Another significant judgement was published on 4 October 2017 by the European Court of Justice (C-164/16), which addresses leasing from a value added tax perspective, and also changes current practice to a certain extent.
Current practice: leasing from the angle of VAT
In terms of VAT, and keeping things simple, there are two types of financial leasing: closed-end and open-end.
- In the case of closed-end leasing, when the leasing period expires and if all the instalments have been paid, the ownership right to the leased item automatically passes to the lessee upon payment of the last instalment.
- With open-end leasing the lessee has the option to obtain the ownership right of the leasing item, but this is at the discretion of the lessee.
Based on these definitions the VAT system treats the two kinds of leasing separately. Closed-end leasing is considered a supply of goods based on the VAT Act (and the EU’s Value Added Tax Directive), while open-end leasing is a service (rental). In the case of closed-end leasing the VAT payment liability arises in one lump sum when possession of the leasing item is handed over, for the entire principal amount (irrespective of the fact that legally the ownership right is not ceded), while for open-end leasing the VAT payment liability arises when the individual instalments are invoiced.
Brief description of case examined by the Court
The case in hand involved Mercedes Benz Financial Services UK Ltd and the British tax authority. Mercedes-Benz offered three types of contract for leasing motor vehicles: a standard hire agreement known as “Leasing”, a “Hire Purchase” agreement, and a leasing agreement with an option to purchase called “Agility”.
The “Leasing” agreement excludes any transfer of ownership and sets a maximum mileage beyond which the customer is liable to pay a penalty. The “Hire Purchase” and “Agility” agreements, on the other hand, provide for a transfer of ownership, but on different terms.
In a “Hire Purchase” agreement there is an option based on which the customer can buy the vehicle when the agreement expires for a symbolic amount (normally GBP 95). Yet since the sum of the instalments equals the entire cost of the vehicle, from an economic perspective there is then no point in waiving the option to a vehicle that has been paid in full.
Under an “Agility” agreement, the monthly instalments are lower, and the total instalments thus represent only approximately 60% of the vehicle sale price, including the cost of financing. If a user wishes to exercise the option to purchase the vehicle, they must therefore pay approximately 40% of the sale price. This represents the estimated average residual value of the vehicle.
It was clear to the parties that “Leasing” falls within the category of open-end leasing (i.e. rental), while “Hire Purchase” obviously corresponds to closed-end leasing (i.e. a supply of goods). The problem came with the “Agility” version.
The judgement
According to the ECJ – and we quote from the judgement – a “contract for hire which provides that in the normal course of events ownership is to pass at the latest upon payment of the final instalment” (Article 14(2)(b) of the VAT Directive), must be interpreted as applying to a leasing contract with an option to purchase if it can be inferred from the financial terms of the contract that exercising the option appears to be the only economically rational choice that the lessee will be able to make at the appropriate time if the contract is performed for its full term, which is for the national court to ascertain.
Essence of the judgement
To determine whether a given framework is a supply of goods or a service it is not enough just to examine whether the leased item automatically passes to the lessee upon payment of the last instalment. It must also be analysed in the case of a purchase option whether the transfer of the ownership right does in fact depend on a rational decision by the lessee.
What happens now?
With this judgement the ECJ has added a subjective factor to the equation, which could cause some headaches in the future. In certain cases for example it can be very difficult to ascertain what size of option really does prompt a genuine decision from the lessee. Also up for discussion is what a rational decision means from the perspective of companies (buying a 5-year-old used car can be rational for a private individual, but for a company this is by no means so clear-cut, even if some revenue could be generated from subsequently selling the 5-year-old car). This means the tax authority could reclassify current open-end leasing frameworks as supplies of goods, and demand payment of the VAT in one amount from the lessor when the leased item is handed over.
When leasing company cars it is also important whether the purchase is deemed a supply of goods or a vehicle rental, since while the VAT on the purchase of passenger cars cannot be deducted, the VAT on car rentals can (if utilisation for business purposes is proven).
So to avoid tax risks we definitely recommend reviewing the VAT statuses of leasing contracts, with due consideration of the ECJ’s decision referred to above.
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