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Changes to accounting standards in the corporate finance arena

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Long-running litigation between HMRC and Mercedes-Benz Financial Services UK is finally nearing its conclusion. The case concerns a hybrid form of agreement which HMRC claim is hire purchase but which Mercedes asserts is a lease.

The classification is important in asset finance transactions as it can affect whether the arrangement is on or off balance sheet, who is entitled to claim allowances for the equipment and what the correct VAT treatment is.

Goods or services?

The dispute concerned Mercedes’ Agility product. Amongst other things, this product included an option for the customer to buy the vehicle at the end of the term of the agreement. However, unlike a standard HP arrangement (where the option to purchase fee is a nominal amount), the cost to the customer of exercising the option was around 40% of the original price of the car. Mercedes therefore considered it a leasing product.

The VAT Directive sets out different VAT treatment according to whether a transaction is a supply of goods or a supply of services. A hire purchase agreement is regarded as a supply of goods whilst a lease is a supply of services. This is significant as VAT of 20% is payable at the outset of a hire purchase agreement – under a lease VAT is payable on the individual rental payments and is spread over the life of the agreement. More importantly, if the customer chooses not to buy the vehicle at the end of the agreement, if HMRC’s view is correct, the customer would have paid VAT on the full value of the car when entering into the agreement, even where he or she decided not to go on to acquire title by exercising the option.

The Court’s decision

The Court of Justice of the European Union delivered its judgement on 4 October. At less than 6 pages long, the judgement is remarkably succinct. It notes that the key test as to whether a transaction is for the sale of goods is whether transfer of ownership must be certain to occur ‘in the normal course of events’. The court indicated that this will be the case where the exercise of the option is the only economically rational choice for the customer to make at the time the option is exercisable.

What happens next?

The case still needs to be finally decided by the Court of Appeal. However, given the way in which the Agility product was structured it seems almost certain that the court will rule in favour of Mercedes – that the product is a supply of services rather than a supply of goods. This is on the basis that, because the cost to the customer of exercising the option is substantial, there is no certainty that the customer will trigger it and acquire the vehicle.

It will be interesting to see whether the case prompts funders to review their offerings and introduce hybrid products which will amount to supplies of services. If this is the route they choose they will need to take some care to ensure that they offload the end of lease risk, such as through manufacturer or supplier buyback arrangements.

In the corporate finance arena there is already a move, driven in part by changes to accounting standards, towards structuring asset finance products as supplies of services rather than supplies of goods. The Mercedes case is only likely to increase the trend.

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