Arsene Taxand - VAT & indirect taxes

The compatibility of local taxes in the light of the common VAT system

Reflections concerning the Italian regional tax (IRAP) which has been challenged before the European Court of Justice (1).
This case, which should be heard by the European Court of Justice (ECJ) in the first half of 2006, will shed light on the compatibility of a tax such as IRAP with the EU prohibition on national turnover taxes other than VAT.

As such, it will have implications far exceeding the boundaries of Italy, insofar as it raises questions on the following issues:

- the founding principles of VAT under both the First and Sixth VAT Directives;

- the role of the ECJ and any limitations it may introduce in the light of the principle of legitimate expectations and the budgetary challenges facing individual States.

I. The founding principles of the EU VAT system

The basic principle of VAT, i.e., payment by installments and upstream deduction of input VAT, was first introduced in France in 1948, well before ratification of the Treaty of Rome.

The treaty focused specifically on harmonizing indirect taxes (Article 93); after ratification, the Neumark Report, which noted that more than half of the European Community's Member States had different systems of expenditure taxation (cascade taxes, taxes collected at the final consumer stage, a special single tax levied on categories of products, etc.), considered that only a VAT-type system was likely to provide an effective solution to the challenges of economic integration of Member States.

Therefore, cumulative multi-stage taxation and the single tax levied on retail transactions were to be phased out in favor of VAT on consumption, proportional to the price of the product, regardless of the number of transactions involved in the manufacturing and distribution process.

On April 11, 1967, the First VAT Directive required Member States to replace their cumulative multi-stage taxation systems by the Community VAT system and defined this common system of VAT as “the application to goods and services of a general tax on consumption exactly proportional to the price of the goods and services, whatever the number of transactions which take place in the production and distribution process before the stage at which tax is charged”.

Article 2 of the Directive reiterated the principle of prior deduction of input VAT and the application of the common system of value added tax up to and including the retail trade stage.

The final recital of the First VAT Directive, displaying particular foresight, anticipated preparations for the single market and the need to remove tax borders between EU Member States. Based on proposals made by the Commission to the Council, it provided for harmonization of VAT with the ultimate aim of abolishing taxes on imports and the remission of taxes on exports between Member States.

The Council’s Second VAT Directive affirms the general principles of the First Directive.

The Third, Fourth and Fifth VAT Directives postponed the effective date of application of the First VAT Directive to January 1, 1973.

Finally, on May 17, 1977, the Council adopted the Sixth VAT Directive.

As such, insofar as the ultimate aim of the First VAT Directive was clearly to remove tax borders between Member States and to set up a future system to apportion VAT between Member States based on economic mechanisms, it was natural that the First Directive (like Article 33 of the Sixth VAT Directive) should seek to prevent the introduction or maintaining of any taxes similar to VAT or, if not similar, any taxes that would be likely to interfere with the creation of this Common Market.

Clearly, the removal of tax borders in 1993 and the proposals made by the Commission in 198 7 and 1996 to establish the Single Market along the lines originally intended by those who drew up the First Directive, have not been an unequivocal success: witness the maintenance in effect of the transitional VAT arrangements, confirmed by the Commission as recently as 2003.

This change in policy and the Commission’s decision to abandon a definitive system of VAT now raises the issue of the scope and continuing relevance, against this background, of Article 33 of the Sixth VAT Directive and the prohibition on cumulative multi-stage taxes.

II. The scope of Article 33 of the Sixth VAT Directive

European Court of Justice case law has dealt with the essential features of VAT on a large number of occasions, in particular within the scope of preliminary rulings regarding the application of Article 33 of the Sixth VAT Directive.

This Article stipulates that “the provisions of this directive shall not prevent a Member State from maintaining or introducing taxes on insurance contracts, taxes on betting and gambling, excise duties, stamp duties and, more generally, any taxes, duties or charges which cannot be characterised as turnover taxes”. In January 2003, the Article was made subject to “the condition that these taxes, duties or charges do not give rise to border-crossing formalities in trade between Member States”.

As Alain Philippart rightly proposed in his commentary of October 2002, Article 33 of the Sixth VAT Directive as applied since January 1, 1993, should not preclude the maintenance or introduction of taxes in addition to VAT, provided two conditions apply simultaneously:

- the tax must not be comparable to the common system of VAT;

- the tax must be levied only on sales within the national territory.

This interpretation, which may be made notably in the light of an ECJ decision concerning the compliance of an Austrian tax on non-alcoholic beverages and ice cream with the February 23, 1992 Excise Duty Directive (ECJ March 9, 2000, Case C-437/97 Evangelischer), makes it possible to define the scope of Article 33 of the Sixth VAT Directive.

- Article 33 was not originally intended to prohibit all new turnover taxes, but only taxes comparable to VAT; for this purpose, it refers back to the First VAT Directive and its definition of the essential features of VAT;

- in its new wording since 1993, Article 33 also appears to be intended to prevent the return of multi-stage taxes when these are levied on sales that take place outside the national territory;

- this does not mean that when taxes are compatible with Article 33 of the Sixth VAT Directive, they cannot be challenged in the light of the general prohibition on multi-stage taxes set out in the First VAT Directive for sales inside or outside the national territory, or in the light of the general principles of the Treaty of Rome and, in particular, Article 95 concerning the elimination of tax discrimination.

So, let us recap on the historical developments discussed above:

- the original purpose of the First VAT Directive was to define the essential features of the new common system of VAT and to abolish the old multi-stage taxes, thus enabling the creation of a new common system of VAT and ultimately, a definitive VAT system across all Member States;

- however, ten years on, the scope of Article 33 of the Sixth VAT Directive had been narrowed, and confined to preventing the creation of similar taxes likely to compete with VAT and which could disrupt the functioning of this common system;

- moreover, since 1993, the prohibition on multi-stage taxes under Article 33 is also more limited, i.e., it only applies when they are levied on sales that take place outside the national territory;

- where the definition of the essential features of VAT in the light of Article 33 refers back to the original legislation, i.e., to the First VAT Directive, this Directive could moreover be applied separately from the Sixth VAT Directive in order to prevent all multi-stage taxes whether levied inside or outside the national territory.

As such, even though the initial political objectives underpinning these directives have since changed, which means that they must be analyzed with greater perspective and less mechanically, they are still intended to be applied as the ECJ has stated on a number of different occasions.

III. The essential features of VAT

Based on paragraphs 1 and 3 of Article 2 of the First VAT Directive, ECJ case law has singled out four essential features of VAT:

- it is a general tax that applies to supplies of goods or services;

- it is proportional to the price of those goods or services, whatever the number of transactions carried out;

- it is charged at each stage of the production and distribution process; and

- finally, it is imposed on the value added of the goods and/or services in question.

In the case brought to contest the IRAP, in his groundbreaking opinion, the Advocate General, F.G. Jacobs, considered that even though the second and fourth of these essential features of VAT were not present in a manner identical to VAT, IRAP nevertheless has the essential features of VAT and should be deemed to be in breach of Article 33 of the Sixth VAT Directive (2).

If this analysis is subsequently confirmed by the ECJ, it is likely to call into question the compatibility of a tax that brought in over €120 billion in tax revenue for the Italian treasury over the period in question.

It may also have an important impact on the assessment made of a number of taxes in other Member States. For example, the planned reform of taxe professionnelle (business tax) in France, with the proposed introduction of a business tax levied on value added (Fouquet Commission) could well have been impacted by this decision (however, as this proposed reform in France was abandoned for other unrelated reasons, this has now put an end to the debate on this issue).

It was against this background that the Italian government, with the backing of the governments of other Member States, succeeded in having the case reopened in December 2005, which is in itself a remarkable feat in the history of the ECJ.

Pending a final decision, this opinion may be interpreted in three different ways:

• The simplified interpretation would be to consider that in order to make Article 33 truly effective, it is not necessary for every aspect of a tax to be identical to intra-community VAT; without however definitively abandoning two of the four essential features of VAT as the Advocate General proposes, it is clear that it is easy to bypass legislation that prohibits a tax that is identical in all its aspects to VAT, by altering certain features of the tax in question.

This first, simplified interpretation does not challenge the entire scope of Article 33 but seeks instead to interpret the essential features of VAT in a more flexible manner so that these provisions can have a more useful effect.

• We may also conceive of a second, more complex interpretation: the scope of Article 33 of the Sixth VAT Directive should be assessed in the light of all of the provisions of the First Vat Directive. The purpose of such a reappraisal would be twofold: avoiding taxes comparable to VAT and precluding multi-stage taxes on value added, with no possibility of distinguishing between the cumulative multi-stage taxes initially targeted in the First VAT Directive and those targeted in the Sixth VAT Direc tive from 1993 onwards.

Under this interpretation, which we consider to be closest to the initial 1967 and 1977 objective, in order to make it possible to establish a common and definitive system of VAT in the Member States, the question is no longer one of analyzing the essential features of a tax in the light of the Sixth VAT Directive and, after noting its legality under Article 33, going on to analyze the compatibility of the tax with regard to the prohibition on multi-stage taxation laid down in the First VAT Directive. Instead, what needs to be considered is that the provisions of the First VAT Directive on the prohibition of multi-stage taxes are now incorporated into the provisions of Article 33 of the Sixth VAT Directive.

• Finally, a third interpretation may be put forward by Advocate General Stix-Hackl, although at the present time, this has not been developed by Advocate General Jacobs: the economic analysis of a tax and its effects on businesses must also be taken into account, regardless of the practical terms and conditions of collection and deduction of the tax, in order to determine whether this tax bears any similarity to another tax. If this analysis were to be developed further, it would become apparent that it is extremely difficult to attempt to define the essential, current features of VAT on the basis of legislation dating from 1967 and 1977, insofar as the initial objectives of implementation of a harmonized, single VAT system and of apportionment of tax income were subsequently abandoned. The judge to whom the case is referred back would then have to analyze not only the modus operandi of VAT but also its objectives and effects for businesses in the country concerned.

If we start to examine the objectives of VAT, its economic effects and the amount it brings in, we can begin to appreciate the complexity of such a task. As the Conseil d’Impôts (French Tax Commission) noted in its 2001 Report on VAT, the basis of calculation for VAT is not value added but the final consumption and Gross Fixed Capital Formation (GFCF) of households, plus the intermediate consumption and GFCF of public authorities.

Thus, VAT is mainly levied on final consumption with a number of residual effects. It is not levied on the entire amount of value added (VA) as the portion of value added incorporated in the company's capital expenditure and exports is exempt from VAT. Finally, it taxes VA generated abroad and incorporated in imports (3).

This last interpretation would appear to suggest that VAT is such an “intelligent” tax that it can be adapted to different political objectives and that it is extremely difficult to accurately define its essential characteristics or in any event to limit these essential characteristics to its practical modus operandi.

Moreover, VAT evolves in accordance with political objectives and constraints: the current VAT no longer corresponds to the system originally envisaged. So should we really consider the four essential features of VAT as being set in stone?

Finally, from the outset, did the import VAT procedure, which was necessary to promote healthy price competition throughout the Community, adhere to the four essential features of VAT? This is a valid question: firstly VAT levied on imports is not transaction-based (import VAT is due on a pro forma value basis even if no sale takes place); the essential feature relating to proportionality to the price, whatever the number of transactions carried out is not intended to be applied in the case of a tax related to cross-border trade; lastly, although it does indeed apply to value added, unlike VAT in general, this corresponds to the total pre-import value added generated by the different businesses.

To sum up, regardless of the approach and reasoning that are ultimately adopted by the ECJ, we think it only reasonable to expect that the two foll owing principles should be given both a broad and clear interpretation:

- VAT must not have to compete with a tax that is similar to it in terms of that tax’s modus operandi, objectives and effects;

- cumulative multi-stage taxes, whether they are applied strictly within a national territory or not, should not exist within the European Community.

Therefore legitimate questions will persist with regard to the compatibility of a certain number of taxes based on these two different principles. Although the ECJ has already handed down decisions concerning certain taxes grounded on the first principle mentioned above, e.g., regarding the Organic tax (French social security compensation tax), the debate could be reopened on other grounds. Other taxes such as the taxe sur les salaires (tax on wages) have complicated features that may be challenged on more than one count.


IV. Concerning the useful effect of a possible decision of non-compliance

Within the scope of his opinion and the conclusion reached that IRAP is incompatible with European Law, the Advocate General considered that it may be appropriate for the Court to reopen oral proceedings to examine possible conditions for, and the means of, limiting the effects of this incompatibility over time.

The principle of limitation of the effects over time is nothing new; it was already implemented in the EKW and Wein case (C-437/97) and could be envisaged here on account of both the good faith shown by the Italian Government, which submitted draft provisions relating to IRAP to the Commission, and the risk of serious repercussions for Italian public finances.

However, unlike the aforementioned decision, one of the areas of reflection mentioned by the Advocate General concerns not the limitation of effects over time but the absence of useful effect for the taxpayer. This approach, which has merely been touched on for the present, is apparently that adopted by the German Constitutional Court: a declaration of incompatibility coupled with a future date. Taxpayers may not rely on this incompatibility to initiate legal proceedings against the state before said date, which is deliberately chosen to allow enough time for new legislation to be adopted.

While we fully appreciate the great risk of disruption for the Italian regional authorities of a decision to the effect that IRAP is incompatible, we believe that the roles of a constitutional court and those of a national or EU court should be more clearly distinguished.

The power of court judges to take into account the practical and financial consequences of their decisions and to send out a clear message aimed at encouraging changes to be made to legislation for the future, places considerable responsibility on the ECJ and provides greater room for flexibility in any analysis; nevertheless, this power must continue to be exercised within the scope of the necessary separation of powers between the judiciary, legislature and executive and, in our opinion, it must not deprive a decision that is favorable to taxpayers of all useful effect.

As such, we consider that, in the event that the ECJ were to confirm the non-compatibility of IRAP and in the light of the imperious necessity of limiting the consequences of such a decision, it would be preferable to hand down a decision with a useful effect for taxpayers who submitted claims prior to the decision; in particular, the judge could adopt the proposal made by Advocate General Tizzano in the Wien and Meilicke case (C-292/04) and consider that the decision takes effect from the date on which the order for submission to another court which originally gave rise to the case is communicated to the OJEC.

(1) Case C-475/03, Banca Popolare di Cremona v. Agenzia Entrate Ufficio Cremona; question submitted for a preliminary rul ing and opinion of the Advocate General F.G. Jacobs of March 17, 2005.
(2) He noted in this respect that the amount of IRAP borne by the final consumer could vary considerably depending on the number of transactions: he also noted that the procedure for taxing value added differed substantially from that provided for under the VAT system.
(3) Which may lead to a temptation in certain quarters to try to promote a social VAT as a bulwark against globalization and relocation.

Alain Recoules.