When Lakhani approached me regarding complexity of VAT on services and asked as to what type of typical issues and problem can arise? I agreed with pleasure to share my experience. The subject and scope of the VAT application on services is not only twisted but also requires a deep understanding of taxation principals due to its trivial nature.
I told Lakhani that some of the leading issues settled by European Court of Justice (ECJ) can be discussed as law in our country (VAT on services) is still under preparation. But I assured him that general principles on 'taxability', 'jurisdiction', 'taxable person', 'taxable event', taxable supply, Tax exemption Adjustments, etc bear a common phraseology among different jurisdictions, hence understanding of the general principles elucidated by courts of different jurisdiction will give us grounds and material for understanding the complexities of issues arising between taxpayer and tax department.
I drew his attention towards a reported case of ECJ on a VAT tax issue: (Finanzamt Uelzen v Dieter Armbrecht (European Court Reports 1995: 1-02275) The issue was settled by the European Court of Justice.
According to the available facts one Armbrecht, a hotelier, owned a building comprising a guesthouse, a restaurant and premises used as a private dwelling. In 1981, he sold the building and opted to apply VAT on the supply. However, he did not charge VAT (on the sale) with respect to the part of the building he used as a dwelling. In his tax return for the year 1981, Armbrecht claimed an exemption of tax to the extent of value related to that part of the property, which was not used for business purpose, and was to be used for private use. As a consequence of an audit, a tax officer rejected the claim of Armbrecht by treating the property as a single unit and raised the demand for VAT.
The court of the first instance accepted the plea of the taxpayer and ordered that so much of the transaction as it relates to the private use was not taxable. The tax officer challenged the validity of the said order by way of an appeal. The appellate court, not sure about the impact of EU directive on the subject, stayed the proceedings and referred the matter to ECJ under Article177 of the EEC Treaty.
The European Court of Justice ruled that when a taxable person sells property, part of which he had chosen to reserve for his private use, he does not act with respect to the sale of that part as a taxable person. The apportionment between the part allocated to the taxable person's business activities and the part retained for private use must be based on the proportions of private and business use in the year of acquisition and not on a geographical division. The taxable person must, moreover, throughout his period of ownership of the property in question, demonstrate an intention to retain part of it among his private assets.
The adjustment of the input tax deduction under Article 20(2) of the Sixth Directive (Article 187 of the VAT Directive) must be limited to the part of the property assigned to the business. The court considered the questions referred by the Bundesfinanzhof (Appellate Court). In fact, the German court had asked for the ECJ's opinion on the following issues:
-- Where an immovable property is disposed of, does the portion of the property used for business purposes constitute a separate item of supply for the purposes of Article 5(1) of the Directive?
-- Is an immovable property of which part of the rooms are used for private purposes and part for business purposes used wholly for the purposes of taxable transactions of the business under Article 17(2) of the Directive, or is it also possible for just the portion used for the purposes of the business to be assigned to the business?
-- Can the adjustment of the input-tax deduction under Article 20(2) of the Directive be limited to the portion of an immovable property used for business purposes?
Accordingly, the court considered the arguments of both the parties. The German government maintained that it had the right to legislate and charge VAT tax by treating the (sold) property as one unit. The court considered Article 2(1) of the sixth directive. The provisions of said Article provide that a taxable person has to act "as such" or in other words sale transaction must be business-oriented in order to attract levy of tax. The court also interpreted Article 17(2)(a) of the sixth directive and stated that for seeking an adjustment of tax, the goods and services are to be meant for business purposes. The court further observed that adjustments are allowable to the extent the goods or services are meant for business purposes. The court further observed that tax will be chargeable on that part of sale which was in furtherance of business. The court observed that tax adjustment under Article 20(2) of sixth directive was admissible to that portion of sold product that was assigned to business, thus the input tax adjustment is also permissible only to that extent.
The most significant paragraph of the judgement stated:
"-- There is no provision in the EC Directive which precludes a taxable person, who wishes to retain part of an item of property amongst his private assets from excluding it from the VAT system..."
This interpretation makes it possible for a taxable person to choose whether or not to integrate into his business, for the purposes of applying the directive, part of an asset, which is in use of his private use. That approach concurs with one of the basic principles of the EC Directive, namely that a taxable person must bear the burden of VAT only when it related to goods or services which he uses for private use and not for his taxable business activities. The availability of that option does not impede the application of another rule stated by the court in Case C-97/90 Lennartz v Finanzamt Muenchen III [1991] ECR I-3795, to the effect that capital goods used both for business and private purposes may nonetheless be treated as business goods the VAT on which is in principle wholly deductible.
The advocate general of ECJ had pointed out in his opinion that an apportionment between the part allocated to the taxable person's business activities and the part retained for private use must be based on the proportions of private and business use in the year of acquisition and not on a geographical division. The taxable person must, moreover, throughout his period of ownership of the property in question, demonstrate an intention to retain part of it amongst his private assets.
It is established that if the taxable person chooses to exclude part of an item or property from his business assets, that part never forms part of those assets. He cannot, therefore, be regarded as using goods forming part of his business assets for the purposes of Articles 5(6) and 6(2)(a) of the EC Directive. Consequently, that part, which is not used of providing taxable business services or deliveries, does not fall within the scope of the VAT system and must not be taken into account for the application of Article 17(2)(a) of the EC Directive.
Since, as is clear from the answer given to the second question, the right to deduct input tax under Article 17(2) of the EC Directive applies only to the part of the relevant asset assigned to the business, the adjustment of that deduction must also be limited to that part of the asset.
The court decided that:
-- Where a taxable person sells property part of which he had chosen to reserve for his private use, he does not act with respect to the sale of that part as a taxable person within the meaning of Article 2(1) of the Sixth Council Directive.
- Where a taxable person sells property part of which he had chosen at the time of acquisition not to assign to his business, only the part of the property assigned to his business is to be taken into account for the application of Article 17(2) of the said directive.
-- The adjustment of the input-tax deduction under Article 20(2) of the said directive must be limited to the part of the property assigned to the business.
So Lakhani, I said, "These are the practical examples which arise in VAT application"
Lakhani, thanked me, and admitted that the existing consultants require serious training in this area. I guided him to approach Delphi Institute of Taxation and Management, Karachi ([email protected]) in this regard, who are well-equipped with the tools to impart such training.
(The writer is a Harvard graduate and an Advocate and is currently working as an associate with Azim-ud-Din Law Associates Karachi.)
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