Overseas branch input VAT recovery

The ECJ has delivered its judgment in the Morgan Stanley case (Case C-165/17) on the correct method for calculating deductible branch input VAT where a branch incurs costs that are used in whole or part by its head office in another Member State. The Court has, in essence, endorsed a complex approach which requires, in cases where the input VAT is used for the transactions of the head office, the amount of deductible input VAT to be determined based on the proportion of the taxable activities of the head office, provided that those transactions would also be taxable in the Member State where the branch is located. In essence, therefore, the test requires a “dual layer” approach and the relevant transactions for which input VAT deduction is sought must be taxable in both Member States.

Background

Morgan Stanley Paris branch was a fixed establishment of Morgan Stanley UK. The Paris branch carried out banking and other financial transactions for its local clients (in respect of which it had opted to be liable to VAT) and also supplied services to the UK head office in return for transfers. The Paris branch deducted all of the input VAT attributable to those two categories of services.

The French tax authorities considered that input VAT attributable to the Paris branch’s activities performed for its UK head office was not fully deductible, since these transactions fell outside the scope of VAT. Instead, the tax authorities only allowed a deduction for a fraction of such input VAT based in part on the activities of the UK head office.

Morgan Stanley appealed arguing that since its own external supplies were fully taxable, then all its residual input VAT should be recoverable. The French courts decided to refer questions to the ECJ. In particular, the questions distinguished between two situations:

• Where the input VAT was wholly attributable to the activities of the UK head office.
• Where the input VAT was essentially residual input VAT.

Decision of the ECJ

A branch and its head office are not, of course, separate taxable persons (except where the branch is part of a separate VAT group registration at least following the ECJ’s decision in the Skandia case (C-7/13)). This raises the question whether it is necessary or possible to look through to the activities of the head office to determine the VAT recovery on expenses used by the branch or whether it is possible to limit attribution to the local supplies of the branch.

The ECJ noted that the Paris branch and the UK head office must be seen as a single taxable person. There was nothing to suggest that the Paris branch acted independently and so should be regarded as a separate entity for VAT purposes. As such, the services provided by the Paris branch to the UK head office fell outside the scope of VAT and simply constituted “non-taxable internal flows of funds”. This was essentially sufficient to reject the French Government’s argument that the calculation of the deductible proportion of input VAT should be based on the outside the scope transactions between the Paris branch and the UK head office.

Instead, the Court pointed out that, pursuant to Article 169(a) of the Principal VAT Directive a taxable person is entitled to deduct input VAT used for the purposes of transactions carried out in a different Member State to the extent that such VAT would be deductible if they had been carried out within the Member State where it carries out taxable transactions. This right is subject to two conditions: (a) the transactions carried out in a Member State other than the State in which the VAT is paid must be taxed in the Member State where they are carried out and (ii) those transactions would also be taxed if they were carried out in the Member State where the input VAT is incurred. This requires, therefore, a dual layer approach. In this case, therefore, recovery of French input VAT depends on the relevant transactions giving rise, in principle, to VAT recovery in both France and the UK. This is, of course, fundamentally different to the approach to input VAT recovery in relation to the local supplies made by the Paris branch.

Therefore, the Court concluded that it “follows that a branch registered in a Member State is entitled to deduct, in that State, the VAT charged on the goods and services acquired which have a direct and immediate link with the carrying out of the taxed transactions, including those of its principal establishment established in another Member State… on condition that those transactions would also give rise to deduction if they had been carried out in the State in which that branch is registered.”

What about the situation (as in the present case) where the input VAT is incurred in connection with both exempt and taxable transactions? What is the correct way to calculate the deductible portion? Article 173(1) requires that the deductible proportion must be based on “all the transactions” carried out by the taxable person. However, the Court explained that this must be interpreted as referring only to all those transactions that the mixed use goods/services have been used for (not all the economic transactions of the taxable person. Therefore, in the case of a branch incurring “mixed use expenditure” used for both taxable and exempt transactions carried out by its principal establishment in another Member State, it is necessary to apply a deductible fraction in which (a) the denominator is based on the relevant turnover (ie the turnover of those transactions for which the mixed use expenditure is used) and (b) the numerator is the turnover of the taxable transactions carried out by the principal establishment, in respect of which VAT would also be deductible if they had been carried out in the Member State in which the branch was located. So, a dual layer test is also necessary in this context.

Secondly, the Court considered the situation where the branch incurred input VAT that was used both for its own local transactions and also in relation to the services it provided to its head office ie where the input VAT was residual input VAT. In such a situation it was again necessary to determine the correct deductible proportion. In this case, the denominator would be all the turnover of the “taxable person”. The numerator in this case would be made up of the taxable transactions carried out by the branch and also the taxable transactions carried out by the principal establishment provided that such VAT would also be deductible if those transactions had been carried out in the State in which that branch is registered.

Comment

The VAT recovery position of expenses incurred by a branch in relation to the activities of its head office and vice versa is a complex area, especially where the business is not fully taxable. This decision will need to be carefully considered by affected businesses seeking to ensure that they are able to maximise their input VAT recovery.

It should be noted, however, that where jurisdictions are involved that have either applied the Skandia approach to branch VAT grouping or historically regarded VAT groups as separate taxable persons, these issues should not arise where either the branch or the head office are part of a separate VAT group.