The Federal Tax Court has asked the European Court of Justice (ECJ) for a preliminary ruling on whether a company whose owners and employees may have rendered themselves liable to prosecution by procuring a contract duplicitously can claim for input-tax relief for their defence costs under German law.

Under German income tax law, in principle the Federal Tax Court permits the deduction of defence lawyers' costs as income-related expenses (if there is a professional link); however, the issue of input-tax relief with regard to these costs remains open. The topic has barely been discussed in legal commentary. However, the prevailing view is that input-tax relief should always be granted on defence lawyers' costs if the company of the taxpayer endorsed the offence which, in turn, served the purpose of enhancing the business.

The significance of the questions put to the ECJ should not be underestimated in practice beyond the narrow application of this case and the issues related to the area of compliance. If investigative proceedings are commenced against employees, or if a complaint is filed against them in further proceedings, many companies assume the costs of employees' legal advice, which may be covered by a directors' and officers' liability insurance policy where appropriate. Every company is obviously interested in avoiding a situation in which employees' behaviour affects the company's reputation, especially as the company itself can become the victim of sanctions,(1) and any advantages gained by the company from the alleged criminal offence can be skimmed off.(2)

The expense in such proceedings is often considerable. The matter in dispute concerned input-tax relief of approximately €26,000. In major proceedings this amount can add up quickly(3) if lengthy court proceedings, complex facts or many employees are involved. In this respect input-tax relief constitutes either a considerable saving in costs or an additional burden.


The plaintiff was the majority shareholder of GmbH and its director. After GmbH had received and executed a construction contract, the public prosecutor commenced criminal law investigative proceedings against the plaintiff. The plaintiff was accused of having received confidential information regarding competitors' offers during the tender for a construction project which it successfully used to underbid competing offers. Money is alleged to have changed hands (ie, corruption). The investigative proceedings were curtailed at a later date pursuant to Section 153a of the Criminal Procedure Code in return for the payment of a fine.

The plaintiff was represented in the investigative proceedings by lawyers. According to the fee agreement concluded when the mandate was granted, both the plaintiff and GmbH instructed the lawyers. However, the lawyers charged only GmbH for their services. The plaintiff, as the controlling entity, deducted input tax which the tax authorities rejected.

The first issue was whether companies can claim input-tax relief for defence lawyers' costs in favour of employees if they have borne the costs in this respect. Under national law the issue is decided pursuant to Section 15(1) No 1 of the VAT Act. When interpreting this statute, the Federal Tax Court must base its view on Article 17(2)(a) of Directive 77/388/EEC.(4) A taxable person is entitled to input-tax relief in circumstances where services (for which it paid value-added tax (VAT) and which were provided by another taxable person) are used for the purposes of the taxed transactions.

Despite ECJ case law already issued in this respect, the Federal Tax Court saw a need for further interpretation with regard to the phrase 'purpose of the taxed transactions'. If this phrase was interpreted correctly and input-tax relief could be considered, the Federal Tax Court asked the ECJ a second, follow-up question: does instruction by two principals prevent (full) input-tax relief?


Based on ECJ case law, the Federal Tax Court considered that there were two possible interpretations of the expression 'purposes of the taxed transactions' with regard to the first question. As a starting point, the ECJ based the criterion of designated purpose on the requirement of a direct connection between initial and final performance. However, in the case at hand, the question was how this link was to be determined.

In the Federal Tax Court's view this could be based either on the "objective circumstances (or nature) of the turnover"; however, whether the services provided originated exclusively in the taxable activities was also considered to be important.

In the first case of a reference for a preliminary ruling, input-tax relief would not be allowed because the lawyers' work served to protect the private (ie, non-commercial) interests of both guilty parties against personal prosecution measures.

In the second case, the contrary conclusion was reached because the lawyers' services could not have been engaged without GmbH's tax-liable turnover activity.

The second reference for a preliminary ruling in the present case resulted from the fact that no further agreements had been concluded with the lawyers specifying which party (the VAT-liable GmbH, its controlling entity or the non-VAT-liable private person in each case) was responsible for paying their fees or to what extent.

The Federal Tax Court considered that there are three ways in which Article 17(2)(a) of Directive 77/388/EEC can be interpreted. It could apply to:

  • the party to whom the invoice is issued for settlement;
  • each of the principals, if the invoice – and thus the input tax amount – is divided proportionally; and
  • specific principal(s), if an internal agreement exists which governs which party must bear the costs.


Until the issue has been clarified by the ECJ or the Federal Tax Court the following procedure is recommended in similar cases. In the case of pending VAT advance self-assessments or annual returns, full input-tax relief should be claimed for legal fees with the inclusion of a note stating that this refers to input tax from defence costs and that proceedings are pending before the ECJ. If this is not declared, tax authority officials could suspect the input-tax claim of being a criminal tax offence.(5)

If the tax authorities reject such a claim, an objection should be filed, making repeated reference to the pending preliminary ruling proceedings before the ECJ – if necessary, linked to a motion for suspension of enforcement. As a rule, a responsible tax authority will then suspend proceedings until a decision has been made by the ECJ or the Federal Tax Court.

As regards the second reference for a preliminary ruling in cases in which the company must bear all costs regarding employees, this must first be documented. On the other hand, care should be taken that:

  • only the company appears as principal in regard to the employees' legal counsel;
  • the statement of fees is sent only to the company; and
  • the fees are paid only by the company.

Only then, after all possible interpretations, will full input-tax relief be secured – subject to the condition that the ECJ recognises input-tax relief at all.

For further information on this topic please contact Björn Demuth or Markus Eberhard at CMS Hasche Sigle by telephone (+49 711 976 40), fax (+49 711 976 49 00) or email ([email protected] or [email protected]).


(1) Section 30 of the Administrative Offences Act.

(2) Section 73ff of the Criminal Code; Section 29a of the Administrative Offences Act.

(3) As recently in Siemens and MAN.

(4) Now Article 168(a) of Directive 2006/112/EC.

(5) Section 370 of the Tax Code.