A client was looking to buy a commercial vehicle and the dealer is offering either an HP agreement or a personal contract purchase (PCP) agreement. There can be differing implications for VAT recovery depending upon the type of agreement.
This is a common question due to the proliferation of different types of financing for vehicles. HMRC’s manual distinguishes between a supply of goods, such as a traditional hire purchase arrangement and a supply of services. The guidance states:
“If the possession of goods is transferred … under agreements which expressly contemplate that the property also will pass at some time in the future (determined by, or ascertainable from, the agreements but in any case not later than when the goods are fully paid for)… then it is… a supply of goods”.
In simple terms, therefore, a hire purchase agreement expressly contemplates that title will pass at the end of the term of the agreement, whereas lease agreements, with large balloon payments, for example, may equally end with the lessee walking away from the agreement. This is explored further:
“Some final payments, or payments due at the end of the term of the agreements, are referred to as option payments. These payments are often very small such that it is very unlikely that the customer would not make the payment. In these circumstances, it is clear at the outset of the contract that in the normal course of events title will pass. Therefore, there is a supply of goods at the outset.”
The importance of this distinction between a supply of goods and a supply of services is the impact on the timing of VAT recovery. In a supply of goods, the VAT is chargeable and therefore recoverable at the outset and the VAT invoice/finance agreement should show the VAT as a “lump sum” amount payable upfront and the monthly finance payment should be net of any VAT. Conversely, in a supply of leasing services, the VAT is chargeable and therefore recoverable on each periodic payment and a VAT schedule should be provided by the finance company detailing these payments.
So far so straightforward you may think until presented with a PCP arrangement, where multiple options are available to the lessee and the option payment is substantial. Could it be reasonably argued that ownership will pass in the normal course of events, which was considered in the CJEU case Mercedes Benz Financial Services:
The Court arrived at the conclusion that a judgment must be made by the supplier at the outset of the contract as to what the customer, acting as a rational economic actor, would do when entitled to exercise the option. If the customer could profitably sell the asset for more than the cost of the final optional payment, then if they act rationally it can be expected that they will buy the asset. However, if the optional payment is expected to be the approximate open market value of the asset (or more) at the time the option must be exercised, then the customer may equally choose to purchase the asset or return it. Under such circumstances, it is not the case that in the normal course of events title is to pass.
As such the correct treatment of PCP contracts will depend on the level at which the final optional payment is set:
• If at the start of the contract, it is set at or above the anticipated market value of the goods, it is a supply of leasing with VAT on each instalment;
• If at the start of the contract, it is set below the anticipated market value, such that a rational customer would buy the asset when they exercise the option, it is a supply of goods with a separate supply of finance. VAT is due on the supply of goods in full at the outset and the finance is exempt from VAT.
Consequently, the timing of VAT recovery will depend on the type of agreement and the lessee should be directed by the lessor’s treatment. 
 Reproduced from Croner Taxwise