Spain: Capital Subsidies And The Right To Deduct Vat

The right to deduct input Value Added Tax (VAT) is a fundamental element in the operation of the tax, the general rule being that there is a right to deduct so long as the taxable person uses the acquired goods or services for activities which are in turn subject to VAT.

This rule has been set out in the Sixth Council Directive 77/388/EEC of 17 May 1997 on the harmonisation of the laws of the Member States relating to turnover taxes - Common system of value added tax: uniform basis of assessment, which establishes in Article 17 that:

"1. The right to deduct shall arise at the time when the deductible tax becomes chargeable.

Therefore, said right to deduct the amounts of input VAT is only limited in those exceptional cases in which the goods or services acquired do not come to form a part of the business assets of the taxable person.

Notwithstanding the foregoing, the Sixth Directive establishes a new limit on the right to deduct input VAT in those cases, set out in Article 17(5), in which the taxable person carries out both transactions which are subject and exempt from VAT.

For these cases it establishes the so-called pro rata rule by virtue of which only the proportion of the VAT that relates to the transactions subject to the tax carried out by the taxable person, in relation to the total volume of his operations, can be deducted.

Indeed, it is precisely in the article in which the Sixth Directive regulates, among other things, the calculation of the pro rata rule (Article 19) that the possible impact on said calculation derived from the receipt of subsidies by the taxable person is established.

Article 19 of the Sixth Directive, having determined the amounts that should appear as the numerator and the denominator in the fraction to be used to calculate the pro rata share, establishes that:

"The Member States may also include in the denominator the amount of subsidies, other than those specified in Article 11 A (1) (a)."

Regardless of the nature of the subsidies that could influence the determination of the pro rata rule, it is interesting at this time to draw a first conclusion based on the above:

The Sixth Directive only provides for a limitation on the deduction of VAT when certain subsidies are received in the two following circumstances:

1. when the subsidised goods are not related to the business activity carried out by the taxable person;
2. when the taxable person enters into transactions that give rise to the right to deduct at the same time as entering into other transactions that do not give rise to such right; the amount of the subsidies being included in the denominator of the pro rata rule.

Other than in the cases set out above, merely receiving subsidies does not prevent the full deduction of input VAT in the case of taxable persons who only carry out transactions subject to the tax.

This is the interpretation that has been adopted by the European Court of Justice (ECJ) in various judgements. Among these, the decision of 11 July 1991 (C-97/90) should be highlighted and in which the ECJ held that the exercising of the right to deduct input VAT should be guaranteed by the Member States in all cases except those which are expressly regulated in the Sixth Directive.

Notwithstanding the above, the Spanish legislator, making use of the faculty provided for in the last subsection of Article 19 set out above, introduced in Law 37/1992 on VAT (amendments foreseen by Law 66/1997 on Tax, Administrative and Social Order Measures) two new situations that limit the right to deduct VAT:

1. on the one hand, the amendment of Articles 102 and 104 of the Spanish VAT Law extends the scope of application of the pro rata rule to all circumstances in which the taxable person receives subsidies which aren’t included in the taxable base (i.e. subsidies not linked to price), including them in the pro rata share, and
2. on the other hand, a special rule is introduced (in the second paragraph of Article 104(2)(2) of the VAT Law) by virtue of which, "the capital subsidies granted to finance the purchase of certain goods and services, acquired by reason of transactions subject to and not exempt from the tax, shall only reduce the amount of the deduction from the amounts sustained or paid for said operations to the same degree in which they have contributed to their financing".

In the two preceding situations, the VAT Law appears to exceed the authorisation granted in the Sixth Directive by introducing limitations to the right to deduct input VAT by those taxable persons who acquire goods and rights that are earmarked for use solely in business activities that exclusively involve activities subject to and not exempt from the tax.

Indeed, the limit placed on the deduction of VAT arising from the receipt of subsidies constitutes a true restriction on the exercise of said right that, despite having been included in the article regulating the general pro rata share, is actually articulated as a ground of limitation and restriction on the right to deduct, which is additional to those contained in Articles 95 and 96 of the VAT Law.

The foregoing evidences the incorrect transposition of the Sixth Directive by the Spanish State inasmuch as,

1. Article 95 of the VAT Law excludes, on the one hand, the right to deduct input VAT on goods and services not earmarked, directly and exclusively, to the business or professional activity of the taxable person, said limitation basically being supported by the aforementioned Article 17(2) of the Sixth Directive, and
2. In Article 96 of the VAT Law, the limitation applies to goods and services intended by the taxable person to meet needs not falling within the ambit of his economic activity and, in this sense, Article 17(6) of the Sixth Directive establishes that, "Value added tax shall in no circumstances be deductible in expenditure which is not strictly business expenditure, such as that on luxuries, amusements or entertainment".

Therefore, in both cases the Spanish legislator has foreseen those situations in which the right to deduct the input VAT sustained is limited due to the fact the goods and services acquired are not intended to be used in the course of economic activities and, all of the above, with regard to what is expressly established in the Sixth Directive.

It is obvious that it would not be possible to include the mere receipt of certain subsidies as an additional situation to those set out in Articles 95 and 96 of the VAT Law in which the right to deduct VAT is limited, so long as the subsidised assets are earmarked for the business activity carried out by the taxable person and are not of a non-business, luxury or entertainment nature.

In addition, it should be remembered that given that the system of deductions is the central point around which VAT operates, a system aimed at achieving neutral application of the tax in relation to the economic operators that take part in the cycle of production and distribution of goods and services, said neutrality can only be achieved through the correct exercise of the deduction right.

In the interests of achieving said neutrality, the ECJ has made it crystal-clear that the right to deduct VAT, regulated in Articles 17 et seq. of the Sixth Directive, forms an inseparable part of the mechanism of the tax and that, in principle, it cannot be limited (in this regard the joint cases C-110/1998 to C-147/1998, Gabalfrissa and others, stand out).

All of the above indicates that the introduction of limitations to the established right to deduct input VAT in the ambit of activities subject to the tax, beyond the limits set out in the Sixth Directive, is a clear and unjustified infringement of the principle of the neutrality of VAT applicable to all the aforementioned economic operators.

Undeniable proof of the strength of the arguments made is the fact that the European Commission has brought infringement proceedings against Spain, currently before the ECJ, for the breach of the Sixth Directive in relation to the limitation of the right to deduct input VAT and the receipt of subsidies not directly linked to price.

Before drawing a line under the foregoing thoughts, it is appropriate to at least point out the practical issue of the principal of the supremacy of EC law and its effects on the case in question.

The so-called "direct effect" of EC law permits the direct application of the provisions of an EC directive, to the detriment of national legislation considered incompatible with it, when a Member State fails in its obligation to correctly transcribe the directive and the provision of the directive which an individual wishes to invoke is sufficiently clear and precise, expressing an obligation in unequivocal terms, and is not conditional or dependent upon any prior EC or Member State action.

In this regard, the ECJ has held that subsections (1) and (2) of Article 17 of the Sixth Directive regulate with absolute precision the requirements to be met to give rise to and establish the scope of the right to deduct, in such a way that the Member States have no margin for manoeuvre in the application of the same.

It would therefore appear clear that the right to deduct, as it is regulated and guaranteed in the Sixth Directive, constitutes a right that individuals are entitled to invoke before the Spanish courts for the purposes of opposing a national regulation that is incompatible with said provision.

On this basis, the Spanish legislator’s attempts to restrict the right to deduct input VAT, as determined in the Sixth EC Directive, on the grounds of having received certain subsidies, and the consequential prejudicial effects on said right, remain open to challenge.