Watch out! Activities of the head office may impact the VAT recovery methodology of the branch

04/02/19

Background

On 24 January 2019, the Court of Justice of the European Union (“CJEU”) released its decision in the Morgan Stanley’s case (C-165/17).

The French branch of Morgan Stanley & Co International Plc (a company established in the UK) was supplying financial services to local customers. These services were subject to VAT in France as a result of the Option for Taxation of Financial Services in France. The French branch was also engaged in internal transactions with its UK head office, i.e. it was supplying services to the head office in return for which it received transfers.

The French branch incurred (i) expenses that were used exclusively for the purpose of the internal transactions with its UK head office and (ii) expenses that were used both for providing services to third parties as well as for the internal transactions with its UK head office. The French branch recovered input VAT in full on these costs.

The French authorities considered that the French branch was not entitled to recover input VAT on the costs used for the internal transactions with the UK head office (as these transactions are outside the scope of VAT). However, by way of mitigation, it allowed recovery of a fraction of the input VAT based on the input VAT recovery of the head office.

With regard to mixed expenditures (attributable to external transactions carried out by the French branch and to internal transactions with the UK head office), the French authorities considered that such expenses were only partially deductible and applied the head office’s prorata (adjusted according to the French branch’s turnover with VAT recovery).

Questions referred to the CJEU

The French Supreme Court decided to ask the CJEU which method should be used to compute the input VAT deduction right of a branch that incurred:

(i) costs that are used exclusively for the internal transactions with the head office in another Member State?

(ii) costs that are used simultaneously for the activities performed by the branch with third parties and for internal transactions with the head office in another Member State?

CJEU decision

In a nutshell, the CJEU ruled that the French branch should compute its input VAT recovery right by taking into account the activities performed by its head office, for expenses that related fully or partially to the operations of the head office.

For the two situations, the Court states that a double layer test has to be applied. Hence, the Court applies a limitation of input VAT recovery based on the cumulative application of the legislation of both Member States. Thus, the French branch can only recover input VAT on these expenditures to the extent that the related supplies give right to recovery in both the UK and France.

(i) Costs incurred by the branch that are exclusively used for the purpose of the internal transactions with the head office in another Member state:

For costs incurred by the French branch that are used only for internal transactions with the UK head office, the computation of the input VAT recovery should take into account only the turnover derived from the activities performed by the head office related to the expenses incurred by the branch. The VAT recovery ratio for these expenses should be computed as follows:

(ii) Costs incurred by the branch that are used for both internal transactions with the head office in another Member state and for its own activities with third parties

For costs incurred by the French branch that are used both for the transactions of the branch as well as for the internal transactions with the head office in the UK, the computation of the input VAT recovery on related expenses should be based on both the turnover of the branch as well as the turnover of the head office.

Practical implications

The methodology used to determine the input VAT recovery of Luxembourg businesses engaged in both VAT exempt and VAT taxable activities is often not easy and requires an in-depth analysis of the expenses incurred and to determine their connection with output transactions.

This case brings an additional layer of complexity for businesses that are established in multiple countries through branches, in case where either the head office or the branches are engaged in internal transactions. But it also opens a right to deduct input VAT for branches that do not (only) generate their own revenues, but are allocated revenues by their head office. The CJEU recognizes that the deduction right cannot be disallowed because the branch’s revenues are out of the VAT scope. One has to consider the activities of the head office then.

However, the impact of this case should be limited for branch structures where no expenses are incurred by a branch or the head office for the purpose of internal transactions.

In principle, Luxembourg businesses already have, as a first step, to identify costs that are in direct and immediate link with a specific activity so as to determine whether VAT incurred on those costs is recoverable or not. As a second step, input VAT on costs that cannot be directly allocated to any specific activity can be recovered through the use of a specific key of allocation (if it better reflects the use of the costs). Then, only in a final step, VAT can be recovered by using the general turnover-based prorata. This VAT recovery methodology was recalled by the Luxembourg VAT Authorities in the Circular n°765 dated 15 May 2013.

Further to this decision, multiple steps should in principle be followed for the calculation of the VAT recovery of branches in Luxembourg, assuming these branches are engaged in internal transactions with their head office or other branches:

  1. Direct allocation of the expenses incurred exclusively for a VAT exempt or VAT taxable activity of the head office;
  2. Direct allocation of the expenses incurred exclusively for a VAT exempt or VAT taxable activity of the branch;
  3. New prorata as described above for the expenses incurred in relation to internal transactions with the head office but used for VAT exempt and VAT taxable activities by the head office;
  4. New prorata as described above for the expenses incurred simultaneously for internal transactions with the head office and for the activities of the branch towards third parties;
  5. Specific key of allocation for the overhead costs of the branch or turnover-based prorata if not possible (for expenses that relate only to the activities performed by the branch with parties other than the head office).

This additional complexity can be dealt with by using analytical accounting systems allowing to track each expense incurred and to determine for the benefit of which activity it is used. This may imply updates and developments in the existing accounting systems to take into account the new methodology suggested in the Morgan Stanley case.

For completeness, we note that at least two other items should be considered in relation to head office /branch structures although they have not been dealt with in the present case. In case a taxpayer has multiple establishments, it should in principle first determine which establishment is the actual beneficiary of the services in the light of Implementing Regulation 282/2011. This topic is not addressed by the CJEU because this was not part of the questions referred to but the appropriate allocation of expenses that is used by multiple establishments is a prior step to the recovery of input VAT on such costs.

The case also does not address the possible interactions with the Skandia case. Although from a Luxembourg VAT perspective the expectation is that the Morgan Stanley case should not find application where either the branch or the head office is part of a VAT group (because the internal transactions should no longer be disregarded for VAT purposes), it is worth monitoring the developments in the other Member States as there may be some different interpretations.

If you have any questions, please reach out to your usual PwC contacts. We would be pleased to assist you in assessing the impact of the judgment and contemplating the potential adjustments to your existing VAT recovery methodology.

1. PwC Luxembourg (www.pwc.lu) is the largest professional services firm in Luxembourg with 2,870 people employed from 76 different countries. PwC Luxembourg provides audit, tax and advisory services including management consulting, transaction, financing and regulatory advice. The firm provides advice to a wide variety of clients from local and middle market entrepreneurs to large multinational companies operating from Luxembourg and the Greater Region. The firm helps its clients create the value they are looking for by contributing to the smooth operation of the capital markets and providing advice through an industry-focused approach.

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Contact us

Marie-Isabelle Richardin

VAT Partner, PwC Luxembourg

Tel: +352 49 48 48 3009

Frédéric Wersand

VAT Partner, PwC Luxembourg

Tel: +352 49 48 48 3111

David Schaefer

Director, PwC Luxembourg

Tel: +352 49 48 48 3202