TREATMENT OF FACTORING VAT

VAT treatment of factoring following European Court of Justice ruling in the MKG-Kraftfahrzeuge-Factory GmbH (case C-305/01).

Introduction

This article examines the effect of the MKG European Court of Justice ruling on various transactions, principally true and quasi-factoring, and invoice discounting. These terms are often used imprecisely which can sometimes mislead, so it is important to ascertain the nature of the transaction itself and not how it is described in order to determine the VAT treatment.

In brief, the Court held that true factoring in which a business purchases debts assuming the risk of the debtors’ default is an economic activity for the purposes of Articles 2 and 4 of the Sixth Directive which does not come within the exemption for certain financial transactions and is therefore a taxable activity with the right to deduct VAT on inputs.

The concept of making a supply for the purposes of VAT is not necessarily identical with the performance of an obligation for the purposes of the law of contract. The nature and reality of the supply must be looked at, as the true construction of a contractual document may not always answer the VAT treatment, although it is usually helpful.

In this context it may be useful to quote from Laws J. of the UK Queen’s Bench Division, in the case of Customs and Excise Commissioners v Reed Personnel Services Ltd. (1995) STC 588.

• “in principle, the nature of a VAT supply is to be ascertained from the whole facts of the case”
• “many of the cases which have caused difficulty in the VAT field, requiring resolution by the higher courts, have concerned situations involving three parties”
• “the concept of VAT supply is not coterminous with the concept of contractual duty”.

These quotes are particularly apt in interpreting this judgement, which raises very difficult issues in its application.

VAT treatment of debt factoring

Article 13(B) of the Sixth VAT Directive provides for exemption for transactions concerning debts and other negotiable instruments, but excluding debt collection and factoring. This exemption is transposed into paragraph (i) (c) of the First Schedule to the VAT Act 1972, as amended.

Revenue had always accepted that pure debt collection, including a charge for debt collection or administration provided in accordance with a debt factoring contract, did not come within the terms of the exemption and was a taxable activity with the right to deduction. However, Revenue regarded true factoring as being a financing operation, being essentially the granting of credit by the debt factor and, as such, exempt without the right to deduction.

As indicated above the European Court of Justice considered the treatment of true factoring for VAT purposes in the case of MKG-Kraftfahrzeuge - Factory GmbH, case C-305/01. Revenue is implementing the judgement but understands that there may be a need to provide guidance for practitioners and taxpayers as to how it will interpret the judgement.

Where the factoring arrangements mirror the scenario outlined in the judgement Revenue accepts that these are taxable activities with the right to deductibility. However, difficulties arise as to whether certain transactions are debt factoring for the purposes of the Sixth Directive.

What is debt factoring?

The judgement related essentially to true factoring, which is where the factor purchases debts owed to his client without enjoying a right of recourse against the client if the debtors default and which in turn invoices its clients in respect of commission. This activity was held to be a taxable economic activity.

The Court ruled that

“....a business which purchases debts, assuming the risk of the debtors default, and which in return, invoices its clients in respect of commission pursues an economic activity for the purposes of Articles 2 and 4 of that directive, so that it has the status of taxable person and thus enjoys the right to deduct tax under Article 17 thereof ”.

In arriving at its conclusion the court observed (paragraphs 77 and 78) that:

“the term debt collection must be interpreted as encompassing all forms of factoring. In accordance with its objective character, the essential aim of factoring is the recovery and collection of debts owed to a third party. Therefore, factoring must be regarded as constituting merely a variant of the more general concept of debt collection, whatever the manner in which it is carried out.

Moreover, the term debt collection refers to clearly circumscribed financial transactions, designed to obtain payment of a pecuniary debt, which are clearly different in nature from the exemptions set out in the first part of Article 13 B(d)(3) of the Sixth Directive”.

True and Quasi-Factoring

The case which was the subject of the judgement related to a true factoring agreement however reference was made also to quasi-factoring.

Both of these types of agreement are similar to the extent that the services the factor provides are essentially the same i.e. managing and recovery of the debts owed to their clients. As stated at paragraph 13 of the judgement, quoting from the German guidelines “the activities carried out by the factor for the client in cases of quasi-factoring are the grant of credit, assessment of debtor solvency, management of debtor accounts, preparation of analyses and statistical material and debt collection. This involves the provision of a number of principal services.”

In the case of true factoring there may not be a grant of credit but all the other aspects of factoring, i.e., assessment of debtor solvency, management of debtor accounts etc. would be expected. The essential distinction between true factoring and quasi-factoring is that true factoring is done on a non-recourse basis (the factor assumes the risk of the debtors’ default) and quasi-factoring is carried out on a recourse basis (the factor has recourse against the original supplier in the event of non-payment by the debtor).

From the judgement in relation to true factoring and from what was stated in the judgement in relation to quasi factoring both are considered to be taxable activities with VAT deductibility allowed in relation to inputs attributed directly to the factoring services.

The Court considered at paragraph 54 that

“first of all there is no valid justification for treating true factoring and quasi-factoring differently from the point of view of VAT, given that in both cases the factor makes supplies to the client for consideration and accordingly pursues an economic activity. Any other interpretation would draw an arbitrary distinction between those two categories of factoring and would make the business concerned bear, in the course of certain of its economic activities, the cost of the VAT without giving it the possibility of deducting that cost in accordance with Article 17 of the Sixth Directive”

It is important to bear in mind that it is the actual activity carried out which determines the VAT treatment, as the term factoring may be used in agreements to describe a variety of different services. As indicated in paragraph 64 of the judgement, it is necessary to have regard to the objective character of the transaction in question in applying the exemption provided for in Article 13.

Revenue’s view of what constitutes debt factoring

Revenue’s interpretation of the judgement is that for a transaction to be debt factoring and therefore to come within the terms of the judgement, there must be a clear nexus between the factor and the debtor. The factor, as envisaged by the ECJ judgement, must have the possibility of collecting the debts itself.

It has been suggested that an arrangement, involving the contractual purchasing of the debt but with the actual collection being outsourced back to the vendor, who would then act as agent for the purchaser, comes within the scope of the judgement. Revenue accept that the purchaser of the debts, by relieving the vendor of the risk of default, is carrying on an economic activity but regards this as an exempt financial service. The purchaser of the debts is the recipient of a debt collection service from the vendor. The purchaser of the debts is not engaged in debt factoring or debt collection. The debt collection service provided by the vendor as agent for the purchaser is a taxable service but the VAT on that supply is not deductible in the hands of the purchaser.

The granting of credit

The question of interest charged in relation to the granting of credit, although part of the MKG case, was not addressed by the Court. Revenue is of the view that where, as part of a factoring agreement, the factor grants its client credit and charges interest on this advance the grant of credit constitutes an exempt supply. The granting of credit element of the factoring agreement must not be regarded as ancillary to a “debt collection” service but rather as another principal supply which is exempt under the provision of the First Schedule.

VAT deductibility

VAT deductibility arises in both true and quasi-factoring transactions as described above where the factor provides services in relation to the management and recovery of its clients debts.

Where there is a granting of credit for which interest is charged an apportionment of the factor’s inputs will be required.

In deriving a correct apportionment, any interest accruing to the factor should be included in the denominator (the Revenue Guide to Apportionment of input tax is available on the Revenue website www.revenue.ie/pdf/guideapp.pdf and may be useful in this regard).

Naturally, where an undertaking is involved in both factoring and invoice discounting operations or purchase of debts without provision of a factoring service then there will also be an apportionment and the practitioner should discuss this with the appropriate local Revenue official.

Invoice Discounting

Invoice discounting is not factoring and does not mirror the true factoring model which was the subject of the ECJ judgement. From an economic point of view, factoring and invoice discounting can appear to be similar economic services. They target similar business needs and are often services offered by the same providers.

However, a factoring agreement completely discharges the customer from managing his debts, an invoice discounting agreement does not. This is the essential difference between the two. The invoice discounter does not provide the customer with an actual debt collection service (see paragraphs 77 & 78 of the ECJ judgment quoted above). On the contrary, the principal service being provided with invoice discounting is the provision of credit, which is an exempt activity. The invoice discounter has no involvement in the collection of the debts or the sales ledger and credit control function.

Revenue is of the view that such transactions remain exempt, as was the practice until now, and that the ECJ ruling does not affect the existing VAT treatment. Invoice discounting is not considered to be a variant of debt collection.

Further queries

Queries regarding the general application of the principles laid down in the MKG judgement as outlined here should be referred to:

VAT Interpretation Branch (Property and Financial Services),
Indirect Taxes Division,
Dublin Castle.

Telephone: 674 8648 or 674 8353.

Queries regarding specific cases should be addressed to the Revenue office dealing with the case.