Calculation of the (Pre-) Pro Rata under EU VAT Law

Mandy Gabriël and Herman van Kesteren European Union Calculation of the (Pre-) Pro Rata under EU VAT Law Mandy Gabriël and Herman van Kesteren* Where taxable persons use inputs for taxed and exempt purposes, they have to attribute the costs of the inputs to both categories of transactions, commonly on the basis of a pro rata calculation. In this article, the authors analyse the ECJ s decision in Securenta, in which the ECJ seems to have presented a new scenario, i.e. the method for determining the rate of deduction in respect of inputs used by taxable persons for the purposes of carrying out both economic and non-economic activities, which the authors label as pre-pro rata. The article is followed by several comments made by Paul Lasok to the authors conference paper. 1. Introduction Under Art. 9 of the VAT Directive, 1 any person who, independently, carries out in any place any economic activity qualifies as a taxable person, whatever the purpose or results of that activity. The taxable person s economic activities can be fully taxed or fully exempt, or specific activities may be taxed whereas others are exempt. However, the activities of taxable persons are not limited to economic activities. Taxable persons can also carry out non-economic activities, i.e. activities that are outside the scope of (EU) VAT. Establishing the nature of the outgoing transactions is necessary for the purpose of determining whether and, if so, to what extent, taxable persons can deduct VAT charged to them on the purchase of goods and services. 2 In principle, taxable persons are entitled to deduct that VAT in so far as they use the goods and services for the purposes of carrying out taxed transactions. 3 Where they use the inputs for both taxed and exempt purposes, taxable persons have to attribute the costs of the inputs to both categories of transactions, either by directly attributing the inputs to specific output transactions or by attributing them to their total economic activities by reference to turnover derived from the two categories of transactions. In the latter case, the deductible proportion is commonly based on a pro rata calculation. It follows from case law of the Court of Justice of the European Union (ECJ) that, contrary to a literal interpretation of Art. 174 of the VAT Directive, only income ( turnover ) derived from economic activities can be taken into account for the purposes of calculation of the pro rata. This view of the ECJ has given rise to several questions, which should be, but have not yet fully been, answered by the ECJ. In respect of non-economic activities, the pro rata mechanism is not completely sidelined: where the taxable person s economic activities benefit from non-economic activities and the costs of the inputs relating to the non-economic activities can be linked to the totality of economic activities, the pro rata calculation still applies. 4 One of the unanswered questions results from the ECJ s judgment in Securenta. 5 On that occasion, the ECJ seems to have presented a new scenario new in the sense that it is not expressly covered by the currently existing provisions of the VAT Directive, i.e. the method for determining the rate of deduction in respect of inputs used by taxable persons for the purposes of carrying out both economic and non-economic activities. According to the ECJ, it is up to the Member States to establish to that end appropriate methods and criteria, which must be consistent with the principles underlying the common system of VAT. It is clear from the ECJ s judgment in Securenta that that method for apportioning input VAT must be applied before application of the existing pro rata. It can therefore be labelled as pre-pro rata. In order to correctly calculate the pre-pro rata, more guidelines or rules are required and also the ECJ s judgment in SKF 6 may affect the new rules. Previously, the ECJ tended to treat sales of shares by holding companies as non-economic activities. 7 However, in its judgment in SKF, the ECJ held (on the basis of the extension theory ) that the disposal of shares in a subsidiary by a holding company that is involved in the management of that subsidiary can constitute an economic activity, which is exempt from VAT. This fairly surprising view may also have an important impact on the pre-pro rata and pro rata fractions. * Mandy M. Gabriël is an Indirect Taxes Consultant for PricewaterhouseCoopers Eindhoven and a PhD researcher at Maastricht University. Herman W.M. van Kesteren is an Indirect Taxes Partner at PricewaterhouseCoopers Amsterdam, a professor of indirect taxation at Tilburg University and a judge in s-hertogenbosch and The Hague. 1. Council Directive 2006/112/EC of 28 November 2006 on the common system of value added tax, OJ L 347 of 11 December 2006. 2. Hereafter referred to as input VAT. 3. Art. 168 of the VAT Directive. 4. ECJ judgments of 27 September 2001 in Cibo Participations SA v. Directeur régional des impôts du Nord-Pas-de-Calais, Case C-16/00, [2001] ECR I-6663; and of 26 May 2005 in Kretztechnik AG v. Finanzamt Linz, Case C-465/03, [2005] ECR I-4357. 5. ECJ judgment of 13 March 2008 in Securenta Göttinger Immobilienanlagen und Vermögensmanagement AG v. Finanzamt Göttingen, Case C-437/06, [2008] ECR I-1597, Para. 34. 6. ECJ judgment of 29 October 2009 in Skatteverket v. AB SKF, Case C-29/08, [2009] ECR I-10413. 7. At least, in so far as the activities are not comparable to those of a commercial, professional share dealer. See also ECJ judgment of 14 November 2000 in Floridienne SA and Berginvest SA v. Belgian State, Case C-142/99, [2000] ECR I-9567, Para. 28. 332 INTERNATIONAL VAT MONITOR SEPTEMBER/OCTOBER 2011 IBFD

Calculation of the (Pre-) Pro Rata under EU VAT Law 2. Right to Deduct Input Tax In order to safeguard the neutrality of the VAT system, the VAT Directive contains a set of rules on the right to deduct input VAT. This deduction system is aimed at entirely relieving taxable persons of the VAT paid or payable in the framework of all their economic activities, provided that these activities are subject to VAT. 8 The right to deduct may not in principle be limited and must be exercised immediately in respect of all VAT charged on transactions relating to inputs. 9 The transactions of taxable persons are rarely fully taxed or fully exempt their output is frequently a combination of taxed and exempt transactions and the purposes for which taxable persons make specific investments and purchase other inputs may vary widely. Specific inputs may be directly attributable to taxed transactions and others only to exempt transactions. For the purposes of direct attribution, the inputs must have a direct and immediate link with a subsequent taxable transaction; the ultimate aim pursued by the taxable person by carrying out that transaction is irrelevant. 10 Where particular inputs are directly attributable to particular output transactions, the entitlement to deduct the related VAT is based on Art. 168 of the VAT Directive. Where the acquired goods and services are used for both taxed and exempt transactions, the inputs do not necessarily have to be attributed to individual output transactions. If the costs of the inputs are part of the general overhead costs and are, as such, components of the prices of the output transactions, the related VAT can be deducted on the basis of the pro rata. 11 Thus far, there are obviously three options: the inputs can be attributed to the taxable person s taxed transactions, to its exempt transactions or to its economic business activities as a whole. In the latter case, a proportional division into deductible and non-deductible input tax is required. This is where the rules governing partial deduction come into play. 12 These rules, however, only apply with regard to economic activities. 13 3. Partial Deduction in Respect of Economic Activities 3.1. The pro rata mechanism The rules on partial or proportional deduction of VAT laid down by the VAT Directive prevent the costs of the inputs having to be attributed to individual output transactions. Where taxable persons purchase goods or services for the benefit of their overall business activities, the related costs are general costs or overheads. On the basis of the VAT Directive, the deductible proportion of the VAT on a taxable person s overheads is to be determined by applying a single fraction based on turnover proportions. Member States may deviate from this rule and authorize or require taxable persons to determine multiple proportions, such as proportions relating to separate parts of their businesses. They may also authorize or require taxable persons to determine the rate of deduction of input VAT on the basis of actual use of the inputs. 14 The numerator of the turnover ( pro rata ) fraction 15 consists of turnover derived from taxed transactions, and the denominator of total turnover (derived from taxed and exempt transactions). 3.2. Turnover to be taken into account Member States may include subsidies other than subsidies directly linked to the price of goods or services in the denominator of the pro rata fraction, 16 and they must exclude from the pro rata fraction turnover derived from, inter alia, supplies of used capital goods and incidental transactions involving real estate and financial services. 17 The denominator of the pro rata fraction does not include dividends because... the receipt of dividends is not consideration for any economic activity... and does not fall within the scope of VAT. 18 Also, interest must be excluded from the pro rata fraction, if the granting of loans does not constitute an economic activity 19 and does not constitute the direct, permanent and necessary extension of a taxable activity under those circumstances, the interest is categorically excluded from the pro rata, not on the ground that it is an incidental (financial) transaction. 20 As the ECJ decided in Kretztechnik, 21 the pro rata mechanism designed for economic activities can also be applied to costs made in the framework of non-economic activities. Kretztechnik issued shares in order to increase its capital for the benefit of its economic activity in general. According to the ECJ, the costs that Kretztechnik 8. ECJ judgments of 14 February 1985 in D.A. Rompelman and E.A. Rompelman-Van Deelen v. Minister van Financiën, Case 268/83, [1985] ECR 655, Para. 19; of 22 February 2001 in Abbey National plc v. Commissioners of Customs & Excise, Case C-408/98, [2001] ECR I-1361, Para. 24; and of 21 March 2000, Gabalfrisa and Others, [2000] ECR I-1577, Para. 44. 9. ECJ judgment of 6 July 1995, BP Soupergaz, C 62/93, [1995] ECR I 1883, Para. 18; and in Gabalfrisa (see note 8). 10. ECJ judgment of 6 April 1995 in BLP Group plc v. Commissioners of Customs & Excise, Case C-4/94 [1995] ECR I-983, Para. 19. 11. ECJ judgment of 8 February 2007 in Investrand BV v. Staatssecretaris van Financiën, Case C-435/05, [2007] ECR I-1315, Para. 24. 12. Laid down in Arts. 173-175 of the VAT Directive. 13. Where the proportion of deductible input VAT is based on a fraction regarding turnover, turnover resulting from non-economic activities is not taken into account; ECJ judgments in Floridienne and Berginvest, note 7, Para. 32; and in Cibo Participations, note 4, Paras. 39 and 44. 14. It follows from the explanatory memorandum to Art. 14(5) of the proposal for the Sixth Directive that this discretion is conferred on Member States as a means to avoid inequalities which may work to the detriment or advantage of taxable persons (see Proposal of 20 June 1973 for a Sixth Council Directive on the harmonization of Member States concerning turnover taxes, COM(73) 950). 15. Art. 174 of the VAT Directive. 16. Subsidies directly linked to the price of transaction will probably be included in the pro rata fraction because they form part of the consideration. 17. Art. 174(2) of the VAT Directive. 18. ECJ judgment of 22 June 1993 in Sofitam, Case C-333/91, [1993] ECR I-3513, Para. 13. See also, inter alia, ECJ judgments in Cibo Participations, note 4, Paras. 39 and 44, and in Floridienne and Berginvest, see note 7, Para. 32. 19. ECJ judgment in Floridienne and Berginvest, see note 7, Para. 32, 20. ECJ judgment of 11 July 1996 in Régie Dauphinoise-Cabinet A. Forest Sarl v. Ministere du Budget, Case C-306/94, [1996] ECR I-3695, Para. 22 21. ECJ judgment in Kretztechnik, see note 4. IBFD INTERNATIONAL VAT MONITOR SEPTEMBER/OCTOBER 2011 333

Mandy Gabriël and Herman van Kesteren incurred in connection with the transaction formed part of its overheads. Since overhead costs are a component of the costs of the output transactions, there is a direct and immediate link to the whole economic activity. 22 As it exclusively carried out taxed transactions, Kretztechnik was entitled to fully deduct the VAT incurred on services acquired in conjunction with the issue of shares. In other words, although proceeds 23 derived from non-economic activities are disregarded, the deductibility of VAT on costs made in connection with these non-economic activities is determined by applying the pro rata mechanism designed for economic activities. 3.3. Pro rata after SKF On the basis of previous case law, the acquisition, holding, issue and sale of shares by holding companies were believed to be non-economic activities (at least, if those activities were not carried out by share dealers). It follows from the ECJ s judgments in, inter alia, Kretztechnik and Investrand, 24 that the VAT on costs relating to these non-economic activities may still be deductible, if it can be demonstrated that they relate to the taxable person s overall economic activities and qualify as general costs. In SKF, 25 the ECJ held that the sale of shares in subsidiaries can constitute an economic activity. In line with the extension theory, the sale of shares by a managing holding, carrying out economic activities, 26 can be seen as an economic activity. However, the ECJ added that this economic activity is exempt. 27 The question remains of how this decision will affect the deductibility of VAT on costs relating to the sale of shares. Bearing Kretztechnik in mind, deductibility can be optimized by stating that the costs relate to the taxable person s overall business activities. The ECJ allowed for such an approach in its decision in SKF. 28 However, since, according to the ECJ, the sale of the shares formed the direct, permanent and necessary extension of SKF s economic activities, it seems rather difficult to argue that the (exempt) sale of shares can be excluded from the pro rata fraction. 29 An economic activity can hardly be classified as incidental for the purposes of calculating the pro rata fraction, if it constitutes the direct, permanent and necessary extension of the taxable person s business. 30 The calculation of the deductibility of the input tax remains much easier if the costs of the inputs can be directly and immediately linked to the disposal of the shares, thus influencing the selling price of the shares: in that case, the input tax will not be deductible at all. 31 The remuneration for the disposal of shares made by managing holding companies was initially (at least in the Netherlands) treated as income derived from a noneconomic activity. However, following SKF, it has to be treated as income derived from an economic activity. Whether a pro rata mechanism is needed in order to establish the deductibility of VAT on costs relating to the disposal depends on the possibility of attributing the inputs to the overall economic activities or to the disposal itself. 4. Partial Reduction in Respect of Economic and Non-Economic Activities 4.1. Pre-pro rata mechanism It is clear that the pro rata mechanism can only be used in respect of economic activities. The VAT Directive does not provide for a mechanism to establish a deductible proportion where the taxable person s output consists of both economic and non-economic activities. The latter was the case in Securenta. 32 According to the case file, 33 Securenta carried out three types of activities: non-economic activities, exempt economic activities and taxed economic activities. In order to acquire the capital necessary for its activities, Securenta issued shares and formed atypical silent partnerships. It was in dispute how the right to deduct VAT incurred on expenditure relating to the acquisition of capital must be determined. Unlike in Kretztechnik, the ECJ could not simply apply the pro rata rules because Securenta s transactions did not solely consist of economic activities. On the basis of the observations of the referring national court, the ECJ found that the expenditure connected with the acquisition of capital was not solely attributable to Securenta s economic activities. It concluded that the VAT on that expenditure was deductible only to the extent that the expenditure was connected to the latter activities, which gives rise to the question of how the VAT must be apportioned to the economic and non-economic activities. 4.2. Determination of the pre-pro rata According to the ECJ in Securenta, Member States must ensure that the calculation of the proportion of economic to non-economic activities (the pre-pro rata) objectively reflects the part of the input expenditure actually to be attributed to the respective two types of activities. Member States have some discretion in determining the methods and criteria for apportioning input VAT between 22. Id, Para. 25. 23. Since the term turnover is less appropriate in relation to proceeds derived from specific non-economic activities, in particular the issue of shares, we exclusively use that legal term in the context of calculation of the pro rata. In the context of calculation of the pre-pro rata, we use the broader term proceeds. 24. ECJ judgment in Investrand, see note 11, Paras. 28 and 29. 25. ECJ judgment in SKF, see note 6. 26. In its order of 12 July 2001 in Welthgrove BV v. Staatssecretaris van Financiën, Case C-102/00, [2001] ECR I-5679, the ECJ reiterated that the involvement of a holding company in the management of a subsidiary only constitutes an economic activity if it takes the form of transactions subject to VAT. 27. Under Art. 135(1)(f) of the VAT Directive, transactions in shares are exempt from VAT. 28. ECJ judgment in SKF, see note 6, Para. 68. 29. Id, Para. 33. 30. See ECJ judgment of 29 October 2009 in NCC Construction Danmark A/S v. Skatteministeriet, Case C-174/08, [2009] ECR I-10567, Para. 30 et seq. See also ECJ judgment in Régie Dauphinoise, note 20, Para. 22. 31. ECJ judgment in Régie Dauphinoise, see note 20, Para. 71. 32. ECJ judgment in Securenta, see note 5. The ECJ repeated its view in its judgment of 12 February 2009 in Vereniging Noordelijke Land- en Tuinbouw Organisatie (VNLTO) v. Staatssecretaris van Financiën, Case C-515/07, [2009] ECR I-839. 33. The ECJ observed that it was apparent from the information provided by the referring national court that certain of Securenta s activities were to be classified as non-economic activities. 334 INTERNATIONAL VAT MONITOR SEPTEMBER/OCTOBER 2011 IBFD

Calculation of the (Pre-) Pro Rata under EU VAT Law economic and non-economic activities. The ECJ added that, in exercising that discretion, Member States have the right to apply any appropriate method, without being restricted to a single method only. 4.3. Proceeds to be taken into account The most straightforward mechanism for attributing input tax to economic and non-economic activities would be based on proceeds 34 (turnover) derived from those activities, analogous to the normal pro rata fraction, i.e.: proceeds derived from economic activities proceeds derived from economic and non-economic activities The question arises of how close the analogy between the pro rata and pre-pro rata fractions may or must be. The normal pro rata fraction must be calculated per year and must be fixed as a percentage (rounded up to a figure not exceeding the next whole number). It seems plausible that the pre-pro rata fraction must fulfil the same conditions. The question which then arises is whether it would be appropriate for Member States to prescribe an apportionment method based on proceeds derived from economic and non-economic activities. 4.4. Comparison of pro rata and pre-pro rata One of the issues in applying the pro rata by analogy concerns the receipt of non-taxable subsidies 35 by charitable organizations as remuneration for activities outside the scope of VAT. Inclusion of those subsidies in the prepro rata would have a dramatic impact on the charities. Where 50% of their income consists of subsidies, charities would only be entitled to deduct half the burden of input VAT. 36 Another issue is that specific non-economic activities, such as transactions carried out free of charge, have no relationship with turnover or proceeds. For other organizations, such as holding companies and investment vehicles, it would be inappropriate to take all non-taxable proceeds into account for the purposes of calculating the pre-pro rata. It is clear that also for companies such as Kretztechnik, specific categories of nontaxable proceeds should be disregarded in this respect. Although the issue of new shares was a non-economic activity, the capital acquired through this non-taxable action did not decrease the company s rate of deduction (it remained 100%). In that case, the only relevant factor for calculating the deductible proportion was the nature of the activities for which the new funds were used. The question also arises of whether the application of a pre-pro rata would have an effect on Securenta s rate of deduction. Securenta s capital was used for the purposes of both economic and non-economic activities. It seems irrational that a company s rate of deduction would decrease on account of the issue of shares, if its economic activities are fully subject to VAT. It seems rational to ignore proceeds derived from the issue of new shares for deduction purposes, on the ground that, unlike Securenta s investment activities, the issue of shares is an incidental (financial) transaction. For the purposes of calculating the normal pro rata fraction, incidental financial transactions must be excluded from the denominator. 37 It would be consistent with that approach to also exclude incidental non-economic financial transactions from the denominator of the pre-pro rata fraction. Another example of incidental financial transactions that should be excluded from the pre-pro rata fraction is the (non-taxable) disposal of shares. If, for example, Securenta had sold its investment portfolio, this disposal would be a non-taxable transaction because Securenta would have acted in its capacity as a non-taxable person. Inclusion of the proceeds of this sale in the denominator of the new pre-pro rata fraction would not reflect economic reality, as required by the principle of neutrality. The above examples illustrate that a pre-pro rata fraction based solely on income without the possibility to exclude proceeds derived from certain incidental transactions would not have the effect that input expenditures are attributed to economic and non-economic activities in an objective manner. 4.5. Actual-use formula The actual-use approach laid down by Art. 173(2)(c) of the VAT Directive not to be calculated on an annual but on an ad hoc basis - would be a more appropriate method to determine the rate of deduction for individual inputs. Application of that method would be in line with the ECJ s decision in Securenta that Member States must establish methods and criteria appropriate to that aim and consistent with the principles underlying the common system of VAT. In that regard, the ECJ held that, where the Directive does not contain the guidance necessary for such precise calculations, Member States are required to exercise their discretion having regard to the aims and broad logic of the Directive, 38 in particular the principle of neutrality on which the common system of VAT is based. Accordingly, Member States must exercise their discretion in such a way as to ensure that deduction is made only for that part of the VAT that is proportional to the amount relating to transactions giving rise to the right to deduct. They must therefore ensure that the calculation of the proportion of economic to non-economic activities objectively reflects the part of the input expenditure actually to be attributed to those two categories of activi- 34. For the terminology in this context, see note 23. 35. These are not subsidies which can be seen as consideration for supplies of goods or services. 36. Which result seems to contradict the ECJ judgments of 6 October 2005 in Commission of the European Communities v. French Republic, Case C-243/03, [2005] ECR I-8411, and in Commission of the European Communities v. Kingdom of Spain,Case C-204/03, [2005] ECR I-8389, Para. 26, in which the ECJ decided that Member States are not allowed to restrict the right to deduct input tax if fully taxable persons receive subsidies. 37. Art. 174(2)(b) of the VAT Directive. 38. See, to that effect, ECJ judgment of 14 September 2006 in Hausgemeinschaft Jörg und Stephanie Wollny v. Finanzamt Landshut, Case C-72/05, [2006] ECR I-8297, Para. 28. IBFD INTERNATIONAL VAT MONITOR SEPTEMBER/OCTOBER 2011 335

Mandy Gabriël and Herman van Kesteren ties. According to the ECJ, in exercising their discretion, Member States have the right to apply, if necessary, an investment formula or a transaction formula or any other appropriate formula, without being restricted to only one of those methods. 4.6. Investment formula Application of an investment formula would be a more appropriate method for determining the rate of deduction of VAT on expenses relating to raising new capital by companies. In that case, the rate of deduction depends on the purposes for which the proceeds derived from the issue of the shares are used. This method was advocated by the European Commission and some Member States as being more appropriate than the transaction formula 39 in the case of Securenta. The question is whether this formula is indeed more suitable where capital is raised through the issue of shares, as this approach is based on the presumption that it is possible to determine to what extent the newly acquired funds are used for economic and non-economic activities. In practice, it will be very difficult to determine the source of the funds used for purchasing specific goods and services and, in addition, those goods and services will simultaneously be used for the two categories of activities. An apportioning method based on actual use of inputs for the purposes of carrying out economic and non-economic activities seems to be a more suitable method. The proceeds-based and investment formulas will certainly not be a solution for all cases in which input tax must be apportioned between economic and non-economic activities. For example, where charitable organizations receive non-taxable subsidies and use those funds for purchasing goods and services used for both their economic and non-economic activities, the best method for apportioning the input tax is probably one which is based on the extent to which the goods and services are used by the charitable organization for its economic and non-economic activities. If the charity uses the goods and services to the extent of only 10% for its non-taxable activities, whereas the subsidy amounts to 50% of its total income, a rate of deduction of 90% seems more appropriate in terms of tax neutrality. 4.7. Other unsolved issues As regards apportioning input VAT to economic and non-economic activities, much is still unclear and it can only be hoped that the European legislator will provide more clarity in this respect. In this context, determining the initial rate of deduction in a particular situation is not the only concern. It should also be clear what the consequences are of a subsequent change in the use of the goods and services. The use of inputs may change immediately following initial deduction of the related VAT, or one or several years later. In other words, the question is whether the initial deductions must be adjusted and, if so, whether a distinction must be made between goods and services or between capital and current expenditures. The relationship between the normal pro rata and pre-pro rata mechanisms should also be clear, especially if they are to each have their own adjustment mechanisms. Under the ECJ s judgment in Armbrecht, the application of the existing adjustment rules must be limited to that part of the assets assigned to the business, 40 which means that initial input tax deductions cannot be adjusted if the use of the goods shifts between taxable and non-taxable purposes. Under the new Art. 168a of the VAT Directive, which came into effect on 1 January 2011, 41 the principles of the existing arrangements for adjusting initial input tax deduction in respect of immovable business assets that are used for both business and private (non-business) purposes also apply to the annual deemed supply that is aimed at correcting initial full deduction on account of private use of the assets. That provision is at least a good start. The new legal arrangements to be included in the VAT Directive for initial deduction and subsequent adjustments of VAT relating to inputs used for both economic and non-economic purposes should however not only apply to goods but also to services, and they should clearly indicate the relationship between private and nonbusiness use of business assets. 42 5. Summary and Conclusions Taxable persons are entitled to deduct input VAT to the extent they use the related goods and services for the purposes of carrying out taxed transactions. If the inputs are used for both taxed and exempt transactions, the input VAT must be apportioned, either by directly attributing the inputs to specific outputs or by attributing them to the taxable person s total economic activities. In the latter case, the deductible proportion can be established on the basis of a pro rata fraction based on turnover. In respect of non-economic activities, the pro rata mechanism is not completely sidelined. The economic activities of a business may even benefit from non-economic activities being carried out. In such cases, where the costs of inputs relating to non-economic output transactions can be linked to the taxable person s total economic activities, the pro rata fraction still applies. However, where inputs cannot be fully linked to the taxable person s total economic activities, the existing pro rata mechanism cannot be used and, under Securenta, Member States have to establish appropriate deduction methods and criteria, consistent with the principles un- 39. The transaction formula presumably refers to the apportionment method based on turnover. 40. ECJ judgment of 4 October 1995 in Dieter Armbrecht v. Finanzamt Uelzen, Case C-291/92, [1995] ECR I-2775, Para. 32. 41. By Council Directive 2009/162/EU of 22 December 2009 amending various provisions of Directive 2006/112/EC on the common system of value added tax, OJ L 10/14. 42. In its judgment in VNLTO (see note 32), the ECJ decided that the selfsupply rules laid down by Art. 26 of the VAT Directive are limited to private and non-business use of business assets, and do not apply to the use of those assets by a business for its non-economic activities. VNLTO s non-economic activities (safeguarding the interests of its members) were still part of its business activities. 336 INTERNATIONAL VAT MONITOR SEPTEMBER/OCTOBER 2011 IBFD

Calculation of the (Pre-) Pro Rata under EU VAT Law derlying the common system of VAT. Before attributing inputs to taxed and exempt economic transactions, taxable persons have to attribute input tax to economic and non-economic activities (the pre-pro rata). Calculating the pre-pro rata solely on the basis of turnover or proceeds without the possibility to exclude certain incidental transactions would not objectively reflect the use of the inputs for economic and non-economic activities. Application of an investment formula would be a more appropriate method for apportioning VAT relating to the issue of shares. However, the investment formula is also not ideal, for example in the case of charities that receive non-taxable subsidies. Moreover, it is difficult to apply that formula in practice. Ad hoc apportionment of input VAT on the basis of actual use of individual goods and services would be the preferred option for determining the rate of deduction of VAT relating to individual inputs. The existing rules for adjusting initial input tax deductions only apply to changes in the use of business goods for taxed and exempt purposes. From 1 January 2011, the principles underlying the existing adjustment rules also apply to goods that are used for both business and private (non-business) purposes. The rules to be introduced for the purposes of determining the rate of deduction in respect of inputs used for economic and non-economic purposes must be more comprehensive and include services as well. European Union The Right To Deduct for Partially Exempt Bodies Paul Lasok* 1. Introduction The question of the right of bodies engaged in making both taxed and exempt supplies ( partially exempt bodies ) to deduct input tax is a sub-topic of the more general question of input tax deduction. Theoretically, in relation to partially exempt bodies, the only question to be considered is the methodology to be used to calculate the deductible input tax. However, that question conceals a number of other questions that need to be considered and that take us back to the more general question of input tax deduction, primarily: what are we trying to achieve by input tax deduction and what kind of expenditure is in principle deductible? The starting point for a consideration of those questions (which do not call for a definitive exposition in the present context) is inevitably to be found in the model of VAT that one is using and, for practitioners, in how the policy questions arising from that model have been resolved in practice by the legislature. For example, the EU model of VAT is based on transaction chains and provides that input tax is deductible in so far as inputs are used for taxed transactions. That model was adopted because the EU VAT system was designed for the specific purpose of resolving problems in the application of turnover taxes to transnational transactions (or transaction chains) within the European Union (i.e. transactions or transaction chains involving more than one tax jurisdiction). Accordingly, the EU VAT system is based on considerations that are not relevant to a tax that is intended to operate only within a single tax jurisdiction, albeit that the EU system applies the same approach to input tax deduction relating to national transactions. An important consequence of the EU model is the need to allocate inputs to the correct transaction chain (or to that transaction chain to the correct extent) so that, in the case of the problematic transaction chains (the transnational ones), the correct tax treatment is given in the correct tax jurisdiction. An additional feature of the EU model the one that is of concern here is the presence, in the model, of transactions that are exempt from VAT. Such transactions are not taxed but, in the EU model, do not permit the deduction of input tax. The transaction chain, for VAT purposes, therefore ends where there is an exempt transaction. Thus, in the case of a partially exempt trader, the ability to deduct input tax arises, in the context of the EU model, only to the extent that inputs can be included in a transaction chain producing a taxed output. A further complication arises from the phenomenon of the so-called non-economic activity, i.e. the use of inputs for a purpose that does not amount to the making of a taxed or an exempt transaction. Of course, that complication may apply to all traders, not just those who are partially exempt. Although a consideration of non-economic activities is not strictly relevant to what is considered here, a brief word should, perhaps, be made about that topic. The general category of non-economic activities comprises a range of diverse situations that, for VAT purposes, cannot be assumed to produce the same tax consequences. At the risk of overgeneralization, some forms of non-economic use, properly understood, involve internal * Paul Lasok QC FIIT MA (Cambridge), LLM (Exeter University), PhD (Exeter), Head of Chambers, Monckton Chambers, England. IBFD INTERNATIONAL VAT MONITOR SEPTEMBER/OCTOBER 2011 337