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Cite as: [2003] UKVAT V18236

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Abbey National PLC v The Commissioners of Customs and Excise [2003] UKVAT V18236 (17 July 2003)

18236

VAT bad debt relief – conditional sale agreement – allocation of instalment payments between goods and credit charge in the case of a mixed or composite supply – whether allocation made by terms of agreement – no – whether allocation to be made in accordance with taxpayer's accounting treatment – no – whether statutory method of apportionment contrary to Sixth VAT Directive and Community law – no – VAT Act 1994 section 36 – VAT Regulations 1995 regulations 170 and 170A – Sixth VAT Directive Article 11 C (1) – appeal dismissed

LONDON TRIBUNAL CENTRE

ABBEY NATIONAL PLC Appellant

- and -

THE COMMISSIONERS OF CUSTOMS AND EXCISE Respondents

Tribunal: Mr A E SADLER (Chairman)

Mr K C MANTERFIELD, FCA

Sitting in public in London 12, 13 and 14 May 2003

Dr David Southern of Counsel, instructed by the Corporate Solicitor of Abbey National plc, for the Appellant

Mr Kenneth Parker, QC and Mr Timothy Ward of Counsel, instructed by the Solicitor for the Customs & Excise, for the Respondents

DECISION

The appeal and the issues in summary

The appeal of Abbey National plc ("the Appellant") relates to a decision of the Commissioners contained in a letter dated 3 August 2000, in which the Commissioners stated their intention of raising an assessment for VAT of £91,439 for the Appellant's VAT quarterly accounting period ended 30 June 2000. By their letter dated 11 November 2002 the Commissioners reduced the assessment to £18,096, and it is this reduced assessment which is the subject of this appeal. We were informed that a second appeal, against a substantially larger sum assessed, and which turns on the same issue as this appeal, has been stood over pending our decision in this case.

The Appellant, as well as being the parent company of the well-known banking and financial services group, is the representative member of the VAT group which at all material times included its wholly-owned indirect subsidiary company, Wagon Finance Limited ("Wagon Finance"). The appeal relates entirely to the business of Wagon Finance and to transactions to which it was a party in the period 1 July 1995 to 31 December 1998. Throughout that period Wagon Finance carried on a business which consisted primarily of the provision of finance for the purchase of vehicles (for the most part motor-cars) by private individuals on credit terms, usually in the form of conditional sale agreements. Some of Wagon Finance's customers defaulted under their agreements, failing to pay all the instalments due, and giving rise to a bad debt for Wagon Finance. As described below, under the VAT treatment applicable to instalment credit finance transactions (where there is a taxable supply of goods and also an exempt supply of credit), such default gives rise to an entitlement for Wagon Finance (or, strictly, the Appellant) to claim bad debt relief for VAT purposes in respect of the VAT which it has paid to the Commissioners in relation to the supply of the goods but which it has failed to recover from the customer because the customer has so defaulted.

The issue between the parties in this appeal relates to the way in which, in these circumstances, and for the purposes of VAT, the aggregate amount received under a conditional sale agreement at the time of default should be allocated between the goods element and the credit element so as to determine the amount of VAT which (because it relates to the goods element) can be regarded as recovered from the customer and (in consequence) the balance which should be regarded as not so recovered by reason of the customer's default: it is this unrecovered balance for which the Appellant can make a claim from the Commissioners under the VAT bad debt relief provisions.

In summary, the Commissioners argue that there is specific legislation which applies to determine for VAT purposes, in these circumstances of a "mixed" supply of goods (taxable) and credit (exempt), the allocation of instalments received as between the goods element and the credit element and the consequent amount which (because it relates to the goods element) is to be treated as unrecovered VAT for which relief is available. (There is a complication in this appeal, explained below, in that the Commissioners have applied the legislation on a concessionary basis and the law has since been changed to reflect this concessionary basis.) The Appellant argues that such legislation (even as applied by concession) does not apply in its terms to Wagon Finance's circumstances, and that such legislation is in any event inconsistent with the over-riding terms of the Sixth Directive on VAT – instead the allocation for VAT purposes of instalments received as between the goods element and the credit element should be determined by reference to implicit terms in the relevant instalment credit finance agreements and the accounting entries which Wagon Finance is compelled by relevant accounting standards to make when it accounts for those instalments.

The Appellant argues that instalment payments received under the instalment credit finance agreements Wagon Finance enters into should be allocated between the goods element (principal or credit balance) and the credit element (interest or finance charge) on an amortisation, or sum of digits, basis where the constant rate of interest implicit in the agreement is applied to a reducing balance of principal so that the principal is reduced to zero at the end of the term of the agreement. The Commissioners argue that the relevant VAT legislation applies so that instalment payments received must be allocated between the goods element and the credit element by straight-line apportionment, each payment over the life of the agreement being so allocated in the proportions of the total cost of the goods and the total credit (interest element) cost.

If the allocation of instalments received as between goods and credit is made on the basis for which the Appellant contends, then at the point when the customer defaults less has been allocated to the goods element than is the case if the legislative system of allocation (for which the Commissioners contend) applies. The result is that the amount of VAT regarded as unrecovered by reason of the bad debt (and therefore eligible for VAT bad debt relief) is greater applying the Appellant's basis of allocation than is the case if the Commissioners' basis of allocation is applied – the difference between the two amounts of VAT regarded as unrecovered as a result of applying the different bases of allocation gives the amount which is assessed and against which the Appellant appeals.

The VAT context and legislation

As stated, Wagon Finance enters into transactions whereby it sells goods (mostly motor-cars) to its customers on instalment credit finance terms, usually by conditional sale agreements (the relevant terms of these agreements, and the relevant statutory framework which applies under the consumer credit legislation to most of the transactions entered into by Wagon Finance, is discussed below). The essence of the arrangement is that the car is sold on deferred payment terms, with Wagon Finance extending credit to the customer, and the total amount paid by the customer by instalment payments reflects both the price of the car and the credit which Wagon Finance has made available.

It is necessary to understand first the VAT treatment of a sale made on instalment credit finance terms. Such a sale is regarded for VAT purposes as a supply of goods (the car) and also a supply of services (the provision of credit). In the present case the supply of goods is a taxable supply at the standard rate and the supply of services is an exempt supply (if the car is second-hand, special rules may apply to determine the extent of the standard-rated supply, but nothing turns on that in this appeal). The conditional sale agreement will specify an amount which is the "total cash price of goods" (that is, the price which would be paid if the car were sold for immediate cash settlement of the price), and it is common ground that the VAT payable in respect of the sale of the car is fixed by reference to that amount. The balance of the amount paid under the conditional sale agreement (identified in the agreement as the "total charge for credit") is regarded for VAT purposes as the consideration given for the provision of credit for which no VAT is chargeable as it is an exempt supply of services.

When Wagon Finance sells a car under a conditional sale agreement it must charge the customer VAT on the supply of goods (by reference to the total cash price) and account to the Commissioners for that VAT. The VAT legislation relating to the time of supply requires Wagon Finance to account for the whole of that VAT when possession of the car passes to the customer – effectively this will be when the customer drives the car away having signed his conditional sale agreement and paid whatever deposit is required under that agreement. Wagon Finance is out of pocket at this point, since it must make immediate payment of all the VAT chargeable on the sale of the car, but it will receive payment for the car (including recovery of the VAT which it has already accounted for) by instalments over the lifetime of the conditional sale agreement.

If the conditional sale agreement runs its full course, all instalments will be paid, and Wagon Finance will recover all the VAT chargeable (and which it has accounted for) on the sale of the car. If, however, the customer defaults and Wagon Finance is unable to recover outstanding instalments, the VAT bad debt relief provisions take effect so that (in broad effect) Wagon Finance is able to reclaim from the Commissioners that portion of VAT it has accounted for on the sale of the car but which it has failed to recover from the customer because of his default.

The principle is clear, but the difficulty arises when (as with a conditional sale agreement or other form of sale on instalment credit finance terms) there is a "mixed" or "composite" supply, that is, a taxable supply alongside an exempt supply, and where payments made are consideration for both supplies. When the customer defaults, what amounts respectively are to be regarded as having been paid for the taxable supply on the one hand and for the exempt supply on the other?

The Sixth VAT Directive sets out the general rules which Member States are required to implement by domestic legislation. Article 11 A (1)(a) provides the general rule which governs the amount on which VAT is chargeable:-

The taxable amount shall be:

(a) in respect of supplies of goods and services other than those referred to in (b), (c) and (d) below, everything which constitutes the consideration which has been or is to be obtained by the supplier from the purchaser, the customer or a third party for such supplies including subsidies directly linked to the price of such supplies…

Article 11 C (1) deals with cases where adjustment is required to the taxable amount:-

In the case of cancellation, refusal or total or partial non-payment, or where the price is reduced after the supply takes place, the taxable amount shall be reduced accordingly under conditions which shall be determined by the member states.

However, in the case of total or partial non-payment, member states may derogate from this rule.

Thus it is a requirement of the Sixth Directive that the taxable amount must be reduced in the case of bad debts (that is, where there is "total or partial non-payment"), but subject to the right of a Member State to derogate from this rule.

The domestic legislation enacted by the UK to deal with bad debt relief is to be found in section 36 of the Value Added Tax Act 1994 and regulation 170 of the Value Added Tax Regulations SI 1995/2518. For the purposes of this appeal the relevant parts of the legislation are as follows:-

Bad debts

(1) Subsection (2) below applies where –

(a) a person has supplied goods or services and has accounted for an paid VAT on the supply,

(b) the whole or any part of the consideration for the supply has been written off in his accounts as a bad debt, and

(c) a period of 6 months (beginning with the date of the supply) has elapsed.

(2) Subject to the following provisions of this section and to regulations under it the person shall be entitled, on making a claim to the Commissioners, to a refund of the amount of VAT chargeable by reference to the outstanding amount.

(3) In subsection (2) above "the outstanding amount" means –

(a) if at the time of the claim no part of the consideration written off in the claimant's accounts as a bad debt has been received, an amount equal to the amount of the consideration so written off;

(b) if at that time any part of the consideration so written off has been received, an amount by which that part is exceeded by the amount of the consideration written off;

and in this subsection "received" means received either by the claimant or by a person to whom has been assigned a right to receive the whole or any part of the consideration written off.

…

(5) Regulations under this section may –

…

(f) include such supplementary, incidental, consequential or transitional provisions as appear to the Commissioners to be necessary or expedient for the purposes of this section;

…

(6) The provisions which may be included in regulations by virtue of subsection (5)(f) above may include rules for ascertaining –

(a) whether, when and to what extent consideration is to be taken to have been written off in accounts as a bad debt;

(b) whether anything received is to be taken as received by way of consideration for a particular supply;

(c) whether, and to what extent, anything received is to be taken as received by way of consideration written off in accounts as a bad debt.

….

Regulation 170 (Attribution of payments) of the VAT Regulations 1995 is as follows:-

170 - (1)Where –

(a) the claimant made more than one supply (whether taxable or otherwise) to the purchaser, and

(b) a payment is received in relation to those supplies,

the payment shall be attributed to each such supply in accordance with the rules set out in paragraphs (2) and (3) below.

(2) The payment shall be attributed to the supply which is the earliest in time and, if not wholly attributed to that supply, thereafter to supplies in the order of the dates on which they were made, except that attribution under this paragraph shall not be made to any supply if the payment was allocated to that supply by the purchaser at the time of payment and the consideration for that supply was paid in full.

(3) Where –

(a) the earliest supply and other supplies to which the whole of the payment could be attributed under this regulation occur on one day, or

(b) the supplies to which the balance of the payment could be attributed under this regulation occur on one day,

the payment shall be attributed to those supplies by multiplying, for each such supply, the payment received by a fraction of which the numerator is the outstanding consideration for that supply and the denominator is the total outstanding consideration for those supplies.

For reasons which will become apparent, it is also helpful to set out the provisions of regulation 170A of the Value Added Tax Regulations. Regulation 170A has effect from 1 January 2003, and therefore is not in its terms applicable to this appeal. Regulation 170 is, as from 1 January 2003, subject to regulation 170A:

170A – (1) Where-

(a) the claimant made a supply of goods and, in connection with that supply, a supply of credit;

(b) those supplies were made under a hire purchase, conditional sale or credit sale agreement; and

(c) a payment is received in relation to those supplies (other than a payment of an amount upon which interest is not charged),

the payment shall be attributed to each supply in accordance with the rules set out in paragraph (2) below.

(2) The payment shall be attributed –

(a) as to the amount obtained by multiplying it by the fraction A/B to the supply of credit; and

(b) as to the balance, to the supply of goods,

where –

A is the total of the interest on the credit provided under the agreement under which the supplies are made (determined as at the date of the making of the agreement); and

B is the total amount payable under the agreement, less any amount upon which interest is not charged.

(3) Where an agreement provides for variation of the rate of interest after the date of the making of the agreement then, for the purposes of the calculation in paragraph (2) above, it shall be assumed that the rate is not varied.

It will be seen that the scheme of the UK legislation is as follows:-

1 Section 36 entitles the taxpayer to claim a refund of VAT which has been paid on a supply of goods or services where the whole or part of the consideration for the supply has been written off in the taxpayer's accounts as a bad debt.

2 The refund is to be calculated by reference to the "outstanding amount": that is the amount written off as a bad debt (less the amount (if any) which, although written off, has been received).

3 Where, as in the case of the Appellant, the person claiming bad debt relief has made more than one supply to the defaulting purchaser (in this case, a taxable supply and an exempt supply) and there has been some payment in relation to those supplies, there has to be attribution of the payment received to each supply.

4 The general attribution rule is that payments are attributed in time order, that is, first to the supply which is the earliest in time, and after that has been treated as paid for in full, the balance of the payments (if there is such a balance) is attributed to the next in time supply, and so on. This "first in time" attribution is displaced where the purchaser has allocated the payment to a particular supply and the consideration for that supply was paid in full.

5 If the various supplies to which the payment could be attributed occur on the same day, the payment is attributed to each supply on a straight-line apportionment basis by reference to the outstanding consideration for the supply as a proportion of the total outstanding consideration for all supplies.

6 Where regulation 170A applies (that is, in the case of conditional sale agreements and other instalment credit finance arrangements), the straight-line apportionment applies regardless of whether the exempt and taxable supplies are first made on the same day. The straight-line apportionment is made by reference to the proportion of the total credit charge at the outset of the agreement to the total amount payable under the agreement (less any amount on which interest is not charged, such as an initial deposit).

In the case of conditional sale agreements these provisions can work in a particular way (which, the Commissioners were prepared to concede when introducing the concession referred to below, might produce an unfair result): as mentioned, in the case of such agreements there is a taxable supply of the goods and an exempt supply of credit, so that payments made must be attributed to those respective supplies. Under the VAT rules relating to the time of supply of goods and services (not in dispute in this appeal), in the case of the supply of goods, the time of supply is the date when possession of the goods passes to the purchaser (or when the VAT invoice is issued, if earlier); in the case of the supply of the services (the credit), since the credit is supplied over the period of the agreement, there is a separate and successive supply each time a payment is received, and the supply is treated as taking place only to the extent covered by the payment. Since, therefore, the taxable supply of goods takes place before any supply of credit takes place (and not on the same day), the Commissioners have previously proceeded on the basis that regulation 170(2) applies, so that payments are attributed first to the supply of goods, and only after payment in full for the goods can any balance be attributed to the exempt supply of credit, with a consequent reduction in (or perhaps elimination of) the amount outstanding for which VAT bad debt relief can be claimed in respect of the supply of the goods. The initial decision of the Commissioners against which the Appellant appealed applied regulation 170(2), to this effect.

In December 2001 the Commissioners announced that, as a matter of concession, regulation 170(2) would no longer be applied in the case of supplies under hire-purchase or conditional sale agreements: instead, taxpayers were given the right to allocate payments between the goods and the credit supplies by applying the straight-line apportionment as provided in regulation 170(3), notwithstanding that the supply of goods and the supply of credit did not occur on the same day according to the time of supply rules. The initial decision of the Commissioners in relation to the Appellant was amended so as to apply regulation 170(3) to the circumstances of the Appellant in this concessionary way. This significantly improved the position for the Appellant by reducing the amount paid by the defaulting purchaser which fell to be allocated to the taxable supply of goods, and consequently increasing the amount for which VAT bad debt relief could be claimed in respect of the supply of the goods. Nevertheless, the Appellant argued that a different method of allocation should apply, based on the contractual terms and the accounting treatment of payments received, which increased still further the amount qualifying for VAT bad debt relief. The Appellant therefore continued its appeal.

New provisions were introduced with effect from 1 January 2003 as regulation 170A which puts on a statutory footing the straight-line apportionment concessionary treatment extended by the Commissioners to suppliers of goods under instalment credit finance agreements.

In this appeal the Commissioners were prepared to argue their case by reference to the concession they had announced (with a straight-line method of allocating payments received between the credit and the goods in the proportions of the total cost of credit (interest element) and the total cost of the goods, following regulation 170(3) and foreshadowing regulation 170A), rather than relying on the application of regulation 170(2), which was the basis of the initial decision giving rise to the appeal. Whilst it is convenient to characterise the approach of the Commissioners to the key issue of allocation of payments as being the "statutory formula" (as opposed to the "accounts/contracts formula" for which the Appellant contends), that approach as it relates to the circumstances of this appeal is concessionary.

Evidence and findings of fact

For the Appellant we heard evidence from Mr. K. W. Horlock, and Ms D.E. Roberts from Wagon Finance, and Dr. R. Barnes who appeared as an expert witness for the Appellant. For the Commissioners we had evidence in the witness statement of Mr. P. J. Leung and the witness statement of Mr. P. Hannick, both officers of the Commissioners.

Mr. Horlock was actively engaged in the management of the business of Wagon Finance during the period relevant to the appeal. His evidence related to the nature of that business and the instalment credit finance agreements which it entered into with its customers. We were shown examples of conditional sale agreements entered into by Wagon Finance. We find the following facts from Mr. Horlock's evidence (from his witness statement and from his cross-examination by Mr. Parker for the Commissioners and from the sample agreements referred to by Mr. Horlock):-

1 Wagon Finance specialises in the provision of finance for the purchase of new and second-hand cars and motorcycles. It raises its funds for its business solely by borrowing from its parent company, paying interest on the borrowed funds, and entering into financing transactions with its customers on a basis intended to result in a specified net percentage return on the credit advanced to those customers and an overall specified return on shareholder funds invested in the business.

2 Wagon Finance provides finance to customers exclusively by means of conditional sale agreements. A customer approaches, say, a car dealer wishing to purchase a car and requiring finance to make that purchase. If Wagon Finance agrees to finance the purchase of the car, Wagon Finance purchases the car from the dealer for the price which the customer has agreed to pay for the car (less any deposit paid by the customer), and immediately resells the car to the customer on the terms of a conditional sale agreement. Wagon Finance makes no profit from the purchase and re-sale of the car as such – its profit is made from the provision of the finance extended to the customer over the life of the conditional sale agreement. Wagon Finance pays the car dealer a commission for the business introduced.

3 The terms of the conditional sale agreement require the customer to pay fixed amount instalments (usually monthly) over the period of the agreement, and on payment of the final instalment the title to the car is transferred from Wagon Finance to the customer.

4 Most, but not all, of the conditional sale agreements which Wagon Finance enters into are "regulated agreements" within the terms of the Consumer Credit Act 1974. The terms of the agreements must therefore comply with the detailed legislation in and derived from this Act, which regulates all the material terms of conditional sale agreements. In Wagon Finance's practice, the form of conditional sale agreements used for car sales which (because the price exceeds the statutory maximum) are outside the consumer credit legislation will nevertheless follow in all material respects the form of the "regulated agreements".

5 Regulated agreements must specify the total cash price of the car (part of which may be paid by initial deposit or part exchange); the amount of credit provided (in effect the credit extended by Wagon Finance for the total cash price of the car less any deposit); the total charge for credit (i.e. the aggregate amount of "interest" over the life of the agreement); the total amount payable by instalments (the amount of credit plus the total charge for credit); the number of instalments and their frequency; and the amount of each instalment. The agreement must also state the "annual percentage rate of charge" ("APR"), which is the total charge for credit expressed as an annualised percentage interest rate applied to the amount of credit provided – the implicit annual rate of interest paid by the customer on the credit advanced to him by Wagon Finance over the life of the agreement.

6 Wagon Finance enters into three broad types of conditional sale agreement: full repayment contracts (where the total amount payable is repaid by a fixed number of equal instalments); dealer subsidy contracts (where, again the total amount is repaid by a fixed number of equal instalments, but the total charge for credit under the agreement is a reduced amount (with a consequent reduction in the APR) because the car dealer (by way of sales promotion) is prepared to meet part of the cost of credit by making a subsidy payment to Wagon Finance at the outset of the agreement); and personal contract plans (where the final instalment is a "balloon" payment of a substantial amount reflecting the anticipated residual value of the car at the end of the agreement period – all prior instalments are reduced accordingly). A personal contract plan may be combined with a dealer subsidy contract.

7 In the case of regulated agreements, the consumer credit legislation gives certain statutory rights to a customer and these must be specified in the terms of the conditional sale agreement. These rights limit the entitlement of Wagon Finance to repossess cars on default by a purchaser. The purchaser may also terminate the agreement without further liability if he has paid (or pays on termination) half the total instalments and returns the car. Subject to these statutory rights, if a purchaser wishes to terminate the agreement and retain the car, or if a purchaser defaults in performance of his contractual terms, he is required to pay the balance of unpaid instalments (less the trade value of the car as reduced by sale costs if it is recovered by Wagon Finance), but Wagon Finance is then required to give a rebate of credit charges calculated by a statutory formula (so that, where the credit is repayable by equal instalments at equal intervals, as in full repayment contracts, the rebate is calculated by the "rule of 78" (sum of digits) formula, as referred to below).

8 The conditional sale agreements entered into by Wagon Finance do not specify how each instalment is allocated between a charge for the credit provided (or an interest charge) and the repayment of the credit provided (or principal repayment). It is possible to calculate such an allocation by reference to the APR stated in the agreement. A customer has no right to require such a calculation to be made. In the case of the "personal contract plan" agreements, it is not specified that the final "balloon" instalment is to be allocated to repayment of the credit. Again, it is possible to calculate such an allocation by reference to the other instalments and the APR. A customer has no right to require such a calculation to be made.

9 The losses which give rise to the claim for VAT bad debt relief in this appeal are losses which arise when a customer fails to meet his contractual obligations and, notwithstanding any action which Wagon Finance takes to recover outstanding instalments or to repossess (and, if successful, to resell) the car, Wagon Finance is unable to recover the full amount due to it.

As mentioned, Mr. Horlock in giving his evidence referred us to sample conditional sale agreements entered into by Wagon Finance. The key financial provisions of those agreements are mentioned above. For the sake of completeness we set out the remaining terms of those agreements which may be relevant in this appeal:-

1 Each agreement sets out on the frontsheet of the document the name and relevant details of the customer, and what is described as the "Financial and Goods Details", namely the description of the vehicle, the cash price of the goods, the amount of the deposit, the total amount of credit extended, the total interest charge (which, together with an administration fee gives the total charge for credit), the payable balance by instalments (being the total amount of credit extended plus the total charge for credit), the total amount payable (being the payable balance plus deposit), the APR, the number of monthly instalments and the date of the first instalment (one month after the date of the agreement), and the amount of each instalment.

2 There is a separate statement of the "Wagon Payment Protection Plan" – this is a form of insurance cover provided by a third party for payment of the instalments in the event of death, disability or redundancy of the customer (the detailed terms are not relevant): the amount of the premium is extended as credit by Wagon Finance to the customer, who pays the amount (plus credit charge) by instalments on the same occasion as he pays instalments for the vehicle. The agreement states the amount of the insurance premium, the total charge for credit, the total amount payable, the APR (which may not be the same as for the instalment payment arrangements for the vehicle), and the number, frequency and amount of the instalments.

3 There is a statement of the customer's "total monthly instalments", which is the aggregate of the monthly instalment amounts payable for the vehicle and for the insurance cover. It is provided in the agreement (Cl. 17) that payments received from the customer shall be applied proportionally between the conditional sale and the insurance loan parts of the agreement subject to the Consumer Credit Act 1974.

4 The agreement also sets out on the frontsheet the statutory rights relating to termination. They are expressed in the following terms:

REPOSSESSION: YOUR RIGHTS

If you fail to keep to your side of this agreement but you have paid at least one third of the total amount payable under this agreement, that is £[ ], we may not take back the goods against your wishes unless we get a court order…If we do take them back without your consent or a court order, you have the right to get back all the money you have paid under the agreement.

TERMINATION: YOUR RIGHTS

You have a right to end this agreement. If you wish to do so, you should write to the person authorised to receive your payments. We will then be entitled to the return of the goods and to half the total amount payable under this agreement, that is £[ ]. If you have already paid at least this amount plus any overdue instalments, you will not have to pay any more, provided you have taken reasonable care of the goods.

5 The agreement is expressed to be a conditional sale agreement between the customer and Wagon Finance. Wagon Finance agrees to sell and the customer agrees to purchase the goods on the terms set out in the agreement (including the frontsheet).

6 Cl. 1 of the Conditional Sale Terms requires the customer to pay the instalments specified in the frontsheet; to pay interest on overdue instalments and other sums due at the specified APR; and to maintain, insure, retain possession of the goods, etc.

7 Cl. 2 provides that property in the goods will pass to the customer when the customer has paid all the instalments and other sums due under the agreement.

8 Cl. 3 gives Wagon Finance the right to end the agreement and take the goods on the happening of any of the specified events of default (including the customer's failure to pay any instalment on is due date; any breach of any of the terms of the agreement; death or insolvency of the customer). Cl 4 is in the following terms:-

"If this Agreement is ended under Clause 3 above you [the customer] shall pay to us [Wagon Finance]:

all instalments in arrears at that time plus interest under Clause 1.2 above; plus

the total of the instalments which would have fallen due after ending the Agreement if it had not ended at that time, less

the trade value of the goods if recovered by us, less the costs of sale

We will give you any rebate of credit charges under the [Consumer Credit] Act upon receiving full payment from you."

9 There are corresponding default and termination provisions in relation to the payment of instalments for the insurance cover.

10 Separately, there is a statement headed "YOUR RIGHTS" which includes the following:

"The Consumer Credit Act 1994 covers this agreement and lays down certain requirements for your protection which must be satisfied when the agreement is made. If they are not, we cannot enforce the agreement against you without a court order.

The Act also gives you a number of rights. You have a right to settle this agreement at any time by giving notice in writing and paying off all amounts payable under the agreement which may be reduced by a rebate…."

11 The final sheet of the agreement includes the "Supplier's Declaration to Wagon Finance Limited". By this the supplier (the car dealer) offers to sell Wagon Finance the goods described in the frontsheet of the agreement at the total cash price to enable Wagon Finance to enter into the agreement with the customer. The supplier gives certain warranties to Wagon Finance as to the ownership, insurance, recorded mileage etc of the vehicle, and confirms that the agreement was completed and signed by the customer on the supplier's trade premises.

12 In the case of agreements which are "personal contract plans" (with a "balloon" payment as the final instalment), the instalment details on the frontsheet separately specify the amount of the final instalment, but in all other respects the terms of the agreement are identical to those where all the instalments are equal in amount.

Dr. Barnes is Assistant Professor of Accounting at London Business School. He has degrees in Mathematics and Finance and a PhD in Accounting. He is a member of the Institute of Chartered Accountants in England and Wales. He gave evidence as to the appropriate method of allocating the finance charge payable under a hire-purchase contract or a conditional sale agreement over the term of the contract. He also gave evidence as to the requirements of the relevant accounting standards on the subject of allocating finance charges payable under such contracts. His evidence, as it related to the matters on which he was expert, was not challenged by the Commissioners, and we therefore accept it. It was as follows:-

1 In the case of a conditional sale agreement there are three recognised methods for allocating the finance charge accruing over the contract period between the accounting periods which fall within the contract period. These methods equally apply to allocate or identify the finance charge within each instalment payment (effectively treating each instalment period, monthly or whatever, as a separate accounting period). These methods, and their consequences, can be illustrated by a simple example of a finance company selling a car on hire-purchase or conditional sale terms to a customer, where the total cash price of the car is £19,000, and the customer pays an initial deposit of £1,000 followed by 36 monthly instalment payments of £600 each. Thus the amount of credit provided is £18,000, the total amount payable by instalments is 36 x £600 = £21,600, and the total charge for credit is £21,600 - £18,000 = £3,600.

2 The simplest allocation method is the straight-line method. The total charge for credit is divided by the number of instalments to determine the finance charge attributable to each monthly instalment. Thus £3,600 is divided by 36, giving £100 which, out of each instalment of £600, is the finance charge/interest element (the remaining £500 being a repayment of credit/principal). This gives a constant finance charge amount for each instalment, notwithstanding that the outstanding amount of credit/principal is reducing by £500 month by month. In consequence, with these figures, the effective rate of interest in month 1 is 0.56%, whereas in month 36 the effective rate of interest has increased to 20%. The amount of finance charge/interest for any month is therefore not directly and proportionately related to the outstanding balance of credit/principal for that month. Put differently, the straight-line method of allocating the finance charge does not result in a constant implicit interest rate (or rate of return) applied to the reducing balance of outstanding credit/principal as the instalments are paid month by month. In this respect it has the advantage of simplicity, but in economic terms it produces a result which is far from reasonable.

3 By contrast, the actuarial method takes as its premise the requirement that, for each month, the amount of the finance/interest charge must be directly and proportionately related to the outstanding balance of credit/principal for that month. That is achieved by using a constant rate of interest applied to the outstanding balance of credit/principal for any month, which gives the amount of the finance charge for that month (the balance of the monthly instalment being the amount treated as repaying the credit/principal). In the simple example above, a monthly rate of interest of 1.0207% is the constant rate (referred to as the implicit interest rate in the agreement) which, applied in relation to 36 instalment payments of £600 each, reduces the credit/principal amount to zero on the final monthly payment whilst giving an aggregate finance charge over the period of the contract of £3,600. Applying this method, in month 1 the amount of finance charge/interest is £18,000 (outstanding credit balance) x 1.0207% = £183.73, and the balance of the monthly instalment £(600 – 183.73) = £416.27 is allocated to repayment of credit/principal. Therefore the outstanding credit balance for month 2 is £(18,000 – 416.27) = £17,583.73. The constant interest rate of 1.0207% applied to this balance gives a finance charge for month 2 of £179.49, and the balance of the £600 instalment is treated as a further reduction in the outstanding credit balance. In this way, in each successive monthly instalment, the finance charge element reduces and the credit repayment element increases. By month 36 the final instalment of £600 is allocated at to £593.94 to credit repayment (reducing the credit balance to zero) and as to £6.06 (1.0207% of £593.94) to finance charge (giving an aggregate finance charge over the 36 months of £3,600). In the context of a conditional sale agreement which is a regulated agreement, the APR which must be stated in accordance with the requirements of the consumer credit legislation is the implicit interest rate determined by applying the actuarial method of allocation to the instalment terms of the agreement (the monthly rate of 1.0207% in the example, when annualised, would give the APR for that agreement).

4 The "rule of 78" (or "sum of the digits") method of allocation is best described as an approximation of the (mathematically complex but precise) actuarial method. It has the same objective of allocating the finance charge/interest element on a basis which ensures a direct and proportionate link between the outstanding credit balance at each month and the amount of the finance charge for that month. It works by first calculating the "sum of the digits", so that in a conditional sale agreement with 36 monthly instalments the sum of the digits is 1 + 2 + …. + 36 = 666. The amount of the finance charge within the instalment in month 1 is 36/666ths of the total finance charge over the life of the contract (i.e. in the example above, 36/666ths of £3,600 = £194.59), and the balance of the instalment, £(600 – 194.59) = £405.41, is treated as reducing the outstanding credit balance); in month 2 the finance charge is 35/666ths of the total finance charge (£189.19), and so on until month 36, where the finance charge is 1/666ths of the total finance charge (£5.41). In this ways the total finance charge is allocated over the lifetime of the contract in a proportionate calculation, but the method is inexact and gives an effective interest rate which is not constant (in the example used, the monthly implicit rate in month 1 is 1.08%, reducing to 0.91% in month 36). The rule of 78 method is a commercially acceptable alternative to the actuarial method, but in some circumstances it can yield significantly different results from the mathematically correct actuarial method, and in those circumstances where the differences are material in their particular context the actuarial method should be used to allocate finance charges over the life of the agreement.

5 The relevant UK accounting standard, Statement of Standard Accounting Practice 21, Accounting for Leases and Hire Purchase Contracts, requires that "the total gross earnings under a finance lease [and by extension, also a hire-purchase or a conditional sale agreement] should normally be allocated to accounting periods to give a constant periodic rate of return to the lessor's net cash investment in the lease in each period": para. 39. International and US accounting standards impose similar requirements. Thus in order to comply with accounting standards a company which sells goods on conditional sale terms must apply the actuarial method, or the rule of 78 method if that does not produce a materially different result, to determine in its accounts for each accounting period during the currency of the conditional sale agreement the finance charge to be allocated to the respective accounting periods.

Ms Roberts is an Associate of the Institute of Chartered Accountants in England and Wales, and at the relevant times was the Financial Controller of Wagon Finance, with responsibility for drawing up its management and statutory accounts. Her evidence related to the accounting treatment by Wagon Finance of the conditional sale agreements. She also produced a financial analysis of sample conditional sale agreements. We find the following facts from Ms Roberts's evidence (from her witness statement and from her cross-examination by Mr. Parker for the Commissioners, from the statutory accounts of Wagon Finance to which Ms Roberts referred in her evidence, and from her financial analysis of the sample agreements):-

1 For the relevant years the statutory accounts of Wagon Finance have been prepared on a consistent basis, and accepted by the auditors of the company without any qualifications.

2 To comply with the relevant accounting standards, Wagon Finance was required to record in its statutory accounts all income earned in an accounting period and expenditure incurred in earning that income matched to the same period. Wagon Finance complied with this requirement in the case of fixed rate conditional sale agreements (that is, all its retail finance business) by using the rule of 78 method to allocate the finance charge over the duration of the agreement. The finance charge so treated as earned in an accounting period goes into the profit and loss account for that period. The portion of the instalment payment which is allocated to the repayment of credit/principal reduces the loan asset in the balance sheet in the accounts.

3 Use of the rule of 78 is standard throughout the consumer finance sector to allocate the finance charge income over the lifetime of fixed rate conditional sale agreements, and also for calculating the amount of rebate paid to customers on early termination of their agreements, in accordance with the consumer credit legislation. It is accepted that the rule of 78 method is not as precise as the actuarial method, giving a stepped series of finance charge receipts, rather than an exact constant rate of return, but it affords a close approximation to the actuarial method and is an easier basis of calculation.

4 A straight-line apportionment method applied to ascertain the finance charge earned by Wagon Finance from an agreement in any accounting period would not have effect to match the finance charge received with the expenditure incurred (i.e. the interest paid by Wagon Finance on its borrowings) in that accounting period to earn the finance charge income. Relative to interest expenditure incurred on borrowings, the straight-line method produces losses in the early period of the agreement (when, in relation to credit outstanding, the finance charge is low), and profits in the later period (when, in relation to the reduced balance of credit outstanding, the finance charge is high). If the statutory accounts for the relevant years had been drawn up using the straight-line apportionment to determine the finance charge accruing in an accounting period it is likely that the accounts would have been qualified by the auditors as not complying with the applicable accounting standards and not therefore giving a true and fair view of Wagon Finance's financial state or performance.

5 When a customer defaults and a bad debt arises, that bad debt will comprise two elements: (a) the balance of the price of the vehicle (the amount of credit outstanding); and (b) the finance charge (interest) outstanding. Wagon Finance has a bad debt procedure for monitoring and making provision for the default. Once the procedures for recovery of the debt are concluded, and the amount of the bad debt quantified, the capital element of the unrecovered balance is charged to the profit and loss account as a deduction for accounting purposes, and the balance of finance charge outstanding is deducted from future interest receivable and no further credits for finance charge are recognised in the profit and loss account.

6 Under the consumer credit legislation, a customer purchasing goods under a regulated agreement has the right to terminate early his conditional sale agreement. Subject to certain statutory rights, he is then required to pay the balance of instalments due whereupon he is paid a rebate, calculated (by reference to the APR specified in the agreement) on a statutory formula basis (the formula is derived from the rule of 78 in the case of fixed-rate agreements). The purpose of the rebate is to readjust the aggregate amount of the finance charge so that it properly relates to the actual (i.e. reduced) period over which credit has been extended – the monthly instalments will have been calculated at the outset on the basis that the credit is to be extended on a reducing balance basis over the full term of the agreement.

7 In the case of "dealer subsidy" agreements, no reference is made to the "dealer subsidy" arrangement in the conditional sale agreement, nor is the customer necessarily aware of the subsidy, although its effect is, of course, reflected in the instalments payable and the (reduced) APR stated in the agreement. The "dealer subsidy" received by Wagon Finance may be netted off against the commission which Wagon Finance pays the dealer for introducing the customer.

8 In the case of "personal contract plans", the terms of the conditional sale agreement do not allocate the "balloon" payment as a payment for the car, or in reduction of the outstanding credit balance: the payment is simply expressed as the final instalment payment.

9 By reference to the sample conditional sale agreements produced in evidence, if the rule of 78 method (as against the straight-line method) is used to allocate each instalment payment as between the finance charge/interest element and the credit repayment/principal element, the outstanding balance of credit/principal (representing the cost of the car) reduces more slowly by applying the rule of 78 method. This is so for each type of agreement, but is less so in the case of "dealer subsidy" agreements (where the dealer subsidy reduces the amount of finance charge paid over the life of the agreement by the customer) and also in the case of "balloon" payments under "personal contract plans", where the bulk of the credit repayment/principal is not discharged until the final "balloon" instalment.

10 It follows that, on default giving rise to a bad debt, since the outstanding balance of credit/principal (representing the unpaid purchase price of the car) reduces more quickly where the straight-line method of allocation is used than is the case where the rule of 78 method of allocation is applied, the bad debt attributable to the unpaid purchase price of the car is less where the straight-line method of allocation is used than is the case where the rule of 78 method of allocation is used.

11 By reference to the sample agreements and tables produced as part of the evidence of Ms Roberts:-

(a) In the case of a "standard" conditional sale agreement, where the capital/amount of credit provided was £2,000, the total charge for credit was £787.84, the APR was 25.6% and the agreement required the customer to pay 36 monthly instalments of £77.44 (disregarding the payment protection insurance instalments), at the time of default by the customer (month 22), the capital balance applying the rule of 78 was £959.95, and the capital balance applying the straight-line apportionment was £777.78;

(b) In the case of a "dealer subsidy" conditional sale agreement, where the capital/amount of credit provided was £3,332, the total charge for credit was £354.40, the APR was 6.8%, and the agreement required the customer to pay 36 monthly instalments of £102.40, at the time of the default by the customer (month 2), the capital balance applying the rule of 78 was £3,258.76, and the capital balance applying the straight-line apportionment was £3,239.44. Had the agreement run until month 22, the capital balance applying the rule of 78 would have been £1,282.77, and £1,203.12 applying the straight-line apportionment;

(c) In the case of a "personal contract plan" conditional sale agreement (i.e. with a "balloon" payment as the final instalment), where the capital/amount of credit provided was £10,324.21, the total charge for credit was £2,936.75, the APR was 9.9%, and the agreement required the customer to pay 47 monthly instalments of £178.77 and a final instalment of £4,680, at the time of the default by the customer (month 12), the capital balance applying the rule of 78 was £9,452.56, and the capital balance applying the straight-line apportionment was £8,654.17 (using the re-computed figures supplied by the Commissioners at the hearing).