Calculation of the (Pre-) Pro Rata under EU VAT Law - empcom.gov.in

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economic and non-economic activities. The ECJ added that, in exercising that discretion, Member States have the right to apply any appropriate method, without being restricted to a single method only. 4.3. Proceeds to be taken into account The most straightforward mechanism for attributing input tax to economic and non-economic activities would be based on proceeds34 (turnover) derived from those activities, analogous to the normal pro rata fraction, i.e.: proceeds derived from economic activities proceeds derived from economic and non-economic activities The question arises of how close the analogy between the pro rata and pre-pro rata fractions may or must be. The normal pro rata fraction must be calculated per year and must be fixed as a percentage (rounded up to a figure not exceeding the next whole number). It seems plausible that the pre-pro rata fraction must fulfil the same conditions. The question which then arises is whether it would be appropriate for Member States to prescribe an apportionment method based on proceeds derived from economic and non-economic activities. 4.4. Comparison of pro rata and pre-pro rata One of the issues in applying the pro rata by analogy concerns the receipt of non-taxable subsidies35 by charitable organizations as “remuneration” for activities outside the scope of VAT. Inclusion of those subsidies in the prepro rata would have a dramatic impact on the charities. Where 50% of their income consists of subsidies, charities would only be entitled to deduct half the burden of input VAT. 36 Another issue is that specific non-economic activities, such as transactions carried out free of charge, have no relationship with turnover or proceeds. For other organizations, such as holding companies and investment vehicles, it would be inappropriate to take all non-taxable proceeds into account for the purposes of calculating the pre-pro rata. It is clear that also for companies such as Kretztechnik, specific categories of nontaxable proceeds should be disregarded in this respect. Although the issue of new shares was a non-economic activity, the capital acquired through this non-taxable action did not decrease the company’s rate of deduction (it remained 100%). In that case, the only relevant factor for calculating the deductible proportion was the nature of the activities for which the new funds were used. The question also arises of whether the application of a pre-pro rata would have an effect on Securenta’s rate of deduction. Securenta’s capital was used for the purposes of both economic and non-economic activities. It seems irrational that a company’s rate of deduction would decrease on account of the issue of shares, if its economic activities are fully subject to VAT. It seems rational to ignore proceeds derived from the issue of new shares for de- Calculation of the (Pre-) Pro Rata under EU VAT Law duction purposes, on the ground that, unlike Securenta’s investment activities, the issue of shares is an incidental (financial) transaction. For the purposes of calculating the normal pro rata fraction, incidental financial transactions must be excluded from the denominator. 37 It would be consistent with that approach to also exclude incidental non-economic financial transactions from the denominator of the pre-pro rata fraction. Another example of “incidental financial transactions” that should be excluded from the pre-pro rata fraction is the (non-taxable) disposal of shares. If, for example, Securenta had sold its investment portfolio, this disposal would be a non-taxable transaction because Securenta would have acted in its capacity as a non-taxable person. Inclusion of the proceeds of this sale in the denominator of the new pre-pro rata fraction would not reflect economic reality, as required by the principle of neutrality. The above examples illustrate that a pre-pro rata fraction based solely on income – without the possibility to exclude proceeds derived from certain incidental transactions – would not have the effect that input expenditures are attributed to economic and non-economic activities in an objective manner. 4.5. Actual-use formula The actual-use approach laid down by Art. 173(2)(c) of the VAT Directive – not to be calculated on an annual but on an ad hoc basis - would be a more appropriate method to determine the rate of deduction for individual inputs. Application of that method would be in line with the ECJ’s decision in Securenta that Member States must establish methods and criteria appropriate to that aim and consistent with the principles underlying the common system of VAT. In that regard, the ECJ held that, where the Directive does not contain the guidance necessary for such precise calculations, Member States are required to exercise their discretion having regard to the aims and broad logic of the Directive, 38 in particular the principle of neutrality on which the common system of VAT is based. Accordingly, Member States must exercise their discretion in such a way as to ensure that deduction is made only for that part of the VAT that is proportional to the amount relating to transactions giving rise to the right to deduct. They must therefore ensure that the calculation of the proportion of economic to non-economic activities objectively reflects the part of the input expenditure actually to be attributed to those two categories of activi- 34. For the terminology in this context, see note 23. 35. These are not subsidies which can be seen as consideration for supplies of goods or services. 36. Which result seems to contradict the ECJ judgments of 6 October 2005 in Commission of the European Communities v. French Republic, Case C-243/03, [2005] ECR I-8411, and in Commission of the European Communities v. Kingdom of Spain,Case C-204/03, [2005] ECR I-8389, Para. 26, in which the ECJ decided that Member States are not allowed to restrict the right to deduct input tax if fully taxable persons receive subsidies. 37. Art. 174(2)(b) of the VAT Directive. 38. See, to that effect, ECJ judgment of 14 September 2006 in Hausgemeinschaft Jörg und Stephanie Wollny v. Finanzamt Landshut, Case C-72/05, [2006] ECR I-8297, Para. 28. © IBFD INTERNATIONAL VAT MONITOR SEPTEMBER/OCTOBER 2011 335
Mandy Gabriël and Herman van Kesteren ties. According to the ECJ, in exercising their discretion, Member States have the right to apply, if necessary, an investment formula or a transaction formula or any other appropriate formula, without being restricted to only one of those methods. 4.6. Investment formula Application of an investment formula would be a more appropriate method for determining the rate of deduction of VAT on expenses relating to raising new capital by companies. In that case, the rate of deduction depends on the purposes for which the proceeds derived from the issue of the shares are used. This method was advocated by the European Commission and some Member States as being more appropriate than the “transaction formula” 39 in the case of Securenta. The question is whether this formula is indeed more suitable where capital is raised through the issue of shares, as this approach is based on the presumption that it is possible to determine to what extent the newly acquired funds are used for economic and non-economic activities. In practice, it will be very difficult to determine the source of the funds used for purchasing specific goods and services and, in addition, those goods and services will simultaneously be used for the two categories of activities. An apportioning method based on actual use of inputs for the purposes of carrying out economic and non-economic activities seems to be a more suitable method. The proceeds-based and investment formulas will certainly not be a solution for all cases in which input tax must be apportioned between economic and non-economic activities. For example, where charitable organizations receive non-taxable subsidies and use those funds for purchasing goods and services used for both their economic and non-economic activities, the best method for apportioning the input tax is probably one which is based on the extent to which the goods and services are used by the charitable organization for its economic and non-economic activities. If the charity uses the goods and services to the extent of only 10% for its non-taxable activities, whereas the subsidy amounts to 50% of its total income, a rate of deduction of 90% seems more appropriate in terms of tax neutrality. 4.7. Other unsolved issues As regards apportioning input VAT to economic and non-economic activities, much is still unclear and it can only be hoped that the European legislator will provide more clarity in this respect. In this context, determining the initial rate of deduction in a particular situation is not the only concern. It should also be clear what the consequences are of a subsequent change in the use of the goods and services. The use of inputs may change immediately following initial deduction of the related VAT, or one or several years later. In other words, the question is whether the initial deductions must be adjusted and, if so, whether a distinction must be made between goods and services or between capital and current expenditures. The relationship between the normal pro rata and pre-pro rata 336 mechanisms should also be clear, especially if they are to each have their own adjustment mechanisms. Under the ECJ’s judgment in Armbrecht, the application of the existing adjustment rules must be limited to that part of the assets assigned to the business, 40 which means that initial input tax deductions cannot be adjusted if the use of the goods shifts between taxable and non-taxable purposes. Under the new Art. 168a of the VAT Directive, which came into effect on 1 January 2011, 41 the principles of the existing arrangements for adjusting initial input tax deduction in respect of immovable business assets that are used for both business and private (non-business) purposes also apply to the annual deemed supply that is aimed at correcting initial full deduction on account of private use of the assets. That provision is at least a good start. The new legal arrangements to be included in the VAT Directive for initial deduction and subsequent adjustments of VAT relating to inputs used for both economic and non-economic purposes should however not only apply to goods but also to services, and they should clearly indicate the relationship between private and nonbusiness use of business assets. 42 5. Summary and Conclusions Taxable persons are entitled to deduct input VAT to the extent they use the related goods and services for the purposes of carrying out taxed transactions. If the inputs are used for both taxed and exempt transactions, the input VAT must be apportioned, either by directly attributing the inputs to specific outputs or by attributing them to the taxable person’s total economic activities. In the latter case, the deductible proportion can be established on the basis of a “pro rata” fraction based on turnover. In respect of non-economic activities, the pro rata mechanism is not completely sidelined. The economic activities of a business may even benefit from non-economic activities being carried out. In such cases, where the costs of inputs relating to non-economic output transactions can be linked to the taxable person’s total economic activities, the pro rata fraction still applies. However, where inputs cannot be fully linked to the taxable person’s total economic activities, the existing pro rata mechanism cannot be used and, under Securenta, Member States have to establish appropriate deduction methods and criteria, consistent with the principles un- 39. The “transaction formula” presumably refers to the apportionment method based on turnover. 40. ECJ judgment of 4 October 1995 in Dieter Armbrecht v. Finanzamt Uelzen, Case C-291/92, [1995] ECR I-2775, Para. 32. 41. By Council Directive 2009/162/EU of 22 December 2009 amending various provisions of Directive 2006/112/EC on the common system of value added tax, OJ L 10/14. 42. In its judgment in VNLTO (see note 32), the ECJ decided that the selfsupply rules laid down by Art. 26 of the VAT Directive are limited to private and non-business use of business assets, and do not apply to the use of those assets by a business for its non-economic activities. VNLTO’s non-economic activities (safeguarding the interests of its members) were still part of its business activities. INTERNATIONAL VAT MONITOR SEPTEMBER/OCTOBER 2011 © IBFD
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