The Court of Justice of the European Union (CJEU) has passed judgment on this Bulgarian referral (Case C‑132/16) concerning the right of a taxable person to deduct input tax in respect of services provided free of charge relating to the construction or improvement of a property owned and used by a third party. The full judgment can be read here

Iberdrola Inmobiliaria Real Estate Investments (Iberdrola) owned parcels of land on which it intended to develop a holiday village.  The village, once completed, would then be used to generate rental income.  However, in order to connect the village to the existing communal sewerage system, the local municipal waste-water infrastructure had to be extensively renovated.  In order to move forward with the project Iberdrola and the municipality concluded a contract in which Iberdrola undertook to carry out the required work at its own expense.  The renovation was then carried out by a building contractor and Iberdrola deducted input tax in respect of the costs incurred which was subsequently refused by the tax authority.

On appeal, the Administrative Court held that Iberdrola had supplied the municipality with a service free of charge but that this had served the purposes of Iberdrola’s economic activity and considered that the deduction of input tax must be allowed.  The tax authority appealed this decision and the Supreme Court referred the case to the Court of Justice of the European Union (CJEU).

On 6 April 2017, the CJEU delivered the opinion of Advocate General Kokott (AG). The AG opined that a mere causal link between inputs and economic outputs is not sufficient for the deduction of input tax and concluded that the deduction of input tax should be precluded. While this case does not involve a charity we were concerned that it may dilute Sveda ruling which allowed a broader approach to be taken in deciding whether input tax was recoverable. Indeed, the AG, in the opening of his opinion, specifically called on the court to have specific regard for Sveda and the uncertainty which that judgement has caused in some Member States.

On 14 September 2017, the CJEU released its judgment. It noted that the deduction of VAT is intended to relieve a business of the burden of VAT payable on goods or services acquired in the course of its economic activities provided those activities are themselves subject, in principle, to VAT.  In determining whether Iberdrola has the right to deduct VAT on the works undertaken on the waste water infrastructure, it is therefore necessary to determine whether there is a direct and immediate link between the renovation services and a taxable output transaction by Iberdrola or its economic activity.

Disagreeing with the Advocate General, the CJEU held that it was clear that without the renovation of the waste water infrastructure, it would have been impossible to connect the village, which Iberdrola planned to build, to the sewerage system.  The renovation was essential for completing the project and without it, Iberdrola would not have been able to carry out its economic activity.  These circumstances demonstrate a direct and immediate link between the services supplied and Iberdrola’s taxable supplies.  The fact that the municipality also benefited from the renovation does not justify the deduction of VAT being denied provided the referring court is satisfied of such a direct and immediate link.

The CJEU also noted that it is for the referring court to determine whether the renovation services went beyond that which was necessary in order to allow the connection of the village.  To the extent that it does not, it would be necessary to recognise the right to deduct VAT.  However, if the services exceeded that which is necessary, the existence of a direct and immediate link between that service and Iberdrola’s taxable activity would be partially broken and any deductible VAT would need to be apportioned.

On the face of it this is a positive decision as the tax payer won and the input tax recovery was allowable. However, the court declined the opportunity to clarify the Sveda decision, as suggested by the AG and, furthermore, the judgment does seem to open up the opportunity for further challenge regarding whether the level of services would be considered “necessary”. It will be interesting to see if and how HMRC responds to this decision.

Dermot Rafferty is a Senior Manager at EY

Readers may also be interested in this commentary on the Durham Cathedral case (which was based on the precedents set in Sveda) by Graham Elliott.