IBR engagement letters matter
A Supreme Court judgement issued on 11 May highlights how drafting of engagement letters can have a significant impact on the ability of a company to recover VAT.
The ruling may impact on how Independent Business Review (IBR) and other engagements are structured where there are third parties to the payer who also benefit from the engagement output.
In October 2002, Airtours Holidays Transport Ltd (“Airtours”) was in serious financial difficulties. It was suggested to Airtours that it should commission a report to satisfy the 80 or so banks and other financial institutions (“the Institutions”) from which it had borrowed money that its proposed restructuring and refinancing proposals were viable. The Institutions were agreeable to this. Subsequently, PwC were appointed to produce a report (“the Report”), a decision in which both the Institutions and Airtours were involved.
The terms of PwC’s appointment were set out in a letter addressed to “the Engaging Institutions” (“the Letter”) and attached terms and conditions (together, “the Contract”). The Contract provided that Airtours was to pay PwC’s fees (including VAT) for producing the Report and related work, and Airtours duly did so in due course. Airtours then sought to deduct that VAT as input tax in its VAT returns for the relevant periods.
HMRC challenged Airtours’ ability to do so. While HMRC accepted that the Contract was of commercial benefit to Airtours, they contended that Airtours was not entitled to deduct the VAT on PwC’s fees as input tax because PwC’s services under the Contract were not “supplied to” Airtours.
Airtours appealed to the First-tier Tribunal, who found for Airtours. The Upper Tribunal allowed HMRC’s appeal. The Court of Appeal dismissed Airtours’ appeal and Airtours subsequently appealed to the Supreme Court.
Supreme Court judgement
The Supreme Court dismissed Airtours’ appeal by a majority of 3 to 2 meaning that Airtours is unable to recover VAT in relation to the payment made to PwC for the Report.
In order for the VAT charged by PwC and paid by Airtours to be reclaimable as input tax, it must be “VAT on the supply to [Airtours] of any goods or services”. The issue of whether there was a supply of services by PwC to Airtours gave rise to two principal questions which the Supreme Court considered.
The first was whether PwC agreed, under the terms of the Contract, to supply services, and in particular to provide the Report to Airtours.
The Supreme Court considered that PwC’s commitment to provide the services described in the Contract was a contractual commitment to the “Engaging Institutions”, and not to Airtours. This was because:
- (i) the Letter was addressed “To the Engaging Institutions”, and not to Airtours;
- (ii) the Letter provided that the Institutions had retained PwC; there was no suggestion that Airtours had done so;
- (iii) the Letter provided that any reports were “for the sole use of [those] institutions”;
- (iv) the Letter stated that the Report was to be provided to the Institutions and Airtours was only to be provided with a copy, which could be redacted;
- (v) the Letter recognised a duty of care on the part of PwC to the Institutions, but did not acknowledge one to Airtours;
While Airtours did countersign the Letter, it had to do so in order to be bound by certain provisions, such as those relating to the payment of PwC’s fees. The fact that Airtours, rather than the Institutions, was to pay PwC for the services, was considered to raise a prima facie expectation that PwC would owe a duty to Airtours to provide those services. However, the Institutions wanted the services; there was no indication Airtours would have still paid for those services had that not been the case.
The second question arose from Airtours’ argument that, in any event, in order to succeed on this appeal, it did not have to show that it had a contractual right to require the services under the Contract to be provided to the Institutions by PwC to succeed. Rather, Airtours argued that the facts that (i) it had a substantial commercial interest in the services being provided by PwC and (ii) it not merely countersigned the Contract but thereby agreed to pay PwC for the services, justified the conclusion that the services were “supplied” to Airtours, as well as the Institutions.
In delivering the judgement of the Supreme Court Lord Neuberger, Lord Mance and Lord Hodge agreed that UK Court and European Court of Justice judgments were clear that where the person who pays the supplier is not entitled under the contractual document to receive any services from the supplier, then, unless the documentation does not reflect the economic reality, the payer has no right to reclaim by way of input tax the VAT in respect of the payment to the supplier.
Lord Clarke and Lord Carnwath each give judgments dissenting on the analysis of both the Contract and the commercial reality of the relationship between Airtours and PwC. Lord Clarke concluded that, in this case, PwC was making two distinct supplies, one to Airtours, and another to the Institutions. Lord Carnwath considered that it was inappropriate to resolve the appeal on a narrow legalistic approach to construction of the Contract, particularly where the distinction between services to Airtours and services to the Institutions is unlikely to have been seen as of any practical significance to the parties. He further considered that the argument that Airtours, having paid a significant retainer to PwC, did not have an enforceable right, was impossible to accept, either as a matter of contractual construction or as a matter of economic reality.
Although the judgement is based on the specific facts of this particular case, restructuring professionals providing Independent Business Reports may face pressure from the company subject to the IBR to issue engagement terms with the company rather than banks or other finance providers who may also benefit from the IBR and also to have a specific right to receive a copy of the report.
Engagement letters should set out clearly who is to benefit from the IBR while at the same time ensuring appropriate safeguards are included to reflect duty of care to those who may place reliance on the IBR. Payment terms should be clearly documented and differentiated as being distinct from service provision where this is appropriate.