Loan sub-participation arrangements qualify as exempt supply of credit

The CJEU has held that that the supply made by a sub-participator under a sub-participation agreement with the originator of a loan falls within the VAT exemption for the grant of credit: O. Fundusz lnwestycyjny Zamknięty reprezentowany przez O (Case C-250/21). The Court accepted that such a supply amounted in essence to the financing the initial loans.

In practice, the decision may owe much to the important practical implications for the market in such transactions, which may have been adversely affected by a decision that such supplies were taxable.

Background

The case involves a Polish referral concerning the correct VAT treatment of a sub-participation agreement. Under such an arrangement, a lender sub-contracts all or part of its risk under an existing loan agreement to another financial institution. It does not involve any transfer of rights or obligations under the original loan, but rather creates a new set of rights and obligations between the existing lender and the sub-participant. The original loan and relationship between the original lender and borrower remain in place and are unaffected.

In the specific case, an investment fund paid an originating lender (such as a bank) an amount and in return the lender agreed to pay to the investment fund the proceeds obtained by it under the original loans covered by the sub-participation agreement. This removes the cash flow and the risk from the originator’s balance sheet, but the originator remains the legal owner of the assets. The investment fund contended that its supply was exempt, but Poland’s Minister for Finance rejected that contention and issued a tax ruling that the fund’s services did not fall within the VAT exemption and were subject to VAT.

The investment fund appealed that tax ruling, which was annulled by the Regional Administrative Court. It considered that the objective of a sub-participation agreement was to ensure that the originator had access to funding, and in return for making the funds available to the bank, the investment fund received the proceeds of the receivables that are subject to the sub-participation agreement. Those proceeds were similar to interest paid under a loan agreement. The Polish tax authority appealed, and the matter has been referred to the CJEU.

AG Opinion

The Advocate General opined that the supply made by the sub-participator under the sub-participation agreement with the originator did not fall within the VAT exemption for the grant of credit. The AG considered that the transfer of risk was a significant element of that supply, and that element did not fall with the VAT exemption. Essentially, the supply was in part risk management and that took it outside the exemption. Equally, however, the AG candidly recognised that the question put to the Court has “important practical implications for the law related to securities, since the answer the Court provides may affect the performance and attractiveness of such financial transactions, making this case of a sensitive nature”.

Decision of the CJEU

The first question was whether the sub-participator makes any supply at all in these circumstances. The Court was in agreement with the AG on this question, noting that there was reciprocal performance in this case involving the payment of an upfront amount by the sub-participator to the originator, which in return agrees to transfer to the sub-participator the proceeds of the receivables. “The originator receives a service in return for consideration which corresponds to the difference between the estimated value of the proceeds from the receivables and the amount of the financial contribution paid by the sub-participant.” The Court rejected any suggestion that it was relevant, for the purposes of determining whether a supply of services is effected for consideration, that the remuneration did not take the form of a payment of a commission or specific fees.

Did that supply fall within the exemption for the granting of credit under Article 135(1)(b) of the 2006 VAT Directive? The Court noted that the granting of credit consists in the provision of capital in return for remuneration, but equally stressed that the interpretation of the exemption must be consistent with the objectives pursued by it and comply with the requirements of the principle of fiscal neutrality inherent in the common system of VAT. As with other exemptions, it is the nature of the supply that determines whether it falls within the exemption and not the identity of the supplier. As such, the exemption cannot be limited to loans and credits granted by banking and financial institutions only.

The Court’s analysis of the service provided by the sub-participant was that it amounted to a single supply which consists, essentially, in a payment of capital in return for remuneration. The AG had considered that the transfer of risk to the sub-participant was an additional feature in this situation that took the supply outside the scope of the exemption for the grant of credit. However, the CJEU’s answer to this was the fact that “the sub-participant is exposed to potential losses and thus bears the credit risk is inherent in any grant of credit, regardless of whether that risk stems from non-payment by the debtors of the receivables from which the proceeds are transferred to it or from the insolvency of its direct co-contractor”.

Accordingly, the Court concluded that the fact that the sub-participant had no legal remedy against the originator in the event of default by the debtors of the receivables from which the proceeds are transferred to it and the fact that the debt securities remained in the originator’s assets did not affect the essential nature of a sub-participation transaction, which consisted in financing the initial loans. Equally, the fact that there was no security or guarantee in place in favour of the sub-participator did not affect this analysis.

Finally, the Court was bolstered in in its conclusion by the fact that this interpretation of the concept of ‘granting of credit’ was consistent with the objective pursued by that provision, which consists, inter alia, in avoiding an increase in the cost of consumer credit.

Comment

The decision of the Court will be very welcome in that the loan sub-participation market (and financial markets more generally), which are typically dependent on transactions not being subject to any VAT.

Although this case appears to be based on a rather specific and unusual form of Polish law sub-participation, the nature of the Court’s ruling and it reliance on the objective pursued by Article 135(1)(b) more generally, should ensure that it can be applied more widely in other sub-participation structures, where these are not already covered by other exemptions (such as a VAT exempt sale of a debt).

More generally, the Court’s analysis does stress the importance of the objective pursued by the exemptions. Whether this may widen the scope of the exemption for the grant of credit to other financial transactions or products which may not take the form of loans but may in substance transfer financial risks and rewards remains to be seen.