Report for the Hearing delivered in Case 416/85

I — Summary of the facts

Article 28 (2) of the Sixth Council Directive of 17 May 1977 on the harmonization of the laws of the Member States relating to turnover taxes — Common system of value-added tax: uniform basis of assessment (Directive 77/388/EEC, hereinafter referred to as the Sixth Directive, Official Journal L 145, p. 1) provides as follows :

The last indent of Article 17 of the Second Council Directive of 11 April 1967 on the harmonization of legislation of Member States concerning turnover taxes (Official Journal, English Special Edition 1967, p. 16), to which Article 28 of the Sixth Directive refers, provides that:

Article 28 of the Sixth Directive therefore provides for exemption from VAT with refund of the tax paid at the preceding stage. Under that system VAT is paid at all stages of the distribution chain except the retail stage. At that stage the consumer is not required to pay VAT and the retailer receives a refund of the input tax paid.

The United Kingdom used the possibilities of exemption provided for in Article 28 to retain a system known as zero-rating, now governed by Schedule 5 of the Value-added Tax Act 1983 (which reenacted almost in its entirety Schedule 4 of the Finance Act 1972). The system of zero-rating applies to the supplies specified in a list comprising 17 groups of goods and services and, according to the Commission (source: Report from the Commission to the Council annexed to the reply; extracts reproduced on page 3 of the reply), covers some 35% of private consumption in the United Kingdom, whereas — again according to the Commission — in other Member States such as Italy, Belgium and. Denmark similar systems of relief only apply to a relatively small part of the VAT base.

Consequently, VAT coverage in the United Kingdom is limited to 44% of private consumption as compared with 90% in most other Member States (source: extracts from the White Paper on the completion of the internal market reproduced by the Commission at page 6 of its reply).

Zero-rating differs from the system of exemption with refund inasmuch as no VAT is charged on zero-rated goods and services at the various suges of the marketing chain. Consequently, at the retail stage there is no VAT to refund.

Despite that difference, the Commission accepts that, as far as the fiscal result is concerned, the system of zero-rating as applied by the United Kingdom is equivalent to the system of exemption with refund of the VAT paid at the preceding stage, provided for by Article 28 (2) of the Sixth Directive.

The Commission also accepts that the system of zero-rating does not affect the Community's own resources and that it was already in force on 31 December 1975, the material date for the purposes of the Sixth Directive.

However, the Commission contests the application ratione materiae of the zero rates in the United Kingdom. In its letter of 19 October 1981 to the United Kingdom Government, the Commission maintained that certain of the zero rates provided for by the Value-added Tax Act 1983 were not in conformity with the requirements laid down by Article 28 (2) of the Sixth Directive. Consequently, it requested the United Kingdom, pursuant to Article 169 of the EEC Treaty, to submit its observations on the matter.

In its reply of 25 February 1982, the United Kingdom Government defended the zero rates in question and proposed that discussions on the matter be opened. Following those discussions the Commission withdrew its objections to the zero-rating of some of the categories of goods and services mentioned in its letter of 19 October 1981. However, it adhered to the observations which it had made concerning the following groups of goods and services:

Consequently, on 4 September 1984 the Commission sent to the United Kingdom Government a reasoned opinion as provided for by Article 169.

By a letter of 6 November 1984 the United Kingdom Government asked the Commission for further clarification on certain points. However, the discussions which followed produced no result. Consequently, the Commission lodged the present application, which was registered at the Court on 10 December 1985.

II — Written procedure and conclusions of the parties

The written procedure followed its normal course. Upon hearing the report of the Judge-Rapporteur and the views of the Advocate General, the Court decided to open the oral procedure without any preparatory inquiry.

The Commission claims that the Court should declare that:

the United Kingdom contends that:

III — Submissions and arguments of the parties

A — General observations

The Commission maintains firstly that the method used by the United Kingdom in applying zero rates goes far beyond anything contemplated in the Sixth Directive. It accepts that the system of zero-rating does not affect the Community's own resources and that, at national level, it produces the same fiscal results as a system of exemption with refund as envisaged by Article 28 (2) of the Sixth Directive; however, the Commission considers that when used on such a large scale this form of tax relief is liable to undermine the process of the progressive harmonization of VAT. The use of zero rates should therefore be limited to the transactions which meet the criteria laid down in Article 28 (2) of the Sixth Directive and the last indent of Article 17 of the Second Directive.

By permitting the Member States to retain certain exemptions, those provisions constitute a major exception to the general principle that all supplies of goods and services are to be taxed and must therefore, in the Commission's view, be interpreted strictly.

The Commission then considers the conditions laid down in the last indent of Article 17 of the Second Directive. That article provides that exemptions may be granted only:

As regards social reasons, the Commission accepts that the Member States have a margin of discretion in determining the social reasons which justify tax relief. In its reply the Commission concedes that it may not challenge measures taken by a Member State in pursuance of a social policy unless it can be shown that the social policy is not sufficiently clearly defined or that the measures in question are either not justified or disproportionate.

Further, the Commission accepts that an exemption which is justified for social reasons may not be called in question because it may incidentally benefit a category of consumer which does not require the social benefit. However, in its view the fact that, in the case of a product or service which may be put to a variety of uses, certain uses may be zero-rated does not mean that the other uses which do not fulfil the conditions laid down by the directives may also be zero-rated.

As regards the requirement that the exemption must be granted for the benefit of the final consumer, the Commission first of all defines the term final consumer and distinguishes it from the term taxable person in Article 4 of the Sixth Directive. The final consumer is the person who acquires the goods or services without having any right of deduction (judgment of 1 April 1982 in Case 89/81 Staatssecretaris van Financiën v Hong Kong Trade Development Council [1982] ECR 1277). Taxable persons, on the other hand, are always entitled to deduct their input tax from the output tax for which they are liable.

According to the Commission, in referring to the final consumer Article 17 of the Second Directive means persons who are at the final suge in the distribution chain and have no right to deduct VAT.

Moreover, it is inherent in the exemption with refund mechanism provided for by the Sixth Directive that the benefit only goes to the final consumer. It was therefore designed to be of direct and immediate benefit to persons at the final stage of a production or distribution chain. Consequently, exemptions which are only of indirect benefit to the final consumer are not in conformity with Article 28.

The Commission accepts that the system of zero-rating applied in the United Kingdom is equivalent to the system of exemption with refund provided for by the Sixth Directive. However, it points out that, unlike exemptions, zero rates apply not only at the final stage but at all stages of the commercial chain.

Consequently, it is necessary to determine how far up the commercial chain zero-rating can go and still fulfil the requirements laid down in Article 28. In general terms, the Commission considers that zero-rates may be applied to transactions which would qualify for deduction of VAT under a system of exemptions with refunds. In other words, only products which are bona fide inputs for a product which is itself zero-rated may be zero-rated. As an illustration of this the Commission states that it would not accept that farmers' boots could be zero-rated simply because food is zero-rated.

The United Kingdom contests the Commission's restrictive interpretation of Article 28 (2) of the Sixth Directive and the last indent of Article 17 of the Second Directive.

As a general point the United Kingdom observes that in the Sixth Directive the Council placed great stress upon the vital need to provide for a transitional period to allow national laws to be gradually adapted. At the time when the Sixth Directive was adopted it was clearly envisaged that measures allowing the retention of reduced rates and exemptions would continue in force for many years.

The United Kingdom emphasizes that Article 28 lays down a procedure for the progressive abolition of reduced rates and exemptions (on the basis of reports submitted by the Commission to the Council every five years) and that as yet the Commission has made no specific proposals in that regard. It claims therefore that the Commission's motive is to bypass the procedural requirements of the Sixth Directive in the hope of achieving a result which it has not yet even proposed to the Council. In order to do so the Commission is stretching the interpretation of the Community rules in question.

According to the United Kingdom, Article 17 does not constitute an exception but forms part of a general rule, in relation to which the need for transitional provisions was seen to be vital.

The United Kingdom maintains that, in its judgments of 1 February 1977 (Case 51/76 Verbond van Nederlandse Ondernemingen v Inspecteur der Invoerrechten en Accijnzen [1977] ECR 113) and 11 July 1985 (Case 107/84 Commission v Germany [1985] ECR 2655), the Court did not accept that Article 17 constituted an exception or that it should be interpreted strictly.

As regards more particularly the requirements for tax relief laid down by Article 17, the United Kingdom maintains first of all that the Member States enjoy a margin of discretion in determining their own social policies and hence in determining what measures are justified by social reasons. Such a measure cannot be challenged unless the social reason is not sufficiently clearly defined or unless the measure is unjustified or disproportionate.

However, where there is a social reason for the introduction of tax relief, that reason cannot be negated by the existence of some other reason, whether primary or secondary or subsidiary.

As regards the requirement that the exemption should benefit the final consumer, the United Kingdom defines that term as meaning the person at the end of a particular distribution chain rather than a person who has no right to deduct VAT.

The United Kingdom further observes that Article 17 does not require that it should only or solely be the final consumer who benefits. On the contrary, it is sufficient for the purposes of that provision if the final consumer gains an indirect benefit, for example by way of lower prices.

The restrictive interpretation proposed by the Commission is in conformity neither with the letter nor with the spirit of the articles in question and would be liable to render ineffective rules which were considered to be vital within the context of the Sixth Directive.

As regards the question of inputs, the United Kingdom observes that the Commission seems to have misunderstood the operation of zero rates in the United Kingdom. The United Kingdom does not, as a matter of course, zero-rate all inputs which go towards the production of a zero-rated supply.

B — Specific observations

Group 1 — Food

The Commission considers that the contested items in this group are too remote to form part of the direct production and distribution chain of food (which is zero-rated) and hence do not fulfil the requirement of benefiting the final consumer. The Commission also questions whether the use of zero-rating in this manner for social purposes is proportionate to the end sought.

The United Kingdom, on the other hand, observes that the zero-rating of the items in question plays an essential role in preventing the increase in food prices which would occur as a result of the input VAT paid being passed on to the final consumer. Moreover, it does not accept the remoteness test advanced by the Commission and argues, for example, that an animal awaiting slaughter (which the Commission does not accept as correctly zero-rated) is equally proximate or remote from the final consumer as a potato awaiting harvesting (which the Commission accepts to be correctly zero-rated).

Group 2 — Sewerage services and water supplies

As regards the disposal of sewage, it should be noted that in the United Kingdom this service is normally paid for by a rate based on property values. Services are provided on a commercial basis and hence fall within the scope of VAT only where premises are too remote to be connected to the main drainage systems and sewage enters into cesspools, septic tanks and the like.

The Commission challenges the zero-rating of such services in so far as they are supplied to industry. There is no social justification for such relief.

The United Kingdom observes that it would be inequitable to tax such services while rate-funded services did not bear tax. It adds that it is most unlikely that there are many industrial concerns which rely on cesspits.

The Commission replies that, in view of this limited use, there should be no difficulty in repealing the offending provisions.

As regards supplies of water, the Commission does not accept that either of the criteria laid down by Article 17 are met. Supplies of water to industry are zero-rated, yet the United Kingdom has not specified the social reasons for this.

According to the United Kingdom, it is principally the individual who benefits from supplies of potable water, even where it is supplied to industry. Moreover, the Commission accepts, in relation to Luxembourg, a Member State which exempts water from VAT (see the answer to written question No 1243/85, Official Journal 1986, C 87, p. 6), that water as a basic necessity warrants special tax treatment.

With respect to that specific point, the Commission replies that the exemption of water in Luxembourg is based on another paragraph of Article 28 (namely paragraph 3 (b)).

Group 6 — News services

The Commission accepts that the requirements of Article 28 are fulfilled in the case of services supplied directly to the public and of supplies to undertakings which themselves have zero-rated outputs. On the other hand, the Commission contests the zero-rating of the supply of news services to producers of positively rated services.

According to the United Kingdom, the function of news services is broadly equivalent to that of newspapers (which are zero-rated). Services supplied to undertakings whose supplies are positively rated may be regarded as an incidental benefit (since the main beneficiaries of such services are newspapers); that incidental benefit cannot negate the social reasons which justify generally the zero-rating of this type of supply.

Group 7 — Fuel and power

The Commission contests the zero-rating of fuel and power which is not supplied to the final consumer. It observes that as a result of the zero-rating of such supplies the largest consumers of fuel and power, namely industrial users, do not pay VAT. Such relief is not in conformity with Article 28 because such inputs are too remote to form part of the production chain of products which are correctly zero-rated.

The Commission adds that administrative difficulties alone cannot justify the total exclusion of inputs of fuel and power to the whole of industry from the scope of VAT.

According to the United Kingdom, the administrative difficulties involved in limiting the application of zero rates to final consumers alone would probably be insurmountable.

Moreover, in sectors which at present are partly exempt, in particular schools and hospitals, the imposition of VAT at the full rate would have undesirable social effects.

Group 8 — Construction of buildings etc.

The Commission emphasizes that it does not seek to enter into a discussion concerning the validity of the United Kingdom's social policy in the area of housing. However, the Commission considers that, with the exception of local authority housing, the indiscriminate zero-rating of the housing sector is disproportionate to the objectives pursued.

According to the United Kingdom, there can be no simple distinction for VAT purposes between private and public sector housing. All housing fulfils a social need, particularly since it is now the private sector which provides an increasing proportion of housing for the needier section of the community.

Moreover, the Commission wholly disregards the social reasons for building schools and hospitals or other civil engineering works and the resultant benefit to the consumer.

Group 17 — Clothing and footwear

In the Commission's view, protective clothing sold to employers does not constitute an input forming part of the production chain of zero-rated products. Consequently, such clothing cannot qualify for relief under Article 28 (2).

According to the United Kingdom, this relief is intended to promote industrial safety, since the imposition of a positive rate of VAT would have the effect of discouraging employers from providing protective clothing for their employees. Moreover, such clothing must be considered separately and not as an input in the production process. The employer is the final consumer of the goods concerned.

1 Language of the Case: English.