Introduction
Readers of Legalflyer will be aware from previous editions that the European Commission successfully challenged the UK's VAT zero rate for supplies of aircraft and parts on the basis that the UK's existing rules for aircraft (contained in VATA 1994, Sch 8, Group 8) did not correctly implement the provisions of Article 148 of Council Directive EC 2006/112. The UK rules provided that any supply of an aircraft with a take-off weight exceeding 8000kg and neither designed nor adapted for use for recreation or pleasure should be zero-rated. However, the exemption provided for in Article 148 is tested by reference to the airline rather than the aircraft, applying to supplies of aircraft and parts that are "used by airlines operating for reward chiefly on international routes".
Many interested parties in the aviation industry were concerned that an amended rule that more closely reflected the European provisions would be difficult to apply in practice. In recognition of this concern, HMRC conducted a two-month consultation with a limited group of interested parties on the changes to be made.
In the March 2010 Budget, the UK government announced that it would introduce legislation to bring the UK's zero-rating of aircraft into line with Article 148. This legislation was to be implemented on 1 September 2010. On 22 June 2010, the coalition government confirmed that amended legislation would be introduced; however, due to pressure from the aviation industry, they announced that the implementation date would be put back to 1 January 2011.
Draft legislation published
The draft implementing legislation has now been published and is expected to be introduced in the next Finance Bill (that is, after the summer recess). The draft legislation is very brief, basically reflecting the wording in Article 148. However, HMRC have also recently circulated a draft revised form of Notice 744C Ships and Aircraft. This revised Notice has not been formally published and until the legislation is actually confirmed by enactment the draft Notice can only be taken as a guide to HMRC's intended application of the revised rules. Having said that, it does provide the most detail to date of how the changes are expected to apply in practice. As previously announced, the definition of qualifying aircraft will be split into two categories. The first category will apply to aircraft used by a State institution and will largely reflect the current exemption (that is, aircraft of a weight of not less than 8000kg that are neither designed nor adapted for use for recreation or pleasure). The second category will be available to non-State users and will reflect the terms of the exemption provided for in Article 148 (applying to any aircraft used by an airline operating for reward chiefly on international routes).
The revised Notice confirms that it is not necessary for a particular aircraft to be used on international routes as the test is based on the airline itself. This was to be expected, as it simply reflects the position established by the European Court of Justice in Cimber Air A/S v Skatteministeriet (Case C-382/02) [2005] STC 547.
Key interpretation points
"Airline" will be defined as an undertaking which provides services for the carriage by air of passengers or cargo. The word "undertaking" appears to have been selected in order to encompass as wide a range of entities as possible and HMRC note that it will include sole practitioners, corporate bodies and partnerships. An undertaking should fall within the definition of an airline regardless of the number of aircraft that it operates; one aircraft would be sufficient and it may be leased or hired rather than owned.
The concept of "operating for reward" should also be interpreted widely. HMRC state that an airline will be operating for reward provided that it supplies the aircraft in return for a consideration and is operating a business for VAT purposes. There is a significant body of case law in relation to the requirements for a taxpayer to be operating a business for VAT purposes. In particular, provided that there is some consideration for the supply of the aircraft, there should be no requirement for an airline to be operating for profit.
The question of whether or not a route is an "international route" will be tested by reference to the UK's sovereign airspace, which generally extends twelve nautical miles from the coastline. An international route will include any route that is not confined to the UK's sovereign airspace, unless the route starts and ends in the UK. This is an important development. Previously it had been expected that an airline's international operations would be tested by reference to the State where the airline was based, rather than to the UK's airspace. As such, an overseas airline that mainly operates flights between airports within its own territory should nonetheless be regarded as international for the purposes of the UK's revised rules on zero-rating.
For the exemption to be available, the airline must be operating for reward "chiefly" on international routes. HMRC state that this will simply require that an airline's international flights exceed its domestic flights. However, there will clearly be a number of methods for testing the extent of an airline's operations. HMRC acknowledge this in the revised Notice and state that turnover from the respective operations will be particularly significant, but that other criteria (for example, the relative number of passengers carried or mileage flown) may also be taken into account, provided that the result is fair, reasonable and can be verified by HMRC.
Practicalities of monitoring operations
One would expect the monitoring of an airline's domestic and international operations to be one of the most significant practical implications for airlines (especially for those which are on the borderline). Airlines will need to test the extent of their operations on a reasonably frequent basis and will be expected to notify any regular suppliers if there is a change in their qualifying status. Following any material change in an airline's operations (HMRC give the example of a merger) the airline will be required to carry out a further test as soon as practical. In the case of a large airline with a significant fleet this test may not be straightforward. For example, detailed guidance is expected to be introduced to distinguish between different categories of flight, so that testing flights will not be counted, but positioning flights will be counted by reference to the next flight for which the aircraft is being positioned, unless the positioning flight arises as a result of an emergency diversion, in which case it will be counted by reference to the original routing of the diverted flight.
Airlines will be permitted to test the application of the exemption on a particular date by reference to historic flights, which could be over the last financial year, or over a calendar year or over a shorter or rolling period. Airlines will also be permitted to test the application of the exemption by reference to a forward look at their anticipated activities where their projections are supportable and where it can be demonstrated that using historical activities would not be representative because of material changes in their operations. It would appear from the revised Notice that HMRC will afford airlines a reasonable degree of flexibility in choosing the period, frequency and method of testing the extent of the airline's operations. However, airlines will have to be consistent in their application of the tests (or else be able to support any inconsistencies) otherwise HMRC is likely to suspect that an airline is seeking to manipulate the test to ensure a particular outcome.
Impact on UK businesses engaged in repair, maintenance and modification of aircraft
One of the particular concerns that emerged during the consultation period was how the revised rules on zero-rating would be applied by the significant number of UK businesses engaged in the repair, maintenance and modification of aircraft and the supply of their parts. In order to zero-rate such supplies, the supplier would need to know at the time of the supply that the aircraft will be a qualifying aircraft. This may not always be straightforward as the supplier may be engaged to make supplies to multiple customers at relatively short notice and may not always be aware at the time of the supply of the identity of the end user in the supply chain. Take for example the situation where a taxpayer is engaged to supply and install a replacement part to an aircraft whilst that aircraft is being refuelled and prepared for an imminent take-off slot. It will be the supplier's responsibility to ensure that the conditions for zero-rating are met for this supply. To discharge that responsibility the supplier may have to ensure that some form of documentary evidence of the airline's qualifying status is retained.
In the revised Notice, HMRC set a high standard for this evidence, giving the example of a declaration by the customer of its entitlement to zero-rating together with an undertaking to notify the supplier of any changes to that entitlement before the time of the supply and to pay any VAT properly due. However, HMRC state that the documentary evidence could take other forms and it is expected that it will only be necessary to retain such evidence in cases where there is some doubt that the customer qualifies. In the example of the supplier engaged to install a replacement part, if the airline in question is based overseas and operates only a small proportion of its flights within the UK, it may be abundantly clear that the supply qualifies for zero-rating and so it may not be necessary to retain any evidence. In addition, HMRC have noted that, in "normal circumstances", where a supplier is engaged by an airline to make multiple supplies, they would only expect the supplier to obtain one declaration from that airline each year to cover all of the airline's aircraft.
Conclusion
The additional details contained in the revised Notice provide a much clearer picture of how the exemption will apply from 1 January 2011. Many of the industry's concerns have been addressed, although a number of areas of uncertainty remain. It is clear that, at the least, the changes will introduce a significant increase in the compliance burden for customers and suppliers in the aviation industry. We will have to wait for the implementing legislation and the final guidance to be published in order to understand fully how the changes will affect the aviation industry.
Article first published in the August 2010 issue of De Voil Indirect Tax Intelligence.
Matt Hodkin is a partner and David Ward is an associate in the Tax team, Norton Rose LLP, London.
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