ES1.2.2 Examining various forms of financing

The provision of equity to a company does not constitute a supply for consideration within the meaning of Article 4 VAT Act 1968 (Article 24 VAT Directive). According to Court of Justice case law, this is because income obtained from the provision of equity, such as dividends in the case of shares, is a payment arising simply from ownership of the assets. It is unclear, however, as to what exactly characterises income arising simply from ownership, and how this differs from income obtained from transactions performed for consideration. In my view, it would be more appropriate to argue that the relationship between the party providing the equity (in other words, the shareholder) and the party receiving the capital contribution involves too little reciprocity for the transaction to be considered a supply for consideration. This means that transactions within a capital relationship cannot generally be considered to constitute taxable supplies. This conclusion would seem consistent with the approach adopted by the Court of Justice. An exception to the rule that income obtained from a capital investment does not constitute consideration for a supply can be found in Supreme Court case law, which states that, in certain circumstances, profits distributed by cooperative organisations to their members may constitute such consideration. As I see it, the relevant Supreme Court case law is incompatible with Court of Justice case law and so is in breach of EU law.

The provision of equity is characterised by the fact that, unlike a loan, it does not result in a debt for the recipient. This distinction is primarily of a legal nature as the economic distinction between equity and loans is not so unequivocal. In my view it is virtually impossible that funds provided as equity under private law will constitute a loan for the purposes of the VAT Act 1968. Owing to the criterion of economic and commercial reality, however, a loan between associated parties under private law could constitute the provision ofequity under this same Act. Examples of loans constituting the provision of equity for the purposes of the VAT Act and taken from the sphere of direct taxes include sham loans [schijnleningen], participating loans [deelnemerschapsleningen] and loans where the creditor knew when granting the loan that the debtor would be unable to repay it [bodemlozeputleningen]. The provision of equity can also be assumed in the case of entities without legal personality and constituting ‘any person’ within the meaning of Article 7(1) VAT Act 1968 (Article 9(1) VAT Directive).

An activity seeking solely to obtain dividends and capital gains from the provision of equity is not an economic activity. More specifically, it does not involve exploiting tangible or intangible property for the purpose of obtaining income on a continuing basis, given that it does not entail supplying a service for consideration. Consequently the criterion of income production is not fulfilled. As a result, a person or entity who solely acquires and holds shareholdings is not an entrepreneur within the meaning of Article 7 VAT Act 1968 (Article 9 VAT Directive) and is not entitled to deduct input VAT. Whether the parties contributing and receiving the capital are part of the same group of companies makes no difference whatsoever in this respect.

In certain circumstances, however, it is possible for a shareholding to comprise part of a more comprehensive range of transactions performed by an operator and that in their totality constitute an economic activity. In this situation, the activity of acquiring and holding a shareholding is of an economic nature. According to case law, this applies in any event in the case of (i) securities traders, (ii) shareholders involved in managing the entity in which they invest and in the supplies performed for consideration (‘intervening shareholders’) and (iii) shareholders for whom the investment is a direct, permanent and necessary extension of a taxable activity (‘extension shareholders’). In my view, this list should not be regarded as limitative; in other words, there are also other circumstances in which the acquiring and holding of shareholdings may be regarded as being of an economic nature, and specifically as ‘other transactions’ performed by an entrepreneur. These circumstances could include the investing of temporary cash surpluses. The legal position in this respect, however, is not entirely certain as it is not generally easy to make a clear distinction, in the abstract, between shareholdings that are of an economic nature and shareholdings that are not, given that the distinction between these two categories depends very much on the facts of the case. If a shareholding comprises an economic activity, and so is of an economic nature, the costs that the shareholder incurs in order to acquire and hold the investment are part of the shareholder’s general expenses. The shareholder is then eligible to deduct input VAT, except insofar as any exempt supplies restrict that entitlement. Income obtained from shareholdings does not affect the deductible proportion.

In principle, disposing of a shareholding to another party constitutes the supply of a service for consideration. However, this service is exempt from VAT, even if the disposing party is an entrepreneur. This means there is no entitlement to deduct input VAT on the direct costs of the disposal, except if the acquiring party is established outside the European Union and the disposing party is an entrepreneur. The disposal also affects the deductible proportion of a disposing party who is an entrepreneur, unless the disposal is an incidental financial transaction. The disposal of a shareholding may consequently also have implications for the extent to which input VAT can be deducted on general expenses that are barely or not at all related to theshareholding. As far as the disposal of shareholdings is concerned, the judgment in AB SKF created legal uncertainty in a number of respects. The Court of Justice suggested, for example, that the disposal of a shareholding held by a party not classified as an entrepreneur could also be of an economic nature. That, in my view, is illogical. The judgment in this case can also be interpreted to mean that an entrepreneur’s disposal of a shareholding must always be part of the taxable activities or a direct, permanent and necessary extension of those taxable activities. If that were the case, the disposal of a shareholding could never constitute an incidental financial transaction and would always affect the deductible proportion. As I see it, however, the disposal of a shareholding must also be able to constitute other transactions in the disposing party’s economic activities and be incidental. The judgment in AB SKF would seem to suggest lastly that the costs of disposing of a shareholding, even if they may appear to be direct costs, should nevertheless be regarded, as far as possible, as general expenses. This would mean that, in the case of disposals of shareholdings, costs incurred would be more likely than in other contexts to be regarded as general expenses rather than as direct costs, which would not be a very consistent approach.

Case law on shareholdings, which in my view also applies, in principle, to other types of participating interests (i.e. other rights, not being debt claims, participating in the profits of a company), shows general signs of a tensionbetween systematic purity on the one hand and a wish on the other hand, wherever possible, to allow input VAT to be deducted. This is because there is often clearly no question of consumption in the case – primarily – of holding companies. The picture arising from case law is that subtle and sometimes rather arbitrary distinctions made between shareholders can result in very different practices with regard to the way VAT is imposed. Moreover, disposals by a fiscal unity (Article 7(4) VAT Act 1968) and disposals comprising all or part of a totality of assets (Article 37d VAT Act 1968) can also produce differing outcomes. Whether this sufficiently reflects the principles of equality before the law and legal certainty is very much doubted.

The entity in which a party invests, and so which receives the equity contribution, is in a clearer position. The Court of Justice has ruled that raising equity by issuing shares does not constitute a supply of services for consideration, and neither does the admittance of a person to a partnership. It can be concluded from this that issuing or creating shares or other types of participating interests does not generally constitute the supply of services for consideration. As far as the economic nature of the services and the right to deduct input VAT are concerned, the principle to be applied is ‘followthemoney’; in otherwords, input VAT relating to expenses incurred when raising equity is eligible for deduction insofar as the funds raised are used to pursue an economic activity.

The second method of financing examined was funding provided in the form of bonds and other transferrable debt instruments. Bonds are in any event treated in the same way as equity, specifically shares, under the VAT Act 1968. For the sake of brevity, reference is made to the discussions set out above. For the purposes of the VAT Act 1968, bonds are transferrable securities representing a monetary loan divided into equal parts. The fact that bonds are treated as equivalent to equities is remarkable, given that there is a clear quid pro quo for bondholders, who lend money in return for the right to receive an agreed rate of interest. That is clearly a contractual relationship, within which supplies for consideration would in other circumstances be regarded as being performed. But not in the case of loans provided by bondholders. In Harnas & Helm the Court of Justice ruled there to be no reason to treat bonds differently from equities, given that transactions in these instruments are exempt in the same provision in the VAT Directive (Article 135(1)(f) VAT Directive).

Even more surprising was the Court of Justice’s finding in EDM that transactions in certificates of deposit and Treasury notes constituted the supply of services for consideration, and more specifically the provision of credit. These instruments share certain similarities with commercial paper (which is issued by enterprises) and, like bonds, are also transferrable debt instruments. There would not seem to be any good reason, therefore, to treat bonds differently from these instruments for the purposes of the VAT Act 1968. As no explanation for this differing treatment is given and as certificates of deposit and Treasury notes were largely of subordinate importance in the EDM case, I do not exclude the possibility that, to this extent, the decision taken was not a matter of principle. As I see it, it is also unlikely in any event that the Court of Justice has reconsidered its earlier ruling on bonds, as has sometimes been suggested in the literature. What is more likely is that the reason why commercial paper, certificates of deposit and Treasury notes are to be treated differently is that these instruments are not generally suited for private investors.

In other situations, case law has found the granting of credit to constitute an exempt service supplied for consideration, providing such consideration is indeed obtained. Although interest is the usual form of consideration provided in return for the granting of credit, other amounts payable under a credit agreement can also constitute consideration. It is important in this respect to note that the granting of credit does not relate only to private loans, but may also include deferred payments, instalment credits, hire purchase, financial leases and certain derivatives and commodity trades. The first three examples in any event require separate consideration to have been agreed if a transaction is to be recognised as the granting of credit. In contrast to what the Dutch State Secretary of Finance seems to believe, case law contains no requirement, in my view, for this consideration to be in the form of an agreed interest rate. It follows from the structure of the VAT Act 1968 (and the VAT Directive) that credit is not regarded as being granted in the case of prepayments and the granting of limited rights [beperkte rechten] constituting a supply under Article 3(2) VAT Act 1968.

One of the reasons why, in principle, the granting of credit represents the supply of a service for consideration is because it can constitute an economic activity on its own merits; i.e. the exploiting of tangible or intangible property for the purpose of obtaining income on a continuing basis. It can be concluded from case law that the business or commercial purpose required for this is quickly found to exist. Indeed, the provision of a single interest-bearing loan over a period of years can be sufficient in the case of legal entities. In cases where the granting of credit is part of a more comprehensive economic activity of a largely different nature, it has to be established whether the supply comprises the direct, permanent and necessary extension of a taxable activity or other transactions. In the latter case, the granting of credit may comprise an incidental financial transaction within the meaning of Article 174(2)(b) or (c) VAT Directive, the proceeds of which are excluded from the calculation of the deductible proportion. As explained above, however, the distinction between the direct, permanent and necessary extension of a taxable activity and other transactions is vague.

The basic assumption with regard to the deductibility of input VAT is that tax paid on costs incurred in the granting of credit is not deductible as these activities’ exemption from VAT means that no taxed transactions occur. The only exceptions are if the customer is resident outside the European Union or if a direct relationship exists with goods designated for export. The scope of both these exceptions can be interpreted in various ways and is, therefore, uncertain. In my view, the first exception, which would seem the most important in practice, should be subject to a strictly grammatical interpretation of the VAT Act 1968 (and the VAT Directive); in other words, only the place of residence of the customer matters, and not that of any permanent establishment for which the credit may (ultimately) be intended. The current text of Article 15(2)(c) VAT Act 1968 can produce outcomes that are at odds with the principle of equality before the law. A Dutch bank, for example, can grant a loan on more favourable terms to an entrepreneur resident outside the EU and wanting to invest in Dutch real estate than it can to an entrepreneur resident within the EU.

In principle, remuneration received in return for credit should be taken into account when calculating the deductible proportion. Two possible remedies may be applied in situations where this distorts the deductible proportion. The first of these is to disregard the interest, based on the direct effect of Article 174(2)(b) or (c) VAT Directive, on the grounds that the granting of credit is seen as an incidental financial transaction. This would require the activities to be regarded as other transactions, while the granting of credit should also imply only very limited use of supplies purchased and constituting general expenses. The second remedy is to establish an apportionment formula for determining the entitlement to deduct input VAT on the basis of actual use. Court of Justice case law could conceivably be interpreted to allow an adjusted turnover formula, in which only the net interest received (i.e. interest received less interest paid) is taken into account, to be used as an apportionment formula. Judging, however, by Supreme Court case law on the actual use method, Dutch law would not currently seem to allow use of an adjusted turnover formula.

Being granted credit has no other VAT-related implications for the borrower. If, however, the borrower purchases non-exempt supplies in the process of obtaining credit and does not use the borrowed funds exclusively for taxed transactions, the input VAT is in principle non-deductible or not fully deductible. That is not so much a consequence of being granted credit, but rather the nature of the supplies performed as part of the borrower’s economic activity.

The odd man out, lastly, is financing provided through factoring and other forms of debt acquisition. The outcomes under the VAT Act 1968 in this respect can vary, depending on the circumstances. At one end of the spectrum is the incidental acquisition of non-interest-bearing debt at its economic value. In these circumstances, acquisition of the debt does not result in a taxable transaction on the part of the acquiring party. The acquiring party is not then regarded as performing an economic activity or as being entitled to deduct input VAT. At the other end of the spectrum is the continuing acquisition of interest-bearing debt in return for consideration. In these circumstances, the activity performed by the acquiring party will constitute an economic activity, within which the party performs both taxed and exempt supplies. The taxed supplies comprise factoring, or at least the collecting of receivables for the party transferring the assets. The exempt supplies are those in the form of credit granted to debtors and possibly also to the party transferring the assets. The extent of any entitlement to deduct input VAT in these circumstances depends, in principle, on the relative proportions of the remuneration received for the various supplies and on whether the credit granted falls within the scope of Article 15(2)(c), VAT Act 1968. In addition, and in exceptional circumstances, incidental financial transactions within the meaning of Article 174(2)(b) or (c) VAT Directive may be considered to exist. Any remuneration received on these transactions should be excluded when calculating the deductible proportion.

The case law shows, in my view, that the decisive issue in determining whether a taxed transaction exists is whether the parties have agreed remuneration for the supplies that are to be performed by the acquiring party. Although agreeing remuneration may indicate that the acquiring party is operating in an economic and commercial sphere when accepting the transfer of receivables, it also creates opportunities for tax planning. This is because by charging remuneration, a party acquiring receivables may be classified as an entrepreneur in certain circumstances and so be entitled to deduct input VAT. By simultaneously increasing the price agreed to be paid, the parties could achieve the same outcome as if agreement had not been reached on remuneration. In this way, the subjective nature of remuneration offers parties an element of freedom to set it at a level of their choosing.

Case law has certainly not yet clarified the right of debt purchasers operating in the economic sphere to deduct input VAT. The primary question is whether this is affected by any exempt granting of credit to the transferring party after the debt has been transferred. To this extent, the legal position can be regarded as uncertain. Legal uncertainty also exists with regard to the acquisition of non-performing, interest-bearing debts. Although there are reasons to assume, in certain circumstances, that these activities constitute the supply of services for consideration and that they are of an economic nature, it remains a grey area.

The question for the recipient of financing (also the party transferring the receivables) is whether the transfer constitutes a supply of services for consideration. In my view, that should not be the case because this would otherwise result in irrational double counting. It would also mean that the service would be exempt, with the result that the transferring party’s entitlement to deduct input VAT could be substantially restricted. In my estimation, however, the Court of Justice is likely, in principle, to consider the transfer of receivables to constitute an exempt service. This is because interpreting the provisions differently would not readily accord with the approach that the Court has adopted with regard to disposals of equities and bonds. If such transfers are treated as an exempt service, input VAT would not be deductible on direct costs incurred. In my view, however, transfers of receivables would still not, in principle, affect the deductible proportion. This is because I would regard such transfers as other transactions performed during the course of an economic activity and having little if any effect on purchases of supplies classified as general expenses. This means that the transfer would constitute an incidental financial transaction within the meaning of Article 174(2)(b) or (c) VAT Directive. This view is certainly open to debate, however. If the judgment in AB SKF is seen as assigning particularly wide-ranging scope to the extension criterion, this could easily extend to the transfer of receivables.

All in all, the method of financing chosen by an enterprise has been found to make a difference from a VAT perspective. The differences arising concern entrepreneurship, the imposition (or otherwise) of VAT on financing provided and the deductibility of input VAT. Not only do the various funding methods produce different outcomes with regard to these aspects of the VAT Act 1968 (and the VAT Directive), but the final outcomes in terms of VAT payable are also not necessarily the same.