contracts, the rebate is calculated by the "rule of 78" (sum of digits) formula, as referred to below).

8 The conditional sale agreements entered into by Wagon Finance do not specify how each instalment is allocated between a charge for the credit provided (or an interest charge) and the repayment of the credit provided (or principal repayment). It is possible to calculate such an allocation by reference to the APR stated in the agreement. A customer has no right to require such a calculation to be made. In the case of the "personal contract plan" agreements, it is not specified that the final "balloon" instalment is to be allocated to repayment of the credit. Again, it is possible to calculate such an allocation by reference to the other instalments and the APR. A customer has no right to require such a calculation to be made.

9 The losses which give rise to the claim for VAT bad debt relief in this appeal are losses which arise when a customer fails to meet his contractual obligations and, notwithstanding any action which Wagon Finance takes to recover outstanding instalments or to repossess (and, if successful, to resell) the car, Wagon Finance is unable to recover the full amount due to it.

As mentioned, Mr. Horlock in giving his evidence referred us to sample conditional sale agreements entered into by Wagon Finance. The key financial provisions of those agreements are mentioned above. For the sake of completeness we set out the remaining terms of those agreements which may be relevant in this appeal:-

1 Each agreement sets out on the frontsheet of the document the name and relevant details of the customer, and what is described as the "Financial and Goods Details", namely the description of the vehicle, the cash price of the goods, the amount of the deposit, the total amount of credit extended, the total interest charge (which, together with an administration fee gives the total charge for credit), the payable balance by instalments (being the total amount of credit extended plus the total charge for credit), the total amount payable (being the payable balance plus deposit), the APR, the number of monthly instalments and the date of the first instalment (one month after the date of the agreement), and the amount of each instalment.

2 There is a separate statement of the "Wagon Payment Protection Plan" – this is a form of insurance cover provided by a third party for payment of the instalments in the event of death, disability or redundancy of the customer (the detailed terms are not relevant): the amount of the premium is extended as credit by Wagon Finance to the customer, who pays the amount (plus credit charge) by instalments on the same occasion as he pays instalments for the vehicle. The agreement states the amount of the insurance premium, the total charge for credit, the total amount payable, the APR (which may not be the same as for the instalment payment arrangements for the vehicle), and the number, frequency and amount of the instalments.

3 There is a statement of the customer's "total monthly instalments", which is the aggregate of the monthly instalment amounts payable for the vehicle and for the insurance cover. It is provided in the agreement (Cl. 17) that payments received from the customer shall be applied proportionally between the conditional sale and the insurance loan parts of the agreement subject to the Consumer Credit Act 1974.

4 The agreement also sets out on the frontsheet the statutory rights relating to termination. They are expressed in the following terms:

REPOSSESSION: YOUR RIGHTS

If you fail to keep to your side of this agreement but you have paid at least one third of the total amount payable under this agreement, that is £[ ], we may not take back the goods against your wishes unless we get a court order…If we do take them back without your consent or a court order, you have the right to get back all the money you have paid under the agreement.

TERMINATION: YOUR RIGHTS

You have a right to end this agreement. If you wish to do so, you should write to the person authorised to receive your payments. We will then be entitled to the return of the goods and to half the total amount payable under this agreement, that is £[ ]. If you have already paid at least this amount plus any overdue instalments, you will not have to pay any more, provided you have taken reasonable care of the goods.

5 The agreement is expressed to be a conditional sale agreement between the customer and Wagon Finance. Wagon Finance agrees to sell and the customer agrees to purchase the goods on the terms set out in the agreement (including the frontsheet).

6 Cl. 1 of the Conditional Sale Terms requires the customer to pay the instalments specified in the frontsheet; to pay interest on overdue instalments and other sums due at the specified APR; and to maintain, insure, retain possession of the goods, etc.

7 Cl. 2 provides that property in the goods will pass to the customer when the customer has paid all the instalments and other sums due under the agreement.

8 Cl. 3 gives Wagon Finance the right to end the agreement and take the goods on the happening of any of the specified events of default (including the customer's failure to pay any instalment on is due date; any breach of any of the terms of the agreement; death or insolvency of the customer). Cl 4 is in the following terms:-

"If this Agreement is ended under Clause 3 above you [the customer] shall pay to us [Wagon Finance]:

all instalments in arrears at that time plus interest under Clause 1.2 above; plus

the total of the instalments which would have fallen due after ending the Agreement if it had not ended at that time, less

the trade value of the goods if recovered by us, less the costs of sale

We will give you any rebate of credit charges under the [Consumer Credit] Act upon receiving full payment from you."

9 There are corresponding default and termination provisions in relation to the payment of instalments for the insurance cover.

10 Separately, there is a statement headed "YOUR RIGHTS" which includes the following:

"The Consumer Credit Act 1994 covers this agreement and lays down certain requirements for your protection which must be satisfied when the agreement is made. If they are not, we cannot enforce the agreement against you without a court order.

The Act also gives you a number of rights. You have a right to settle this agreement at any time by giving notice in writing and paying off all amounts payable under the agreement which may be reduced by a rebate…."

11 The final sheet of the agreement includes the "Supplier's Declaration to Wagon Finance Limited". By this the supplier (the car dealer) offers to sell Wagon Finance the goods described in the frontsheet of the agreement at the total cash price to enable Wagon Finance to enter into the agreement with the customer. The supplier gives certain warranties to Wagon Finance as to the ownership, insurance, recorded mileage etc of the vehicle, and confirms that the agreement was completed and signed by the customer on the supplier's trade premises.

12 In the case of agreements which are "personal contract plans" (with a "balloon" payment as the final instalment), the instalment details on the frontsheet separately specify the amount of the final instalment, but in all other respects the terms of the agreement are identical to those where all the instalments are equal in amount.

Dr. Barnes is Assistant Professor of Accounting at London Business School. He has degrees in Mathematics and Finance and a PhD in Accounting. He is a member of the Institute of Chartered Accountants in England and Wales. He gave evidence as to the appropriate method of allocating the finance charge payable under a hire-purchase contract or a conditional sale agreement over the term of the contract. He also gave evidence as to the requirements of the relevant accounting standards on the subject of allocating finance charges payable under such contracts. His evidence, as it related to the matters on which he was expert, was not challenged by the Commissioners, and we therefore accept it. It was as follows:-

1 In the case of a conditional sale agreement there are three recognised methods for allocating the finance charge accruing over the contract period between the accounting periods which fall within the contract period. These methods equally apply to allocate or identify the finance charge within each instalment payment (effectively treating each instalment period, monthly or whatever, as a separate accounting period). These methods, and their consequences, can be illustrated by a simple example of a finance company selling a car on hire-purchase or conditional sale terms to a customer, where the total cash price of the car is £19,000, and the customer pays an initial deposit of £1,000 followed by 36 monthly instalment payments of £600 each. Thus the amount of credit provided is £18,000, the total amount payable by instalments is 36 x £600 = £21,600, and the total charge for credit is £21,600 - £18,000 = £3,600.

2 The simplest allocation method is the straight-line method. The total charge for credit is divided by the number of instalments to determine the finance charge attributable to each monthly instalment. Thus £3,600 is divided by 36, giving £100 which, out of each instalment of £600, is the finance charge/interest element (the remaining £500 being a repayment of credit/principal). This gives a constant finance charge amount for each instalment, notwithstanding that the outstanding amount of credit/principal is reducing by £500 month by month. In consequence, with these figures, the effective rate of interest in month 1 is 0.56%, whereas in month 36 the effective rate of interest has increased to 20%. The amount of finance charge/interest for any month is therefore not directly and proportionately related to the outstanding balance of credit/principal for that month. Put differently, the straight-line method of allocating the finance charge does not result in a constant implicit interest rate (or rate of return) applied to the reducing balance of outstanding credit/principal as the instalments are paid month by month. In this respect it has the advantage of simplicity, but in economic terms it produces a result which is far from reasonable.

3 By contrast, the actuarial method takes as its premise the requirement that, for each month, the amount of the finance/interest charge must be directly and proportionately related to the outstanding balance of credit/principal for that month. That is achieved by using a constant rate of interest applied to the outstanding balance of credit/principal for any month, which gives the amount of the finance charge for that month (the balance of the monthly instalment being the amount treated as repaying the credit/principal). In the simple example above, a monthly rate of interest of 1.0207% is the constant rate (referred to as the implicit interest rate in the agreement) which, applied in relation to 36 instalment payments of £600 each, reduces the credit/principal amount to zero on the final monthly payment whilst giving an aggregate finance charge over the period of the contract of £3,600. Applying this method, in month 1 the amount of finance charge/interest is £18,000 (outstanding credit balance) x 1.0207% = £183.73, and the balance of the monthly instalment £(600 – 183.73) = £416.27 is allocated to repayment of credit/principal. Therefore the outstanding credit balance for month 2 is £(18,000 – 416.27) = £17,583.73. The constant interest rate of 1.0207% applied to this balance gives a finance charge for month 2 of £179.49, and the balance of the £600 instalment is treated as a further reduction in the outstanding credit balance. In this way, in each successive monthly instalment, the finance charge element reduces and the credit repayment element increases. By month 36 the final instalment of £600 is allocated at to £593.94 to credit repayment (reducing the credit balance to zero) and as to £6.06 (1.0207% of £593.94) to finance charge (giving an aggregate finance charge over the 36 months of £3,600). In the context of a conditional sale agreement which is a regulated agreement, the APR which must be stated in accordance with the requirements of the consumer credit legislation is the implicit interest rate determined by applying the actuarial method of allocation to the instalment terms of the agreement (the monthly rate of 1.0207% in the example, when annualised, would give the APR for that agreement).

4 The "rule of 78" (or "sum of the digits") method of allocation is best described as an approximation of the (mathematically complex but precise) actuarial method. It has the same objective of allocating the finance charge/interest element on a basis which ensures a direct and proportionate link between the outstanding credit balance at each month and the amount of the finance charge for that month. It works by first calculating the "sum of the digits", so that in a conditional sale agreement with 36 monthly instalments the sum of the digits is 1 + 2 + …. + 36 = 666. The amount of the finance charge within the instalment in month 1 is 36/666ths of the total finance charge over the life of the contract (i.e. in the example above, 36/666ths of £3,600 = £194.59), and the balance of the instalment, £(600 – 194.59) = £405.41, is treated as reducing the outstanding credit balance); in month 2 the finance charge is 35/666ths of the total finance charge (£189.19), and so on until month 36, where the finance charge is 1/666ths of the total finance charge (£5.41). In this ways the total finance charge is allocated over the lifetime of the contract in a proportionate calculation, but the method is inexact and gives an effective interest rate which is not constant (in the example used, the monthly implicit rate in month 1 is 1.08%, reducing to 0.91% in month 36). The rule of 78 method is a commercially acceptable alternative to the actuarial method, but in some circumstances it can yield significantly different results from the mathematically correct actuarial method, and in those circumstances where the differences are material in their particular context the actuarial method should be used to allocate finance charges over the life of the agreement.

5 The relevant UK accounting standard, Statement of Standard Accounting Practice 21, Accounting for Leases and Hire Purchase Contracts, requires that "the total gross earnings under a finance lease [and by extension, also a hire-purchase or a conditional sale agreement] should normally be allocated to accounting periods to give a constant periodic rate of return to the lessor's net cash investment in the lease in each period": para. 39. International and US accounting standards impose similar requirements. Thus in order to comply with accounting standards a company which sells goods on conditional sale terms must apply the actuarial method, or the rule of 78 method if that does not produce a materially different result, to determine in its accounts for each accounting period during the currency of the conditional sale agreement the finance charge to be allocated to the respective accounting periods.

Ms Roberts is an Associate of the Institute of Chartered Accountants in England and Wales, and at the relevant times was the Financial Controller of Wagon Finance, with responsibility for drawing up its management and statutory accounts. Her evidence related to the accounting treatment by Wagon Finance of the conditional sale agreements. She also produced a financial analysis of sample conditional sale agreements. We find the following facts from Ms Roberts's evidence (from her witness statement and from her cross-examination by Mr. Parker for the Commissioners, from the statutory accounts of Wagon Finance to which Ms Roberts referred in her evidence, and from her financial analysis of the sample agreements):-

1 For the relevant years the statutory accounts of Wagon Finance have been prepared on a consistent basis, and accepted by the auditors of the company without any qualifications.

2 To comply with the relevant accounting standards, Wagon Finance was required to record in its statutory accounts all income earned in an accounting period and expenditure incurred in earning that income matched to the same period. Wagon Finance complied with this requirement in the case of fixed rate conditional sale agreements (that is, all its retail finance business) by using the rule of 78 method to allocate the finance charge over the duration of the agreement. The finance charge so treated as earned in an accounting period goes into the profit and loss account for that period. The portion of the instalment payment which is allocated to the repayment of credit/principal reduces the loan asset in the balance sheet in the accounts.

3 Use of the rule of 78 is standard throughout the consumer finance sector to allocate the finance charge income over the lifetime of fixed rate conditional sale agreements, and also for calculating the amount of rebate paid to customers on early termination of their agreements, in accordance with the consumer credit legislation. It is accepted that the rule of 78 method is not as precise as the actuarial method, giving a stepped series of finance charge receipts, rather than an exact constant rate of return, but it affords a close approximation to the actuarial method and is an easier basis of calculation.

4 A straight-line apportionment method applied to ascertain the finance charge earned by Wagon Finance from an agreement in any accounting period would not have effect to match the finance charge received with the expenditure incurred (i.e. the interest paid by Wagon Finance on its borrowings) in that accounting period to earn the finance charge income. Relative to interest expenditure incurred on borrowings, the straight-line method produces losses in the early period of the agreement (when, in relation to credit outstanding, the finance charge is low), and profits in the later period (when, in relation to the reduced balance of credit outstanding, the finance charge is high). If the statutory accounts for the relevant years had been drawn up using the straight-line apportionment to determine the finance charge accruing in an accounting period it is likely that the accounts would have been qualified by the auditors as not complying with the applicable accounting standards and not therefore giving a true and fair view of Wagon Finance's financial state or performance.

5 When a customer defaults and a bad debt arises, that bad debt will comprise two elements: (a) the balance of the price of the vehicle (the amount of credit outstanding); and (b) the finance charge (interest) outstanding. Wagon Finance has a bad debt procedure for monitoring and making provision for the default. Once the procedures for recovery of the debt are concluded, and the amount of the bad debt quantified, the capital element of the unrecovered balance is charged to the profit and loss account as a deduction for accounting purposes, and the balance of finance charge outstanding is deducted from future interest receivable and no further credits for finance charge are recognised in the profit and loss account.

6 Under the consumer credit legislation, a customer purchasing goods under a regulated agreement has the right to terminate early his conditional sale agreement. Subject to certain statutory rights, he is then required to pay the balance of instalments due whereupon he is paid a rebate, calculated (by reference to the APR specified in the agreement) on a statutory formula basis (the formula is derived from the rule of 78 in the case of fixed-rate agreements). The purpose of the rebate is to readjust the aggregate amount of the finance charge so that it properly relates to the actual (i.e. reduced) period over which credit has been extended – the monthly instalments will have been calculated at the outset on the basis that the credit is to be extended on a reducing balance basis over the full term of the agreement.

7 In the case of "dealer subsidy" agreements, no reference is made to the "dealer subsidy" arrangement in the conditional sale agreement, nor is the customer necessarily aware of the subsidy, although its effect is, of course, reflected in the instalments payable and the (reduced) APR stated in the agreement. The "dealer subsidy" received by Wagon Finance may be netted off against the commission which Wagon Finance pays the dealer for introducing the customer.

8 In the case of "personal contract plans", the terms of the conditional sale agreement do not allocate the "balloon" payment as a payment for the car, or in reduction of the outstanding credit balance: the payment is simply expressed as the final instalment payment.

9 By reference to the sample conditional sale agreements produced in evidence, if the rule of 78 method (as against the straight-line method) is used to allocate each instalment payment as between the finance charge/interest element and the credit repayment/principal element, the outstanding balance of credit/principal (representing the cost of the car) reduces more slowly by applying the rule of 78 method. This is so for each type of agreement, but is less so in the case of "dealer subsidy" agreements (where the dealer subsidy reduces the amount of finance charge paid over the life of the agreement by the customer) and also in the case of "balloon" payments under "personal contract plans", where the bulk of the credit repayment/principal is not discharged until the final "balloon" instalment.

10 It follows that, on default giving rise to a bad debt, since the outstanding balance of credit/principal (representing the unpaid purchase price of the car) reduces more quickly where the straight-line method of allocation is used than is the case where the rule of 78 method of allocation is applied, the bad debt attributable to the unpaid purchase price of the car is less where the straight-line method of allocation is used than is the case where the rule of 78 method of allocation is used.

11 By reference to the sample agreements and tables produced as part of the evidence of Ms Roberts:-

(a) In the case of a "standard" conditional sale agreement, where the capital/amount of credit provided was £2,000, the total charge for credit was £787.84, the APR was 25.6% and the agreement required the customer to pay 36 monthly instalments of £77.44 (disregarding the payment protection insurance instalments), at the time of default by the customer (month 22), the capital balance applying the rule of 78 was £959.95, and the capital balance applying the straight-line apportionment was £777.78;

(b) In the case of a "dealer subsidy" conditional sale agreement, where the capital/amount of credit provided was £3,332, the total charge for credit was £354.40, the APR was 6.8%, and the agreement required the customer to pay 36 monthly instalments of £102.40, at the time of the default by the customer (month 2), the capital balance applying the rule of 78 was £3,258.76, and the capital balance applying the straight-line apportionment was £3,239.44. Had the agreement run until month 22, the capital balance applying the rule of 78 would have been £1,282.77, and £1,203.12 applying the straight-line apportionment;

(c) In the case of a "personal contract plan" conditional sale agreement (i.e. with a "balloon" payment as the final instalment), where the capital/amount of credit provided was £10,324.21, the total charge for credit was £2,936.75, the APR was 9.9%, and the agreement required the customer to pay 47 monthly instalments of £178.77 and a final instalment of £4,680, at the time of the default by the customer (month 12), the capital balance applying the rule of 78 was £9,452.56, and the capital balance applying the straight-line apportionment was £8,654.17 (using the re-computed figures supplied by the Commissioners at the hearing).

The evidence of the Customs & Excise officers related to the processes of the appeal (in the case of Mr. Leung, a tax specialist officer assigned to the Appellant) and (in the case of Mr. Hannick, a Senior Policy Advisor working in the Supply of Goods Policy Team), an outline of the relevant legislation and the change in policy on the part of the Commissioners leading to the concession applied to the Appellant in relation to regulation 170 and the enactment of regulation 170A. Their evidence was not challenged by the Appellant. No findings of fact are required from their evidence, and the policy of the Commissioners as stated by Mr. Hannick is as referred to in paragraphs 16 to 18 above.

The Appellant's case

Dr. Southern summarised the Appellant's case in two basic propositions: (1) the Appellant should be entitled to VAT bad debt relief to the extent of the actual VAT it fails to recover on the default of the customer; and (2) in the case of a conditional sale agreement and any similar form of instalment credit finance agreement, the amount of actual VAT which it fails to recover must be worked out by allocating instalment payments made up to the time of default between finance charge and outstanding credit on the basis that the customer is paying a finance charge calculated at a constant rate implicit in the instalment payment terms of the agreement and expressed as the APR in that agreement. He argued that these propositions are commercially and rationally correct and are also correct as a statement of the position in law. He argued that this approach is in accordance with Community law, and that domestic law should be interpreted to be consistent with and to give effect to Community law.

The Appellant's principal submission is that in the case of each conditional sale agreement there is, by the terms of that agreement, an allocation of part of each instalment payment to the finance charge with the balance of the instalment payment allocated to (and thereby reducing) the outstanding balance of capital or credit extended. Since there is such an allocation by the terms of the agreement, that resolves the point, and the actual allocation should not be displaced by the provisions in regulation 170 of the Value Added Tax Regulations 1995 which introduce a different basis of allocation (the straight-line method). At the most, the "statutory" basis of allocation provided for in regulation 170 (as applied by concession in this appeal) should apply only in cases where the contractual terms make no provision for allocating payments between finance charge and outstanding credit and where, accordingly, the amount received in payment for the goods (and in consequence, the amount still to be paid which has become the bad debt) cannot be ascertained from the agreement between the parties.

The key to understanding the allocation of instalment payments lies in the APR which must be stated in each contract regulated by the consumer credit legislation. The APR is both the cause and the consequence of the instalment payment structure: the provider of credit finance decides upon the basis on which he requires the credit he has extended to be repaid and the return he requires from his investment over the life of the agreement and these factors determine the instalment payment structure. The instalment payments imply an interest rate which is expressed in the agreement as the APR. In turn the APR (by applying the actuarial method or an approximation of it, the rule of 78) fixes the amount of the instalment payment allocated to the finance charge for the purposes of the accounts of the provider of the finance, leaving the balance of the instalment payment allocated to the outstanding balance of credit extended. The instalment payment structure in the agreement necessarily entails the fixing of the APR, and the APR necessarily applies to allocate the instalment payments between finance charge and credit outstanding.

This is consistent with the early termination rights provided for in the consumer credit legislation, where the customer decides to pay the balance of instalments and retain the goods, or where the customer defaults: on payment of the balance of the instalments due under the agreement there is a right to a rebate calculated by the relevant statutory formula: where the agreement provides for equal instalments at equal intervals the formula is the rule of 78, which is applied to adjust the finance charge as explained by Ms Roberts in her evidence: see The Consumer Credit (Rebate on Early Settlement) Regulations 1983.

Wagon Finance, as the person making the supplies, is therefore able to determine from the terms of the agreement the allocation of each payment between finance charge and reduction of credit. It needs to do so in order to draw up its statutory accounts in a way which complies with accounting standards so that the accounts comply with legal requirements without qualification. Its accounting systems and records allow this to be done for every individual agreement. Therefore it would be inconsistent with the terms of the agreements themselves, with the necessary accounting entries and with commercial reality to argue that there is no allocation of instalment payments is this way.

Dr. Southern argued that the history of the regulation of credit transactions demonstrates that Parliament has consistently looked at the structure of payments within the contract terms when it comes to defining or specifying interest rates. Thus the Moneylenders Act 1927 provides for a straight-line method of apportionment to calculate the annual percentage rate of interest from payments made under the moneylender contract where the contract itself does not specify the interest rate. More recently, and to meet criticisms of the straight-line method, the concept of APR has developed, and that is now set out in the Consumer Credit (Total Charge for Credit) Regulations 1980 (as amended): the formulae are complex, but essentially the rate is determined as the annual rate which results in the instalment payments under the contract (adjusted to net present value) being equal to the net present value of all credit under the contract.

This legislative approach of working from the structure of contractual payments is consistent with the approach taken by the accountants, as is clear from the evidence of Dr. Barnes: the accounting treatment required under SSAP 21 in the case of a finance lease (and, by extension, in the case of a conditional sale agreement) requires the calculation of the rate of interest implicit in the lease from the amounts which the lessor expects to receive and retain under the terms of the lease: see para. 24 of SSAP 21. This constant rate of interest must then be applied to apportion payments under the lease between the finance charge and a reduction in the balance of outstanding credit in order to allocate the total finance charge to individual accounting periods during the term of the lease: see para. 35 of SSAP 21.

The legislative approach and the accountancy approach work from the premise of a constant rate of return implicit from the amount and pattern of instalment payments under the agreement. That is achieved only by an allocation of payments applying the actuarial method (or the rule of 78 as a convenient approximation). The straight-line method of allocation does not achieve this, since it results in an interest rate, as the credit balance reduces over the period of the agreement, which is in inverse proportion to the declining credit balance – a result which, according to the evidence of Dr. Barnes, is far from reasonable in economic terms as well as unacceptable for accountancy purposes.

Dr. Southern's second principal submission followed on from this: he argued that the relevant principles of VAT to be found in the VAT Directives and in European Community law require that VAT bad debt relief is available to the taxpayer on a basis which is commercially reasonable and consistent with accounting treatment. If Wagon Finance is entitled to calculate its VAT bad debt relief on the basis of the contractual terms and the consequent accounting entries, that is an application of section 36(3) VATA 1994, and no difficulty arises. But if the Commissioners argue that Wagon Finance must apply the straight-line statutory method in regulation 170 to calculate its bad debt relief, then the Appellant contends that the UK domestic legislation is not in accordance with the Directives and Community law, and therefore does not apply.

Three basic elements in the VAT system are relevant. First there is a principle of neutrality in applying the VAT system: for the taxpayer who is not the final consumer the input tax paid can be set against the output tax charged. Secondly, the VAT system operates on an accounts basis, not a cash basis. This accounts basis is found in Article 11 A (1)(a) of the Sixth Directive, in the words: "The taxable amount shall be…everything which constitutes the consideration which has been or is to be obtained by the supplier from the purchaser…." Thirdly, VAT is, in the jurisprudential terms of European Community law, a subjective tax, that is, it is the consideration payable under the actual contractual arrangements entered into by the parties which governs the amount of tax chargeable, and only in limited and specified circumstances can the taxing authority substitute alternative, objective, consideration: see Naturally Yours Cosmetics Ltd v C&E Comrs (Case 230/87) [1988] STC 879; Empire Stores Ltd v C&E Comrs (Case C – 33/93) [1994] STC 623; BP Supergas Anonimos v Greece (Case C – 62/93) [1995] ECR I-1883 (at para.35, I – 1918); and C&E Comrs v Bugeja [2000] STC 1 and [2001] STC 1568 (CA).

The neutrality principle and the accounts basis are important in understanding the scheme of VAT bad debt relief as it applies to the credit instalment finance business carried on by Wagon Finance. Under the accounts basis, as required by Article 11 A (1) the supplier accounts for VAT on the sale of the goods notwithstanding that at that time the supplier has not received the cash payment for the goods or recovered the VAT chargeable on the sale. But neutrality is achieved by Article 11 C (1) of the Sixth Directive, which may be regarded as the mirror image of Article 11 A (1)(a). Article 11 C (1) (as applicable to the Appellant's case) provides: "In the case of…partial non-payment…the taxable amount shall be reduced accordingly under conditions which shall be determined by the member states. However, in the case of…partial non-payment, member states may derogate from this rule." If Article 11 C (1) is seen in its proper relationship to Article 11 A (1), any reduction in the taxable amount (by way of bad debt relief) must be made by reference to the same figures and the same accounting basis which applied when the tax was charged and accounted for at the time of supply.

Article 11 C (1) requires that the taxable amount should be reduced, in the case of bad debts, under "conditions" which the individual member states determine in the domestic legislation giving effect to this part of the Directive. There is, however, a limit placed on the scope of such "conditions": they cannot be such as will alter the basic rules imposed by the Article, but must relate only to matters of administration, evidence or procedure. In particular they cannot have effect so as to substitute a different taxable amount from that required by the Directive: Skatteministeriet v Henrikesn (Case 173/88) [1990] STC 768; EEC v Germany (Case C-427/98) [2003] STC 301.

The essence of the Commissioners' case is that whilst VAT has to be accounted for on an accounts basis when the conditional sale agreement is entered into, when there is default, and it comes to the question of quantifying the VAT which should be repaid (because, as a result of the bad debt, it has not been recovered from the customer), a formula must be applied which is arbitrary and does not related to the figures appearing in the taxpayer's accounts. The VAT treatment for which the Commissioners contend is assymetrical and cannot be justified on policy grounds. It is inconsistent with the accounts basis of VAT and is contrary to the neutrality principle.

Article 11 C (1) permits the member state to derogate from the general rule requiring relief from bad debts in the case of partial non-payment. The Commissioners do not assert that they are using the right of derogation to justify their insistence on applying the straight-line method, but the question arises whether that is the de facto position. However, the right to derogate is restricted by the principles of Community law. Thus the taxing authority cannot charge VAT in amounts exceeding the tax paid by the taxable person: Goldsmith's (Jewellers) Ltd v C&E Comrs (Case C-330/95) [1997] STC 1073. Further, there is an established principle of proportionality requiring the taxing authority to act (even where it is exercising its derogation rights) in a way which is the least detrimental to the essential principles and objectives of the tax laid down by the Community legislation: Garage Molenheide BVBA and others v Belgium (Case-286/94) [1998] STC 126; C R Smith Glaziers (Dunfermline) Ltd v C&E Comrs [2003] STC 419. This principle of proportionality is applied in the Advocate-General's opinion in Finanzamt Sulingen v Walter Sudholz (Case C-17/01) (the judgement of the Court has yet to be handed down), which is a case dealing with a formula basis for deduction of input tax in the German domestic VAT legislation, where the issue is whether the formula of a standard 50% deduction in the case of partial business use of a car is compatible with a right to derogate: the Advocate-General's opinion is that the proportionality principle requires that the standard formula deduction may be an appropriate fallback and as such is not invalid, but it should not be applied in circumstances where there is a more accurate way of calculating the amount of recoverable input tax. The Appellant's submission is that the application of the straight-line method of apportionment to VAT bad debt relief claims undermines the fundamental principles of VAT and is therefore a disproportionate limitation beyond the scope of any derogation right. At most it can be justified as a rule of thumb to be applied in circumstances where the amount of VAT bad debt relief cannot be quantified by some other method. It is the Appellant's case that it can show, in the case of each conditional sale agreement it enters into, the amount of VAT unrecovered from the customer whose default has caused the bad debt. That being so, even if the provisions of regulation 170 can be justified as a derogation from the Directive, they can be so justified only as a fallback formula, and cannot be applied where there is a more precise way of calculating the amount of the bad debt.

The Commissioners' case

Mr. Parker for the Commissioners argued a simpler case: the essence of his case is that the terms of the individual conditional sale agreements do not allocate instalment payments between the finance charge and the credit balance, and the accounting treatment adopted by Wagon Finance in relation to instalment payments is irrelevant to the issue. Accordingly it is appropriate for the Commissioners to apply a standard formula method for calculating bad debt relief – it has to do so because the matter is not resolved by the terms of the agreements. This is achieved by the provisions of regulation 170 (as applied in this case by concession) which in their terms implement the Sixth Directive in a manner consistent with its objectives and in a way which is reasonable and therefore not illegal under Community law. Those provisions are therefore within the powers of the Commissioners and must be applied to the Appellant to calculate its entitlement to VAT bad debt relief.

For the Commissioners the central issue in the case is whether or not there are terms in the individual conditional sale agreements which effectively allocate instalment payments between the finance charge element (the consideration for the exempt supply of services) and the credit balance element (the consideration for the taxable supply of goods). This appears to be accepted by the Appellant also as the key issue, although the Appellant introduces alongside it what is the different question of how it is required to treat the instalment payments in its books of account.

The problem in determining the amount of bad debt relief arises from the supply, in the same transaction and under the same agreement, of two different things, the goods and the credit. If there is simply a supply of goods in a transaction, it will be clear from the contract and its execution how much has been paid, and how much is unpaid as a bad debt. There is no need in such a case for special allocation methods to quantify for VAT purposes the amount of the bad debt. In the case of composite supplies, the starting point is the same: see what the parties have contributed by way of consideration (see the Bugeja case, above) by analysing the contract terms to find what is supplied for what consideration. If the contract terms do not yield up an answer there has to be a legislative solution. This is the approach of the Sixth Directive, and it is applied domestically by section 36 VATA 1994 and regulation 170.

The Commissioners' submission is that the individual conditional sale agreements do not make an allocation of instalment payments. They specify the cash price, the amount of the deposit, the amount of credit, the aggregate amount payable in instalments with the interval of instalments and the amount of each instalment. The agreements also contain specific early termination provisions which, in summary, and subject to certain statutory rights in the case of the agreements regulated by the consumer credit legislation, require the customer to pay in full all future instalments due and outstanding at termination, but with the customer receiving back a rebate calculated in a particular way.

The early termination provisions are a key factor in the analysis of the agreements. The case of Forward Trust Ltd v Whymark [1990] 2 QB 670 analyses the nature of the agreement between the parties when there is early termination of an instalment credit finance agreement regulated by the consumer credit legislation. The issue was whether the finance house was entitled to judgement for an amount equal to all outstanding instalments at the time of termination (on breach of the agreement) as reduced by the amount of the rebate; or whether the finance house was entitled to judgement for an amount equal to all outstanding instalments at that time, with the customer having the right to discharge that judgement in full by paying the net sum (i.e. the amount of the outstanding instalments less the amount of the rebate). The Court of Appeal held that the terms of the agreement, taking into account the statutory rebate provisions, were such that, at the time of his breach, there was due and owing by the defaulting customer the full amount of instalments then outstanding. Judgement should be entered for that full amount, but could be discharged by payment of the net amount after taking account of the rebate due to the customer.

This legal nature of the conditional sale agreement distinguishes it from a reducing balance loan, where each payment is allocated between interest and repayment of capital, and where, on early termination the parties can ascertain the amount of outstanding capital, and the borrower is simply required to pay off that amount. The Appellant has argued its case as though a conditional sale agreement regulated by the consumer credit legislation is simply a form of reducing balance loan, but the two forms of finance are fundamentally different. In the conditional sale agreement, as the Appellant's witnesses conceded, the customer cannot point to a provision in the agreement which specifies or allows him to calculate at any time the amount of the outstanding credit balance, nor can he, as of right, ask what that balance is: this is because his obligation is simply to pay all the instalments. Similarly, in the "dealer subsidy" contracts, the effect of this, and the allocation by Wagon Finance of the amount to payment of the finance charge, is not a term of the contract between Wagon Finance and the customer (although the terms of that contract reflect the effect of such allocation); neither, in the case of a "balloon" payment in a "personal contract plan", is the final instalment allocated in any way by the contractual terms as between the finance charge element and the credit balance element.

The Appellant places great reliance on the APR which must be specified in each contract, arguing that it is a term of the contract which gives rise to an implied allocation of each instalment between finance charge and credit balance. However, this is to mis-state the purpose and contractual effect of the statement of the APR. Its function is to tell the customer the true cost of the credit extended to him over the life of the agreement: it does not, and cannot, change the nature of the agreement itself. Further, Wagon Finance does not apply the APR for the purpose of allocating instalments between finance charge and credit balance: the APR is calculated from the instalment terms by the actuarial method, whereas Wagon Finance applies the rule of 78 (sum of digits) to determine, for its internal accounting records, the amount of finance charge received on each instalment payment and the consequent reduction in the credit balance. This consistently overstates the outstanding balance, as against the amount of that balance calculated by the application of the APR.

The Appellant also relies on the consumer credit rules which determine the amount of the rebate on early termination of a regulated agreement (the Consumer Credit (Rebate on Early Settlement) Regulations SI 1983/1562). However, these rules do not in themselves tell us how instalment payments made up to the point of early termination should be allocated between finance charge and credit balance – their purpose is to apply a method (using the rule of 78 in the case of equal instalment payments) to calculate a rebate on payment of all outstanding instalments so as to take account of the effect of early payments and bring the net position back to ensure that the specified APR has been applied in the circumstances of the transaction as now completed.

Therefore, in the Commissioners' submission, the contract terms do not provide for the way in which the parties have given consideration for the credit supply and the goods supply respectively. The accounts treatment of the instalment payments by Wagon Finance is a separate matter and in itself does not tell us what the contractual terms are as between the parties. Neither can the Appellant argue that it is necessary to view the arrangements only from the position of the supplier claiming the bad debt relief: it is necessary to look at the position of both parties, to ensure consistency of treatment, since the customer may be a trader who must know how his input tax is affected by the adjustment for bad debt relief.

Since the contracts entered into by Wagon Finance do not tell us how, in the case of the relevant composite supply, the consideration has been allocated to the two supplies by the parties, legislation must step in to provide a method, which will apply to both parties where relevant. Neither Article 11 C (1), nor any other provision in the Sixth Directive specifies rules for allocating payments for the purposes of VAT bad debt relief in the case of composite supplies, and so Member States enjoy a wide margin of discretion in establishing rules to deal with this situation. This discretion must, however, be exercised in a manner which does not contravene the general principles of EC law, and the rules adopted must implement the broad purpose of the Directive: Case 14/83 Von Colson and Kamann v Land Nordrhein Westfalen, para 15.

Taking the second point first, the discretion has been so exercised by the enactment of regulations 170 and 170A, and in this way the provisions of Article 11 C (1) have been implemented – the UK legislation is not an exercise of any right of derogation permitted by the Article. The Commissioners do not dissent from the propositions put forward by the Appellant from the cases cited in relation to the restraint on the exercise of the right to derogate, but they are not relevant in circumstances where the domestic legislation is enacted to fill a gap arising where the parties have not agreed between themselves how the consideration is allocated.

As to whether the UK legislation, as an exercise of discretion, contravenes Community law, this will be so only if it is so irrational as to be unreasonable. That is not the case here. What we have is a number of different methods for allocating instalment payments: the actuarial method; the rule of 78 (sum of digits) method; and the straight-line method. For accounting purposes the actuarial method may be the preferred method, according to the evidence of Dr. Barnes, (although in some situations the outcome, applying the three different methods, is not materially different) but that is not to say that the straight-line method is irrational or capricious – there is a logical link between the means chosen (the straight-line method) and the ends satisfied (ascertainment of an amount eligible for bad debt relief). It is a method which is obvious, simple to understand and easy to operate, so that any customer can calculate the result, and both finance house and customer have mirror-image treatment for VAT purposes.

For the purposes of VAT bad debt relief the provisions of regulation 170 (as applied to the Appellant in this case, effectively as though regulation 170A had been enacted) are therefore effective to deal with cases, such as this, where the parties themselves in their contract have not allocated the consideration between the two supplies.

The Decision

It is our decision that the Appellant's appeal should be dismissed. We agree with the Commissioners' submission that the terms of the conditional sale agreements entered into by Wagon Finance do not provide, expressly or impliedly, for an allocation of consideration by the parties to the two supplies made pursuant to that agreement. Accordingly, a legislative apportionment must be made to determine the amount which qualifies for VAT bad debt relief. Although the method chosen by the Commissioners to make such an apportionment is not the only method, and may not be the method which most closely accords with the basis of apportionment which the Appellant is required to adopt in preparing it accounts, it cannot be struck down on the basis that it is either contrary to the system of harmonised VAT, or (on the grounds that it is so irrational as to be unreasonable) contrary to Community law.

For both parties the issue of first importance is that of the terms of the conditional sale agreements, and in particular whether they include provision to allocate a portion of each instalment payment to the payment of the finance charge payable under the agreements with the balance of necessity allocated to repayment of the reducing credit balance. If the terms of the agreements so provide, the VAT bad debt relief should follow from that allocation, since the payments so allocated will comprise the actual consideration given and received for, respectively, the exempt supply of credit and the taxable supply of goods: see Bejuga case.

The submissions by both sides on this point are set out in some detail above, as is the evidence adduced by the Appellant. The terms of the conditional sale agreements which were included in the documents before us are a question of fact for our decision, and we have concluded that they do not include provision to allocate instalment payments as to the finance charge and as to the outstanding credit balance, nor can such an allocation be implied into the agreements by any other terms or by the consumer credit legislation.

Each agreement specifies crucial financial and payment terms (as required by the consumer credit legislation in the case of regulated agreements, and by Wagon Finance's practice in the case of unregulated agreements). Those terms include the cash price of the goods (less deposit), the total credit charge, the total amount paid (in instalments) by the customer, the amount of each instalment payment, the number of instalment payments, the frequency of instalment payments, and the APR applicable to the transaction. It is correct, as the Appellant submits, that the APR is the interest (or finance charge) annualised rate implicit from those financial and payment terms calculated so as to reduce the outstanding credit balance to zero on the final payment and at a constant rate of interest applied to the reducing credit balance. It is also correct that a numerate customer of an enquiring mind and equipped with a sophisticated calculator, or a spreadsheet and the appropriate software programme, could apply the APR so as to determine how, in the underlying financial basis to the agreement, each payment he makes can be regarded as dividing between finance charge and outstanding credit. But that is not to say that the APR, simply specified as it is in the agreement, and even when taken in conjunction with the other financial and payment terms, results in the agreement of the parties that each instalment payment will be allocated in particular portions – to achieve that requires a further step which is not to be found in the agreements. It is reasonable to assume that the true purpose of the regulatory requirement to specify the APR is to notify the customer of the cost of the credit he is obtaining if the agreement runs its course, no doubt so that he can compare that cost with other forms of finance (including a loan on a reducing balance basis), or similar finance provided by another finance house. The point is also worth making that the only time at which the APR is shown as having a function in the agreement is in the sub-clause relating to the payment of interest by the customer on overdue instalments – such interest is at the APR.

It should be noted, in addition, that Wagon Finance itself does not regard the APR as the factor which determines the allocation of payments to finance charge and credit balance, since for its own accounting purposes it uses a similar, but nevertheless different, basis of making that allocation, namely the rule of 78. Thus our notional numerate customer with calculator could not actually work out from the APR stated in his contract the allocation which Wagon Finance itself makes from the contractual payments. It may, as we heard from Dr. Barnes, be that the rule of 78 is a rule which can regarded for accounting purposes as an acceptable approximation to the actuarial method which gives the APR figure in the agreement, but since the Appellant's case on this issue invests the APR with such significance it is reasonable to expect a consistency of approach in Wagon Finance's own treatment of what is claimed to be a crucial contractual provision.

It is not surprising that there are no provisions in the conditional sale agreement allocating each instalment payment in this way, since such provisions are not required for the purposes of the transaction which the parties have entered into. The customer needs to be able to identify the cost of the goods and the amount he is paying for the benefit of delayed payment for those goods. He needs to know the amount, frequency and number of the instalments he has to pay. But he is not, as Mr. Parker pointed out, paying off a loan where, at any time, he can discharge his debt by paying off the outstanding balance. He is instead obligated to make the agreed instalment payments, and (subject to statutory rights) must make all those payments even if he terminates the agreement before it has run its course: see Forward Trust Ltd v Whymark [1990] 2 QB 670. This is what Cl. 4 of the agreements produced in evidence provides. On making payment of the outstanding instalments he has a right to a rebate on statutory terms so that his total credit charge is adjusted to reflect the changed credit terms, but that adjustment, even though made by reference to the APR (or the rule of 78 approximation of it) does not perform the function of allocating prior instalment payments between finance charge and credit balance.

The Appellant argued that we should nevertheless view the agreement from the supplier's position, and that from that perspective the financial terms of the agreement, together with the accounting treatment which Wagon Finance is required to adopt in relation to the instalment payments, result in Wagon Finance receiving consideration for the goods and for the credit on the allocation basis appearing in its accounts, and the VAT treatment should follow accordingly: that would be consistent with section 36(3) VATA 1994. This line of argument was broadened to the more general point that the VAT system operates on an accounts basis, as required by Article 11 A (1)(a), and bad debt relief should be available in a manner which accords with that basis. We do not accept this approach. It is true that it is the supplier of the goods and services who needs to establish the amount of consideration received when the customer defaults in order to claim bad debt relief, but the amount of such consideration cannot be determined from the interpretation which one party places on the transaction or its internal accounting treatment, even where that is governed by accounting standards. That does not seem to us to be consistent with the line of authorities cited to us in support of the proposition that the tax charge is based on the consideration payable under the contractual terms agreed by the parties. Apart from other factors, if the customer is a VAT-registered trader he has an interest in the matter, so that some objectivity is required. As for the broader point, we did not see from the case argued before us that there is a general principle of the VAT system which can be applied to permit a taxpayer to claim a particular relief on the basis of the accounting treatment of the underlying transactions – VAT is not a tax which necessarily follows accounting principles applied to the supplies on which the tax is charged.

If the instalment payments are not allocated by the terms of the agreements, and cannot be regarded as allocated by reason of the way in which Wagon Finance allocates them in its books of account, some method of allocation must be applied to determine the amount treated as received as consideration for the goods so that the bad debt can be quantified and the relief claimed. The Commissioners argue that regulation 170 of the VAT Regulations 1995 (as applied in this case) properly and lawfully fulfils this function: the Appellant accepts that some method of allocation must be imposed, but argues that the method adopted by regulation 170 (as applied) is uncommercial and unreasonable and should give way to an accounts-based method, which reflects commercial reality and is therefore reasonable.

A preliminary matter is the question of the statutory provision applicable to this case: as mentioned at para. 19 above, the appeal as it eventually came before us relates to a decision of the Commissioners based on their concessionary application of regulation 170(3) in circumstances where that concessionary treatment was subsequently enacted (and with an effective date later than the events giving rise to this appeal) as regulation 170A. Dr. Southern pointed out what he saw as certain shortcomings in the terms of regulation 170(3), but in substance the case was argued before us by reference to the formula terms as now appearing in regulation 170A. Our decision must relate to regulation 170(3) as applied by concession in this case, and we regard the concessionary treatment as applying regulation 170(3) so that it accords with the terms of regulation 170A and the method of allocation as there set out. It follows (although we cannot decide the point as such) that we would have reached the same decision had regulation 170A itself been in force at the date material to the relevant events in this appeal.

We heard extensive submissions from the parties on the question of whether the statutory formula in regulation 170(3), as applied in this case, is consistent with the Sixth Directive and in accordance with Community law, and we have endeavoured to set out above the arguments put to us. Dr. Southern argued in detail that, even in the context of a system to "fill the vacuum" where the parties themselves have not allocated the consideration in the case of a mixed or composite supply, the statutory method of apportionment found in regulation 170(3) is contrary to what he identified as the neutrality principle and the accounts principle inherent in Article 11 C (1) read in its proper context as the corresponding provision to Article 11 A (1)(a). He argued further that although there is a right of derogation in implementing Article 11 C (1), regulation 170 goes beyond what is permitted since, out of a choice of methods which the Commissioners could have adopted, in regulation 170 they have chosen to adopt a method which is at odds with commercial reality and therefore offends the principle of proportionality to be found in Community law.

We found Mr. Parker's case for the Commissioners more persuasive. It is clear that, in order to give effect to Article 11 C (1) in the context of a mixed or composite supply where the parties themselves have not specified the consideration given, a member state must specify some rule for apportioning consideration in order to provide a system of bad debt relief envisaged in the most general terms by that Article. There is no requirement that such a rule should be based on the accounting treatment which the taxpayer claiming the relief is required to adopt since, as we have said, there is no general principle that VAT charges or reliefs must follow the accounting treatment applied to the transactions which comprise the relevant supplies. The principle of neutrality as identified by the Appellant may well require that bad debt relief is available to the taxpayer, but that is not to say that the method of calculating that relief must follow the accounting treatment adopted by the taxpayer.

Mr. Parker argued that the Commissioners have a wide margin of discretion in the way they may, in implementing Article 11 C (1), provide for a means of apportioning consideration between different supplies made in the same transaction. The method chosen, and enacted in regulation 170(3) as applied in this case, is objective and independent of the particular circumstances of individual taxpayers (and is therefore of general application), it is easily understood and applied across the range of taxpayers, and it can be conveniently administered by both the taxpayer and the taxing authority. It is a method which, as its purpose, is directed at giving a measure of relief, and the way in which it apportions consideration is consistent and compatible with that purpose. It aims to allocate payments between the exempt supply (the finance charge) and the taxable supply (the goods, represented by the credit balance) and that aim is achieved by the method chosen.

It is not sufficient that the Appellant should be able to say that there is a different, or more precise, method of apportionment, or even a method which is more commercial in the sense of according with the method of apportionment which Wagon Finance and similar taxpayers are required to adopt for the purposes of their accounts. The burden is on the Appellant to show that the method of apportionment in regulation 170(3) as applied is irrational to the point that no person acting reasonably would seek to impose it as a means of making bad debt relief available. Only then can it be said that the Commissioners have acted beyond the discretion they have in this matter. The Appellant's objection to the straight-line method of apportionment is that it does not result in a constant, or near constant, implicit interest rate applied to a reducing balance: the amount of finance charge in each payment is not proportionate to the reducing balance and therefore, in the evidence of Dr. Barnes, in economic terms it produces a result which is far from reasonable. That may mean that the statutory formula is not the ideal for Wagon Finance's business. But it is a rational (even if simple) approach fairly directed to the matter it purports to deal with, where issues of accounting treatment and economic terms are not the only considerations for a system which must be of general application for the body of taxpayers. The figures which we were given by Ms Roberts in the course of her evidence, showing the different results in the sample agreements where the customer defaulted, do illustrate the Appellant's point that the rule of 78 method of apportionment gives a more favourable result to the taxpayer in this context than does the straight-line apportionment, but those figures also show that, in the context of Wagon Finance's business, the difference is not so great as to lead inevitably to the conclusion that the straight-line method of apportionment is beyond the bounds of reason. Rather, our conclusion is that the Appellant cannot impugn the provisions of the regulation on the basis that they are irrational to the point where they cannot be justified within the scope of the discretion which the Commissioners have in this instance, and that accordingly those provisions (as applied by concession in this case) are effective to determine the bad debt relief available to the Appellant for its VAT purposes in the circumstances giving rise to this appeal.

We therefore dismiss the Appellant's appeal against the reduced assessment of £18,096 made by the Commissioners in their letter dated 11 November 2002 to the Appellant. We make no order as to costs.

A E SADLER

CHAIRMAN

RELEASED: 17 July 2003

LON/00/0929

BAILII: Copyright Policy | Disclaimers | Privacy Policy | Feedback | Donate to BAILII
URL: http://www.bailii.org/uk/cases/UKVAT/2003/V18236.html

	[Home] [Databases] [World Law] [Multidatabase Search] [Help] [Feedback]
	United Kingdom VAT & Duties Tribunals Decisions
You are here: BAILII >> Databases >> United Kingdom VAT & Duties Tribunals Decisions >> Abbey National PLC v The Commissioners of Customs and Excise [2003] UKVAT V18236 (17 July 2003) URL: http://www.bailii.org/uk/cases/UKVAT/2003/V18236.html Cite as: [2003] UKVAT V18236