Establishing economic reality - Rio Tinto London Ltd v HMRC

Establishing economic reality -

                      Rio Tinto London Ltd v HMRC

Tarlochan Lall, Monckton Chambers

The First-tier Tribunal’s decision in Rio Tinto London Ltd v The Commissioners for Her
Majesty’s Revenue & Customs [2014] FTT 1059 (TC) is principally concerned with VAT
repayments and the inter-relation between claims under s80 Value Added Tax Act 1994
(“VATA”) and adjustments under regulation 38 of the Value Added Tax Regulations 1995
(“reg 38”). It contains useful commentary on the circumstances in which credit notes
can be issued. Perhaps most interestingly it illustrates how economic reality – which
determined the VAT outcome – was established in the face of provisions in documents,
actual payment of a significant amount and recognition of the payment in the accounts,
all of which were essentially disregarded in determining the VAT result. The case is not
concerned with the abuse of rights doctrine.

Rio Tinto passed on investment costs to its pension schemes in the period 1973 to 2010.
VAT was charged on all those costs. Rio Tinto realised that those charges included an
element of management costs on which VAT should not have been charged. In line
with HMRC’s guidance in Notice 700/17 ‘Funded Pension Schemes’, the overcharged VAT
related to 30% of the charges. In parallel to making a Fleming claim, Rio Tinto sought
to deal with the overcharge by way of adjustment of consideration under reg 38, which
was not subject to limitation periods. The issue was whether Rio Tinto was entitled to
rely on reg 38 to secure repayment of the overcharged VAT. The First-tier Tribunal held
that reg 38 did not apply.

More relevant details on the facts

Rio Tinto’s pension department incurred third party costs plus VAT in managing the
pension schemes. That VAT was recoverable as Rio Tinto’s input tax as those costs related
to the ongoing management of the pension schemes in line with guidance in Notice
700/17. Rio Tinto also had employment and related costs which were also attributable
to the pension schemes. These costs were recharged to the pension schemes without
VAT and were not the subject of the dispute with HMRC.

The dispute related to pension investment costs. Until 2007, Rio Tinto employed an in-
house investment manager, so the bulk of the investment management costs consisted
of salary and incidental costs. From 2007 the investment management was outsourced
to external managers. VAT was charged on all the pension investment costs recharged
to the pension funds in the period 1973 to 2010. Rio Tinto, however claimed that 30%

of the pension investment costs were management costs and they should not have
carried VAT when recharged to the pension funds.

Rio Tinto sought advice on making a Fleming claim by the 31 March 2009 deadline
for the overpaid VAT. A provisional claim under s80 VATA was made, but for reasons
which are not entirely clear that claim did not relate to the whole of 1973 to 2010
period. In parallel, Rio Tinto sought to make a price adjustment for the pension
investment costs made for the whole of the 1973 to 2010 period under reg 38,
such adjustment not being subject to any time limits. The price adjustment was
made by Rio Tinto issuing a credit note to the pension funds for £6,085,106.38
and £1,064,893.62 VAT giving a total of £7.15m. The pension funds were paid that
amount. That payment was recognised in Rio Tinto’s accounts. Rio Tinto claimed
the £1,064,893 of VAT. HMRC refused the claim, which lead to this appeal.

Notice 700/17

Although the full £7.15m payment was processed, there was confusion over
whether Rio Tinto intended to adjust the price by £6,085,107 or just refund the
VAT of £1,064,893 to the pension funds. For reg 38 to apply, there needed to be a
‘decrease in consideration which included an amount of VAT’. In other words a price
adjustment of £7.15m, inclusive of VAT, was needed.

The confusion arose from the practical effect of guidance in paragraph 2.7 of Notice
700/17. That paragraph states:

          “If the supplier issues a single tax inclusive invoice for both kinds of services
          you will have to split the costs between management and investment
          services. You may, by way of a simplification agreed with the sector, treat 30
          per cent of the costs as for management services when a third party:

            -- provides both the pension fund’s management and investment services;
            and

            -- issues one single tax invoice.”

That paragraph is concerned with input tax the employer can recover. Essentially,
the employer may recover circa 30% of the input tax. That paragraph is silent on how
the underlying charges are treated. Paragraph 2.6 indicates that the input tax can
be recovered even if the pension fund reimburses the employer. Paragraph 2.6 also
makes clear that output tax should not be charged when the costs are passed onto
the pension fund. This provided grounds for concluding that in order to recover the
VAT, Rio Tinto did not need any price adjustment as such: the charges representing
management costs could be passed on to the pension funds but VAT did not have to
be charged on them. As VAT had been charged on all the pension investment costs

passed to the pension funds, 30% of the VAT had been overcharged.

The Tribunal’s finding on the price adjustment

The onset of the financial crisis around March 2008 led to Rio Tinto’s pension funds
being in deficit such that their anticipated liabilities exceeded their assets. A letter
attached to the notice of appeal revealed that as part of the process of dealing with
the deficit, Rio Tinto agreed to reduce charges previously made to the pension funds
and review the tax the tax treatment of those adjustments. One of Rio Tinto’s key
witness admitted at the hearing that the only overcharges related to VAT and the
VAT exclusive amount had not been overcharged. This led the Tribunal to find that

          “The price adjustment was simply an artificial mechanism used by the
          Appellant effectively to procure a VAT credit of £1,074,893 and resulted in
          the Fund receiving a “windfall” benefit of £6,085,107 for no apparent reason
          other than to procure this credit (and possibly to boost the assets of the Fund).
          Certainly the price adjustment did not seem to have been made because there
          was anything wrong with the consideration paid or the services supplied.”

The Tribunal therefore concluded that “the appropriate mechanism for re-claiming
overpaid VAT [was] a claim ... under section 80 VATA, not under regulation 38.”

Economic reality

In arguments on behalf of Rio Tinto, recent and now familiar decisions were cited.
It was accepted that it was necessary to look at the economic reality of the price
adjustment with the judgment of the CJEU in HMRC v Newey (trading as Ocean
Finance) Case C – 653/11 [2013] STC 2432 at [42] – [45] (“Newey”)) being cited. It was
also accepted that labels used by the parties were not conclusive (Secret Hotels2
Ltd (formerly Med Hotels Ltd) v HMRC [2014] UKSC 16 (“Secret Hotels”) and HMRC v
Aimia Coalition Loyalty UK Limited [2013] UKSC) 15). It was also accepted that all
the relevant facts and circumstances in reaching a view on the commercial and
economic substance of the transaction had to be considered.

On the evidence before the tribunal, the £7.15m payment had been processed with
a supporting credit note. That payment had been recognised in Rio Tinto’s accounts.
Evidence was also given that in order to bridge the pension deficit, the trustees of
the pension funds would not accept contributions to the funds and had agreed a
price reduction. These appeared to be powerful commercial and economic factors
of substance. Rio Tinto argued that it had remedied the over-charged VAT to the
pension funds by giving a “proper credit”, which should be given effect.

In behalf of HRMC, the following paragraphs from the CJEU’s decision in Newey were
cited:

“42      As regards in particular the importance of contractual terms in
          categorising a transaction as a taxable transaction, it is necessary to bear in
          mind the case-law of the Court according to which consideration of economic
          and commercial realities is a fundamental criterion for the application of the
          common system of VAT (see, to that effect, Joined Cases C-53/09 and C-55/09
          Loyalty Management UK and Baxi Group [2010] ECR I-9187, paragraphs 39
          and 40 and the case-law cited).

          43 Given that the contractual position normally reflects the economic and
          commercial reality of the transactions and in order to satisfy the requirements
          of legal certainty, the relevant contractual terms constitute a factor to be
          taken into consideration when the supplier and the recipient in a ‘supply of
          services’ transaction within the meaning of Articles 2(1) and 6(1) of the Sixth
          Directive have to be identified.

          44 It may, however, become apparent that, sometimes, certain contractual
          terms do not wholly reflect the economic and commercial reality of the
          transactions.

          45      That is the case in particular if it becomes apparent that those
          contractual terms constitute a purely artificial arrangement which does not
          correspond with the economic and commercial reality of the transactions.”

Fatal to Rio Tinto’s case was its key witness accepting that the pension funds had
not been overcharged the VAT exclusive charges, but just the VAT on those charges.
That engaged the artificiality override in paragraph 45 of the Newey decision cited
above. At paragraph 107, the Tribunal said:

          “As we have explained, the Appellant initially put forward an argument
          that Notice 700/17 justified the price adjustment i.e. justified the payment
          of £6,085,107 plus VAT of £1,064,893. This justification formed part of Mr
          Poulopoulos’s witness statement and Ms Brown’s skeleton argument. In
          cross-examination, however, Mr Poulopoulos accepted that the net of VAT
          charges recharged by the Appellant to the Fund had been correct all along.
          The seemingly hopeless argument based on the meaning of Notice 700/17
          was abandoned without explanation. It was only the VAT amount on those
          charges which the Appellant now questioned.”

The case therefore turned on its facts. The Tribunal, applying now well established
principles held, at para 127:

          “Whether a price adjustment constitutes a decrease in consideration within
          regulation 38 is, in our view, a matter to be determined on an objective view
          of the facts but taking account of the economic and commercial reality.
          In reaching our decision we have treated the reason for the adjustment as

relevant insofar as it sheds light on those economic and commercial realities.
          Moreover, whilst the terms or labels attached to the price adjustment by the
          Appellant and the Fund are relevant, they cannot change the true economic
          and commercial substance of the arrangement.”

The Tribunal noted that although the trustees did not want a contribution because
it would necessitate further discussions with the contributing employers, it was
not imperative that the price adjustment had to be by way of a reduction of the
consideration. Whether the ‘windfall’ the pension funds received was a contribution
was a matter “for others to decide” and did not concern the VAT matter before
the tribunal. The tribunal was not bound by the accounting treatment of the
price adjustment. It was not presented with evidence of the basis on which such
treatment was correct. Furthermore, in light of the acceptance at the hearing that
the VAT exclusive charges had been correctly recharged, whether Rio Tinto’s auditors
would have accepted that the accounting treatment was correct was “a matter of
speculation”.

Although the Tribunal was presented with a range of relevant facts and circumstances
which on their face appeared to support a reduction of consideration required for
the application of reg 38, essentially the evidence did not stack up. It did not reflect
the economic reality that the only overcharge to the pension funds was of VAT. This
case is therefore probably more significant for illustrating the critical examination
evidence is likely to be subjected to in establishing economic reality and applying
the artificiality override in Newey.

This case note was first featured in the February 2015 issue of De Voil.

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