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A basic principle of value added taxation is that input VAT, even though incurred by an entrepreneur on the purchase of a good or service for his enterprise (input supply), is not creditable against VAT charged by the entrepreneur and payable to the tax authorities (output VAT) if the input supply was used to perform an output supply which benefits from a VAT exemption. Output supplies which normally would have been exempt from VAT but which technically speaking are not (because they were performed outside of Germany or without payment and hence outside of the scope of the German VAT law) are treated the same way: VAT on input supplies used to perform such output supplies is not creditable. If an entrepreneur makes output supplies of both sorts, i.e. some of which qualify for the input VAT credit and some of which do not, he is required to match input VAT to the output supply to which it economically relates and is entitled to a corresponding partial credit.
Banks are perennially concerned with this feature of VAT law because their core business is largely exempt from VAT (sec. 4 no. 8 UStG). The input VAT they incur (for instance, when they purchase equipment or data processing services: input supplies) is not creditable to the extent the input supply is used to perform tax-exempt output supplies. However, an important exception exists to the general rule: some of the supplies exempted under sec. 4 no. 8 qualify for the input VAT credit provided they
- relate to goods exported to destinations outside the EU (sec. 15a par. 3 no. 1 (b) UStG) or
- are performed outside Germany (or without consideration) and their recipient (the bank's customer) is resident outside of the European Union (sec. 15a par. 3 no. 2 (b) UStG). Lending outside of the EU is a prime example.
Because of the above exemptions, and also because they perform some supplies not covered by the exemptions in sec. 4 no. 8 UStG, banks face the difficult, but economically very important job of segregating creditable input VAT from non-creditable VAT and defending their apportionment vis-a-vis the tax authorities.
Until 1992 banks were permitted to use a simplified apportionment procedure whereby they in essence analysed only their goods and services delivered (output supplies), divided these into supplies qualifying and those not qualifying for the input tax credit, and then received a credit for input VAT paid based on the ratio of revenue from qualifying output supplies to revenue from total output supplies (so-called Bankenschluessel or bank apportionment formula). This procedure was, however, abolished from 1992 on.
2. Berger System Of Input Tax Apportionment
2.1 Background And General Approach
Since 1992 banks have been faced with the formidable task of determining their creditable input VAT by analysing both input and output supplies to determine which in fact match to which based on economic criteria. To systematise this procedure, Dr. Hanno Berger, a senior tax official based in Frankfurt am Main, advanced proposals in public lectures held in the summer of 1994 which have since become known as the Berger System. It should be emphasised that, to date, this system has neither been endorsed nor repudiated by the tax authorities in an official pronouncement.
Dr. Berger proposes a two-step approach:
Step 1: Horizontal Classification Of Input VAT
The input VAT incurred by the entire enterprise is analysed and allocated to the various component parts of the business, e.g. head office, branches, consolidated subsidiaries. Input tax is attributed to a particular business unit essentially depending on whether a connection can be established with the unit's output goods and services.
For example, the approach to attribution of input VAT to the head office is as follows:
Head Office Input VAT =
Input VAT on goods and services provided to the head office plus Input VAT on goods and services provided to other dependent sub-parts of the business (or to VAT consolidated companies), but which relate to the head office's output supplies less Input VAT on goods and services provided to the head office, but which relate to the output supplies of other dependent sub-parts of the business (or of VAT consolidated companies)
The allocation to the other sub-parts of the business follows the same pattern. After the allocation is complete, there are no input or output supplies which are allocable to more than one business unit.
Step 2: Vertical Classification Of Input VAT
The VAT attributable to each component part of the business is analysed and matched with supplies which confer the input tax credit and those which do not. The point of departure is thus the input VAT attributable to each component part.
2.2 Preliminary Elimination Of Disqualified Input VAT
Input VAT attributable to a particular part of the business is reduced by input tax which is completely disqualified from the credit for reasons unrelated to VAT exemptions, e.g. because the VAT is not separately stated in an original invoice (formal requirement) or because it relates to non-entrepreneurial activities, such as non-recourse factoring.
2.3 Identification Of Input VAT Not Requiring Apportionment
The remaining input VAT is then analysed for amounts which are either fully disallowed, because associated with tax exempt output supplies, or fully creditable. An input VAT amount is fully creditable if the input good or service to which it relates was used by the bank solely to perform a taxable output supply or an output supply which would have been taxable had it been performed in Germany. Also creditable in full is the input VAT on an input supply used exclusively for tax-exempt output supplies to non-EU countries as discussed in section 1 above.
2.4 Apportionment Of Remaining Input VAT
The input VAT remaining after step 2.3 was paid on input supplies used in part to perform output supplies which qualify for the input tax credit and in part for output supplies which do not qualify. Such input tax is apportioned based on economic criteria. This need not, however, involve minute analysis of each transaction. Where appropriate formulae can be identified, these may be used. For instance, if an identified amount of input VAT relates to a block of output building rental activities, the VAT regulations indicate an apportionment based on the usable square footage rented subject to VAT to total rented square footage, provided the spaces involved are all roughly comparable (height, outfitting, etc.). Internal cost accounting records may be used in making the allocation. While apportionment based on sales (output supplies) is in general not allowed, it is still permitted as a method of last resort (ratio of output supplies qualifying for the credit to total output supplies - UStR 208 par. 3 sent. 4).
3. Critique Of Berger System
Credit transactions with customers resident outside of the European Union are generally handled by a bank's head office. Under the Berger System, they are therefore allocated to the head office. Because of the exception discussed above, these output transactions qualify for the input tax credit. However, the head office of a bank as a rule incurs relatively little input tax because the bulk of purchasing is done by the more numerous local branch offices. However, the output transactions handled by the local branches are of a sort almost completely disqualified from the input tax credit. A classification of input tax based on a business unit approach thus results in a considerably reduced amount of creditable input tax compared with the old sales-based approach.
This is illustrated by the following examples:
3.1 Input VAT Apportionment Under Old Revenue-Based Method (Bank Apportionment Formula = Bankenschluessel)
The VAT regulations prescribe apportionment under this method based on the relationship of revenue from output supplies which confer a VAT credit to those which do not (cf. sec. 1 above). However, apportionment based on revenue, particularly that generated outside of the European Union by foreign branch banks, would frequently subject banks to unreasonable cost. In practice, VAT apportionment is therefore often based on credit volume, i.e . the ratio of loan volume conferring a VAT credit to the total principal amount of loans extended. In our opinion, the results yielded by this alternative method are not at variance with those of the official bank apportionment formula. This conclusion is supported by the fact that interest and other revenue earned on loans is presently comparable whether the loan is made inside or outside the European Union.
The following example is thus constructed using loan volume, as this is a common practice.
DM (000) Loans made to borrowers located in - Germany and EU 900,000 (90 %) - Outside EU 100,000 (10 %) Total input VAT 10,000
If creditable input VAT is determined based on loans from qualifying output transactions to total loans, the input tax credit is 10 % of DM 10 million or DM 1 million.
3.2 Input VAT Apportionment Under Berger System
DM (000) Apportionment of total input tax among - Branches: 9500 - Head office: 500
Assuming that, of the DM 500,000 input tax attributable to the head office, half is related to loans to non-EU borrowers and is creditable, the creditable amount would be DM 250,000, one fourth of the amount creditable under the old system.
The Berger System differs from the old bank apportionment method in various ways, in particular by requiring precise allocation of input tax to the various component parts of the business as an initial step. It is precisely this allocation which reduces the VAT credit available to banks, for the following reasons.
Since purchasing by the head office is generally low compared with that of the business as a whole, the head office necessarily incurs less input tax. On the other hand, transactions with non-EU clients, which as a rule confer an input tax credit, are concentrated in the head office. The result under the Berger System is that the head office has a high percentage of output supplies conferring a VAT credit, but only a comparatively small amount of input VAT to which this high percentage can be applied. The resulting input tax credit to the head office is accordingly relatively low.
This is also the decisive reason for the critical attitude of most banks with regard to the system proposed by the tax administration, especially when one considers that transactions with non-EU clients account for a considerable part of overall turnover.
Another drawback of the Berger System is that it takes too little account of customer relations. In practice, customer relationships are not confined to a particular business area and cannot be attributed to any single such area. This poses considerable difficulties when it comes to putting the Berger System into practice. Banks therefore consider this system too detailed because it is not possible as a technical matter to assemble the data needed to implement it.
The practical consequence is that banks have so far scarcely used the Berger System. Instead, they continue to apportion input VAT using the old methods. In the final analysis, this represents a challenge for the tax consulting profession to devise a method of determining creditable input VAT which is acceptable to the banks and the tax authorities alike.
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