Decision in Sight: Is the transfer of August 25, 2011 defaulted debts subject to VAT? Practice Group(s): Finance Tax Encouraging Opinion of the Advocate General from 14th July 2011 in the ECJ Case C-93/10 One of the main controversial points in the context of transactions involving defaulted debts comes closer to a – hopefully positive – decision: In his opinion from 14th July 2011 regarding case C-93/10, Finanzamt Essen-Nordost v. GFKL Financial Services AG, the Advocate General of the European Court of Justice, Niilo Jääskinen, makes the case for the transfer of defaulted bank debts to a buyer, as well as the acquisition of the credit risk and debt collection by the buyer, not being subject to VAT. Indeed, he says that typically the buyer is providing an economic service to the bank. However, with the purchase of defaulted debt at a discount from the face value which reflects the current market value, there is no remuneration rewarded by the bank that is directly linked to that service. The decision from the European Court of Justice on this matter is expected by the end of the year. Background The discussion about VAT liability was triggered by the judgement made by the European Court of Justice in June 2003 regarding M-KG-Kraftfahrzeuge-Factoring-GmbH. The judgement concerned debt collection by a factoring company. The European Court of Justice decided that a business which purchases debts, thereby assuming the risk of the debtor’s default, collects the debts and, in turn, invoices its clients in respect of commission, pursues an economic activity which is subject to VAT. The German tax authorities have also applied the principles of this judgement regarding factoring to the purchase of debts for a price at less than face value. They hold that the basis for the assessment for VAT is the difference between the face value and the purchase price of the debt, less the VAT already included therein. For “defaulted debts” the so-called economic face value takes the place of the face value. Since then the question of how the economic value is assessed and which party should bear any possible VAT charges has always been part of the agenda when negotiating purchase agreements. Added to that, the German tax authorities are not bound to the agreements with respect to the economic face value of the defaulted debt. Thus, the VAT risk has become one of the major factors for the structuring and calculating of transactions involving (defaulted) credit debt. Despite all the criticism, the German tax authorities initially obtained support from the Hesse Finance Court (Hessisches Finanzgericht) during preliminary legal protection proceedings in May 2007, as the Hesse Finance Court did not object to the administrative practice.
Decision in Sight: Is the transfer of defaulted debts subject to VAT? The Proceedings The proceedings before the European Court of Justice were triggered by the legal proceedings of GFKL Financial Services AG against the Finanzamt Essen-Nordost (Tax Authorities for North-East Essen) held before the Düsseldorf Finance Court (Finanzgericht Düsseldorf) . The proceedings concerned the assignment of defaulted debts by a bank to the plaintiff, for a price below the debt’s face value. The Düsseldorf Finance Court disagreed with the German tax authority’s practices and ruled that, for a number of reasons, the collection of defaulted debts does not fall under the scope of the M-KG judgement. Amongst other reasons, the Düsseldorf Finance Court held that the purchaser did not render a service to the seller because the collection of the defaulted debt did not constitute an economic activity on the part of the purchaser. Rather, the purchaser, as the holder of the defaulted debt, collected for his own interests. In December 2009, following the appeal of the Finanzamt Essen-Nordost, the Federal Finance Court (Bundesfinanzhof) finally put the question before the European Court of Justice for a decision. The Federal Finance Court supported the M-KG judgement in that the purchaser provides a service to the seller because the seller is released from the collection of debts and the risk of default. However, they denied that any consideration had been agreed upon and that the consideration was directly linked to the collection of the debt. The Opinion In his opinion from 14th July 2011 the Advocate General essentially subscribes to this view. He also accepts that with the transfer of bank debts and their collection by the purchaser, the purchaser provides a service to the seller. He states, however, that this should not apply to debts traded on the stock exchange or to “pure” assignments, for example in connection with the transfer of business assets through the sale of an enterprise. The seller acquires the advantage through the transfer of risk and the collection of bank debts, which exceeds the purchase price, namely, amongst other things, the possibility to terminate customer relationships and the relief from further legal and public relations issues connected with the collection of the debts. However, remuneration for this is not directly linked to the collection. The seller gives the deduction from the face value of the debt because of the drop in market value, not because the debt is collected from the purchaser. Even if the deduction were classified as a remuneration – as the Federal Finance Court holds – the remuneration would not be directly linked to the service. This is to be verified in the case of “Bad Banks” in each individual case. In contrast to the Federal Finance Court, the Advocate General denies the prerequisite of a VAT exemption or the uniform handling as lending. Should the European Court of Justice not follow his reasonings, he gives further grounds for his decision; with the confirmation of a payment in return for the service, the basis of assessment for VAT would be the difference between the actual amounts obtained from the debtors and the purchase price, not the difference between the (economic) face value and the purchase price. This applies irrespective of the fact that the actual amount is received after a certain period of time, namely after the collection of the debts. It remains open here at which point the VAT is to be levied. The opinion does not contain any express statements regarding non-defaulted bank debts. The treatment of VAT until now with regard to “true” and quasi-factoring, i.e. where the seller remains fully liable with regard to the debtor’s ability to pay, is not called into question. 2
Decision in Sight: Is the transfer of defaulted debts subject to VAT? Outlook As a rule, the European Court of Justice follows the opinion of the Advocate General. However, it is not bound to the opinion and has in the past been known to deviate from it. Whatever decision the European Court of Justice makes, it will most likely increase the legal certainty for the structuring of future transactions. Authors: Rainer Schmitt rainer.schmitt@klgates.com +49.69.94.51.96.290 Dr. Christian Büche christian.bueche@klgates.com +49.69.94.51.96.365 3
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