The rule involves HM Customs & Excise restricting to 50% the proportion of company car hiring or leasing charges that can be declared as a business expense on VAT returns, leading to a reduction in a VAT bill.
This regulation applies where a company car is also used for private purposes and it also frees a business hiring or leasing a car from having to keep records of private mileage, accounting for tax payable on each journey.
The problem with this rule is that it does not comply with standard European Union (EU) VAT directives, even though the European Commission admits it is a 'simplification' designed to help the UK 'combat tax evasion and tax fraud'.
As a result, the British Government has had to apply – every few years – to the Commission and the EU Council of Ministers to be given special dispensation to operate the system. Brussels has so far agreed in 1995 and 2000 to grant the UK de-rogations from standard European VAT legislation, but the latest authorisation expires on December 31 this year and the Commission has voiced concern about its long-term future.
In a memorandum to EU ministers, Brussels had warned that a European Court of Justice (ECJ) ruling requested by Germany's federal finance court could effectively ban the UK system.
German and EU judges were examining the legality of a broader German practice, which limits to 50% deductions to VAT charged on all expenditure relating to vehicles (including purchase, hire and running costs).
But the latest judgement from the ECJ decided that Germany had acted properly when it set a blanket restriction on VAT blocking, adding only that it should not have been made retrospective.
John Lewis, British Vehicle Rental and Leasing Association director general, said: 'Had the judgement, in its totality, gone against the German government, then there would have been a huge additional burden on British industry, along with a heavy impact on the contract hire sector.
'The judgement is actually very good news for the UK contract hire customer because it affirms the principle of blanket restrictions and strengthens the position of the UK.
'That principle is now set in stone and would require new legislation for it to be changed, the likelihood of which is remote in the extreme. We were able to advise HM Customs and Excise of the adverse impact on the industry and its advice in turn would have been incorporated with the UK's submission to the court.'
Background to the case
Walter Sudholz, a German citizen, claimed that the German government had acted illegally in applying a blanket restriction on re-claiming VAT on vehicle purchases in place of a system whereby companies could claim on the ratio of business to private mileage - i.e. if business miles formed 10% of the total mileage then companies could reclaim only 10% of the VAT paid.
Germany applied to the EC for, and was granted, a change from the EU VAT regulations, known as a 'de-rogation', in order to apply a blanket restriction thus removing the administratively costly burden of keeping individual vehicle mileage records by German companies. Where it acted illegally was in applying this restriction retrospectively.
In the UK, HM Customs recognises that the present system is fair and equitable, is administratively straightforward and should not be changed.