VAT and rent free period: the end of a Luxembourg nightmare?

The Luxembourg Tribunal may well have just put a grin on the face of Luxembourg real estate promoters and developers, as two of its recent decisions seem to bring an end to the non-deductibility of input VAT triggered by rent free periods in lease contracts. 

General legal framework

While the Luxembourg VAT Law provides for a VAT exemption applicable to the letting of real estate, it also features the possibility to opt for the application of VAT on a lease contract, to the extent that both the landlord and the tenant are VAT taxable persons, and that the building is chiefly used for the performance of activities granting the right to deduct input VAT.

Yet, the Law also provides that, in case the building would no longer be used for this type of activities within ten years, the landlord is then required to pay back (regularize) the VAT it originally deducted, by a tenth of the amount deducted for each year during which the building is no longer affected to the performance of activities granting the right to deduct.

Example: Company A leases its building to Company B which uses the building for the performance of legal services. Both parties opted for the application of VAT. After 6 years, Company B leaves the building, and is replaced by Company C, a bank, which does not benefit from an input VAT deduction right, and therefore cannot opt for the application of VAT. The use of the building changes, from a VATable lease to an exempt lease. Company A is then required to pay back 4/10^th of the input VAT it originally deducted.

An interpretation of the VAT Authorities…

It is based on an interpretation of these rules that the VAT Authorities oftentimes required from real estate promoters or developers that they regularize their deduction of input VAT, where the leasing contract provided for a rent free period. The VAT Authorities’ position relies on the idea that a free lease is not an economic activity and that, absent a VATable income for the owner of the building, the latter cannot deduct its input VAT.

Example: Company A leases its building to Company B which uses the building for the performance of legal services. Both parties opt for the application of VAT. The lease contract provides for a rent free period of 12 months. Company A deducted all the input VAT associated to the building. After an audit carried out on Company A, the VAT Authorities argue that, in the absence of VATable income for the first 12 months, Company A was not entitled to deduct input VAT. Company A is asked to reimburse a tenth of the input VAT it originally deducted.

That was declared invalid by the Tribunal

This position of the VAT Authorities was recently invalidated in two decisions of the Luxembourg Tribunal. In its decisions, the Tribunal notably argued that the VAT Authorities could not artificially break down a lease contract, which constitutes a global operation, into a non-economic activity on the one hand (the rent free period) and an economic activity on the other hand (the period subject to VAT). The Tribunal also referred to the case law of the Court of Justice of the European Union, which ruled in favor of the deductibility of input VAT incurred on a building, even though the asset remained empty for a significant period of time despite the landlord’s effort to find a tenant in order to enter into a VATable lease agreement.

What’s in it for you?

The decisions are likely to be appealed by the VAT Authorities. Yet, considering the amounts of input VAT associated to these types of operations, one may already want to review its current – and potentially past – VAT position in light of the recent judgments.