The Court of Justice of the European Union (“CJEU”) rendered its judgement in the long-awaited Morgan Stanley case (C-165/17 of 24 January 2019). It concerns the VAT deduction of costs incurred by a branch and used either for transactions of its head-office abroad (“principal establishment”) or for transactions of both the branch and its head-office. Former case-law of the CJUE had stated that services rendered between branch and head-office cannot be taken into account. They fall outside the VAT scope if the risk associated with the economic activity of the branch remained with the head-office (no endowment capital within the branch, see FCE Bank, C-210/04 of 23 March 2006).

It seems the CJEU’s decision is bound to increase the complexity of the calculations in this respect along with the legal uncertainty with respect to situations that, although not explicitly dealt with by the case, might be significantly impacted by its conclusions.

A double test – VAT deduction only if possible in both Member States

First, the case determines that all costs should be linked to the turnover they are used for and that this criterion must be applied cross-border. In other words, VAT borne on costs incurred by a branch and used for the activity of its head-office abroad could only be deducted if and to the extent that such head-office’s activity:

  • be taxed in the Member State of the head-office.
  • would have entitled to a VAT deduction in the Branch’s Member State should it have taken place there.

As many proportions as there are links between costs and mixed activities

In addition to this double test, the CJEU states that only the activities for which the costs are actually used should be taken into account in the proportion calculated for VAT deduction purposes. Where costs of the branch are used for both the taxable as the exempt activities of the head-office, the CJEU states that the VAT deduction proportion should include in the numerator only the specific taxable activities, and in the denominator only the specific taxable and exempt activities for which the costs are used (as opposed to all taxable/taxable and exempt activities as is the case in practice for most allocation keys based on turnover). This rule seems applicable to all taxable persons and all activities (e.g. those of the branch only). It will likely multiply the amount of allocation keys that taxable persons will have to use since each cost will have to be examined to determine which activities it relates to, in which country it takes place, which deduction regime applies to it, etc.

Pure overhead costs: a proportion based on turnover of the head-office and the branch

Only genuine overhead costs that cannot be linked to any of the specific activities, but on the contrary to the whole of the branch and the head-office’s activity would entail a proportion that would take into account the total turnover in the denominator and the turnover giving rise to VAT deduction (pursuant to the double test described above) in the numerator. Total turnover means turnover of the branch as well as of the head-office!

Uncertainty ahead – Proactivity required

Last but not least, many crucial questions result from this case, e.g. could such reasoning apply to all taxable persons and not only those for which a branch and a head-office are concerned? Would the turnover generated by head-office outside of the EU be considered as taxed and potentially entitle the VAT deduction right or not? Should a similar reasoning be held by taxable persons that apply an allocation key based on other criteria than turnover (expenses, use of staff, surfaces of buildings,…)?,…

Should your company be concerned by this case or by one of the questions that arise from it, do not hesitate to contact KPMG. A proactive approach indeed seems recommended in order to obtain legal certainty and avoid costly deduction rectifications in case of potentially international VAT audits.