By Dr. Kurt Dittrich, Linklaters Oppenhoff & Rdler.
On 26 June 2003, the European Court of Justice delivered a judgment on the extent to which the Sixth VAT Directive of 17 May 1977 applies to factoring transactions. The ruling was in response to a case submitted by the German Federal Tax Court (Bundesfinanzhof) in 2001 (File-no. C-305/01) involving the issue of whether a factor involved in true sale factoring (echtes Factoring) is entitled to recover so-called "input" VAT paid to third- party suppliers of goods and services.
The German Federal Tax Court specifically asked:
(i) Does a factoring company also use goods and services it acquires for turnover [within the meaning of VAT law] to the extent that the company purchases receivables and assumes the credit risk for these receivables?
(ii)Does such turnover constitute taxable turnover or at least turnover within the meaning of Article 13 Part B lit. d of the Sixth Directive which can be taxed to the extent that member states have given tax subjects the right to opt for taxation? If so, which type of turn over under Article 13 Part B lit. d of the Sixth Directive is involved?
As a general rule, a party can recover "input" VAT if the party is an entrepreneur and the party charges VAT for the goods or services it supplies to third parties ("output" VAT). If a party conducts a business but the services the party provides are not subject to VAT, such as is partially the case with credit institutions, the party cannot recover all of the VAT it pays.
The European Court ruling
The European Court ruled as follows in response to the two questions posed by the German Federal Tax Court (official translation):
(i) On a proper construction of the Sixth Council Directive (77/388/ EEC) a business which purchases debts, assuming the risk of the debtors' default, and which, in return, invoices its clients in respect of commission pursues an economic activity for the purposes of Articles 2and 4 of that directive, so that it has the status of taxable person and thus enjoys the right to deduct tax under Article 17 thereof.
(ii) An economic activity by which a business purchases debts, assuming the risk of the debtors' default, and, in return, invoices its clients in respect of commission, constitutes debt collection and factoring within the meaning of the final clause of Article 13B(d)(3) ofthe Sixth Directive (77/388) and is therefore excluded from the exemption laid down by that provision.
Assumption of risk as a service subject to VAT?
A careful reading of the European Court's decision indicates that the court did not intend the mere assumption of risk when purchasing receivables to constitute a separate service which triggers VAT.
The European Court's starting point in its analysis was to look at VAT treatment for the collection of receivables. This service is clearly subject to VAT under the final clause of Article 13B(d)(3) of the Sixth Directive ("mit Ausnahme der Einziehung von Forderungen"). The decisive question before the court was whether this only applies to the collection of receivables when the credit risk remains with the seller (unechtes Factoring) or if the collection of receivables is also subject to VAT when the purchaser assumes the credit risk (echtes Factoring). The German tax authorities had taken the position that the collection of receivables is not subject to VAT in the latter case because the factor only collects its own receivables. The European Court rejected this argument and found that the collection of receivables is a service subject to VAT irrespective of whether or not the factor assumes the credit risk.
This conclusion does not, however, support the view that the assumption of risk by itself constitutes a separate service which is subject to VAT. The purchaser of an asset in a true sale inherently assumes the risk associated with the asset. The mere assumption of credit risk in a true sale of a receivable is an automatic consequence of the purchase and cannot be regarded as separate service. Otherwise, the exemption from VAT set forth in Article 13B(d)(3) of the Sixth Directive for transactions with receivables ("im Geschft mit Forderungen") would be hollowed out to the point of having no practical application. Thus, the sale and delivery of a receivable by itself is VAT exempt.
Applicability to Securitizations?
The judgment does not deal with securitizations and, in our view, it should not affect securitizations for the following reasons: Securitiza- tions are different from factoring, particularly since the purchasing vehicle does not render a service by collecting receivables for the seller; rather, the purchasing vehicle appoints the seller as servicer. The main reason for this is that the relationship between the seller and its debtors is not supposed to be affected by the securitization. As a consequence, the purchaser neither services nor intends to service the purchased receivables and, therefore, does not render the service of collecting receivables which is subject to VAT. The question whether or not the purchaser has assumed the credit risk is irrelevant for VAT purposes since the antecedent condition of a collection of receivables is not met. Consequences if Judgment applied to German Securitizations the above argumentation is not shared by the tax authorities, the VAT treatment might be as follows:
1 Assuming that the Purchaser is or is deemed to be tax resident in Germany:
1.1 The economic activity by which the purchaser purchases a receivable and assumes the credit risk would constitute debt collection and factoring which is not VAT exempt.
The tax base was not discussed by the European Court. In our view, it would be equal to the default discount (charged by the purchaser for the assumption of credit risk) but a different view by the tax authorities cannot be ruled out. The input VAT deduction of a corporate seller or a bank could depend on the purchaser being
resident outside the EU. If the seller is not appropriately rated, the rating agencies could ask for a provision.
1.2 The servicing of the receivables by the seller for the purchaser would be subject to VAT. The tax base would be the servicing fee. Some or all of the input VAT could become a cost because the purchaser might not be entitled to fully recover input VAT.
2 Assuming that the Purchaser is tax resident outside Germany
2.1 The analysis under 1.1 above applies. German authorities are likely to tax the service at the place of the recipient.
2.2 The servicing of the receivables by the seller for the purchaser is not subject to VAT.
It should be noted that the European Court Judgment if it applied to securitizations may also affect other European securitizations.