VAT Deduction on Assets Not Owned by Taxpayer – CAAD Arbitration 410/2016-T

Arbitral Decision

I. Report

A…, LDA (hereinafter referred to as "A…", "A…" or Claimant), legal entity no.…, with registered office in…, …, …, came, under Articles 2 no. 1, lit. a) and 10 and following of the Legal Framework for Tax Arbitration, provided for in Decree-Law no. 10/2011, of 20 January, as amended by Article 228 of Law no. 66-B/2012, of 31 December (hereinafter abbreviated as "RJAT") and Articles 1 and 2 of Order no. 112-A/2011, of 22 March, to submit a request for an arbitral ruling on the legality of the acts of additional assessment of Value Added Tax (VAT) no. 2016…, relating to July 2015, and no. 2016…, relating to October 2015.

The Respondent is the TAX AND CUSTOMS AUTHORITY (AT).

The request for constitution of the arbitral tribunal was accepted by the President of CAAD and automatically notified to the Tax and Customs Authority on 19-07-2016.

The Claimant did not proceed with the appointment of an arbitrator, so, in accordance with the provisions of lit. a) of no. 2 of Article 6 and lit. b) of no. 1 of Article 11 of the RJAT, the President of the Deontological Council of CAAD appointed the undersigned as arbitrators of the collective arbitral tribunal, who communicated acceptance of the assignment within the applicable deadline.

On 29-09-2016, the parties were duly notified of this appointment and did not manifest any intention to refuse the appointment of the arbitrators, in accordance with Article 11, no. 1, lit. a) and b), of the RJAT and Articles 6 and 7 of the Deontological Code.

Thus, in accordance with the provision of lit. c) of no. 1 of Article 11 of the RJAT, the Arbitral Tribunal was constituted on 17-10-2016.

Duly notified, the Tax and Customs Authority submitted a response in which it defended the inadmissibility of the claim, raising exceptions and objections.

As it was considered that the facts relevant to the decision had sufficient documentary support, the meeting referred to in Article 18 of the RJAT was dispensed with.

16 February 2017 was set as the date for issuance of the final decision.

The parties submitted written submissions, expressing themselves on the evidence in the case file, reiterating and developing their respective legal positions.

The Claimant requests that the illegality of the additional VAT assessments nos. 2016…, relating to July 2015 (document 1 attached to the arbitral request), and 2016…, relating to October 2015 (document 2 attached to the arbitral request), in the total amount not reimbursed by AT of € 300,222.07, be declared, with its consequent annulment and reimbursement of that amount wrongfully retained by the Respondent, plus compensatory interest at the legal rate, alleging, in summary:

a) The Claimant is engaged in the provision of plastic product manufacturing services, commercialized by other companies in the multinational group to which it belongs - Group B…- an activity it has exercised in Portugal for approximately two decades.

b) The Claimant was the recipient of the above-identified additional VAT assessments relating to the periods of July and October 2015.

c) The aforementioned assessments resulted from corrections made by AT in the course of inspection actions conducted by the Finance Directorate of…, in 2016, which determined, in both cases, the denial of the right to VAT deduction.

d) Since it began its activity, the Claimant adopted the same standard procedure regarding VAT – which it maintained in the exercise in question – deducting the tax borne on imports of goods carried out within the framework of the Manufacturing Services Agreement (document 3 attached to the administrative file) concluded with C… S.A. (hereinafter referred to as C…), a group company based in…, which sometimes gave rise to VAT credit situations and respective reimbursement requests.

e) Indeed, following VAT reimbursement requests made by the Claimant, relating to the periods of July and October 2015, in the amount of € 494,214.00 and € 405,190.21, respectively, as provided in periodic declarations attached to the file on 18.10.2016, AT initiated inspection processes for the identified taxation periods.

f) As a consequence, and despite the clarifications provided by the Claimant, the Tax Authority issued two draft corrections regarding VAT, according to which the tax borne on the importation of goods carried out under the Manufacturing Services Agreement referred to above would not be deductible:

• in the amount of € 163,603.98, for the July period; and

• in the amount of € 136,618.09, for the October period (documents 5 and 6 attached to the arbitral request).

g) For the first time, in 20 years of activity, the Claimant was confronted with AT's opposition to the procedure it had always followed regarding the settlement and deduction of VAT, with AT alleging, in accordance with the conclusions of the draft corrections, that by reason of the ownership of the goods, the Claimant would have allocated them to purposes other than those of its activity.

h) Contrary to this position not only Article 20 of the VAT Code (CIVA), which makes no express or implicit reference to ownership as a requirement for the exercise of the deduction right, but also the understanding of the VAT Services Directorate (DSIVA) already called upon to pronounce on the same question and in the exact circumstances of the case (Information no.…, document 9 attached to the arbitral request), the VAT Directive, namely its Article 168, and the case law of the Court of Justice of the European Union (CJEU), reiterated and consistent in this matter, e.g. judgment of 29 March 2012, delivered in case no. C-414/10.

i) If there are any doubts about the compatibility of Article 20 of the CIVA, in AT's interpretation, with the VAT Directive, this should be the subject of a preliminary reference to the CJEU, in accordance with Article 267 of the Treaty on the Functioning of the European Union (TFEU).

j) AT's position, regarding the (non) deductibility of VAT borne by the Claimant in the periods of July and October 2015, translates not only into an illegitimate appropriation of amounts that it is not entitled to assess or retain for any legal reason, but also transforms the tax into a true cost of the activity developed by it, causing unjustified prejudice to the Claimant and jeopardizing the neutrality of VAT.

k) Such conduct by AT contradicts the functioning of the tax aimed at by the legislature, as results from the community basis of the tax and from all the case law established by the CJEU, regarding the right to VAT deduction, establishing the rule of deduction of tax borne upstream for business purposes, as a fundamental operating rule of the tax (and should be absolutely exceptional the situations in which the same rule can be set aside), and violates the principle of proportionality (Articles 2 and 266, no. 2 of the Constitution of the Republic - CRP).

l) AT does not deny that the VAT in question can (and should) be deducted, but intends to deny the Claimant the right to deduction based on argumentative criteria of a purely formal and extralegal nature, exclusively based on a matter of "ownership".

m) AT did not present in the draft corrections or in the final report, in a clear and coherent manner, the grounds and legal basis supporting the position adopted, in violation of Articles 268, no. 3 of the CRP and 77, no. 1 of the General Tax Law (LGT), thereby prejudicing the Claimant's right of defense.

n) Furthermore, although the Claimant was regularly notified to exercise its right of hearing, which it exercised, this received no response whatsoever from AT.

o) In 20 years, this was the first time that AT invoked the criterion of "ownership" in circumstances identical to those in which it considered such criterion irrelevant (case underlying Information no.… referred to above), thus treating identical situations differently, in clear violation of the principle of equality – Article 13 of the CRP - to which administrative authorities are expressly bound (Articles 266, no. 2 of the CRP and 55 of the LGT).

p) The acts of assessment in question must, therefore, be declared illegal and consequently annulled, as they suffer from defects of form and violation of law, and the amounts wrongfully retained by AT should be reimbursed to the Claimant plus compensatory interest.

In turn, the Respondent came in response to allege, in summary:

a) The additional VAT assessment statements that the Claimant refers to and challenges are nothing more than partial denials of reimbursement requests.

b) Therefore, this tribunal is not materially competent to know of the Claimant's claim, since the act of partial denial of a reimbursement request does not constitute a tax act of assessment.

c) Without prejudice, the Claimant deducted an amount of tax owed on the importation of goods that are not its property and that are not inputs of its activity since it is merely a service provider (molding and assembly of raw materials and production components) to C….

d) All imported goods are the property of C….

e) The remuneration of the aforementioned service provisions is not included in the value of the imported goods.

f) There cannot be a deduction of tax borne upstream that is not connected with a taxable transaction downstream.

g) The importation of the goods to which the tax in the present case relates is connected with the sale of the final product carried out by C… whether on the domestic market or on the intra-community market and not with the transactions carried out by the Claimant.

h) The mechanism of VAT deductions is provided for in Articles 19 to 26 of the CIVA and forms part of the essence of the tax itself, with Article 19 stating that, for the calculation of the tax owed (self-assessment), taxable persons deduct from the tax charged on taxable transactions in a given period, the tax invoiced to them on the acquisition of goods and services by other taxable persons, mentioned in invoices or equivalent documents issued in legal form, in the same period, a situation that should be reflected in the periodic declaration referred to in lit. c) of no. 1 of Article 29 of the CIVA.

i) In the case at hand, the Claimant is subject to the rules governing the right to deduction provided for in the CIVA.

j) Therefore, the arbitral request should be rejected, for lack of merit.

II. Dismissal of Preliminary Matters

1. The Exception of Material Incompetence of the Tribunal

AT raised the exception of incompetence of this arbitral tribunal, on the grounds that, as stated in the preamble of the request, the Claimant is not challenging acts of additional assessment but statements of additional VAT assessment, which implement proposed corrections in inspection actions, conducted by the Finance Directorate of…, following the reimbursement requests submitted by A… in the periodic VAT declarations for the periods of July and October 2015.

By qualifying such additional VAT assessment statements as mere "acts of partial denial of reimbursement requests", the Respondent argues that this Arbitral Tribunal has no material competence to know of the request.

Now, we do not believe that AT is right.

It is clear that the request in the present case translates into the question of whether the additional VAT assessments in question suffer or do not suffer from a defect of illegality. Indeed, closely following the decision by CAAD, in the judgment delivered on 25.10.2016, in case no. 177/2016-T, "it is not a matter of determining the alleged right of reimbursement but rather of the (il)legality of the arithmetic corrections that were made and that underlie the disputed assessments. We are, therefore, faced with a request for a declaration of illegality of tax assessment acts".

Also in accordance with the cited decision, "if we were to follow the understanding alleged by AT, the result would be the exclusion of the competence of any arbitral tribunal to know of the illegality of acts of tax assessment when any VAT assessment was involved, which is totally inappropriate given the very letter of the law, properly and clearly expressed in Articles 2 and 10 of the RJAT, as well as in Article 2 of the binding Order".

The recognition of a VAT reimbursement right is not the object of the request, although it was at the origin of the inspections carried out on the Claimant, which gave rise to the aforementioned arithmetic corrections that generated the additional tax assessments here at issue. It is these assessment acts resulting from the alleged disregard of a set of VAT deductions, by AT, to which the Claimant considers it is entitled that correspond to the object of the request. We are, therefore, at the heart of the process of challenging assessment acts, within the competence of the arbitral jurisdiction.

It should be added that, citing the case law contained in the arbitral judgment delivered in case no. 354/2015-T, of 10 December, there is no legal prohibition on the appraisal of matters relating to the existence or not of rights underlying the assessments or any other questions of legality relating to the acts of the types referred to in Article 2 of the RJAT. An identical understanding has been followed in other arbitral decisions, of which we highlight, also, the one delivered in arbitral case no. 764/2014-T, in judgment of 29-05-2015.

Accordingly, without need for further consideration, the exception raised is considered unfounded, and this Arbitral Tribunal is considered materially competent in view of the provisions of Articles 2, no. 1, lit. a), 5, 6 and 30, no. 1, of Decree-Law no. 10/2011, of 20 January.

1. The Arbitral Tribunal is materially competent and was regularly constituted.

2. The parties have legal personality and capacity, are legitimate, and are legally represented (Articles 4 and 10, no. 2, of the same Decree-Law and Article 1 of Order no. 112-A/2011, of 22 March).

3. The proceedings do not suffer from any nullities.

4. There are no other circumstances that prevent knowledge of the merits of the case.

III. Decision

1. Factual Matters

1.1. Facts Established as Proven

The following facts are considered proven:

a) The Claimant develops its economic activity in five central areas: principally, the provision of plastic product manufacturing services, commercialized by other companies in the multinational group to which it belongs – Group B…; secondarily, the provision of warehousing services, the sale of waste, the sale of packaging, and the purchase on its own account, but on behalf of other group companies, of goods transport services.

b) Specifically, the Claimant develops its activity under a Manufacturing Services Agreement ("Tolling Agreement" – document 3 attached to the administrative file), concluded with C…, a group company based in…, in December 1997.

c) It follows from this Manufacturing Services Agreement that the Claimant undertakes to manufacture the products in conformity and under the instructions and specifications provided by C…, being bound to respect the quality standards of the brand, through the use of know-how, drawings, standards and other requirements issued by C… (Article 2).

d) All raw materials and components that form part of the final product, all work-in-progress products and finished products are the property of C….

e) The amount agreed for the manufacturing service provision by the Claimant corresponds to the costs and expenses incurred, plus a fee equivalent to 15% of their value (Article 6 of the aforementioned Agreement).

f) The process of manufacturing plastic products begins with the acquisition of raw materials and components by C…, in its own name, being subsequently imported by the Claimant, which incorporates them into the final products it manufactures for C…, so that it can ultimately proceed with their sale under the A… brand.

g) With respect to this aspect of the production chain, the Claimant presents itself at the Portuguese customs as "importer of record", acting on account of C…, by virtue of the latter not having any human and technical resources structure that would allow it to carry out imports in Portugal.

h) For this purpose, that is, to proceed with the customs clearance of the aforementioned raw materials and components, the Claimant contracted, in the specific case, D…, Lda. ("D…") as Official Customs Broker in its own name, with the costs of provision of this service being recharged to C….

i) The Claimant provides warehousing services for products in Portuguese territory to E… S.A. (hereinafter "E…") and to C…, which include the storage of products produced both by the Claimant and by other companies in Group B…, as well as by companies that are not part of it.

j) Likewise, it is under a Warehousing Services Agreement - "Warehousing Services Agreement" (document 4 attached to the administrative file), concluded between the Claimant and C…, in 1997, that the Claimant provides warehousing, handling, truck loading and issuance of shipping documents services to C…, with respect to the raw materials, components and finished products that are the property of C….

k) All goods used and manufactured along the production chain, including raw materials, components, finished products and other goods necessary for production, are stored in the Claimant's facilities, whether in …, or in a warehouse leased in …, … — with C…'s goods being physically separated from the others.

l) The value of the warehousing service covers all costs and expenses related to the warehousing services provided under the Warehousing Services Agreement, to which is added a profit margin of 10% on the same (Article 6 of the "Warehousing Services Agreement").

m) In strict connection with the warehousing services provided, the Claimant sometimes proceeds to contract transport services in its own name, but on account of other group entities, subsequently recharging them to C….

n) In the specific case, the transport of goods from their origin to the discharge point in…, is the responsibility of the respective supplier, with the Claimant being able to contract transport itself in exceptional situations, with the charge being recharged to C….

o) The Claimant is classified under the monthly periodicity regime and is a "full" VAT taxable person, to the extent that it carries out exclusively operations with the right to VAT deduction.

p) The services invoiced to C… under the Manufacturing Services Agreement correspond to more than 90% of the transactions carried out by the Claimant.

q) When submitting the periodic VAT declarations for the periods of July and October 2015 (documents 10 and 11 submitted by the Claimant on 18.10.2016), in the amount of € 494,214.00 and € 405,190.21, respectively, the Claimant requested reimbursement of these amounts.

r) As a consequence, AT initiated inspection processes for the above-identified taxation periods, supported by Service Orders nos. OI2015…, of 10 September 2015, and OI2015…, of 11 December 2015, from which resulted the Tax Inspection Reports attached to the administrative file and which are fully reproduced herein, as well as the additional assessments at issue:

• the additional VAT assessment no. 2016… relating to the period of July 2015, in the amount of € 163,603.98, corresponding € 156,729.00 to VAT borne on the importation of goods under the Manufacturing Services Agreement and € 6,874.98 to VAT borne on their transport;

• the additional VAT assessment no. 2016… relating to the period of October 2015, in the amount of € 136,618.09, corresponding € 129,880.39 to VAT borne on the importation of goods under the Manufacturing Services Agreement and € 6,737.70 to VAT borne on the transport of these goods.

s) Both draft corrections then prepared by AT conclude by the non-deductibility of VAT borne by the Claimant on the importation of the goods in question, on the following ground (page 25 of document 5 and page 26 of document 6, above mentioned):

"In view of the above, we conclude that the imported goods described in table I, in relation to which A… deducted VAT are goods that are not its property and therefore are not used for the realization of taxable transactions related to transmission of goods and/or provision of services by the Portuguese entity (A…).

t) Thus concluding: "Therefore, the VAT recorded in the documents of importation of goods owned by C… in the period 2015/07 was deducted incorrectly, in the value of € 156,729.00." (page 25 of the aforementioned document 5) and "Therefore, the VAT recorded in the documents of importation of goods owned by C… in the period 2015/10 was deducted incorrectly, in the value of € 129,880.39." (page 26 of the aforementioned document 6).

u) With respect to the transport services acquired by the Claimant in the same field of activity, the draft corrections conclude in the same manner:

• "In view of the above, we conclude that the TP deducted VAT incorrectly regarding the transport of imported goods that are property of C… (…). Accordingly, they are not intended for the realization of transmission of goods and provisions of persons subject to Tax and not exempt therefrom, in accordance with lit. a) no. 1 of Article 20 of the VAT Code. Therefore, the taxable person incorrectly deducted VAT, in the period 2015/07, in the amount of €6,874.98" (page 28 of the aforementioned document 5).

• "In view of the above, we conclude that TP deducted VAT incorrectly regarding the transport of imported goods that are property of C…, which are described in the previous point. Accordingly, they are not intended for the realization of transmission of goods and provisions of persons subject to Tax and not exempt therefrom, in accordance with lit. a) no. 1 of Article 20 of the VAT Code. Therefore, the taxable person incorrectly deducted VAT, in the period 2015/10, in the amount of €6,737.70" (page 29 of the aforementioned document 6).

v) On 7 April 2016, assessment no. 2016…, relating to July 2015, was issued, from which resulted tax to be reimbursed in the amount of € 330,610.09, transferred on 14 April 2016 to the Claimant's bank account.

w) On 12 April 2016, assessment no. 2016…, relating to October 2015, was issued, from which resulted tax to be reimbursed in the amount of € 288,572.12, transferred on 18 April 2016 to the Claimant's bank account.

x) The Claimant was notified of the statements of the VAT assessments now disputed on 19 and 20 April 2016, respectively.

y) The request for constitution of an Arbitral Tribunal was filed on 18-07-2016.

1.2. Facts Not Established as Proven

Among those alleged, relevant to the decision, none remained unproven.

1.3. Grounds for the Factual Matters

Regarding the factual matters, the Tribunal does not have to rule on everything that was alleged by the parties, but rather has the duty to select the facts that matter for the decision and discriminate the proven from the unproven matters (Articles 123, no. 2, of the Code of Tax Procedure and Process – CPPT - and 607, no. 3 of the Code of Civil Procedure – CCP -, applicable ex vi Article 29, no. 1, lit. a) and e) of the RJAT).

Thus, the facts relevant to the judgment of the case are chosen and selected according to their legal relevance, which is established in consideration of the various plausible solutions to the question(s) of law (cf. previous Article 511, no. 1, of the CCP, corresponding to current Article 596, applicable ex vi Article 29, no. 1, lit. e), of the RJAT).

Thus, taking into account the positions taken by the parties, in light of Article 10, no. 7 of the CPPT, the documentary evidence and the administrative file attached to the case file, the facts listed above were considered proven, with relevance to the decision, bearing in mind that, as stated in the judgment of the TCA-South of 26-06-2014, delivered in case 07148/131, "the probative value of the tax inspection report (...) may have probative force if the assertions contained therein are not challenged".

1. On the Law

2.1. The Request

The present arbitral ruling request has as its objective the annulment of the VAT assessment acts carried out by AT, following the inspection action supported by Service Orders nos. OI2015…, of 10 September 2015, and OI2015…, of 11 December 2015.

The corrections were made in the context of the analysis carried out by AT of the VAT reimbursements requested by the taxable person in the periodic VAT declarations for the periods of 2015/07 and 2015/10, respectively in the amount of € 494,214.00, and € 405,190.21. AT's inspection action was supported by Service Orders nos. OI2015…, of 10 September 2015, and OI2015…, of 11 December 2015.]

In question in the case are:

a) The additional VAT assessment no. 2016… relating to the period of July 2015, in the amount of € 163,603.98, corresponding to (i) € 156,729.00 VAT borne on the importation of goods under the Manufacturing Services Agreement and (ii) € 6,874.98 VAT borne on their transport;

b) The additional VAT assessment no. 2016… relating to the period of October 2015, in the amount of € 136,618.09, corresponding to (i) € 129,880.39 VAT borne on the importation of goods under the Manufacturing Services Agreement and (ii) € 6,737.70 VAT borne on the transport of these goods;

The Claimant further requests payment of compensatory interest on the aforementioned amounts, in accordance with the provisions of Articles 43 of the LGT and 61 of the CPPT.

2.2. Questions to be Decided

The main questions to be decided relate to the legality of the aforementioned assessment acts which result from AT's refusal of the right to VAT deduction borne by the Claimant on the importation of goods and acquisitions of transport services that it made in the periods of July and October 2015.

Let us look at the facts:

a) On the one hand, in the context of the execution of the Manufacturing Services Agreement concluded with C…, with the nature of a work contract, the Claimant proceeded to import, in its own name but on account of C…, raw materials that it used in the respective manufacturing process. The raw materials are the property of C… and are incorporated by the Claimant into the final products resulting from the respective "work undertaken". The delivery to C… of the goods produced by the Claimant constitutes service provisions that the Claimant invoiced to C…. The Claimant deducted the VAT borne on the importation of those raw materials, which it imported in its own name, and which it incorporated into the final products that it manufactured for C….

AT refused the right to deduct this VAT on the basis that the imported goods, in relation to which the Claimant (A…) deducted VAT are goods that are not its property and therefore are not used for the realization of taxable transactions related to transmission of goods and/or provision of services by the Claimant. AT considers that the substantial condition provided for in lit. a) of no. 1 of Article 20 of the CIVA is not thus met, required for the exercise of the right to deduction.

b) On the other hand, the Claimant acquired in its own name transport services for the imported raw materials. The Claimant subsequently recharged to C… the transport charges borne on its account. The Claimant deducted the VAT that was invoiced to it by the transport service providers.

Likewise, AT considered that the Claimant deducted VAT incorrectly regarding the transport of imported goods that are property of C…, by virtue of not being intended for the realization of transmission of goods and provision of services subject to tax and not exempt therefrom, in accordance with lit. a) no. 1 of Article 20 of the CIVA.

In view of the above, the question to be resolved is to decide on the legality of the assessments made by AT which translated into not allowing the Claimant to exercise the right to deduct VAT actually borne by the Claimant, but which relates to transactions involving goods that are not its property.

2.3. Introduction – The Right to Deduction as an Essential Element of the Functioning of the Common VAT System

In the VAT Directive, the right to deduction is first mentioned in Article 1, no. 2, 2nd paragraph, and is developed and characterized in Articles 167 to 192.

In national legislation, it is provided for in Articles 19 to 26 of the CIVA.

First, it is pertinent to recall the elements and characteristics of the VAT system with relevance in the case at issue.

The right to deduction ensures that a taxable person only delivers to the State the VAT that results from the balance between the amount of VAT that it calculates on the taxable transactions it carries out downstream and the amount of VAT that it bears on its acquisitions upstream. This right constitutes one of the most important characteristics of the tax, which is why it has been designated as the "cornerstone" or "master key" of the community VAT system[1].

According to consistent case law of the Court of Justice of the European Union (CJEU), the deduction regime aims to free the entrepreneur entirely from the burden of VAT, owed or paid, in the context of all his economic activities, and including, minimizing, insofar as possible, the financial charges caused by the management of the tax. The common VAT system therefore guarantees perfect neutrality as to the tax burden of all economic activities, whatever the purposes or results of these activities, on the condition that these activities are themselves subject to VAT[2].

Indeed, the principle of VAT neutrality constitutes the foundation of the right to deduction. In this regard, the term "neutrality", as a reflection of the general principle of equal treatment within the common VAT system, should be understood to mean that taxable persons should not be affected by subjection to VAT, that VAT should not constitute a burden for economic operators, that VAT should not influence their business decisions, that VAT should not distort competition, that VAT should not give rise to cumulative or "cascading" taxation effects, in short, that VAT should be exactly proportional to the prices charged throughout the economic circuit of production and distribution.

More specifically, the tax borne on the acquisition of goods and/or services used in the activity of the taxable person (inputs) will have originated, for the economic operator situated in the immediately preceding phase of the economic circuit relating to production and distribution of these goods, a VAT calculation in favor of the State, thereby ensuring the "neutrality" of taxation, by allowing the elimination of taxation at intermediate stages.

The CJEU has further persistently stated that the right to deduction forms an integral part of the VAT mechanism and cannot, in principle, be limited.

In the absence of a provision allowing Member States to limit the right to deduction granted to taxable persons, this right must be exercised immediately in relation to the whole of the tax that burdened the transactions carried out upstream[3], even if this implies a refund of a potential credit to the State.

However, the exercise of the right to VAT deduction borne in upstream transactions in goods and business services is not an absolute and unconditional right. The VAT Directive, in Articles 176, 177 and 395, admits restrictions to this right for reasons of legal security, for conjunctural reasons and with the objective of combating fraud or tax evasion or of simplifying the collection of the tax. Limitations to the right to deduction affect the level of tax burden, so they must be applied in a similar manner in all Member States. Consequently, exceptions are only authorized in the cases expressly provided for by the VAT Directive[4].

Furthermore, the right to deduction still depends on compliance with certain substantial requirements of a subjective and objective nature and the verification of certain conditions of time and form.

This is what we propose to analyze below.

2.3.1. Subjective Conditions

2.3.1.1. In General

To trigger the deduction mechanism, it is necessary that a taxable person, acting as such, carries out the acquisition of a good or service, or proceeds with the importation of a good.

Thus, the acquisition of a good or service for private purposes, unrelated to the exercise of an economic activity, as well as the importation of a good for the same private purposes, does not permit the deduction of VAT borne in the respective transaction, even if that good is subsequently used in the exercise of an economic or business activity. To determine whether a private individual acquires a good in the capacity of a taxable person, consideration must be given to his intention to allocate the good to an economic activity. This intention will be evidenced by the set of data in the specific case, such as the nature of the goods in question and the period elapsed between their acquisition and their respective use in the service of the taxable person's economic activities[5]. Similarly, a good that, at the time of its acquisition, the taxable person decided to allocate only part of it to its business and the other part to private use, only the part of the good allocated to its business should be taken into account, for the purposes of exercise of the right to deduction of VAT borne on the acquisition[6].

That is, the right to VAT deduction borne is reserved for economic operators.

2.3.1.2. In the Case Under Consideration

For the exercise of the right to deduction, as mentioned in their Opinion, attached to the case file, by Professors Xavier de Basto and Odete Oliveira, it is required that it be a taxable person who "meets, in accordance with the rules of our law, the characteristics listed in Article 2 of the CIVA", that is, who uses goods and services in his economic activity whose tax borne he intends to deduct.

Now, in the case under consideration, no doubts were raised regarding the capacity of taxable person inherent in the Claimant, in accordance not only with the provision of Article 2, no. 1, lit. a), but also in lit. b) of the same legal norm, since it carries out imports of goods, in accordance with customs legislation.

The Claimant provides services that are paid in accordance with the contract concluded with C…, the content of which is contained in the Tax Inspection Report and which raises no concerns. In fact, the Claimant provides services under a manufacturing contract, with the nature of a work contract, called a "Toller Agreement", whose materials are wholly or substantially supplied by C… in the capacity of work owner and imported by the Claimant.

Now, it is the importation transaction carried out by the Claimant that is at the center of the issue raised by AT to prevent the exercise of the right to deduction borne by the taxable person on the imports it made, in relation to the periods 2015/07 and 2015/10, based on the fact that "the imported goods described in table I, in relation to which A… deducted VAT are goods that are not its property and therefore are not used for the realization of taxable transactions related to transmission of goods and/or provision of services by the Portuguese entity (A…)" [at pages 106 of the administrative file (PA) in relation to the period 2015/07 and at pages 97 of the same file 3 regarding the period 2015/10], subsequently transcribing Article 20 of the CIVA, and concluding as follows, in relation to the period 2015/07: "the VAT recorded in the documents of importation of goods owned by C… in the period 2015/07 was deducted incorrectly, in the value of € 156,729.00" [at pages 106 of PA1] and, likewise, regarding the period 2015/10: "the VAT recorded in the documents of importation of goods owned by C… in the period 2015/10 was deducted incorrectly, in the value of € 129,880.39".

To this end, by virtue of the exhaustive character of the explanation and the technical rigor with which it is made, the Opinion issued by Professors Xavier de Basto and Odete Oliveira, attached to the file, is transcribed in the part referring to the importation transaction, which portrays the legality of the controversial transaction, as follows:

"In the situation under analysis, the specificity is only that the delivery of materials by the work owner to the executor (contractor) does not occur directly in the national territory, but arrives here only after crossing the territorial boundaries of Portugal and also of the Customs Union. And this presents various consequences, which we must analyze in order to conclude correctly.

"First, that an importation occurs, which the CIVA defines as a taxable transaction in the light of the application of the destination principle in international trade that the tax follows, and whose definition is made by national tax legislation in conjunction with the Customs Code (a Community Regulation)."

"The second consequence is that the entity considered as the importer – taxable person in the importation – is that defined by customs legislation by reference made in lit. b) of no. 1 of Article 2 of the CIVA, which considers as the importer the person who appears as the recipient in the importation document, to the extent that Article 4, no. 18 of the Community Customs Code (CCC) considers as "declarant" the person who makes the customs declaration in his own name or the person on whose behalf the declaration is made, and Article 201, no. 3, 1st paragraph of the CCC says that the debtor is the declarant."

"It should be recalled in this regard that although the VAT Directive considers that VAT on importation can be paid by a taxable person or by a mere debtor (Article 21, no. 2 of the Sixth Directive), the Portuguese legislator did not adopt the same solution, rather considering the importer as always a taxable person, sometimes only with the nature of "debtor" of the tax for application of the destination principle (lit. b) of no. 1 of Article 2 of the CIVA), since in the others, this importer, if a taxable person, is already covered by lit. a) of the same number and article. It should be noted, moreover, that, according to consistent case law of the CJEU, "VAT on importation and customs duties present essential comparable features to the extent that they give rise to the fact of importation in the EU and the consecutive introduction of goods into the economic circuit of Member States. Parallelism which is confirmed by the fact that Article 71, paragraph 1, second subparagraph, of the VAT Directive authorizes Member States to link the taxable event and the chargeability of VAT on importation to the taxable event and the chargeability of customs duties" [This is the doctrine of Judgment C-273/12, of 11 July 2013, no. 41, and the reference made therein to Judgments C-343/89, of 6 November 1990, no. 18 and C-230/08, of 29 April 2010, nos. 90 and 91: "in this regard, it should be recalled that VAT on importation and customs duties present essential comparable characteristics, the taxable event of which is importation into the Union and the subsequent entry of goods into the economic circuit of Member States. This parallelism is, moreover, confirmed by the fact that Article 71, no. 1, second paragraph, of the VAT Directive authorizes Member States to link the taxable event and the chargeability of VAT on importation to customs duties (see, in particular, judgments of 6 December 1990, Witzemann, C‑343/89, Coll., p. I‑4477, no. 18, and 29 April 2010, Dansk Transport og Logistik, C‑230/08, Coll., p. I‑3799, nos. 90 and 91)".

"It should therefore be concluded that the Member States have no margin of maneuver with respect to the requirement of VAT on importation in accordance with customs legislation, in accordance with Article 204 of Regulation no. 2913/92, and it being true, as recalled in the conclusions of Advocate General Juliane Kokott, in Case C-414/10, that "This is the doctrine of Judgment C-273/12, of 11 July 2013, no. 41, and the reference made therein to Judgments C-343/89, of 6 November 1990, no. 18 and C-230/08, of 29 April 2010, nos. 90 and 91: " in this regard, it should be recalled that VAT on importation and customs duties present essential comparable characteristics, the taxable event of which is importation into the Union and the subsequent entry of goods into the economic circuit of Member States. This parallelism is, moreover, confirmed by the fact that Article 71, no. 1, second paragraph, of the VAT Directive authorizes Member States to link the taxable event and the chargeability of VAT on importation to customs duties (see, in particular, judgments of 6 December 1990, Witzemann, C‑343/89, Coll., p. I‑4477, no. 18, and 29 April 2010, Dansk Transport og Logistik, C‑230/08, Coll., p. I‑3799, nos. 90 and 91)" and that if "the right to deduction aims to ensure that value added tax remains economically neutral for undertakings, the deduction of upstream tax borne cannot be denied unless we are dealing with issues of fraud, evasion or abuses, the fight against which is a recognized and encouraged objective of the Sixth Directive, with no margin whatsoever remaining for abusive or fraudulent exploitation of the right of the Union, and as such, if a Tax Administration finds that the right to deduction was exercised fraudulently, it can request, with retroactive effect, the restitution of the amounts deducted and it is for the national judge to refuse the benefit of the right to deduction if it is proven, with objective elements, that this right is invoked fraudulently".

"In the situation at hand, this issue does not arise, and it must be recognized however, and as results from point 45 of the Conclusions of the same Advocate General, in the same case that "As regards the collection of value added tax on importation, it is not, however, discernible why in this case there would be, in general, a greater risk of fraud that would make it necessary to make the right to deduction, in any case, dependent on prior payment of value added tax on importation" and, further on, "Also the proof of importation which, in accordance with Article 18, no. 1, lit. b), of the Directive, the taxable person must present in order to be able to deduct upstream tax paid and which indicates him as the debtor of value added tax and at least allows the calculation of the amount of VAT owed, reduces the possibility of fraud", position recognized in the Judgment at points 30 and 33, with point 34 recognizing that "Indeed, the importation of a good constitutes a physical act that is certified and verifiable by the competent administration, due to the presence of the said good at customs" and that "the circumstance that the debtor of VAT on importation is also the holder of the right to deduction of that VAT also does not appear to increase the risk of fraud or abuse in relation to VAT. On the contrary, as the European Commission argued, the circumstance that one and the same person is, at the same time, debtor of VAT and holder of the right to deduction approaches this situation to that which arises in the context of the VAT self-assessment regime provided for by the Sixth Directive".

Indeed, in accordance with Article 30 of the VAT Directive:

""Importation of goods" means the introduction into the Community of a good that is not in free practice within the meaning of Article 24 of the Treaty"

And, in line with this provision, Article 5, no. 1, of the CIVA, provides as follows:

"Importation is considered the entry into national territory of: a) Goods originating from or coming from third countries and that are not in free practice […][7]

In compliance with the principle of taxation in the country of destination, imports of goods constitute a taxable event, which is why Article 2, no. 1, lit. d), of the VAT Directive, and likewise, Article 1, no. 1, lit. b), of the CIVA, establish that imports are subject to VAT.

Thus, Article 201 of the VAT Directive clarifies that:

"On importation, VAT is owed by the person or persons designated or recognized as debtors by the Member State of importation."

while in Article 2, no. 1, lit. b), of the CIVA, it refers to:

"Taxable persons of the tax are: b) Natural or legal persons who, according to customs legislation, carry out imports of goods."

While Article 201 of the VAT Directive establishes that VAT on importation may be paid by a taxable person or a mere debtor, in the VAT Code the importer is always considered a taxable person, even when it already previously has the capacity of a taxable person under lit. a) of no. 1 of Article 2 of the CIVA, by exercising an economic activity.

And it is a taxable person on importation because, in accordance with customs legislation, it carries out the importation of goods.

Article 70 of the VAT Directive establishes the principle that "the taxable event occurs and the tax becomes due at the moment the importation of goods is carried out". But Article 71, no. 1, 2nd paragraph, of the same Directive clarifies that, "when imported goods are subject to customs duties […], established as part of a common policy, the taxable event occurs and the tax becomes due at the moment when the taxable event and the chargeability of those duties occur"[8].

Likewise, Article 7, no. 1, lit. c), of the CIVA, provides that on importations the tax is owed and becomes due "at the moment determined by the provisions applicable to customs duties, whether or not such duties are owed or other Community charges established as part of a common policy".

Indeed, the national legislator considers that, on importation, the person responsible for paying the customs duties owed is also the person responsible for paying VAT.

Now, in Article 4, no. 12, of the Community Customs Code (CCC) and in Article 5, no. 19, of the Customs Code of the Union (CCU), the person responsible for paying customs duties is designated as "debtor". Specifically, the status of debtor coincides with the person who submits the customs declaration.

When a person submits a customs declaration in his own name but on account of another person ["indirect representation", in accordance with Articles 5, no. 2, of the CCC and 18, no. 1, of the CCU], the person who fills in the customs declaration is the declarant [4, no. 18, of the CCC and Article 5, no. 15, of the CCU] and is also considered as the debtor of the tax [Articles 201 of the CCC and 77, no. 3, of the CCU].

On the other hand, Article 201 of the VAT Directive clarifies that on importation, VAT is owed by the person or persons designated or recognized as debtors by the Member State of importation.

Thus, as stated by Professors Xavier de Basto and Odete Oliveira in the Opinion they prepared, attached to the case file,

"it should therefore be concluded that the Member States have no margin of maneuver with respect to the requirement of VAT on importation in accordance with customs legislation, in accordance with Article 204 of Regulation no. 2913/92".

Finally, in accordance with the provision of Article 19, no. 1, lit. b), of the CIVA, taxable persons have the right to deduct VAT owed or paid on the importation of goods. The deduction is made from the amount of tax they owe.

2.3.1.3. Conclusion

In view of the above, it is understood that, from the perspective of the condition under analysis, nothing prevents the Claimant from exercising the right to deduct the VAT it paid on the importation in compliance with the VAT Code and customs legislation.

The CJEU has already clarified that, in the case of a good being imported, the obligation to pay VAT rests with the person or persons designated or recognized by the Member State of importation[9].

And it has also clarified that, in order to exercise its right to deduct VAT on importation, the taxable person has only the obligation to possess a document evidencing the importation, in which it is indicated as the recipient or importer and which mentions or allows the calculation of the amount of VAT owed[10].

Now, all of this has been proven to be the case in relation to the Claimant.

2.3.2. Objective Conditions

2.3.2.1. In General

In Portuguese legislation, the general principle of non-limitation of the right to deduction, in the terms referred to in the previous point 1, has its expression in Article 19 of the CIVA, which provides for the right to deduct all VAT borne on the acquisition of goods and/or services (inputs) related to the economic activity of the taxable person. The tax borne originated from a VAT assessment made downstream by the economic operator situated in the immediately preceding phase of the economic circuit relating to production and distribution of the same goods. The right to deduction thus ensures the "neutrality" of taxation, by allowing the elimination of VAT charged at intermediate stages of the circuit.

As stated by Professors Xavier de Basto and Odete Oliveira in the Opinion they prepared, attached to the case file,

"the legal construction that informs the tax simultaneously requires that, situated in the "chain of production and distribution of goods", the holder of the right to deduction be also "collector" of the tax in the active transactions it carries out. That is, only downstream collection grants upstream deduction, or, conversely, non-collection downstream must mean non-deduction upstream. The only exception to this principle is non-collection of VAT on exports, intra-community supplies and similar operations, operations with respect to which the right to deduction upstream is maintained, in obedience to the destination principle adopted in international and intra-community trade. Therefore, Article 20 establishes the distinction between transactions that grant the right to deduction and transactions that do not grant such right, establishing that "only the tax that has been charged on goods or services acquired, imported or used by the taxable person for the realization of transmission of goods and provision of services subject to tax and not exempt therefrom can be deducted", and likewise "exports and similar operations", and other very specific operations in which the mechanics of the tax thus requires. Consequently, the tax that has been charged on goods or services acquired for the realization of transmission of goods and provision of services not subject to tax, or subject but exempt, is not deductible."

Indeed, among the various exceptions to the right to deduction is one relating to the practice of exempt transactions, referred to in Articles 132 to 135 of the VAT Directive (the so-called exempt transactions that do not grant the right to deduction), which in Portuguese legislation has its translation in Article 9 of the CIVA.

That is, deduction of VAT borne on the acquisition of goods and services intended for the realization of transactions that do not grant the right to deduction is not permitted. The exercise of the right to deduction is conditional on the inputs being used in the realization of transactions that permit such right.

This important exception to the right to deduction follows from the interpretation a contrario of Article 168 of the VAT Directive, which finds correspondence in Articles 20, no. 1, of the CIVA, and 19, no. 2, of the RITI.

Indeed, Article 168 of the VAT Directive establishes the general rule for purposes of exercise of the right to deduction: VAT borne on the acquisition of goods and services can only be deducted when these goods and services are used for the purposes of taxed transactions carried out by a taxable person. Likewise, deduction of VAT paid on the importation of goods is only permitted when these goods are used in taxed transactions.

To the extent that goods and services are used for the purposes of taxed transactions of a taxable person, the latter acquires the right, in the Member State in which it carried out these transactions, to deduct VAT owed or paid in that Member State on acquisitions made from another taxable person responsible for payment of that VAT, as transcribed (in the part that matters for analysis of the case):

"Article 168

When goods and services are used for the purposes of his taxed transactions, the taxable person shall have the right, in the Member State in which he carries out these transactions, to deduct from the amount of VAT for which he is liable the following amounts:

a) VAT due or paid in that Member State in respect of goods delivered or to be delivered to him and in respect of services supplied or to be supplied to him by another taxable person;

[…]

e) VAT due or paid in respect of goods imported into that Member State."

In turn, Article 169 of the VAT Directive extends the right to deduction to certain exempt transactions and also to a restricted number of non-taxable transactions. The exempt transactions referred to there are those referred to, among others, in Articles 138[11] and 146, no. 1, lit. a)[12], both of the VAT Directive. These transactions require exemption with the right to deduction in order to, by imposition of the principle of taxation in the country of destination, completely relieve goods dispatched or transported destined abroad from VAT. They are therefore commonly referred to as "zero-rated" transactions, although neither the EU legislator nor the national legislator use this expression in their respective legal provisions. On the other hand, the non-taxable transactions that grant the right to deduction, referred to in Article 169 of the VAT Directive, are those that, by virtue of the application of the territoriality rules referred to in Articles 31 to 61 of the VAT Directive, are not taxed in a Member State because they are considered not to be located in the territory of that Member State, but would normally be taxed if they were considered located there.

Articles 168 and 169 of the VAT Directive have their reflection in Articles 20, no. 1, of the CIVA, and 19, no. 2, of the RITI, which determine the following:

"Article 20
Transactions That Grant the Right to Deduction

1 - Only the tax that has been charged on goods or services acquired, imported or used by the taxable person can be deducted for the realization of the following transactions:

a) Transmission of goods and provision of services subject to tax and not exempt;

b) Transmission of goods and provision of services consisting of:

I. Exports and transactions exempt under Article 14;

II. Transactions carried out abroad that would be taxable if carried out in the national territory;

[…]"

"Article 19
Right to Deduction

1 – […]

2 – Likewise, for the purposes of the provision of lit. b) of no. 1 of Article 20 of the VAT Code, the tax that has been charged on goods or services acquired, imported or used by the taxable person can be deducted for the realization of transmission of goods exempt under Article 14.

[…]"

In general terms, it can thus be stated that when a taxable person bears VAT on the importation of goods and on the acquisition of goods and services from other taxable persons, it only has the right to deduct the tax thus borne when it taxes, even if at zero rate, its downstream transactions, or when its non-taxation arises only from the fact that these are transactions that, in view of the application of the tax's territoriality rules, it is concluded cannot be considered located in the national territory.

In other words, if the transactions carried out downstream by the taxable person benefit from any of the exemptions referred to in Articles 132 to 135 of the VAT Directive[13], the taxable person cannot deduct VAT borne on the importation of goods and acquisitions made for the realization of these exempt transactions. Likewise, if the downstream transactions are not subject to VAT for reasons other than those referred to in Article 169 of the VAT Directive and Article 20, no. 1, b), II), of the CIVA, the taxable person is also not granted the exercise of the right to deduct VAT borne on inputs indispensable for the realization of these non-taxable transactions.

For purposes of exercising the right to deduct tax borne in upstream transactions, the CJEU has been referring to the need to establish a direct and immediate link between the goods and services acquired and each taxable transaction carried out downstream[14]:

"[…] taxes charged on upstream goods or services used by a taxable person for the purposes of his taxable transactions can be deducted. The deduction of upstream taxes is linked to the collection of downstream taxes. When goods or services acquired by a taxable person are used for the purposes of exempt transactions or transactions outside the scope of VAT[15], there can be no collection of downstream tax nor deduction of upstream tax. On the other hand, to the extent that goods or services are used for the purposes of downstream taxable transactions, a deduction of the tax charged on them upstream is required in order to avoid double taxation."

The exceptions to the right to deduction just referred to frequently give rise to doubts and indefinitions in the application of the common VAT system that translate into complications, sometimes difficult to resolve, and to diverse interpretations, often difficult to reconcile.

These difficulties require the adoption of detailed rules, and sometimes of complex application, in order to allow, for purposes of VAT deduction, the correct allocation of inputs, in particular, when it comes to a "partial" or "mixed" taxable person, thus designated because it simultaneously carries out downstream taxed transactions and exempt transactions that do not grant the right to deduction. The same occurs when the taxable person is involved in non-taxable transactions or outside the scope of the tax. In these cases, account must also be taken of the existence of goods and services of mixed use, whose allocation to specific transactions is impossible, which implies that, for purposes of exercise of the right to deduct VAT borne on its acquisition, it becomes mandatory to resort to criteria based on proportionality.

That is, the analysis of exercise of the right to deduction is much more complex in cases where the transactions carried out downstream by the taxable person are differentiated from the point of view of their objective incidence, where some are taxed and others exempt (based on Articles 132 to 135 of the VAT Directive / Article 9 of the CIVA) or non-taxable.

That is, difficulties arise, sometimes great, only on the question of determining the correspondence between goods and services acquired upstream and each taxable transaction carried out downstream when different activities are at issue from the point of view of their treatment for purposes of exercise of the right to deduction and, more aggravated, when it comes to goods and services of mixed use where it is not at all possible to establish a direct relationship with a specific transaction carried out by the taxable person. Now, this is not what happens in the case under consideration.

2.3.2.2. In the Case Under Consideration - The Imported Goods and Acquired Services Have a Positive Relationship with the Taxed Transactions Downstream by the Claimant

The exceptions to the right to deduction referred to in the previous point and the difficulties they raise will not be addressed here as they are not relevant in the appraisal of the case sub judice, since the transactions carried out downstream by the Claimant are transactions that grant the right to deduction.

Thus, in the case under analysis, the verification of the condition referred to in Article 168 of the VAT Directive and in Article 20, no. 1, a) and b), of the CIVA will be relevant, which requires that the goods and services acquired or imported be used in the realization downstream of taxed transactions, even if at "zero rate" or of non-taxable transactions by force of application of territoriality rules, that is, the taxable person only has the right to deduct VAT borne on inputs when these goods and services "are used for the purposes of his taxed transactions".

Now, the Claimant deducted VAT borne on the importation of raw materials, which it imported in its own name but on account of C… and which it incorporated into the final products it manufactured for C…, although it invoiced to it only the value of the work undertaken, in accordance with the contract concluded.

Likewise, it deducted the VAT that was invoiced to it by the transport service providers of the imported raw materials. The aforementioned transport services were acquired by the Claimant but on account of C…, which is why the Claimant made a recharge to C… of the value of these transport services.

In both cases AT refused the right to deduct VAT borne by the Claimant on the grounds that the imported goods and transport services acquired, on which the Claimant deducted VAT, relate to goods that are not its property and which were therefore not used for the realization of the service provisions invoiced by the Claimant, in accordance with lit. a) of no. 1 of Article 20 of the CIVA.

It is certainly true that the CJEU, in the context of questions in which exceptions to the right to deduction referred to in the final part of the previous point were discussed, that is, in situations where in the activity exercised by a taxable person coexist transactions that grant the right to deduction with transactions that do not grant this right, expressed the requirement for a "direct and immediate link" of goods and services acquired with taxed or exempt transactions with the right to deduction.

In the Midland Bank Case[16] the CJEU was asked to clarify the nature of the expression "direct and immediate link".

Midland Bank provided financial services to a customer outside the EU who intended to acquire another company. Under the provision of the Sixth Directive rule corresponding to current Article 169, no. 1, lit. c), of the VAT Directive, these financial services, although exempt, permitted the right to deduction of VAT borne upstream. During the process of acquisition of the business by Midland Bank's customer, certain facts occurred that prevented its completion and led to a claim for damages. In this context, Midland Bank contracted legal services from a law firm and bore VAT on the value of these services. The case would be terminated by judicial settlement. Midland Bank deducted VAT borne on the legal services acquired on the basis that they were related to the financial services provided to its customer outside the EU. However, the services provided by the lawyers were acquired as a result of the responsibility of the taxable person being put into question when it carried out the "taxed" operations (provision of financial services) and therefore were borne at a later moment than the provision of financial services. Thus, the tax authorities argued that the legal services acquired aimed to ensure defense of the taxable person in the claim for damages based on acts that had been committed in the provision of financial services to its customer, and therefore the legal services were also related to the Bank's general activities, which were constituted simultaneously by transactions with the right to deduction and transactions without the right to deduction. The CJEU also concluded that the legal services acquired did not have a direct and immediate relationship with the "taxed" transactions, but could be considered general expenses of the activity, by virtue of being related to services provided after the completion of the transaction. The Bank could then deduct VAT borne on the legal services based on a pro rata since these services were used not only for carrying out transactions with the right to deduction but also transactions without the right to deduction.

As to the nature of the "direct and immediate link" that must exist between an upstream transaction and a downstream transaction, it should be noted that the CJEU considered that it would not be realistic to try to enunciate a more precise formulation in this regard. Indeed, given the diversity of commercial and professional transactions, it would be impossible to give a more appropriate response as to how to establish in all cases the necessary relationship that must exist between upstream transactions and those carried out downstream for upstream VAT to be deductible[17].

To the same effect, with regard to the Midland Bank Case, the CJEU had already stated[18]:

"it would not be realistic to try to enunciate a more precise formulation in this regard. Indeed, given the diversity of commercial and professional transactions, it would be impossible to give a more appropriate response as to how to establish in all cases the necessary relationship that must exist between upstream transactions and those carried out downstream for upstream VAT to be deductible. It is for the national courts to apply the criterion to the facts of each case presented to them and to take into account all the circumstances in which the transactions in question took place."

Although the CJEU indicated that it would not be realistic to try to be more specific regarding the determination of the expression "direct and immediate link", various reasoning/criteria can be observed that have been used to assess the existence of the said link.

First, the criterion clearly follows from the provision of Article 1, no. 2, 2nd paragraph, of the VAT Directive. This norm establishes that "in each transaction, the VAT calculated on the price of the good or service is charged, with prior deduction of the amount of the tax that has been charged directly on the cost of the various elements making up the price". According to this reasoning, there is a "direct and immediate link" when the charges related to goods or services acquired, which the taxable person used for purposes of carrying out a taxable transaction downstream, form part of the constitutive elements of the price of this transaction.

In Midland Bank, the result of using this criterion was the non-recognition of total deduction of VAT borne on the acquisition of legal services because these charges occurred after the financial services had been provided that gave rise to the birth of the right to deduction upstream. Generally, the components of cost should occur before the time of the taxable transaction downstream.

However, based on this reasoning, the right to deduction is admitted in favor of the taxable person, even in the absence of a direct and immediate relationship between a certain upstream transaction and one or more downstream transactions with the right to deduction, when the costs of services in question form part of its general expenses and are, as such, constitutive elements of the price of goods it supplies or services it provides. These costs indeed have a direct and immediate relationship with the whole of the taxable person's economic activity[19].

In this sense, the CJEU states, with regard to the Midland Bank Case[20]:

"Indeed, it is true that the expenses incurred to acquire the aforementioned services are a consequence of the downstream transaction. However, they do not normally form part of the constitutive elements of the cost of the downstream transaction, which, however, Article 2 of the First Directive requires. Therefore, the aforementioned services do not have a direct and immediate relationship with the downstream transaction. On the other hand, the cost of these services forms part of the general costs of the taxable person and are, as such, constitutive elements of the price of products of an undertaking. Therefore, these services have a direct and immediate relationship with the whole of the activity of the taxable person, whereby the right to deduction of VAT results from no. 5 of Article 17 of the Sixth Directive and VAT[21] is only, in accordance with this provision, partially deductible."

To the same effect, in the context of the Kretztechnik Case[22], the CJEU clarified that:

"given that, on one hand, the issuance of shares is a transaction that is not covered by the scope of the Sixth Directive and that, on the other hand, this transaction was carried out by Kretztechnik with a view to reinforcing its capital for the benefit of its general economic activity, it must be considered that the costs of the services acquired by this undertaking in the context of the transaction in question form part of its general expenses and are, as such, constitutive elements of the price of its products. These services indeed have a direct and immediate relationship with the whole of the taxable person's economic activity."[23]

Second, the criterion referred to in Article 168, in which the EU legislator only makes the right to deduction dependent on use of goods in taxed transactions. Indeed, this norm permits deduction of VAT borne on inputs "used for the purposes of taxed transactions" of the taxable person.

According to this reasoning, there is a "direct and immediate link" when goods and services acquired or imported by the taxable person were used for the realization of "taxed" transactions downstream.

In Midland Bank, use of this reasoning did not allow the indication of the existence of a direct and immediate link between the charges (legal services) and the downstream transactions (financial services). In fact, the Bank did not use the legal services with a view to the provision of financial services but rather with a view to managing the adverse consequences of the provision of these same financial services. In this sense, the CJEU considered the following[24]:

"A taxable person, which simultaneously carries out transactions with the right to deduction and transactions without the right to deduction, can deduct VAT charged on goods or services acquired by it provided these have a direct and immediate relationship with the downstream transactions that grant the right to deduction […]. However, this taxable person cannot fully deduct VAT charged on upstream services when these have been used, not for carrying out a transaction with the right to deduction, but rather in the context of activities that are only its consequence, unless the taxable person demonstrates, through objective elements, that the expenses related to the acquisition of these services form part of the cost of the various constitutive elements of the price of the downstream transaction."

Although less explicit, this criterion also appears to have played a decisive role in the INZO Cases[25], Schloβtraβe[26] and Ghent Coal[27]. In the INZO Case, the planned economic activity was not carried out. In the Schloβtraβe and Ghent Coal Cases, the planned taxable transactions were not carried out for reasons beyond the will of the taxable person. However, in all three cases, deduction of VAT borne was permitted because the CJEU considered that the respective inputs were acquired with a view to the realization of taxable transactions. The fact that the taxable transactions were not carried out – thus making it impossible to include the costs in the price of the planned transactions – did not alter this conclusion.

Another example of CJEU application of this criterion is the Kopalnia Odkrywkowa Polski Trawertyn Case[28]. Here the CJEU established that it is not in line with the VAT Directive a national law that does not permit either the shareholders or the undertaking constituted by these shareholders to exercise the right to deduct VAT upstream on investment costs (acquisition of real property) incurred by these shareholders, prior to the creation and registration of the undertaking, for the purposes of and with a view to its economic activity.

The CJEU considered that the substantive requirements set out in Article 168, lit. a), of the VAT Directive were met for Polski Travertyn to benefit from the right to deduct VAT relating to the acquisition of the real property good, since this transaction was indeed carried out for the purposes of taxed transactions carried out by this undertaking.

This criterion can not only be used in cases where the taxable person buys or acquires goods or services before carrying out downstream taxed transactions, but also if a taxable person bears costs after having carried out downstream taxed transactions. For example, if the taxable person bore costs after having ceased its economic activity, it can still deduct VAT on the costs based on this criterion[29].

It should further be noted that the CJEU stated that, in application of the principle of VAT neutrality, a taxable person whose sole corporate purpose is to prepare the economic activity of another taxable person and which has not carried out any taxable transaction, can invoke a right to deduction in relation to taxable transactions carried out by the second taxable person[30]. This interpretation of the Directive was relative to the situation where the VAT that the first taxable person wished to deduct related to the services acquired by it for purposes of carrying out taxable transactions provided for by the second taxable person.

Third, in order to assess the existence of the said "direct and immediate link", an inquiry is made as to whether the economic activity could be concretized if the taxable person had not made the acquisitions or imports. Or, in another way, it is important to verify whether acquisitions or imports would have been made if the taxable person had not been involved in the respective economic activity.

This criterion appears to have its origin in the principles generally accepted by community law that establish the relationship between one event (the cause) and another event (the effect).

As to the determination of the direct and immediate link between costs and prices of downstream transactions, it seems, in particular, to be a relevant criterion when the taxable person bears costs after having carried out the downstream transaction. Indeed, it can be stated that if the taxable person bore the costs before carrying out the downstream transaction, the two previous criteria would be sufficient to justify the existence of this link. In Midland Bank, the CJEU used this reasoning of causal connection to establish that upstream transactions (acquisition of legal services) were triggered by downstream transactions (provision of financial services). Although the CJEU does not refer to it explicitly, it seems that the test of causal connection was the decisive criterion for considering the charges as general expenses.

Nevertheless, there are other indications in CJEU case law, in particular in the Wolfram Becker Case[31], where the criterion of causal connection may also be relevant if the taxable person incurs costs at a time prior to the execution of downstream transactions. In the Becker Case, the competent office of the German Public Prosecutor's Office instituted criminal proceedings against two managers of an undertaking whose corporate purpose consisted of carrying out construction work subject to VAT. They were accused of having benefited, prior to the conclusion of a construction contract, from confidential information regarding proposals submitted by competing undertakings and of thus being able to present the most advantageous proposal. Mr. Becker was the majority shareholder in the undertaking that had won the bid. The undertaking bore the legal expenses for defense of Mr. Becker. One of the questions put to the CJEU was whether there was a causal connection between the costs of the legal services and the undertaking's activity. According to the CJEU, such connection did not exist given that there was no legal link between the criminal proceedings and the undertaking. Therefore, the provision of legal services, whose objective was to avoid the application of criminal sanctions against natural persons, managers of an undertaking that is a taxable person, does not give this undertaking the right to deduct, as upstream tax, the VAT borne on the legal services acquired.

The CJEU case law in the Becker Case appears to be illuminating for purposes of the case under consideration in this Arbitral Tribunal. Indeed, in the context of the Becker Case, the CJEU clarified the following[32]:

"[…] it follows from the case law that, in the context of application of the criterion of direct relationship, which is incumbent on Tax Administrations and national courts, it is for these to take into account all the circumstances in which the transactions in question took place (v., in this sense, Midland Bank judgment, already referred to, no. 25) and to take into account only transactions that have an objective relationship with the taxable activity of the taxable person."

"Indeed, the obligation to take into account only the objective content of the transaction in question is the most in line with the objective pursued by the common VAT system, which aims to ensure legal security and facilitate acts inherent to the application of the said VAT (v., in this sense, judgments BLP Group, already referred to, no. 24; of 9 October 2001, Cantor Fitzgerald International, C‑108/99, Coll., p. I‑7257, no. 33; and of 29 October 2009, SKF, C‑29/08, Coll., p. I‑10413, no. 47)."

"The Court of Justice, on the other hand, stated that it is equally by taking into account its objective content that the existence of a direct and immediate relationship between the goods or services provided and a taxable transaction carried out downstream or, exceptionally, a taxable transaction carried out upstream must be established (v., in this sense, Midland Bank judgment, already referred to, no. 32, and, by analogy, as regards the elements to be taken into account to demonstrate the declared intention expressed by a taxable person to allocate a given good to a transaction subject to VAT, judgment of 14 February 1985, Rompelman, 268/83, Collection, p. 655, no. 24)."

"The interpretation according to which account must be taken of the objective content of the goods or services acquired to determine the existence of a "direct and immediate link" between a given transaction and the whole of taxable activity, in the sense of the case law referred to, is not put into question by the circumstance that the Court of Justice, in nos. 33 and 36 of its Investrand judgment, already referred to, considered, in essence, that, when the exercise of a taxable activity is not the sole cause of the realization of certain costs and expenses, these cannot be considered as having a direct and immediate relationship with this activity."

And, further on[33]:

"[…] only the objective relationship between the services provided and the taxable economic activity of the taxable person is determinative (v., in this sense, judgment of 22 December 2010, RBS Deutschland Holdings, C‑277/09, Coll., p. I‑13805, no. 54), under penalty of p[... truncated ...]