I. Issue

In principle, only those entrepreneurs are entitled to input tax deduction who receive services for their enterprise. Pursuant to section 2 para. 1 sentence 1 German Value-Added Tax Act [Umsatzsteuergesetz – UStG], anyone who independently carries out a commercial or professional activity is to be regarded as an entrepreneur. Section 2 para. 1 sentence 3 UStG defines any activity for generating income as commercial or professional, even if the intention to generate profit is missing. It should be noted, however, that contrary to the above legal wording, not “every” activity to generate income is sufficient for establishing an entrepreneurial status. The proceeds generated by the entrepreneur must rather represent value-added tax remuneration for an exchange of services, which, according to German jurisprudence, is not always the case with holding companies.
In the years 2015 and 2016, both the European Court of Justice [ECJ] and the German Federal Fiscal Court [Bundesfinanzhof – BFH] dealt intensively with the question of the entitlement of holding companies to deduct input tax. It can therefore be increasingly observed in practice that tax auditors shed more light on this area. This can have far-reaching financial consequences for the companies concerned, at least if the input tax deduction already claimed is subsequently refused in whole or in part. The aim of this article is, on the one hand, to raise awareness of this issue for holding companies and, on the other hand, to point out possible ways in which tax audit risks can be minimized.

II. ECJ rulings on investment management

The starting point for assessing the entrepreneurial status and thus the entitlement to deduct input tax of a holding company is the case law of the European Court of Justice. Accordingly, the mere acquisition, holding and sale of a participation or shareholding does generally not constitute entrepreneurial activity. This is justified by the fact that although an activity is carried out to generate income through the participation in corporations or partnerships, dividends and other profit participations cannot, however, be qualified as value-added tax remuneration within the framework of an exchange of services.
However, the ECJ does not generally deny holding companies their entrepreneurial status. On the contrary; it considers that such companies can also become entrepreneurial in the context of their investment management if they (i) either directly or indirectly intervene in the management of their subsidiaries, without prejudice to their rights as stockholders or general partners, or (ii) if the holdings in the subsidiaries are not held for their own sake but serve to promote an existing or intended entrepreneurial activity. Interventions in the administration of the subsidiaries require entrepreneurial services within the meaning of the UStG and may, for example, consist of administrative, financial, commercial or technical services. It can be assumed that entrepreneurial activity will be promoted, for example, if the investment is intended to secure favorable purchasing or sales conditions, or if this will have an influence on potential competitors.
Although this ruling of the European Court of Justice has encountered some fierce criticism in legal literature, it has been fully adopted by the national courts and the German tax authorities. Consequently, various types of holding companies with different entitlement to deduct input tax are differentiated under German VAT law.

III. Types of holding companies under German VAT law

If the purpose of a holding company is limited exclusively to the acquisition, holding and sale of participations, it is to be defined as a financial holding company. As explained above, this type of holding company is not to be classified as an entrepreneur with the consequence that the investments in its subsidiaries must be assigned to the non-entrepreneurial area of a holding company and this part of the holding company is not entitled to input tax deduction from input services.
However, if a holding company intervenes in the administration of all subsidiaries, i.e. if services that are subject to VAT are exchanged between the parent company and the subsidiary, the holding company must be qualified as a so-called management or functional holding company. Court rulings recognize the management or functional holding company as an entrepreneur, which means that the shareholdings in the subsidiaries must be allocated to the entrepreneurial area of the holding company. Provided that the management or functional holding company does not generate any VAT exempted sales or services, i.e. in particular no VAT-free sales or services without the possibility to opt for VAT, it is entitled to deduct input tax under the general conditions.
The so-called mixed holding company plays a special role under VAT law. A characteristic feature of this type of holding company is that the company only actively intervenes in the management of some of its subsidiaries, while other participations are only held and managed by the company. A mixed holding is an entrepreneur subject to value added tax only in relation to that part of the investment management which is connected with the provision of value added tax services. This means that the participations or shareholdings must be allocated to the entrepreneurial or non-entrepreneurial area of the holding company and that input tax amounts must be segmented accordingly. In practice, this circumstance can lead to implementation difficulties because no generally applicable method is recognized by case law and administration with regard to the segmentation standard for the deduction of input tax, in particular due to costs of general administration. This means that the amount of input tax deduction of a mixed holding company always depends on the individual case, which requires precise examination and documentation for tax audit purposes.

IV. Potential design and its limits

As the above explanations show, a holding company that provides services against payment to its subsidiaries is to be classified as an entrepreneur liable to VAT, so that it is entitled to the “privilege” of deducting input tax (if applicable, in full). If holding structures are being set up, it is advisable to establish appropriate service relationships with subsidiaries right from the start. The same applies to existing structures. In such cases, too, service relationships can be established in order to claim input tax deduction in future assessment periods, if such relationships do not yet exist.
However, in this respect, the following must particularly be observed:
If capital is only made available to a subsidiary by way of a loan, the ECJ considers that this alone is generally not sufficient to establish the entrepreneurial status of the holding company. Although there is an activity for the sustainable generation of income in the form of interest for the use of capital, but the ECJ nonetheless believes that the provision of financial means usually does not exceed the area of asset management. In this case, the holding company is regularly treated as a private investor who is not entitled to deduct input tax. Only if the loan is granted within the framework of a corporate objective or for a business purpose which is characterized in particular by the interest in making the invested capital profitable should there be an exchange of services relevant to the entrepreneurial nature of the holding company for VAT purposes. The ECJ has left the criteria unanswered on the basis of which the above distinction is to be made. If (exclusively) financial benefits are planned as interference with the administration of a subsidiary, it is advisable to initiate prior consultation with the tax authorities in order to avoid risks relating to the recognition of the entrepreneurial status of the holding company.
It must also be taken into account that the provision of remunerated services may lead to the establishment of a consolidated VAT group between the holding company and the subsidiary. In contrast to income tax law, where the formal act of concluding a profit and loss transfer agreement is an essential element, this requires that the subsidiary as a controlled company is integrated financially, economically and organizationally into the holding company which acts as the controlling company. If the services provided by the holding company are of sufficient significance, this can lead to economic integration. If the holding company additionally holds the majority of voting rights (financial integration) and controls the management of the subsidiary (organizational integration), e.g. by involving the same personnel in the management bodies of both companies, all requirements required for establishing a consolidated VAT group are met. Holding companies should be aware of the consequences of the establishment of a consolidated VAT relationship, which essentially consist in the fact that the holding company is obliged to file a consolidated advance return or annual VAT return and that legal relationships between the companies of the consolidated group are to be regarded as “internal sales”.

V. Conclusion

Holding companies are neither per se entitled to deduct input tax nor are they generally excluded from such deduction. The scope of the input tax deduction rather depends on whether and to what extent VAT services that can be provided in the form of administrative, financial, commercial or technical services are exchanged between the holding company and its subsidiaries.
This circumstance offers structuring potential, but also requires individual consideration, since not every exchange of services between companies is suitable for enabling an input tax deduction by the holding company. It is also necessary to be careful in cases where holding companies do not provide services to all subsidiaries. Due to a lack of relevant jurisprudence and administrative opinion, the main question here is to what extent the holding company is entitled to deduct input tax.
This topic has meanwhile moved into the focus of the financial administration. Affected companies are therefore recommended to continuously review the scope of their entitlement to deduct input tax in order to avoid possible tax audit risks right from the start.