VATSC10172 - Supply: Whether supplies are goods or services: Distinguishing between purchase and hire agreements: “Option” payments

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.

You may encounter option payments which are not small. Agreements providing for substantial option payments are becoming increasingly common. In this event you should again ask the question - will ownership pass in the normal course of events? The meaning of ‘normal Course of events’ was considered by the CJEU in Mercedes Benz Financial Services (MBFS) C-164/16. The Court ruled that:

The words ‘contract for hire which provides that in the normal course of events ownership is to pass at the latest upon payment of the final instalment’, used in Article 14(2)(b) of Council Directive 2006/112/EC of 28 November 2006 on the common system of value added tax, must be interpreted as applying to a leasing contract with an option to purchase if it can be inferred from the financial terms of the contract that exercising the option appears to be the only economically rational choice that the lessee will be able to make at the appropriate time if the contract is performed for its full term, which it is for the national court to ascertain.

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.

Where the optional payment equals or exceeds the anticipated market value the supply is one of leasing services, and the whole of each instalment is subject to VAT. (There is no credit element, as no money has been advanced). See VATTOS9250.

If there is a sizeable final instalment (balloon payment) in addition to a much smaller option payment this is not optional under the contract and should be treated as any other instalment, and the supply is one of goods.