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Finance leases – New guidelines for classification for VAT purposes

Deciding whether, for VAT purposes, a finance lease agreement should be assessed as being a supply (purchase) or other services (rent) would, at present, be determined by the applicable income tax criteria for beneficial ownership (so-called leasing enactments). A substantial revision to the VAT treatment of finance lease agreements is currently expected. In a draft circular from 3.12.2019, the Federal Ministry of Finance (Bundesministerium der Finanzen, BMF) set out plans to incorporate new ECJ case-law into the ordinance on the application of VAT (Umsatzsteueranwendungserlass, UStAE) and, thus, to move away from income tax criteria. The question of how existing agreements should be treated is just as important here as how to deal with divergences that might possibly occur in the future between income tax and VAT.

Finance leases under the current version of the UStAE

At present, the classification of a leased item for income tax purposes also determines the VAT treatment of the lease agreement.

  • If the leased item is attributable to the lessee then this constitutes a supply with the consequence that VAT is incurred immediately (cf. Section 3(5) clause 2 UStAE).
  • Attribution to the lessor results in a classification of ‘other services’ for which the respective VAT has to be paid in instalments.

The relevant criteria for the attribution of the item are, among other things, the ratio of the non-cancellable basic lease term to the average operating life as well as the ratio of the purchase price to book value at the date of expiry of the lease term. According to Section 3.5(6) clause 1 UStAE, lease agreements, as defined in Section 535 of the Civil Code (Bürgerliches Gesetzbuch, BGB), with a purchase option will only be deemed to be a supply on the date when there is mutual manifestation of intent to accept the option. The lessor calculates a purchase price subject to VAT as at the date of supply. The lease payments made by the lessee up to that date generally remain classified under ‘other services’. If the lease payments made previously are credited against the lessee’s purchase price then there can be a retroactive change to the assessment base for VAT.

Definition of supplies according to the ECJ

With respect to the question of whether the classification is that of a supply or other service, the ECJ, in its judgement from 4.10.2017 (C-164/16, Mercedes Benz Financial Services) was of the view that there should be a clear decision on this already when the agreement is concluded. Accordingly, a supply can be deemed to have occurred if the lease agreement provides for a transfer of the ownership of the leased item to the lessee.

In this case, a purchase option can be sufficient. Furthermore, when the agreement is signed, the respective clause in the agreement has to provide for the ownership of the leased item to be transferred automatically to the lessee in the case of a scheduled expiry of the agreement. This should be assumed if a purchase option exists and if the exercise of this option is the only economically rational choice the lessee could make.

Please note: This could then be the case, for example, if under the agreement, when the possibility of exercising the option arises, the aggregate of the contractual instalments corresponds to the market value of the goods, including the cost of financing, and that the lessee is not required, as a result of exercising the option, to pay a substantial sum. The term ‘substantial sum’ potentially still needs to be specified.

Planned transposition of the ECJ judgement into the UStAE

In its above-mentioned draft circular, the BMF disclosed that, to some extent, the ECJ ruling clashes with the current assessment of leasing agreements for VAT purposes under Section 3.5 (5) and (6) UStAE. That is why Section 3(5) UStAE will be revised once the ECJ ruling has been included. Moreover, it is envisaged that the scope of application will be extended to rental agreements. In the event of a cross-border provision for use, in cases of doubt, the aim would be to attribute the leased item in accordance with the law of the other member state.

Please note: The principles set out in the new circular, according to the draft version, will be applied to all cases that are still open. However, there will be no objection to transactions executed prior to the publication date of the BMF circular if all the parties involved are in agreement that the old version of the UStAE should be applied.

Criticism of the BMF draft

Comments on the BMF circular from 3.12.2019 have meanwhile been published. For example, the Institute of Public Auditors in Germany has pointed out that the wording of the non-objection rule does not cover transactions that were treated as services up to the publication of the draft. If, according to the latest opinion, an agreement should be regarded as a supply then, potentially, the advance VAT returns would have to be amended retroactively.

The German Association of Tax Advisers is of the opinion that difficulties will arise in the accounting process and with the proper issuing of invoices. If, from an income tax point of view, a lease agreement should be assumed to be a purchase then this would enable the lessee to depreciate the leased asset and deduct (only) the interest expense as operating costs. If, under the new rules, the same agreement should be assumed to be a service from a VAT point of view because, for example, no purchase option has been agreed, then the lessee has to deduct the input tax on a monthly basis.

Outlook: It remains to be seen how the changes to the UStAE will ultimately be worded in detail. By contrast, following the ECJ judgement, the change is no longer at issue. We will update you once the final decision has been made at the BMF.

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