In O. Fundusz lnwestycyjny Zamknięty reprezentowany przez O S.A. (Case C-250/21) (the “O Fundusz case”), Advocate-General Medina (the “AG”) of the Court of Justice of the European Union (“CJEU“) opined that the supply of services provided by the sub-participant under the sub-participation agreement in question fell outside of the VAT exemption for the granting of credit under Article 135(1)(b) of Directive 2006/112/EC (the directive, “VAT Directive” and such Article, “Article 135(1)(b)”), but left open the question of whether such supply can fall within any other VAT exemption.

LMA-style sub-participation

The sub-participation agreement in this case adopts the arrangement provided under the standard form LMA documentation.

According to the sub-participation agreement in question, the sub-participant pays the grantor an upfront amount upon conclusion of that agreement. In return for that payment, the grantor, which has lent money to the principal debtor, agrees to pay the sub-participant the proceeds obtained by the grantor under the original loan agreement with the principal debtor. While the cash flow and the risk are removed from the grantor’s balance sheet and transferred to the sub-participant, the grantor maintains the legal ownership (and, whilst not dealt with by the AG, presumably the beneficial ownership) of the assets.

Not “granting of credit” but maybe something else?

The AG undertook a literal interpretation, a systematic interpretation and a teleological interpretation of the term “granting of credit” in Article 135(1)(b).

When interpreting the term literally, the AG found that there are two economic purposes in this transaction: (a) the funding by the sub-participant of the original loans provided by the grantor to the principal debtor; and (b) the transfer of credit risk from the grantor to the sub-participant. The second purpose was found based on the fact that the grantor only needs to transfer to the sub-participant the amount that the grantor has actually received from the principal debtor and that the sub-participant does not have a right to pursue the defaulted loan if the principal debtor defaults. The AG opined that these two purposes are indivisible services. By way of analogy with FRANCK (C-801/19), the AG opined that in order for the service in question to fall within the “granting of credit” exemption, the supply of “the granting of credit” must form a distinct whole that has the effect of fulfilling the specific and essential functions of such a transaction. As such, the AG opined that the assumption of credit risk by the sub-participant needs to also constitute a grant of “credit” in order for the service under the sub-participation to fall within the “granting of credit” exemption.

When the AG undertook a systematic interpretation, the AG looked at Article 135(1)(f) of the VAT Directive (“Article 135(1)(f)”), which provides for a VAT exemption for transactions in “other securities.” The CJEU has held in Granton Advertising (C-461/12) that securities confer a property right over legal persons. The AG, therefore, opined that the words “transactions in other securities” within Article 135(1)(f) refer to transactions that are liable to create, alter or extinguish parties’ rights and obligations in respect of securities.  As Article 135(1)(f) covers transactions in securities, which might include a transfer of risk, the AG opined that Article 135(1)(b) should only cover the more traditional credit operations that do not involve the transfer of risk. Therefore, the assumption of risk should not fall within “granting of credit” under Article 135(1)(b).

Importantly, when examining the intended scope of the “transactions in other securities” exemption under Article 135(1)(f), the AG further opined that the transfer of risk aspect of the sub-participation agreement may fall within this exemption. The AG reached this conclusion by comparing the sub-participation in question with synthetic securitisation. As synthetic securitisation takes place “where the transfer of risk is achieved by the use of credit derivatives or guarantees, and the exposures being securitised remain exposures of the originator institution,” the AG found that sub-participation has certain characteristics of a funded synthetic securitisation or at least appears to be similar conceptually to it. Furthermore, the AG noted that synthetic securitisation (to which it was alluded may fall within the exemption under Article 135(1)(f)) serves the same two purposes as sub-participations – providing funding and the transfer of risk.  Nevertheless, the AG left open the question as to whether the “transaction in other securities” exemption applies to the sub-participation in question as a whole.

Then the AG undertook a teleological interpretation, considering that Article 135(1)(b) has two purposes: (a) to alleviate the difficulties connected with determining the tax base; and (b) to reduce the cost of funding. The AG then pointed out that the tax base in this case can be objectively established and that the sub-participation itself may not reduce the cost of funding. One may think that the latter argument is rather puzzling because one would have thought that Article 135(1)(b) would have intended to cut the cost of funding by removing the tax leakage, so whether sub-participation itself would reduce tax cost would seem to be irrelevant.

For the reasons above, the AG opined that the services provided under the sub-participation agreement in question does not fall within the scope of the “granting of credit” exemption under Article 135(1)(b). However, at the same time, the AG also left open the possibility that the sub-participation in question can fall within the “transaction in other securities” exemption.

Is the supply effected for consideration?

The AG also spent some time discussing whether the supply under the sub-participation is effected for consideration. This is because if the supply is not effected for consideration, then the supply is not subject to VAT.

The AG opined that the consideration is the difference between the upfront amount the sub-participant has paid and the amount of the proceeds of the receivables that the grantor transfers to the sub-participant. The AG also opined that the consideration was paid for a service by which the sub-participant supplies liquidity to the grantor and provides protection against credit risk associated with exposure to the underlying loans.

The AG tried to distinguish the sub-participation in question from the arrangement in GFKL Financial Services (C-93/10) (the “GFKL case”). The CJEU in the GFKL case held that an operator who, at his own risk, purchases defaulted debts at a price below their face value does not effect a supply of services for consideration when the difference between the face value of those debts and their purchase price reflects the actual economic value of the debts at the time of their assignment.

The AG in the O Fundusz case (i.e., the present case) distinguished the present case from the conclusion in the GFKL case in three ways. First, the present case does not concern the acquisition of a debt. Second, in the present case, the participant undertakes to bear the risk of the principal debtor’s failing to pay. Third, the debts in the GFKL case were defaulted debts, while in the present case the object of the sub-participation agreement are loans that are not yet due and thus whose recovery cannot be determined at the time of the execution of the upfront payment by the sub-participant.

What’s next?

The AG’s opinion is not binding on the CJEU in this case, so whether the CJEU will adopt the AG’s opinion will be observed with interest. Also, this case only determined whether the sub-participation in question could fall within the “granting of credit” exemption under Article 135(1)(b) and left open the possibility that such sub-participation can fall within the “transaction in other securities” exemption under Article 135(1)(f). Therefore, even if the CJEU adopts the AG’s opinion, it does not necessarily mean that such sub-participation will not be VAT exempt.

Also, the sub-participation in question adopts the arrangement under the standard form LMA participation. It is worth noting, for example, that in an LSTA-style sub-participation, there is a sale of the beneficial interest in the loan by the grantor to the sub-participator.

In addition, and in a UK context, as the current UK VAT provisions were originally transposed from the VAT Directive, the judgment in this case can be persuasive, but it is no longer binding on UK courts after Brexit. Therefore, it remains to be seen whether the UK courts or HMRC will adopt a similar approach if the CJEU adopts the AG’s opinion.