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Alvarez & Marsal Taxand UK LLP
Leigh Clark is Senior Director at Alvarez & Marsal Taxand UK LLP
A holding company's right to reclaim VAT incurred on expenditure has been under increased scrutiny from EU tax authorities for several years and is likely to remain that way for the foreseeable future. This article looks at how CJEU decisions have determined the circumstances in which holding companies may reclaim VAT and why we're likely to see several more decisions on this topic over the coming years.
Holding companies can be found in virtually every group structure. In their simplest form they exist to acquire and hold share capital in other companies. A holding company may own a subsidiary outright, it might own a controlling stake, or it might hold a minority interest without the right to decide how the subsidiary should be run.
A holding company could be set up for several reasons including:
• to manage a large group structure;
• to grant loans to subsidiaries;
• to defend a group of companies against aggressive takeovers; and
• to allow parts of the business to be transferred to another holding company.
In some cases a pure holding company might be used just to hold shares in subsidiaries or to hold shares and to perform trading activities. Those other activities are crucial in determining if a holding company is entitled to claim VAT and, if so, how much can be reclaimed.
The CJEU's approach to pure holding companies is that they have no economic activity and therefore no right to reclaim VAT following its 1991 decision in Polysar Investments Netherlands BV (C-60/90) (“Polysar”). The decision put pure holding companies in the same position as individual consumers who incur VAT on their expenditure but do not carry on an economic activity (at least not in the eyes of European VAT law) and therefore cannot claim VAT. European VAT law uses the term “to carry on an economic activity” to mean broadly the same as “being in business”; only businesses are allowed to register for VAT.
Economic activity for purposes of the CJEU means providing goods or services in return for consideration — be it in money, as is usually the case, or other goods and services. In Polysar, the CJEU held that buying and holding shares with a view to receiving dividends was not an economic activity since it did not amount to “the exploitation of property for the purpose of obtaining income on a regular basis”. Dividend income was merely the result of passively owning shares. This is perhaps fortunate for those of us small-scale investors who buy shares on the stock market; needing a VAT registration requirement solely as a result of receiving dividend income would make investing a very different proposition.
Having an economic activity doesn't necessarily entitle a company to reclaim VAT. A holding company, or any business for that matter, might perform only VAT exempt activities which would make it economically active but without the right to reclaim VAT. VAT exempt supplies, while they are not subject to VAT, generally don't entitle the supplier to reclaim VAT on expenditure attributable to making those supplies. A typical example would be a holding company lending money to subsidiaries and earning interest; granting loans is an economic activity but doesn't allow the lender to claim VAT on its expenditure since granting loans is exempt from VAT.
VAT recovery depends on a business making taxable supplies; that is to say selling goods or services that are subject to either a positive or zero rate of VAT. When a holding company has both taxable and exempt income it will usually be able to reclaim a portion of the VAT that relates to the taxable activities only. There are also a few limited exceptions whereby a supplier can reclaim VAT in relation to making exempt supplies which we will not dwell on here.
Most holding companies' taxable activity will be managing subsidiaries in return for payment (here we use the term holding company to mean a company that doesn't engage in normal trading activity). Following Polysar, several other cases confirmed that a holding company which actively manages subsidiaries should be entitled to some level of VAT recovery.
In Cibo Participations SA (C-16/00) (“Cibo”), a holding company received dividends paid by its subsidiaries as well as management charges. There the CJEU held that being involved in managing subsidiaries constituted an economic activity if it entailed carrying out transactions which were subject to VAT. The costs incurred in buying shares, and the VAT on those costs, may be linked with the holding company's business as a whole and thus form part of the holding company's general overheads.
So far we've concentrated on buying and holding shares. What about one of the objectives of a holding company we mentioned earlier which is to dispose of subsidiaries?
In Investrand BV (C-435/05) (“Investrand”), a CJEU decision from 2008, a holding company owned 44% of a subsidiary which it sold to another party. The Dutch tax authorities denied Investrand VAT recovery on costs relating to disposing of its shares in the subsidiary on the grounds that those costs were attributable to the exempt sale of shares. Investrand argued that disposing of its shareholding was part of restructuring its overall taxable business. The CJEU rejected that line of reasoning however. This highlights another important aspect of VAT recovery which is that transactions must be viewed independently for VAT purposes and cannot be thought of just in terms of facilitating a group's wider taxable activity.
The CJEU decision in AB SKF (C-29/08) from 2010 differed somewhat from Investrand. AB SKF intended to restructure its group which involved disposing of two companies: a wholly-owned subsidiary and a controlled subsidiary. AB SKF provided management services to the two companies and intended to use the sale proceeds to finance other activities of the group. The CJEU decided that the relevant issue was whether the services which the holding company intended to buy in relation to the disposals (valuing shares, assisting with negotiations, legal advice) made up part of its economic activity.
In its decision the CJEU decided that disposing of the shares in its subsidiaries facilitated a group restructuring which was part of the overall economic activity of the group since selling the shares meant income would be received on a continuing basis; i.e. this was an economic activity beyond a simple sale of shares. The holding company would have a right to reclaim VAT if selling the shares was “the direct, permanent and necessary extension of the economic activity of AB SKF and there was a direct and immediate link between the costs associated with the input services and the overall economic activities of the taxable person”. The CJEU left this aspect for the courts of each member state to decide.
So far the situation seems clear; merely holding shares and receiving dividend income is not an economic activity and does not entitle the holder to claim VAT or even to register for VAT. If instead the shareholder actively manages its subsidiary and charges for those services it should be seen as performing taxable activities and should have a right to reclaim at least some of the VAT incurred.
VAT grouping presents a complementary option whereby the holding company joins with one or more of the trading companies in its group to form a single entity for VAT purposes. The UK, Ireland, the Czech Republic, Denmark, Finland and the Netherlands recently successfully challenged the EC's attempt to prevent member states allowing a company to join a VAT group if that company would not be entitled to VAT register in its own right — as would be the case for a pure holding company.
However not all member states allow VAT grouping and, as we'll see below, VAT grouping alone is not a panacea to all VAT recovery issues.
The UK Court of Appeal's decision in BAA Ltd (EWCA Civ 112) (“BAA”) from 2013 shows that VAT recovery issues can be complex even when a parent company actively manages its subsidiaries. In BAA, a consortium of companies sought to buy BAA's UK airport business. The consortium set up a new UK holding company called ADIL to buy the target business. In doing so ADIL incurred several million pounds of professional fees and other services related to the takeover. After the deal was closed ADIL joined the BAA VAT group and sought to reclaim GBP7 million of VAT it had incurred in relation to the acquisition. The UK tax authorities denied this claim arguing that at the time ADIL incurred VAT on those costs it didn't intend to make taxable supplies of management services or to join the BAA VAT group. In the absence of evidence to the contrary, the Court of Appeal agreed with the tax authorities and denied BAA's claim.
This may sound like a surprising outcome given that the BAA business as a whole was generally able to reclaim VAT on its costs. BAA underlined the importance of documenting intentions at the earliest opportunity in a proposed transaction to guard against an unforeseen VAT cost. Merely documenting intentions is of course not enough; board minutes and management service agreements need to reflect the actual intention of the holding company to actively manage its subsidiaries. In practice this may be easier said than done given that many deals are contemplated, and advisers engaged, before a new holding company has been set up.
We looked above at situations in which a holding company charges its subsidiaries for management services. If this is the parent's only source of income does this automatically mean that it can claim VAT on its costs in full?
The short answer is no; a business that makes only taxable supplies (which convey a right to reclaim related VAT) and makes no exempt supplies first needs to apply an “economic activity test” to each input. This aspect of VAT recovery is one that member states have, at least until now, addressed with varying degrees of scrutiny. The economic activity test is sometimes overlooked in favour of jumping right to the question of whether a business makes taxable or exempt supplies. But, as we observed when looking at pure holding companies, holding shares is not an economic activity and this remains the case even when a holding company makes taxable supplies.
The first question a company must answer then is whether an expense relates to non-economic activity — of which holding shares is one. If the answer is yes then some of the VAT may be blocked at the first hurdle. The UK tax authorities among others in the EU are now paying closer attention to ensuring that businesses apply this test properly and have just released new guidance on this topic.
Parent companies which actively manage their subsidiaries may take some comfort from the CJEU's decision in Cibo which clarified that costs incurred in buying and holding shares may form part of the holding company's general costs and be linked to its business as a whole.
What may cause some concern is the UK authorities announcing, as part of their updated guidance on holding activities, that they expect management charges to be set at a level such that the holding company should expect to recoup its costs within five to ten years. This applies even to holding companies which are VAT grouped with the subsidiaries they manage.
With this rule the authorities are trying to stop holding companies charging relatively low management fees and recovering VAT in full while meeting most of their costs with dividend income. This is especially relevant where the subsidiary paying the charges makes exempt supplies and is entitled to less than full VAT recovery; lower management charges mean a lower irrecoverable VAT cost for the subsidiary.
Valuing supplies is a contentious issue when it comes to determining VAT recovery. The principle of direct attribution — that is to say determining VAT recovery on inputs according to the liability of outputs with which there is a direct and immediate link — is not a value test but instead a use test. Taken to an extreme, this guidance on valuation implies that even fully taxable businesses cannot make a loss without there being further ramifications for their VAT recovery.
If ever there was some form of consensus on how holding companies should determine VAT recovery it may been thrown into doubt following the German courts' decision to refer questions to the CJEU in the cases of Beteiligungsgesellschaft Larentia and Minerva mbH & Co. KG (C-108/14 & C-109/14). These referrals will revisit the issues previously addressed in Cibo and AB SKF as to whether a holding company needs to attribute VAT to shareholding activities when it also actively manages the companies in which it holds shares and, if so, how that attribution should be calculated.
We will probably need to wait over a year for the CJEU decision. When it does arrive it promises to give holding companies greater certainty over how to determine their VAT recovery. Until then holding companies would be well advised to review their approach to VAT recovery and prepare a contingency in case the CJEU rules in the German authorities' favour.
Given the EU's approach to VAT recovery in relation to shareholding activities you may be surprised to hear that the approach in other countries with similar VAT systems can differ significantly. Take Switzerland as an example which sits at the heart of the European continent but is not a member of the EU.
Until 2010 Switzerland took a similar approach to holding companies as the EU. However in 2010 Switzerland implemented an approach to holding companies that could hardly be more different; now, as long as a holding owns more than 10% of a subsidiary the Swiss tax authorities see the holding company as having an economic activity. Not only that but the authorities also allow the holding company to reclaim all VAT it incurs in relation to its holding activities without any need to demonstrate active management. This applies even where the subsidiary business is exempt from VAT.
To those of us grappling with the EU's approach to holding companies the Swiss approach is as fresh as the alpine air that fills the country. There are of course many reasons, both tax and non-tax, that affect where a holding company should be set up. But the Swiss approach to VAT plus a fairly generous direct tax regime surely make Switzerland, with all its infrastructure and stability, a favorable place to set up a holding company in Europe.
Until we have more certainty from the CJEU, those of us dealing with the tax affairs of EU holding companies should consider the following points:
• If a new holding company is to be formed in the EU to acquire the share capital of an existing business, the extent to which the holding company will manage its subsidiaries needs to be considered in conjunction with the costs it will incur. Board minutes and management service agreements need to reflect the intentions of the holding company to engagement in active management.
• The level of management charges, combined with alternative sources of income such as dividends and loan interest, should be reviewed in the context of the costs that the holding company is likely to incur.
• Countries outside the EU with more commercially-friendly approaches to VAT recovery should be considered as places to set up a holding company.
If there is one area of certainty in all this it's that more cases on economic activity and VAT recovery will be heard by the CJEU and national courts. EU case law on VAT recovery by holding companies has been a work-in-progress for almost 25 years and unfortunately for EU businesses there is no immediate end in sight.
Leigh Clark is Senior Director at Alvarez & Marsal Taxand UK LLP and may be contacted by email at: firstname.lastname@example.org.
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