Can transferring business activities to a new company in order to benefit from VAT exemption be considered an abuse of law?

The Court of Justice of the European Union (CJEU) addressed this issue in its ruling on 4 October 2024, in the case C-171/23 UP Caffe.

Factual background

The case before the CJEU concerned a Croatian company, UP Caffe, which operates in the hospitality sector and was subject to a tax audit. During the audit, the tax authorities established that the business conducted by UP Caffe had previously been run by another company, SS-UGO, using the same resources, such as premises, staff, and suppliers. Furthermore, before that, it had been conducted as a sole proprietorship by the founder of SS-UGO. The authorities also found that the board member and owner of SS-UGO was employed by UP Caffe, although he was not a member of its governing bodies. Additionally, he was jointly liable with UP Caffe for the rent of the premises and was the only person authorised to access UP Caffe’s bank account.

Importantly, both SS-UGO and subsequently UP Caffe had benefitted from VAT exemption due to their turnover size. Following the audit, the tax authorities concluded that the transfer of the business to the new company (i.e. from SS-UGO to UP Caffe) was artificial and constituted an abuse of law, as its sole purpose was to benefit from VAT exemption—SS-UGO had generated a turnover exceeding the limit for VAT exemption eligibility. As a result, the tax authority issued a decision determining UP Caffe’s VAT liability, while simultaneously granting it the right to deduct VAT.

UP Caffe disagreed with the decision, arguing, among other things, that the domestic regulations prohibiting abuse of law were introduced after the period covered by the audit (1 January – 31 July 2018). The national court questioned whether the tax authority, in the absence of national regulations, could rely on the general principle of EU law prohibiting abusive practices, and ultimately referred the following question to the CJEU: ” Does EU law impose an obligation on the national authorities and courts to determine liability for value added tax (and not to refuse a claim for a refund) where the objective facts of the case indicate that VAT fraud has been committed through the creation of a new company, that is to say, by interrupting the continuity of the previous company’s taxable activity, in the case where the taxable person knew, or ought to have known, that it was participating in such an activity, and where, at the time when the chargeable event occurred, national law did not provide for such a determination of liability? “

What did the CJEU rule?

The CJEU focused on interpreting the principle prohibiting abusive practices and the possibility of applying this principle in the absence of national regulations on the matter. The CJEU recalled that, according to its established case law, a finding of abusive practice in the field of VAT requires that a transaction, despite formally fulfilling the conditions set out by the relevant legal provisions, results in obtaining a tax advantage whose granting would be contrary to the purpose of those provisions. Furthermore, it must be established, based on the objective elements, that the essential purpose of the transaction is to obtain a tax advantage. The CJEU confirmed that the provisions on VAT exemption, provided for in Article 287(19) of the VAT Directive, can also be subject to abuse, and that these provisions had been implemented by the Republic of Croatia.

Although the Court did not specify which circumstances or criteria should be considered when assessing whether the transfer of business activities to another entity benefiting from VAT exemption constitutes an abuse of law, it stated that “if a company is established with the aim of maintaining the ability to benefit from the VAT exemption system provided for in Article 287(19) of the VAT Directive with regard to activities that appear to have previously been carried out by another company at a time when the latter ceased to meet the necessary conditions to benefit from that system, the granting of such a tax advantage would not serve the purposes of that system,” and it is for the referring court to examine this.

The CJEU also emphasised that, in cases of abusive practices, transactions falling within their scope should be redefined in such a way as to recreate the situation that would have existed had the abuse not occurred. The Court further noted that applying the principle prohibiting abusive practices requires determining the situation that would have existed if the transactions constituting the abuse had not taken place.

Ultimately, the CJEU ruled that ” where it is established that the formation of a company constitutes an abusive practice intended to maintain the benefit of the value added tax exemption scheme laid down in point 19 of Article 287 of that Directive 2006/112, in respect of an activity previously carried out, under that scheme, by another company, that Directive 2006/112 requires that the company accordingly formed cannot benefit from that scheme, even in the absence of specific provisions laying down the prohibition of such abusive practices in the national legal system.”

What does the ruling mean for taxpayers?

The judgment aligns with the established case law on the application of the principle prohibiting abusive practices, once again highlighting the importance of this principle in the VAT system, which includes the possibility of applying the principle even in the absence of domestic regulations prohibiting abusive practices.

In my opinion, what is missing from the judgment is a reference to what circumstances determine that the transfer of business activities (essentially an enterprise) to a new entity constitutes an abuse of law. The Court left this issue to the national court to decide, but it seems this is the most interesting aspect of the case.

The factual background of the case was rather brief, although it was indicated that there were certain links between the entities that successively conducted the same business, primarily through the individual who had started the business as a sole proprietor. However, as the factual description indicates, in the case of UP Caffe, which was the subject of the judgment, there were no formal ties with the previous company (SS-UGO), as the former owner did not hold any positions in UP Caffe and was not its shareholder, but only employed by it. This naturally raises the question of whether, if the former business owner had not been an employee of UP Caffe, the company’s use of the exemption would no longer constitute an abuse, or what changes in the business structure would be necessary for UP Caffe’s takeover of the business and use of the small taxpayer exemption to no longer be considered an abuse of law.

There are many possible questions and configurations, but unfortunately, the CJEU addressed this issue very briefly. Nonetheless, the key takeaway is that transferring business activities to other entities solely for the purpose of maintaining an exemption may constitute an abuse of law. It is worth considering this issue in all transactions involving enterprises or organised parts of an enterprise, as well as in transformation or restructuring processes, although in such ventures, the primary goal is usually business-driven rather than achieving a tax benefit.