The Dutch lowest court ruled that a private equity investment fund is not entitled to the recovery of VAT on transaction costs. In this alert we elaborate in more detail on the situation at hand and the main take aways.
The Dutch district court (“court”) ruled in a case on the VAT entrepreneurship status of a private equity investment fund (“the investment fund”). The investment fund was set-up as a limited partnership (a Dutch CV) consisting of one managing partner and two limited partners. The sole director and shareholder of the Managing Partner is the Asset Manager of the investment fund. The duties and responsibilities are transferred by the Managing Partner to the Asset Manager. As such, the Asset Manager is appointed as the manager of the investment fund with full power and authority to provide the services. The investment fund does not employ any personnel. Employees of the Asset Manager are responsible for identifying suitable investments. To assess whether an identified investment opportunity is commercially viable and feasible, third-party expertise is obtained (“preparatory work”). The investment fund, acquires majority interest in the companies through BidCo’s in companies deemed suitable by the Asset Manager. A BidCo is established by the investment fund at the moment that a high level of certainty exists that the intended purchase will proceed. In practice, this means that the establishment of the BidCo takes place shortly before the actual acquisition of the portfolio company. By the time the BidCo is established, the preparatory work has already been completed, and the transaction documentation has been delivered and positively assessed by the Asset Manager.
The investment fund entered into a structuring and support agreement with the BidCo. It follows from this agreement that the investment fund has conducted preparatory work in connection with the acquisition of the portfolio company by the BidCo and that it has provided and will provide the advice and documents related to such work (“transaction documentation”) to the BidCo. For this, the BidCo is required to reimburse the investment fund an amount equal to the costs incurred for the preparatory work. The investment fund further provides supervisory board members to the BidCo’s. The investment fund is entitled to an annual fixed fee in this respect.
The Dutch tax authorities is of the view that the investment fund does not qualify as a VAT entrepreneur and therefore the VAT incurred on transaction costs is not deductible.
The first discussion item is whether the investment fund qualifies as a VAT entrepreneur on the basis that it (i) provides transaction documentation against consideration and/or (ii) it provide board members against consideration. If so, the second discussion item is whether the Asset Manager or the investment fund qualifies as the recipient of the preparatory work.
The court starts with the view of the Dutch tax authorities that the investment fund does not qualify as the recipient of the services. In this respect the court indicates, in line with ECJ case law, that taxable persons are generally free to choose the organizational structures and transaction terms that they deem suitable for conducting their business. When these arrangements are pure artificial and there is no connection with the economic reality and the sole purpose is to obtain a tax advantage, then there might be a abuse of law. In this specific case, the court rules that there are multiple elements that supports the position that the investment fund qualify as the recipient (e.g. agreements signed by managing partner, invoices issued to investment fund etc.) and there is no reason to believe that the contractual provisions do not correspond with the economic reality. Therefore the court is of the view that the investment fund qualifies as the recipient.
The court starts with referring to two Dutch supreme court cases that stipulate (i) that it is required that a service is carried out against consideration and (ii) to be entitled to VAT recovery there should be a link between the costs made and the activities performed.
On the basis of the above conditions, the court rules that the preparatory work was already consumed at the level of the investment fund, and as such there is no direct link between the costs and activities by the investment fund. In this respect the court also takes into account that even when providing the transaction documentation against consideration qualifies as an economic activity it cannot be placed on the same-footing as the preparatory work obtained by the investment fund. Therefore there is, according to the court, an insufficient link between the activity of the investment fund and on-charging the large amount of transaction costs to qualify as a service against consideration.
Supervisory Board members
With respect to the supervisory board members provided against a fixed annual fee, the court refers to case law (more recent then the year in dispute) that providing a supervisory board member does not qualify as an economic activity. Therefore, it cannot be concluded that the investment fund provides services against remuneration to the BidCo’s.
On the basis of the above, the court rules that the investment fund does not qualify as a VAT entrepreneur.
In practice a discussion could occur whether an investment vehicle that outsources all of its day to day activities to a third-party can qualify as recipient of the services. The court confirms that in such case still the contractual arrangements are leading to determine who the recipient is. This provides in our view support in discussion with the Dutch tax authorities on whether an entity has sufficient substance to qualify as recipient when all activities are outsourced.
The court takes into account the level of the fees to determine whether there is a direct link between the fees and a potential service provided. The Netherlands have not implemented the condition that related parties should apply an open market value. Therefore, the level of the fees should in our view not be decisive to determine whether a service against consideration has been rendered. We however note a tendency that this aspect is taken into account by courts and tax authorities. Therefore further substantiating the substance of the management activities and relating fees, including supporting the fees by a TP-study, is recommended. The latter should also benefit the corporate income tax (‘CIT’) position of the relevant entities, as we are also increasingly see discussions on the substantiation of such fees from a CIT perspective.
The court ruling shows that it is important to consider the VAT entrepreneurship status and VAT recovery of transaction costs in an early stage of setting up an investment structure. In our view a couple of aspects could be considered when setting-up an investment fund such as (i) clear description of the added value of the investment fund in the supply chain and (ii) supporting TP documentation for the level of fees. Another aspect would be to already incorporate Bidco’s to anticipate on future transactions instead of incorporation just before closing.
For the private equity sector it is important to closely monitor the developments in this case at the Court of appeal and potentially Dutch supreme court. In the meantime, investment companies should anticipate on the potential outcome of the court proceeding. As such, it is important to always take into account the VAT aspects of a transaction and whether this is supported by among others the contractual arrangements. If you would like to exchange views, please feel free to get in touch with Tim Jansen (firstname.lastname@example.org) of A&M the Netherlands or your usual A&M contact.