United States: The Abbey VAT Case: Implications for Investment Fund Outsourcing

Article 13B(d)6 of the EU Sixth VAT Directive 77/388/EEC (the Sixth VAT Directive) provides that fees arising from the management of special investment funds (as defined by Member States) are exempt from VAT. The European Court of Justice (ECJ) has ruled, in the case of Abbey National Plc and Inscape Investment Fund (joined party) v HM Commissioners of Revenue and Customs (C-169.04 / 4 May 2006), that certain outsourced administration services provided to an investment fund fall within the VAT exemption, whereas depositary services do not.

Abbey National Plc outsourced the administration of certain special investment funds to Inscape and appointed Citicorp as depositary. Both Inscape and Citicorp charged VAT on these services, in accordance with Her Majesty’s Commissioners of Revenue and Customs (HMRC)’s interpretation of the Sixth VAT Directive. Abbey challenged this. Three questions were referred to the ECJ for a preliminary ruling:

• Did the term "management" have an independent EC law meaning, common in each of the member states? Alternatively, did the Article 13B(d)6 exemption empower member states to define what activities constitute the "management" of special investment funds and to define the types of funds which benefited from the exemption?

• If "management" had an independent EC law meaning, did the depositary services provided by Citicorp constitute "management" services for the purpose of Article 13B(d)6?

• If "management" had an independent EC law meaning, did the outsourced administration services provided by Inscape constitute "management" services for the purpose of Article 13B(d)6?

The Advocate General found in favour of Abbey on all 3 questions. However, somewhat unusually, the ECJ handed Abbey a slightly narrower victory, departing from the Advocate General on the question of depositary services. The case will now go back to the UK Courts for the ECJ’s judgement to be applied.

The ECJ held that "management" has an independent EC law meaning, that member states cannot define what constitutes "management," and that Article 13B(d)6 only permits member states to define "special investment funds." The ECJ gave guidance on the operation of the exemption, explaining that its purpose is to facilitate investment in securities for small investors by means of investment undertakings, and to ensure a fiscally neutral common VAT system as regards direct investment in securities compared with investment through special funds. Hence, the exemption applies to those transactions which are specific to the business of the funds. This will include portfolio management and fund administration (see the list of tasks of administering undertakings as set out in Annexe II of the Undertakings for Collective Investment in Transferable Securities Directive 85/611/EEC) ("UCTIS").

The ECJ went on to rule that the Article 13B(d)6 exemption could apply to outsourced management services – the exemption is defined by reference to the nature of the services provided, not by the identity of the person supplying or receiving the services. To qualify, the outsourced services, taken together as a whole, must fulfil the specific functions essential for the management of a special investment fund (as described in Article 13B(d)6). Ancillary services, such as IT systems provision and maintenance, often an essential part of such arrangements, will not so qualify.

The situation is unchanged for the outsourcing of depositary services. The ECJ has upheld HMRC’s long held view that depositary services do not fall within the VAT exemption – these services comprise functions intended to ensure that the fund is managed in accordance with applicable law, and therefore relate to the control and supervision of the fund, not to its management.

In EU countries such as Luxembourg, Ireland and France where depository services are currently VAT exempt, the ruling will lead to a reverse of this position, with a charge to VAT at the standard rate for these services. By contrast, where outsourced investment fund administration services contain the essential elements sufficient to fall within the VAT exemption, the service provider should, going forwards, cease to charge VAT. Further, since the effect of the ECJ’s ruling means that VAT should never have been charged on these services, funds may, depending on the particular circumstances, succeed in claims for repayment of wrongly paid VAT. On the other hand, third party providers may now incur irrecoverable input tax – the cost of which they will likely seek to pass on to their customers; in addition HMRC may seek to recover claims for input tax which should not have been so recovered.

The ECJ, in giving its judgement, has sought to achieve a harmonised EU VAT system for these types of services, as envisaged by UCITS. A wider range of services outsourced by investment funds should now qualify for the VAT exemption. Although the ECJ did leave defining what constitutes a "special investment fund" open to the discretion of each member state (subject to the overriding aim of ensuring fiscal neutrality), overall, this ruling will likely result in significant savings to EU funds providers, who outsource many millions of pounds of administration services. To take full advantage of this, existing outsourcing contracts will need to be carefully reviewed and, in some case, revised and amended; new outsourcing contracts will need to be carefully planned, with particular emphasis on the descriptions of the outsourced service elements.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.