Flashback on ECJ cases C-98/98 (Midland Bank) – Input tax deduction requires a direct and immediate connection between a transaction at an earlier stage and one or more transactions at a later stage

On June 8, 2000, the ECJ issued its decision in the case C-98/98 (Midland Bank).

Context: Value added tax – First and Sixth VAT Directives – Deduction of input tax – Taxable person carrying out both taxable and exempt transactions – Attribution of input services to output transactions – Need for a direct and immediate link

Article in the EU VAT Directive

Articles 17(2), (3) or (5) of the Sixth VAT Directive (Articles 168, 169, 170, 173 of the EU VAT Directive 2006/112/EC).

Article 168 (Origin and scope of right of deduction)
In so far as the goods and services are used for the purposes of the taxed transactions of a taxable person, the taxable person shall be entitled, in the Member State in which he carries out these transactions, to deduct the following from the VAT which he is liable to pay:
(a) the VAT due or paid in that Member State in respect of supplies to him of goods or services, carried out or to be carried out by another taxable person;
(b) the VAT due in respect of transactions treated as supplies of goods or services pursuant to Article 18(a) and Article 27;
(c) the VAT due in respect of intra-Community acquisitions of goods pursuant to Article 2(1)(b)(i);
(d) the VAT due on transactions treated as intra-Community acquisitions in accordance with Articles 21 and 22;
(e) the VAT due or paid in respect of the importation of goods into that Member State.

Article 169
In addition to the deduction referred to in Article 168, the taxable person shall be entitled to deduct the VAT referred to therein in so far as the goods and services are used for the purposes of the following:
(a) transactions relating to the activities referred to in the second subparagraph of Article 9(1), carried out outside the Member State in which that tax is due or paid, in respect of which VAT would be deductible if they had been carried out within that Member State;
(b) transactions which are exempt pursuant to Articles 136a, 138, 142 or 144, Articles 146 to 149, Articles 151, 152, 153 or 156, Article 157(1)(b), Articles 158 to 161 or Article 164;
(c) transactions which are exempt pursuant to points (a) to (f) of Article 135(1), where the customer is established outside the Community or where those transactions relate directly to goods to be exported out of the Community.

Article 170
All taxable persons who, within the meaning of Article 1 of Directive 86/560/EEC ( 1 ), Article 2(1) and Article 3 of Directive 2008/9/EC ( 2 ) and Article 171 of this Directive, are not established in the Member State in which they purchase goods and services or import goods subject to VAT shall be entitled to obtain a refund of that VAT insofar as the goods and services are used for the purposes of the following:
(a) transactions referred to in Article 169;
(b) transactions for which the tax is solely payable by the customer in accordance with Articles 194 to 197 or Article 199.

2. Member States shall lay down detailed rules for the implementation of paragraph 1.

Article 173 (Proportional deduction)
1. In the case of goods or services used by a taxable person both for transactions in respect of which VAT is deductible pursuant to Articles 168, 169 and 170, and for transactions in respect of which VAT is not deductible, only such proportion of the VAT as is attributable to the former transactions shall be deductible.
The deductible proportion shall be determined, in accordance with Articles 174 and 175, for all the transactions carried out by the taxable person.
2. Member States may take the following measures:
(a) authorise the taxable person to determine a proportion for each sector of his business, provided that separate accounts are kept for each sector;
(b) require the taxable person to determine a proportion for each sector of his business and to keep separate accounts for each sector;
(c) authorise or require the taxable person to make the deduction on the basis of the use made of all or part of the goods and services;
(d) authorise or require the taxable person to make the deduction in accordance with the rule laid down in the first subparagraph of paragraph 1, in respect of all goods and services used for all transactions referred to therein;
(e) provide that, where the VAT which is not deductible by the taxable person is insignificant, it is to be treated as nil.

Facts

The Midland is the representative member of a group of companies taken together for the purposes of VAT, which includes the London merchant bank Samuel Montagu & Co. Ltd (hereinafter ‘Samuel Montagu), which supplies services some of which are taxed and some of which are exempt.
In 1987, Samuel Montagu acted as merchant bank for Quadrex Holdings Inc. (hereinafter ‘Quadrex), a corporation registered in Delaware, United States of America. Quadrex wanted to take over Mercantile House Holding Ltd (hereinafter ‘Mercantile), a company quoted on the London Stock Exchange. However, British and Commonwealth Holding plc (hereinafter ‘B & C) was also interested in taking over Mercantile. In August 1987, Quadrex and B & C entered into an agreement under which B & C would buy Mercantile, and then sell the latter’s wholesale broking division to Quadrex. B & C subsequently took over Mercantile. However, Quadrex was not able to purchase the abovementioned division from B & C because it lacked the funds.
A series of legal proceedings was then started in 1988 before the national courts. B & C sued Quadrex for damages for breach of contract. In the context of that dispute, Quadrex claimed that Samuel Montagu should indemnify it for any damages awarded. B & C also sued Samuel Montagu for damages for the alleged negligent misrepresentation by a Samuel Montagu director as to Quadrex’s finances. The claim was finally settled out of court at the end of 1994.
In connection with the agreement between Quadrex and B & C, the solicitors Clifford Chance supplied legal services to Samuel Montagu and were entrusted with all the work connected with the disputes referred to in the preceding paragraph and the litigation arising from it. Clifford Chance invoiced Samuel Montagu for its fees for 1988 to 1995, and it is the VAT charged on those fees which is in issue in the main proceedings.
The Midland claimed that the legal services supplied by the solicitors were entirely attributable to the supply of financial services by Samuel Montagu to Quadrex, which was a supply in respect of which VAT was deductible in accordance with Article 17(3)(c) of the Sixth Directive. Accordingly, the Midland claimed the right to deduct the entire amount of VAT paid on the legal fees invoiced by the aforementioned solicitors.
The Commissioners, for their part, took the view that Samuel Montagu had not used the legal services in issue solely for the purpose of carrying out transactions in respect of which VAT is deductible. They therefore concluded that the Midland was entitled to deduct only part of the VAT.
The Midland appealed to the VAT and Duties Tribunal, claiming in particular that the legal services provided by the lawyers related as a whole to the supply of services made by Samuel Montagu to Quadrex. By decision of 15 May 1996, that tribunal allowed Midland’s appeal, holding that the input VAT paid in respect of the solicitors’ invoices was deductible in its entirety.
The Commissioners appealed against that decision to the High Court of Justice. They argued that the legal services were obtained to defend Samuel Montagu against claimsthat it was liable in damages as a result of acts attributable to it which were performed whilst it was making the supply to Quadrex. The legal services were thus also attributable to Samuel Montagu’s business generally. Since that business consisted of a mixture of supplies in respect of which the right of deduction was available and supplies in respect of which it was not, there should have been an apportionment of the input tax in accordance with Article 17(5) of the Sixth Directive.

Questions

On the proper interpretation of Council Directive 67/227/EEC of 11 April 1967, in particular Article 2, and Council Directive 77/388/EEC of 17 May 1977, in particular Article 17(2), (3) and (5), and having regard to the facts of the present case:

1. Is it necessary to establish a direct and immediate link between a particular input obtainable by a taxable person acting as such and a particular transaction or transactions made by that person in order to

(a) establish the existence of an entitlement to deduct tax charged in respect of the input; and

(b) determine the extent of that entitlement?

2. If the answer to (1)(a) or (b) is in the affirmative, what is the nature of the direct and immediate link and, in particular, in the case of a taxable person making both transactions in respect of which VAT is deductible and transactions in respect of which it is not:

(a) is the test for determining the amount of input tax that is deductible any different as between Article 17(2), (3) and (5) (and, if so, in which respects is it different); and

(b) is such a person entitled to deduct all the input tax charged in respect of an input on the ground that the input was utilised as a consequence of making a transaction falling within Articles 17(2) or (3), in particular Article 17(3)(c)?

3. If the answer to 1(a) or (b) is in the negative:

(a) what is the link that has to be established; and

(b) in the case of a taxable person making both transactions in respect of which VAT is deductible and transactions in respect of which it is not:

(i) is the test for determining the amount of input tax that is deductible any different as between Article 17(2), (3) and (5) (and, if so, in which respects is it different); and

(ii) is such a person entitled to deduct all the input tax charged in respect of an input on the ground that the input was utilised as a consequence of making a transaction falling within Article 17(3)(c)?

AG Opinion

(1) Article 17(2) of the Sixth Directive must be interpreted as meaning that, in circumstances such as those before the referring court, in order to determine whether all the VAT is deductible, it is necessary to establish whether there exists a direct and immediate link between a particular input obtainable by a taxable person acting as such and a particular output transaction or transactions made by that person. If such a link is shown to exist, the taxable person is entitled to deduct all the VAT paid in respect of the input transaction.

(2) Article 17(2) and (3) of the Sixth Directive must be interpreted as meaning that, in order for all the VAT paid in respect of a service by a taxable person, who carries out both transactions in respect of which VAT is deductible and transactions in respect of which it is not, to be deductible, the mere fact that that service was utilised also as a consequence of making a transaction falling within the scope of Article 17(2) or Article 17(3), in particular Article 17(3)(c), of the Sixth Directive is not sufficient.

Entitlement to deduct VAT does arise, however, whenever, in the light of an objective assessment (which it is for the national court to carry out), a service is utilised by the taxable person, according to the normal and regular order of causal chains, to carry out one or more taxable transactions falling within the scope of the abovementioned articles. Such a link exists, in particular, in accordance with the second paragraph of Article 2 of the First Directive, if the amount of the tax paid in respect of the supply of a service was borne directly by the various cost components of the taxable transaction.

In order to establish whether the test for determining the amount of input tax that is deductible is any different as between Article 17(2), (3) and (5), it must first be established what formula has been adopted by the Member State concerned for the determination of the proportional deduction of the VAT, within the meaning of Article 17(5) of the Sixth Directive.

Decision

1. Article 2 of the First Council Directive 67/227/EEC of 11 April 1967 on the harmonisation of legislation of Member States concerning turnover taxes and Article 17(2), (3) and (5) of the Sixth Council Directive 77/388/EEC of 17 May 1977 on the harmonisation of the laws of the Member States relating to turnover taxes – Common system of value added tax: uniform basis of assessment must be interpreted as meaning that, in principle, the existence of a direct and immediate link between a particular input transaction and a particular output transaction or transactions giving rise to entitlement to deduct is necessary before the taxable person is entitled to deduct input value added tax and in order to determine the extent of such entitlement.

2. It is for the national court to apply the ‘direct and immediate link test to the facts of each case before it. A taxable person who makes transactions in respect of which value added tax is deductible and transactions in respect of which it is not may deduct the value added tax in respect of the goods or services acquired by him, provided that such goods or services have a direct and immediate link with the output transactions in respect of which value added tax is deductible, without it being necessary to make a distinction depending on whether Article 17(2), (3) or (5) of the Sixth Directive is applied . However, such a taxable person cannot deduct in its entirety the value added tax charged on input services where they have been utilised not for the purpose of carrying out a deductible transaction but in the context of activities which are no more than the consequence of making such a transaction, unless that person can show by means of objective evidence that the expenditure involved in the acquisition of such services is part of the various cost components of the output transaction.

Summary

Input tax deduction requires a direct and immediate connection between a transaction at an earlier stage and one or more transactions at a later stage. The national court determines this connection on a case-by-case basis. A taxable person can deduct VAT on goods or services used in transactions with a right to deduct, regardless of whether certain articles of the Sixth Directive apply. However, they cannot fully deduct VAT on services used in transactions without a right to deduct, unless they can prove that the costs of those services are part of the price of a later stage transaction.

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