“Simply the best- better than all the rest?” Littlewoods v HMRC [2017] UKSC 70 (01 November 2017)
In a stunning decision which reverses previous High Court and Court of Appeal judgments, the Supreme Court has just ruled that HMRC only needs to pay back simple interest rather than compound interest on VAT mistakenly overpaid by the taxpayer between 1973 and 2004.
In Littlewoods, the overpayment principal amount was reportedly £205m and the simple interest calculated was £268m. The additional compound interest calculated by Littlewoods was reportedly £1.25m and so the total compound interest would have been around £1,520m.*
The statutory framework for payment and calculation of interest back to the taxpayer on overpaid VAT payments, comes from s. 78, 80 of the Value Added Tax Act 1994 (VATA 1994) and s. 197 of the Finance Act 1996 and Air Passenger Duty and other Indirect Taxes (Interest Rate) Regulations 1998, which essentially fix the nominal interest rates that can be applied for each applicable year.
Additional common law claims for payment of compound interest made by Littlewoods on the basis that HMRC had been “unjustly enriched” by the payments and interest savings made either as a “mistake of law” (the Kleinwort Benson principle) or by payments of “undue tax” (the Woolwich Equitable principle) were ruled excluded by implication because of the specific drafting and intention behind s.78 of VATA 1994, as interpreted by the Supreme Court.
The question of how the domestic law in this area should be read, to be consistent with broader European law principles had already been examined by the CJEU in 2012 considering the same Littlewoods facts. The CJEU had left open to national governments the choice of simple or compound interest bases, concluding at para 35: “It is for national law to determine, in compliance with the principles of effectiveness and equivalence, whether the principal sum must bear “simple interest”, “compound interest” or another type of interest.” The CJEU had also added cryptically at para 29 that: “The principle requires that the national rules referring in particular to the calculation of interest which may be due should not lead to depriving the taxpayer of an adequate indemnity for the loss occasioned through the undue payment of VAT” and also observed, with apparent approval, at para 30, that the simple interest Littlewoods had already received “exceeds by more than 23% that of the principal amount”.
This left the Supreme Court to interpret the phrase “adequate indemnity” and they concluded at para 70, that: “In our view there is no requirement in the CJEU’s jurisprudence that the value which the member state, by the award of interest, places on the use of money should make good in full the loss which a taxpayer has suffered by being kept out of his money” and that a “broader meaning” of “reasonable redress” should be applied rather than the “full reimbursement” assumed by the lower courts.
The Supreme Court was also happy with the practice of using simple interest, noting at para 60 that: “The CJEU examined the legislation of 13 other member states….In all but one (Sweden) simple interest is payable, both on the recovery by taxpayers of taxes which were unduly paid and on the recovery by tax authorities of taxes paid late….If the CJEU were seeking to outlaw this practice, we would have expected clear words to that effect. They are absent.”
The Supreme Court clearly also agreed at para 59, with the CJEU on the Littlewoods case facts that “interest which is over 125% of the amount of the principal sum might be such reasonable redress” focussing on the fact that this total simple interest amount appeared large when compared with the principal, rather than the opposing fact that the amount still left unpaid, if compound interest was the right measure, was vastly larger.
Overall this was a more than adequate result for HMRC, particularly since the Supreme Court noted at para 6, that there were “A further 5000 claims for compound interest in connection with VAT or other taxes…stayed pending resolution of these claims. The total amount involved in relation to VAT claims is estimated by HMRC at £17 billion”, most of which HMRC will presumably now save, thus increasing net tax revenue, and helping to reduce fiscal pressure in a time of austerity.
* Calculations:
The calculation of interest amounts (as demonstrated by say the ISDA 2006 Interest Rate Definitions) is a potentially complex issue, but key features can be highlighted as follows. Suppose the annual interest rate is R% simple interest per year, then the nominal value of an investment I paying back principal plus interest at maturity after N years is given by the formula: I*(1+RN) and the nominal value of the pure interest component given by: I*RN. (N.B. The argument below applies to interest rates R which are greater than 0 and years N that are initially greater than 1)
Similarly, if the annual interest rate is R% compounding annually per year, then the nominal value of an investment I paying principal plus interest at maturity after N years is given by the formula I*(1+R)^N (i.e. investment I multiplied by factor (1+R), N times over) and the nominal value of the pure interest component given by: I*(1+R)^N – I.
Typically if the same interest rate R is applied, then the nominal value of accrued interest at maturity calculated using simple interest, namely I*RN will be less than the nominal value of accrued interest at maturity calculated using compound interest, namely I*(1+R)^N – I.
Put another way, if Rs is the simple interest rate and Rc is the compound interest rate and if condition: I*RsN = I*(1+Rc)^N-I holds, then Rs the headline simple interest rate applied must be greater than Rc, the headline compound interest rate. Moreover as the number of years N increases and the compound rate increases, so the value of simple interest rate Rs needed to produce the same total interest as compound rate Rc, rises exponentially.
In these circumstances if the same compound rate Rc is substituted directly into the equivalent simple interest rate calculation, then the total interest amount calculated using simple interest as a proportion of the total interest amount calculated using compound interest, quickly falls towards zero.
In Littlewoods, the total simple interest amount calculated would have only been c. 17.5% of the total compound interest and the estimated total saving by applying simple rather than compound interest calculations to the same interest rates, would have been c. 82.5% of the compound interest rate bill. (As a back of the envelope check, taking N=20 and R=11.5% and a single principal of £205m produces comparable results.)
(Rupert Macey-Dare is a commercial barrister and PhD-economist. These are discussion points of the author and do not necessarily reflect the views of any other individuals or organizations, and do not constitute legal or economic advice. The author gratefully acknowledges helpful comments from Josh Critchlow.)
