The upper tribunal has ruled that no output tax adjustment is permitted on credit notes unless a refund has been given to the customer.
Imagine the following situation: you make an advance payment to a builder for £50,000 + VAT to refurbish your office, a total payment of £60,000. Your business is fully taxable (not partly exempt), so you can claim the £10,000 input tax charge on the builder’s invoice.
However, the builder suffers a heart attack and is unable to complete the job, so he agrees to fully refund you. He issues a credit note for £50,000 + VAT to adjust his original invoice.
This is a contractual obligation because his contract said that he would make a refund if the work was not carried out as agreed. However, the bad news is that you don’t receive your refund because his company goes into liquidation soon after the credit note is raised. How should you report these transactions on your VAT returns?
If you applied the logic of the taxpayer in the case of Inventive Tax Strategies Ltd (In Liquidation)  UKUT 0221 plus three others (herein referred to as ITS), the aborted job would actually cost you £60,000 and not £50,000. This is quite bizarre, but the logic works like this:
- Your payment of £60,000 to the builder is reduced to £50,000 because you will claim input tax on the purchase invoice.
- You enter the credit note through your records.
- Your input tax claim is cancelled out to zero.
- The net cost of the job is now £60,000, because the credit note will never result in a refund.
If you substitute the office refurbishment work in my builder example for tax advice relating to SDLT avoidance schemes, you have the facts of the ITS case. Customers paid an advance fee for tax advice but the scheme in question failed, so they were entitled to a full refund and a credit note was therefore raised by ITS.
However, no refund was made because the companies concerned went into liquidation.
This case was originally heard by the FTT back in 2017, and the judge concluded that the reduced output tax claimed by the taxpayer on their VAT returns had been rightly disallowed by HMRC because there had been no refund paid for the supplies in question.
HMRC argued that in order for ITS to reduce its output tax, there must be “an actual transfer of that consideration” to the customer – in other words, no refund means no output tax credit. The taxpayer’s view was that it had a contractual obligation to provide a refund because the SDLT scheme was “unsuccessful” and this produced a “decrease in consideration” that met the conditions of the VAT Regulations 1995, Reg 38 and therefore an output tax reduction was justified on these grounds.
The judge placed great emphasis on the commercial and economic reality of the situation and dismissed the taxpayer’s appeal: “there has not been an actual repayment and it is not at all clear that there will be any repayment at all. In those circumstances, it is not possible to say that the ‘price has been reduced’ in any commercially or economically real sense.”
In other words, the commercial reality was that ITS had provided tax services and received a fee, and there was no entitlement to reduce the output tax paid on this fee because the company had received consideration which they never repaid.
I think that most readers will be reassured by this decision because the outcome of the ITS proposal would be very unfair and a moral challenge to our favourite tax.
As the UT commented in its report, a taxpayer victory would have produced the ridiculous outcome of the taxpayer having received a standard-rated fee but accounted for no output tax without refunding customers who, had they been VAT registered, would have suffered an input tax clawback because of the credit notes issued under Regulation 38. In summary, common sense has prevailed!
About Neil Warren
Neil Warren is an independent VAT consultant and author who worked for Customs and Excise for 14 years until 1997.