The fine line between taxable and VAT-exempt financing services: assessment of the impact in Luxembourg

Over the last twenty years, Luxembourg has been an attractive hub for structured financing and securitization, developing a flexible regulatory and tax environment for operators of the financing sector.¹

In Luxembourg, the local VAT Law provides for the VAT exemption of:

• the granting and the negotiation of credit, the management of credit by the one having granted credit²
• all transactions — including negotiation — concerning receivables, however “debt collection” is expressly excluded from the scope of this VAT exemption³

The constant need to obtain immediate cash flow and a prohibitive increase of the interest rates especially during these last four years, have made businesses progressively discard stringent bank debts in favor of — more affordable — intra-group private debts and structured financing options such as, inter alia, asset-backed securities, collateralized debt obligations, merchant cash advances, sub-participation agreements, factoring, etc.

Non-recourse factoring is subject to VAT

Factoring is not the primary component of securitization but is closely linked to it. Factoring is defined as a financial transaction where a business will assign its accounts receivable (e.g., loans, invoices) to a third party (called a factor) at a discount. This arrangement allows the business to receive immediate cash flow instead of waiting for the payment terms of the loans/invoices to be fulfilled. Factoring can be structured as either recourse or non-recourse, depending on whether the factor assumes the risk of non-payment by the debtor.

In some cases, businesses simply intend to focus on their own activities, to relieve from the administrative tasks and to outsource the collection of their receivables (customers’ debts) to a specialized agent. Such debt collection services are obviously provided for a fee and, there is undoubtedly a supply of services subject to VAT.   

Another option for businesses consists of selling their customers’ debts to a “factor”, the risk of non-payment by the debtor — loss — is transferred to the factor and the latter has no recourse against the selling business. 

In this particular case, before 2003, the practice in all the EU Member States — with the exception of the Netherlands — was to apply the VAT exemption or simply to consider factoring as falling outside the scope of VAT. 

In 2003, the Court of Justice of the European Union (CJEU) gave a ruling (in “MKG” case-law⁴) according to which VAT should in principle apply to non-recourse factoring: 

• By purchasing receivables, the factor renders a service which consists in relieving the seller of the debt-recovery operations and the risk of the debts not being paid.
• The term “debt collection” must be interpreted as encompassing all forms of factoring. Services provided by a non-recourse factor should be subject to VAT.
• In return for the services thus received, the remuneration corresponds to the difference between the face value of the debts and the amount paid by the factor to the seller for the debts.   

This decision of the CJEU has clearly been subject to numerous comments and controversy.⁵

A few years later, during the 2008 financial crisis, businesses had to navigate the liquidity challenges posed by the economic downturn. It was not uncommon for groups to assign “toxic assets” (e.g., securities and obligations) into special purpose vehicles: we are talking about factoring.

Since the market value of those assets had drastically plummeted, the difference between their face value and their “purchase price” turned out to be quite material. Not to mention that this material difference constitutes a “taxable basis” subject to VAT as per the ruling of the CJEU. 

It is worth mentioning that “MKG” case-law is referred into the (non-binding) administrative footnotes under the relevant provision of the Luxembourg VAT Law.⁶ Despite the huge amounts of VAT at stake, and the potential irrecoverable input VAT for the clients of factors, the Luxembourg VAT Authorities (Administration de l’Enregistrement, des Domaines et de la TVA) did not take a global position, nor did they issue additional written guidelines on this particular question which, all of sudden, became quite relevant for operators of the financing and securitization sectors. 

Purchase of defaulted debts at economic value is not subject to VAT

In 2011, the CJEU had another occasion to rule on the purchases of mortgages on immovable property and debts relating to seventy (70) loan agreements that had been terminated and declared mature. The risk of loss was also transferred to the purchaser in this case. The CJEU specified that the purchaser of defaulted debts does not provide a service on the condition that the difference between the face value of the debts and their purchase price reflects the actual economic value of the debts at the time of their assignment. Such transaction should fall outside the scope of VAT.⁷

This decision provided a very welcome clarification in Luxembourg, in reason of a growing number of transactions on “non-performing” and “unsecured” loans on the local market. However, this decision appears to be confined to circumstances where the purchaser pays only the economic value and takes full risk on the collection. If other services can be identified, another VAT outcome should be considered. Unfortunately, no real criteria were given by the CJEU to assess the “economic value” of a portfolio of defaulted debts. 

Making funds available by using a promissory note is not subject to VAT

In 2020, the CJEU⁸ dealt with a “reverse factoring” situation and the simultaneous conclusion of three types of contracts:

1. A “financial loan agreement”, where the lender issued a bill of exchange to the borrower, who promised to deliver the amount indicated in this promissory note, in cash.
2. A “contract for the assignment of trade receivables”, whose signatories were the lender, the borrower, and a factoring company. The borrower transferred the aforementioned bill of exchange to the factoring company, who, through an operation described as "reverse factoring", paid between 95% and 100% of the amount thereof to the borrower. The latter transferred said amount to the lender’s account, while acting as guarantor of its collection on the due date of the bill of exchange.
3. A “commercial cooperation agreement”, the lender undertook to reimburse to the borrower the interest and expenses invoiced by the factoring company and to pay to the borrower a remuneration amounting to 1% of the amount mentioned in the bill of exchange. 

The issue was whether the proportional commission received by the borrower — in the third agreement — was subject to VAT as consideration for a debt collection service or was VAT-exempt as consideration for the granting of credit or a transaction concerning a financial instrument.    

The CJEU stated that the main purpose of the transaction was to satisfy the borrower's capital needs (i.e., the latter wanted to circumvent a banking ban). The borrower had performed the specific and essential functions for a transaction relating to the bill of exchange. Accordingly, the remuneration received should fall within the scope of the VAT exemption for granting credit and for transactions concerning negotiable instruments.

Invoice factoring and trade factoring, both subject to VAT?

The most recent case in relation to factoring has been submitted this year to the CJEU. It concerns a Finnish company which provides financial services, including factoring. The factoring agreements concluded take either the form of financing guaranteed by invoices (invoice factoring: granting of credit with underlying debts assigned as collateral) or the sale of debts (trade factoring: transfer of the risk of default to the acquirer). In both cases, the Finnish company charges fees and commissions as a consideration for its services provided:

• Factoring commission = percentage of each invoiced debt covered by the agreement, depending on payment term and credit rating

• Arrangement fee = flat rate charge associated with setting-up and activating the factoring process (e.g. AML compliance)

The main question referred to the CJEU is whether these arrangements constitute a VAT-exempt granting of credit. The Advocate General (AG) recently shared his conclusions⁹ on this case and he took, unfortunately, a very extensive approach on the concept of “debt collection”. 

Both the factoring commission and the arrangement fee charged by a factor in connection with a factoring activity taking the form of a sale of debts or the form of financing guaranteed by invoices constitute the consideration for a single and indivisible supply relating to “debt collection”, which is subject to VAT.

The AG establishes a full distinction between classic lending arrangements — VAT-exempt — and factoring arrangements — subject to VAT. Such interpretation might not contemplate the economic aim of a factoring transaction: to sell debts to obtain cash on an immediate basis.             

Further, the AG considers that VAT should apply not only to non-recourse factoring but also to recourse factoring — without transfer of the risk of default. Such interpretation seems to go beyond the CJEU Judges’ orders in the initial case-law (MKG) concerning factoring.  

Although the European Judges tend to follow the conclusions of the Advocate General usually, it is difficult to ascertain anything until the CJEU gives a final ruling on this case. A decision confirming the AG’s opinion would of course be detrimental to the financing sector in Luxembourg.

Impact of a “detrimental” decision in Luxembourg 

As mentioned, a proportion of structured financing transactions are carried out via securitization vehicles in Luxembourg. Several securitization vehicles outsource the management of their investment portfolio to external credit servicers. A typical servicing agreement can include several functions such asset management services, debtors’ data maintenance, financial reporting, loan administration, management of the debtor account and … collection of debts.      

In principle, the VAT exemption applies to management services (including portfolio management) rendered to securitization vehicles and assimilated vehicles.¹⁰ Uncertainty might arise on the servicer agreements which include debt collection as primary function, even if the debt collection does not take a considerable effort in the economic reality.

Obviously, all this calls for more clarity and maybe a modernization of the definition of VAT-exempt financial services. There is a need to establish a framework that ensures legal certainty regarding the VAT treatment of financial services.