VAT deduction right for holding activities

Whether you are a large multinational, a private equity house or an entrepreneur with rapid growth opportunities, you will know that holding companies are widely used to structure investments and facilitate divestments.

With VAT rates increasing in a majority of EU member states, the VAT situation of holding companies is worth being considered, in particular to which extent VAT incurred can be recovered.

Recently, an interesting decision was rendered by the French Council of State in the case L'Air Liquide. Although this is a domestic decision, it is worth being analysed as it offers new perspectives in the field of input VAT deduction right for holding companies.

Before going to the hot topic of the VAT deduction right, it is important to detail the concept of taxable person for holding companies.

The concept of taxable person has been clearly set up by the European Court of Justice (ECJ) on various occasions. The ECJ gave, in first instance, its opinion regarding the VAT status of mere holding companies (companies whose income is limited to dividends). The ECJ considered that the mere acquisition and holding of shares in a company is not to be regarded as an economic activity conferring on the holder the status of a taxable person for VAT purposes.

If the VAT status of pure holding companies is clear, the ECJ has been asked in several cases to determine if holding companies having additional activities were to be qualified as taxable persons for VAT purposes.

It is also common practice that holding companies grant interest-bearing loans to finance their subsidiaries. The ECJ decided that such activity should, in most cases, be considered as an economic activity.

Another important criterion developed by the ECJ refers to the involvement in the management of subsidiaries. Such involvement is notably characterised by services (administrative, accounting services) rendered by the parent company to its subsidiaries enabling them to carry on their activities. Such activities shall give the status of taxable person for VAT purposes.

To summarise, where a company performs activities exceeding the mere passive holding of shares, the chances are that it should be considered as a taxable person for VAT purposes.

Following this brief overview of the concept of taxable person, this article will put forward several key elements of the VAT deduction right.

The status of a taxable person for VAT purposes is of utmost importance as, in the absence of a right to recover input VAT, a cost ranging between 15% and 27% is incurred depending on the country of establishment of the company and the location of its service providers.

Based on the European VAT directive, the right to input VAT deduction relies on a simple concept. Should the goods and services be used for the purposes of the taxable transactions of a taxable person, the taxable person should be entitled to deduct the input VAT incurred in the course of its activities.

The ECJ then decided that to be entitled to deduct the input VAT incurred, the activities carried out by a taxable person must have a direct and immediate link with its taxable activities. The requirement of a direct and immediate link implies that, to be deductible, input VAT incurred is in direct relation to the performance of activities granting the right to deduct input VAT.

Input VAT incurred within the framework of VAT exempt transactions or transactions outside of the scope of VAT should not be deductible. This implies that mere holding companies are not allowed to recover input VAT.

With respect to mixed holding companies, this approach was tempered through several major ECJ cases.

One will remember the Cibo case where a holding company, in addition to its portfolio management, provided advisory and managerial services to its subsidiaries. In this case, the court stated that the direct and immediate link is present when the input expenditure is a component of the cost of the output transaction in respect of which VAT is deductible.

This solution has been confirmed in a different context with the Kretztechnik case in which an operational company decided to increase its capital. In this respect, this company incurred advertising, agent, legal as well as technical advice costs and was allowed to deduct the input VAT on these costs. The court stated that a share issue does not fall under the scope of VAT. However, this operation was carried out to increase the capital of the company for the benefit of its economic activity in general. Therefore, the costs incurred within the framework of the share issue form part of its overheads costs and are therefore component parts of the price of its products. As a consequence, these services have a direct and immediate link with the economic activity of the company and the VAT incurred on these services is consequently deductible.

Precisions were then brought in the Securenta case in which judges decided that the VAT on expenditures connected with the issue of shares is deductible if the expenditure incurred in that regard is a component of the cost of the output transactions which gave rise to the right to deduct. In cases where the expenditure connected with services carried out for the issue of shares and financial holdings is not solely attributable to downstream economic activities, the VAT relating to this expenditure is not deductible. The court concluded on the fact that the determination of the methods and criteria for apportioning input VAT between economic and non-economic activities belongs to the member states.

Another major decision of the ECJ regarding holding companies is known as the AB SKF case. Its main findings are that input VAT on costs incurred for the purpose of disposal of shares can be (partially) deducted to the extent that there is a direct and immediate link between these costs and the overall activities of the active holding company. To establish whether there is such a direct and immediate link, it is necessary to ascertain whether the costs incurred are likely to be incorporated in the price of the shares or whether they are only among the cost components of the holding's products.

Under some circumstances, a disposal of shares in subsidiaries in which a holding company plays an active management role can be qualified as a transfer of going concern outside the scope of VAT. Under this approach and following the AB SKF case, the ECJ recalled a short while ago in the case X BV that input VAT on costs incurred for the purposes of such disposal can be deducted if the costs incurred to acquire the input services are part of the general costs linked to the taxable person's overall economic activity. That condition is met if the cost of input services in relation to this disposal of shares is not incorporated in the sale price of those shares.

These ECJ cases are important as they create opportunities to deduct, at least partially, input VAT incurred within the framework of share disposals. The deduction of input VAT is however not straightforward as it must be considered in the light of all the circumstances surrounding the transactions.

The ECJ recently recalled classical concepts in terms of VAT deduction right within the framework of mixed transactions through its decision in Portugal Telecom concerning the mere acquisition and holding of shares and the VAT deduction on acquisition of goods or services subsequently invoiced to subsidiaries. The court stated that the national tax authorities are allowed to provide for one of the methods for determining the right to deduct and they can lay down a method of calculation which objectively reflects the input transactions actually attributed to taxable and not taxable output activities. Therefore, when the goods and services acquired are both used by the holding company to perform economic transactions giving a right to deduct economic transactions which do not, the deduction is in principle allowed for the part of the VAT which is proportional to the amount relating to the transactions giving a right to deduct with a possibility for the VAT authorities to use a more objective method.

This decision follows the line of the case BLC Baumarkt. In that case, the company had a building built which was let after completion. This letting was partly exempt and partly subject to VAT. The company computed the deductible input VAT by applying a pro rata based on the ratio between the turnover in relation to the commercial letting and the turnover arising from other letting transactions. The German VAT authorities challenged this position and considered that the amount of deductible input VAT had to be determined according to the ratio between the area of the commercial premises and the area of the premises used for living accommodation. The ECJ stated that member states are allowed, for the purposes of calculating the proportion of input VAT deductible for a given operation, to give precedence, to an allocation key other than that based on the VAT pro rata provided that the method used guarantees a more precise determination of the deductible proportion.

Luxembourg is home for holding companies of major international groups. Any development in terms of VAT legislation is therefore crucial.

In this respect, the Luxembourg VAT authorities recently issued a specific circular regarding the input VAT deduction right of companies. This circular letter results in various practical implications.

Until now, a lot of Luxembourg holding companies used a pro rata to determine their input VAT deduction right based on their turnover. Pursuant to this method, input VAT is deductible according to a ratio taking into account the turnover allowing the deduction of VAT and the total turnover falling under the scope of VAT. Sometimes, companies claim for a full deduction of input VAT in relation to certain costs (such as costs recharged to other entities of the group). However, VAT strategies have often been opportunistic and not integrated in the corporate life of companies, notably in terms of accounting treatment.

The VAT authorities aim to have taxpayers allocating costs as much as possible to specific revenues, to determine whether input VAT can be deducted. The allocation of costs can be based on a cost-by-cost basis or on the use of specific keys such as input VAT deduction pro ratas based on the number of employees and square metres allocated to each activity. This circular letter may therefore bring opportunities for businesses, but also imposes a review of the methodology used by taxpayers. It notably foresees that taxpayers should evidence the cost allocation with help of their accounting records, in particular since an analytical accounting software is often used.

The method used to compute the proportion of input VAT deductible should be reviewed but also the practical application. The implementation is of primary importance particularly concerning the accounting treatment of transactions as the bookkeeping should match with the VAT deduction method used on a day-to-day basis. This may also be a good time to discuss whether the input VAT deduction right can be improved, for example via specific pro ratas based on sectors of activity, or on time allocated by the staff to the different activities (for example financing activities and management of subsidiaries).

The VAT regime set up by the ECJ through the various cases mentioned above concerning the VAT deduction on the costs incurred for the purpose of disposal of shares has been implemented in France notably through Pfizer and Michel Thierry's cases. In these cases, the French State Council followed the principles laid down at the European level and decided that the VAT incurred on such transactions is deductible provided the costs incurred are not incorporated in the price of the shares which the seller intends to sell.

The l'Air Liquide case offers a new opportunity of deduction of VAT incurred on such costs. In this case, an operational holding company has undertaken a study to evaluate the opportunity of an acquisition of securities in several subsidiaries of a competing group. It has deducted the VAT on these costs. Finally, the subsidiaries have been acquired by an intermediate holding company of the operational holding company pursuant to a substitution clause and because of the organisation of the group. Considering this, the French VAT authorities refused the VAT deduction on these costs to the operational holding company.

Confronted with this issue, the French State Council made a decision in favour of the parent company in three steps.

On the one hand, it recalled that the VAT incurred on the acquisition costs is deductible as such costs form part of the overheads costs and have a direct and immediate link with the economic activity of the company.

On the other hand, the French Administrative Supreme Court decided that an operational holding company is entitled to deduct VAT on capital costs within the framework of an acquisition of shares that it has decided even if this acquisition has been carried out by an intermediate holding company by application of a substitution clause. The VAT deductibility on such costs is possible provided the operational holding company brings the proof that it will supply taxable services to the subsidiaries newly acquired.

Finally, French judges reminded the principle of the INZO case whereby the ECJ decided that the VAT incurred on unfruitful expenses (such as acquisition or disposal of shares costs) considered as overheads costs is deductible if these expenses have a direct and immediate link with the economic activity of the company, even if this activity is never realised.

This decision also respects the economic reality in case of acquisition of subsidiaries insofar as such decisions are generally taken at the level of the parent company.

This reasoning may open up some interesting horizons for holding activities in Europe.

The recent jurisprudence and the evolution of the practice of VAT authorities should prompt holding companies to revisit their VAT strategy. Experience has shown that VAT on deal costs can mean millions.

Although judgments are based on specific facts, the recent decisions show that the drafting of agreements such as share purchase agreements require the utmost level of attention.

More than ever, we recommend seeking VAT advice from the early stages of a transaction. A review of the various fees, underlying agreements and VAT status of entities involved is required. Certain services can also benefit from VAT exemptions, thus avoiding the issue of input VAT deduction.

Opportunities exist to limit the VAT cost of holding companies but the matter should be tackled in a proactive way. Sometimes forgotten and considered as a minor impact in large transactions, managing VAT should be taken into consideration. With VAT rates increasing over the past few years, it can mean millions and harm the return on investment.

Biography
		Christophe Plainchamp ATOZ-Taxand Tel: +352 26 940 280 Mobile: +352 661 830 280 Fax: +352 26 940 300 Email: christophe.plainchamp@atoz.lu Christophe Plainchamp is a partner and the head of the indirect tax practice of ATOZ – Taxand, a high-end advisory service firm offering comprehensive solutions, encompassing the entire life cycle of an investment entity: from tax planning, design and implementation to compliance and exit planning, with industry focus on private equity, real estate, multinational corporations, financial institutions and family offices. Christophe and his team design, implement and monitor indirect tax planning solutions for national and international clients in the corporate, private equity, real estate and financial services market segments. Before joining ATOZ – Taxand, Christophe worked for several Big 4 firms, where he gained experience in a variety of indirect tax matters. He is a published author and regularly contributes to Luxembourgish and foreign trade publications. Christophe holds a business degree from the University of Liège in Belgium and a postgraduate degree in Luxembourg tax. He is also a Chartered Accountant in Luxembourg. He is an active member of the Indirect Tax Committee of the Luxembourg Fund Association (ALFI).

Biography
		Nicolas Devillers ATOZ-Taxand Tel: +352 26 940 204 Mobile: +352 661 830 204 Fax: +352 26 940 300 Email: nicolas.devillers@atoz.lu Nicolas Devillers is a director with the indirect tax department of ATOZ – Taxand. Nicolas works with clients to develop the most appropriate and advantageous indirect tax solutions to fit their specific needs. Among the engagements carried out over the years, key projects have included assisting in the management of the VAT situation of several holding companies as well as advising on the VAT implications applicable to financial institutions, including Luxembourg banks, various types of investment funds and Luxembourg securitisation vehicles. He is especially known for setting up VAT platforms for young, entrepreneurial organisations in the telecom and e-commerce fields. Nicolas studied partly in the US and holds a degree in finance and economics from HEC Liège (Hautes Etudes Commerciales), and a postgraduate in Luxembourg Tax from the Chambre de Commerce of Luxembourg. He is a member of AMCHAM (Luxembourg American Chamber of Commerce Association) and the author of several articles on VAT and e-commerce, published in leading trade professional journals like International Tax Review.