This is a chapter from the book: "Taxes Crossing Borders (and Tax Professors Too) - Liber Amicorum Prof Dr R.G. Prokisch".
Prof.dr. A.J. van Doesum1 and dr. F.J.G. Nellen2
Our valued colleague Rainer Prokisch is blessed with the ability and drive to explore the fundamental dimension of tax law. Following his example, in this contribution to his Liber Amicorum, we will focus on a fundamental issue in tax law too. And, still following his example, we will do so with a German twist. We will discuss a trend of economic thinking that increasingly influences the interpretation and application of EU VAT. By doing so, we try to approach this topic from a fundamental perspective – meaning that we reflect on the trend with fundamental values (i.e., legal certainty and neutrality) in mind. The German twist is not only that we write this contribution in honor of Rainer, but also that we deliberately restrict ourselves to German cases, which were referred to the CJEU (in particular Phantasialand3 and the pending case W-GmbH4).
This contribution discusses the ‘economic’ approach that the CJEU regularly employs to decide on cases relating to EU VAT.5 In section 2, we provide a legal analysis of the economic approach. Section 3 deals with two important fundamental values in connection with the approach: neutrality and legal certainty. The remainder of this contribution focuses on two German cases in which the economic approach of the CJEU has particular meaning or relevance. Specifically, in section 4, we discuss the (pending) case W-GmbH; it deals with the question to what extent the CJEU should rely on an economic approach rather than a legal approach in order to safeguard the neutrality of VAT. Section 5 concerns the economic approach in the case Phantasialand, in which the CJEU takes into account certain aspects of economic theory in the course of reaching judgment. Section 6 contains the conclusion.
The ‘economic approach’ of the CJEU in EU VAT is based on the concept of ‘economic and commercial reality’ (hereafter: ‘economic reality’). This concept, which has no legal definition, is used by the CJEU to interpret and explain facts in the course of legal proceedings, following which precedence is given to the ultimate economic results of acts rather than to their legal characteristics.6 In this regard, the ‘economic’ approach complements the standard interpretation methods: textual (including linguistic) interpretation (textualism), contextual interpretation and teleological interpretation.7
From CJEU case-law, two primary manifestations of the concept of economic reality can be inferred.8 First, economic reality functions as an external standard of normality that serves in the course of the application of the doctrine of abuse of law. It is used to assess whether the parties involved in the case at hand have acted abnormally or artificially in the course of their commercial dealings and contract negotiations (e.g. to obtain tax advantages of which the accrual would be contrary to the law).9 The second manifestation of economic reality takes place both within and outside the context of the doctrine of abuse of law. In that regard, it serves as a combination of judiciary instruments that is aimed at realizing a purposeful application of VAT through the selection of the relevant facts and their fiscal classification. One example of its application is when the CJEU determines the tax implications of a given case on the basis of the factual conduct of the parties rather than their (asynchronous) contractual arrangements. The CJEU also employs economic reality to make a judiciary selection and classification of the case facts to realize an application of VAT norms that it deems to be appropriate (a ‘VAT reality’), for example, to achieve a neutral outcome. An economic approach or perspective is instrumental to create such a ‘VAT reality’.
The economic approach of the CJEU is strongly associated with the principles of neutrality and legal certainty. Firstly, the principle of legal certainty is a fundamental principle of EU law.10 It requires that a legal system and its application is clear and precise, so that individuals may ascertain unequivocally what their rights and obligations are and may take steps accordingly. Further, the principle of legal certainty demands that EU VAT law is certain and that its application is foreseeable by those subject to it. It must be observed all the more strictly in the case of rules liable to entail financial consequences, such as the EU VAT rules, in order to achieve that those concerned may know precisely the extent of the obligations which they impose on them.11 Following this, the economic approach of the CJEU appears to be curtailed by the principle of legal certainty. The reason is that it will be difficult, if not impossible, for a taxable person to establish the correct VAT treatment of its transactions when that VAT treatment is not dependent on the formal or legal characteristics of the transactions (i.e., contractual and legal reality), but rather on an uncertain ex post economic assessment by a court. As regards this aspect, the principle of legal certainty can be said to have an uneasy relationship with the economic approach of the CJEU.
The second principle that we discuss in this contribution concerns VAT neutrality. In short, it is a ‘fundamental principle of the common system of VAT established by the relevant EU legislation’, and as such has both an economic and a legal dimension.12 The economic dimension provides that VAT should be exactly proportional to the price of the goods and services and not be a cost to businesses (the so-called ‘system neutrality’).13 Conversely, the legal aspect of the neutrality principle entails the reflection in the field of VAT of the (general) principle of equal treatment.14 In an ideal world, the rules laid down in the EU VAT Directive are interpreted and applied in a neutral fashion. In practice, however, this is not always the case, since the rules may be applied or interpreted divergently.
In the context of CJEU case law, VAT neutrality can be a strong driver to abandon a strict legal approach to a case and to adopt an economic approach. The Faxworld case provides a fine example of this.15 In this case, the CJEU allowed a partnership to deduct VAT paid on purchases that were made for the purposes of its legal successor’s taxable transactions. From a strict legal perspective, given the fact that the CJEU considered the partnership as a taxable person separate from the Aktiengesellschaft16, it would be impossible to grant a taxable person (the partnership) a right of deduction which is based on another taxable person’s taxed transactions.17 However, when adopting an economic perspective on the case, depriving a partnership a right of deduction would have resulted in a risk of cascading of VAT, which is in violation of fiscal neutrality. Following this, the CJEU applied an economic approach to the case facts, negating the legal reality. In Polski Trawertyn a similar result was achieved, as the CJEU allowed a newly created partnership to deduct the VAT on investments made by its partners.18 In the latter case, therefore, the concept of the ‘recipient of the supply’ was interpreted from an economic perspective in order to safeguard system neutrality and allow for deduction of input VAT.
An economic approach can be a means of comparing two situations based on their (economic) outcome.19 In that case, it fulfills a role in the context of the principle of equal treatment or – when it concerns transactions which are in competition with each other – in the context of the neutrality principle as a reflection of the principle of equal treatment in the field of EU VAT. In this regard, an economic approach overlaps with or is an element of, economic reality. An economic approach can also be said to play a role in ensuring that the outcome of the application of EU VAT rules to a certain situation is neutral from a system’s perspective, i.e. that VAT is not a cost to a business, that no double taxation or non-taxation occurs and that cascading of VAT is prevented. In this context, it fulfills a role in achieving system neutrality as an external benchmark. The rulings in Faxworld and Polski Trawertyn (see above) can be seen as examples of this manifestation of an economic approach.
In our view, an overly broad application of an economic approach and/or economic reality bears the risk of (perceived) unequal treatment. The two manifestations of an economic approach may be at odds with each other. Transactions which may be similar from a legal perspective may be different from an economic perspective and the other way around. The cases MEO and Vodafone Portugal on the one hand and Societé Thermale d’Eugénie-les-Bains (‘Societé Thermale’)20 on the other are illustrative of this. In Societé Thermale, the CJEU had considered that a deposit paid when booking a hotel room is in fact a compensation for damages, outside the scope of EU VAT, in the event the customer exercises his cancellation option. The cases MEO and Vodafone Portugal revolved around the question whether a termination fee paid by the customer after having cancelled his subscription is either a consideration for a telecommunication service subject to EU VAT, or a compensation for damages which is not subject to VAT.21 From a legal perspective, it is undoubtedly true that there are clear differences between MEO and Vodafone Portugal on the one hand, and Societe Thermale on the other hand. However, from an economic perspective, the differences are less evident.22
This section discusses the currently pending case W-GmbH (C-98/21). Further to this case, we address the question whether the CJEU should rely on an economic approach rather than a legal approach in order to safeguard the neutrality of EU VAT.
W-GmbH exploits his own real estate portfolio. It held majority stakes in each of two limited partnerships under German law, as a limited partner. The other limited partner ('Z') held minority stakes. The general partner was not required to make any investment and does not have any capital share. Consequently, the general partner does not share in any profit or loss and does not possess any voting rights. Both partnerships built properties and sold the individual dwelling units predominantly free of VAT. To enable the partnerships to carry out two future building projects, the limited partner 'Z' would provide extra cash via a shareholder contribution and W-GmbH would provide services 'free of charge' as a shareholder contribution. Both contributions were made in the exact proportion of the limited partner’s stakes in the two partnerships. W-GmbH provided its services partly with its own personnel and its own machinery, and partly with assistance from other companies. Furthermore, in connection with the two construction projects (and separately from the services free of charge), W-GmbH would supply accounting and management services to the two partnerships in return for payment. The essence of the preliminary questions23 is whether a parent company such as W-GmbH, which supplies taxed services for consideration to its subsidiaries can deduct the VAT on various services it procures from third parties and which it subsequently contributes in kind (i.e., supplies free of charge) to its subsidiaries. In the situation of W-GmbH, the subsidiaries are not entitled to an input VAT deduction.
Reviewing the case at hand, we are of the opinion that a strictly legal approach will be rather complicated. The reason is that the case involves a plethora of rather technical legal questions which are related to many rules of EU VAT law. The CJEU would need to establish who the recipient of the services is, whether any input VAT can be attributed to a taxable output transaction which gives rise to a right of deduction, whether the costs of the services can be attributed to the economic activity as a whole of the parent company or subsidiary and if so, whether this gives rise to a right of deduction. What even further complicates matters, is that the case requires answers to some questions of law that have remained unanswered in CJEU case law so far. Examples of such questions are whether a capital contribution in kind constitutes a taxable supply for EU VAT, to what extent input VAT attributable to a capital contribution in kind is deductible and who the recipient of a supply is when the goods or services supplied are consecutively contributed in kind to another company. All in all, a strictly legal approach would in our view be very complicated. Not only would the CJEU be required to address an abundance of legal questions that relate to many EU VAT rules, it would also involve the need to reconciliate the ultimate outcome and considerations which a huge body of earlier CJEU case-law.
What also complicates a strict legal approach is that the company receiving W-GmbH’s contribution does not enjoy a full right of deduction. If one assumes that the contributor is allowed to deduct the VAT on the costs of the goods or services it contributes in kind to a company, without that contribution being subject to EU VAT, a result is reached that is not neutral. This seems the referring court’s concern in W-GmbH. It signals the risk that, “in cases in which a subsidiary is not entitled to full deduction, holdings would be used as ‘intermediaries’ in their entire procurement of services to the effect that the holding supplies most of the services free of charge (= contributes to the subsidiary).”24 The Bundesfinanzhof suggests that in situations like these an abuse of law should be assumed, without having to test whether the conditions for application of this doctrine have been fulfilled. In our view, this is unacceptable for reasons of legal certainty and of proportionality.
With the above considerations in mind, the CJEU may largely or fully rely on an economic approach instead. This would (partly) avoid the need reconciliate the judgment with earlier case law, and the CJEU would not have to interpret countless rules of EU VAT law in light of the rather complex facts of the case. In our view, an economic approach would have a straight-forward outcome: a full right of deduction should be denied to W-GmbH, as otherwise subsidiaries with no or a limited right of deduction would be able to procure goods or services free of VAT. This being said, using an economic approach to avoid unwelcome outcomes in jurisprudence is a doubtful way forward. The reason is that it bears the risk that the rules in the EU VAT Directive and their common judicial interpretation are ignored for the benefit of a straight-forward solution to a complex case. Not using a legal approach that is based on conventional judicial methods potentially violates legal certainty and may lead to unequal treatment. Moreover, a broad application of the economic approach may cause ‘collateral damage’, for example in cases where the companies receiving the contribution have a right of deduction. The solution to one problem may be the cause for the next.
The previous sections of this contribution focused on the economic approach of the CJEU when it employs ‘economic reality’ as an instrument to interpret and explain facts in the course of legal proceedings. However, the economic approach of the CJEU also manifests itself in a more subtle fashion, i.e., by means of rationalizations that are connected with the economic theory. One example of this is the Phantasialand case, in which the CJEU relates to the competitiveness of products, and the potential existence of substitution relations between them.25
The case Phantasialand concerns a theme park located in Germany. The operator of the theme park took the position that the principle of fiscal neutrality precludes a rule of national law which allows the application of a reduced VAT rate to activities of operators of attractions that are not permanently located at the same place (e.g. seasonal and temporary fairs), whereas the activities of operators of permanent attractions are taxed against the standard VAT rate.26 In the course of the ensuing litigation, the national court asked the CJEU whether EU VAT law is to be understood as precluding a rule of national law on the basis of which services of ambulatory attraction operators are taxed against a different VAT rate than services of operators of permanently established attractions.
The CJEU rules that EU VAT law does not preclude a rule of national law on the basis of which services of ambulatory attraction operators are taxed against a different VAT rate than services of operators of permanently established attractions, provided that the principle of fiscal neutrality is not violated. Interestingly, the CJEU employs an economic approach to establish whether or not goods or services are similar and thus in competition with each other, following which the principle of fiscal neutrality would preclude different VAT rates to apply. Firstly, the goods or services must have similar characteristics and they must satisfy the same consumer needs.27 Secondly, any existing differences between the goods or services can have no substantial influence on the decision of the average consumer to opt for the one or the other.28 Further to the latter aspect, the national court should establish whether the respective services are, from the perspective of the average consumer, in a ‘substitution relation’29 – in which case the application of different VAT rates can be of influence on the choices of the consumer, holding the risk of a violation of neutrality.
The question is what the CJEU exactly means when it refers to the concept of ‘substitution relation’. This concept is widely used in the field of micro-economics, and relates to the phenomenon that the increase of the price of one product leads to an upward shift in demand for another product (the ‘substitute’). In relation to its economic approach – i.e. the similarity and competition test – the CJEU notes that “EU law does not preclude a national court which is experiencing particular difficulty in that appraisal from seeking, under the conditions laid down by its national law, an expert opinion as guidance for its judgment”.30 One may wonder whether this implies that competition and substitution relations need to be assessed in a quantitative sense, e.g. by means of measuring the price and demand interdependencies between two products that are possibly subject to different VAT rates. In any case, now the CJEU has provided that substitution relations are relevant for the assessment whether or not fiscal neutrality is violated when two different VAT rates are indeed applied, earlier CJEU judgments arguably appear less convincing. For example, the Segler-Vereinigung Cuxhaven e.V. v Finanzamt Cuxhaven case involves the VAT treatment of the letting of places on caravan sites versus the letting of boat moorings.31 Here, the CJEU simply declares that, because these transactions perform different functions, there is no competition at all, thus allowing the application of different VAT rates.32 In contrast with Phantasialand, no reference is made to substitution effects whatsoever – even though diverging VAT rates may very well motivate a person to take his motor-home (reduced VAT rate) instead of his boat (standard VAT rate) when he goes on a holiday trip. Another example concerns the case Commission v France, involving different VAT rates being applied to reimbursable and non-reimbursable medicines.33 Here, the CJEU provides that a reimbursable medicinal product vis-à-vis a non-reimbursable medicinal product will have a decisive advantage for the final consumer because of the lower price.34 While that may be true, the CJEU also indicates that “the two categories of medicinal products are not similar products in competition with each other”35 – which is a doubtful conclusion when taking into account substitution effects, since reimbursable and non-reimbursable medicines may be identical and thus be in a perfect substitution relation.
Overlooking the CJEU judgment in Phantasialand and the other mentioned cases, the question is what the role of the ‘substitution’ criterion will be in future case law on the application of the VAT rates. In our view, the criterion should be applied and interpreted restrictively, as many products, even dissimilar ones, can be in substitution relations vis-à-vis each other. Thus, a broad application would go against the principle of legal certainty, as it would complicate the levy of VAT and preclude that taxpayers can easily ascertain what their rights and obligations are. In addition, a broad application does not necessarily serve fiscal neutrality, as that principle demands that similar goods are treated equally for VAT purposes. The similarity of products depends, amongst other, on the main characteristics, their use, the needs that they serve, etcetera. Even though there is a positive relationship between the similarity of products on the one hand and the extent of their substitution relation on the other, it is nonetheless possible that relatively dissimilar products are substitutes in an economic sense. An example would be the supply of a downloadable video game versus the supply of a board game – two products which serve the same need for entertainment yet have quite different characteristics (and VAT treatments!). Taking into account these aspects, we are of the opinion that the substitution criterion should not be decisive when assessing whether or not two products are similar and thus in competition with each other.
On occasion, the CJEU relies on an ‘economic approach’ in its cases concerning EU VAT law. One manifestation of this is when the CJEU refers to the concept of ‘economic reality’, which is used to interpret and explain facts in the course of legal proceedings. When it is applied, the CJEU may give precedence to the ultimate economic results of acts rather than to their legal characteristics in order to reach a judgment. While economic reality should not be dismissed as a useful instrument for achieving full neutrality, it should by no means be regarded as a miracle cure for all situations which do not lead to an outcome compatible with the rules of the EU VAT Law. In any case, legal certainty demands that an economic approach and/or economic reality should not be employed as a ‘light’ version of the abuse of law doctrine that is not curtailed by conditions or safeguards. That also implies that an abuse of law ‘by default’ is incompatible with a certain, predictable, and efficient application of VAT. Neutrality is a great good, but so are equality and legal certainty.
Another manifestation of the ‘economic approach’ of the CJEU is that the CJEU on occasion relies on concepts derived from (micro-)economic theory in the course of reaching judgment. The example that we discussed in this contribution is the substitution criterion used by the CJEU in Phantasialand, a case on the application of different VAT rates to transactions with similar characteristics. With regard to legal certainty and fiscal neutrality, we are of the opinion that the criterion should be applied and interpreted restrictively, as many products, even dissimilar ones, can be in substitution relations vis-à-vis each other.
Dear Rainer, we wish you many more good years in good health. You are a striking, driven and charismatic tax expert that no one can ignore. With your German twist, you have greatly contributed to the further development of our beautiful profession. It was always good to see you and we hope to keep in touch. All the best to you.