Germany: Factoring: Finance Ministry Decree Orders General Application of ECJ Case

On June 23, 2003, the ECJ held in the MKG-Kraftfahrzeug-Factoring-GmbH case that factoring was a business activity subject to VAT. This ruling contradicts a specific provision of the German VAT Act making factoring tax-free and therefore excluding the factor from the right to recover input tax. However, the German provision is based on a mistranslation of the Sixth Directive and is therefore invalid - so the ECJ. The Supreme Tax Court followed this judgement in its own ruling on the case in October 2003. The ministry of finance has now followed up with a decree accepting the ruling in principle, but filling out more of the details, especially on the distinction between factoring on the one hand and the assumption of bad debt risks or granting credit on the other. These latter two activities are not factoring and so remain free of VAT.

The decree sees debt collection as the central feature of factoring of short-term debts. There is no distinction between factoring with and without recourse, and any credit or risk-bearing element is seen as secondary to the main function and therefore as irrelevant for VAT. The VAT at 16% is calculated on the factoring margin, that is on the difference between the amount paid by the factor for the debt and the amount collectible by him from the debtor. This margin is deemed to include the VAT, so the actual calculation is 16x/116, where x is the margin. The margin can be averaged if the factor buys a complete book of debts. Any additional factoring fee is also subject to VAT. The VAT is deductible by the original owner of the debt as input tax, unless his deduction is curtailed by his own business activity.

The amount earned by the factor as interest for granting credit is to be separated from the rest of the factoring margin if it is material. This amount is free of VAT. It is deemed to be material if the original debtor is to repay the debt in instalments, or if the debt has a remaining term of a year or more. The two parties may, however, agree to waive the VAT exemption, if the seller of the debt is a business. Debts sold on the condition that the original owner remains responsible for collection (e.g. where the legal title passes as security for a loan) are not regarded as factoring and so have no VAT consequences under this decree. The accounting treatment is irrelevant.

The assumption of the bad debt risk on a troubled debt is a VAT-free part of the transaction if the del credere fee is shown separately in the transaction documents. A trade debt is "troubled" if it is six months overdue when factored, and a loan is "troubled" where the creditor has an immediate right of foreclosure, or where a foreclosure attempt has failed. A debt may be "troubled" for other reasons, but these must be demonstrated by the factor.

The decree applies to debts sold from July 1, 2004 onwards. However, earlier application is permitted.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.