Tax risks for transfer companies - are you prepared?

Companies often need to cut costs, which can be achieved through staff reductions, for example. Transfer companies have established themselves as an indispensable instrument from a labour law perspective. This means that very long notice periods do not have to be observed, and the legal risks associated with disputes over dismissal are avoided by the amicable termination of employment relationships. Ultimately, there is also no social selection requirement, and operational needs can therefore be better taken into account.

Employers are often only marginally concerned with tax issues in this context. In a recent ruling by the Baden-Württemberg tax court (the "Court") dated 16 March 2023 (1 K 2865/21), Value added tax (“VAT”, Umsatzsteuer) issues have now been raised that need to be kept in mind. It concerns the VAT treatment of so-called retention costs that are paid to the transfer company by the previous employer. 

In this article, we explain the conclusion reached by the Court in its judgement and the practical consequences this may have.

What did the Court have to decide on?

The lawsuit was brought by a transfer company. It received the following payments from the former employer into a trust account:

• Administrative costs or overheads (for the realisation of personnel administration and payroll accounting),
• Qualification costs (for profiling and job application training),
• Retention costs (payments to top up the transfer short-time allowance and payment of the entire wage and salary costs after 12 months) and 
• Severance payments for employees leaving the transfer company.

What legal assessment did the Court come to?

The transfer company also received the transfer short-time allowance from the Federal Employment Agency (Agentur für Arbeit).

The transfer company paid out the amounts received to the transferred employees and relevant bodies, insofar as it was not entitled to them. This related in particular to the transfer short-time allowance and the top-up amounts as well as severance payments. The transfer company issued invoices to the former employers for the amounts received, in which it itemised the administrative and qualification costs separately and charged 19% VAT on these. It did not charge VAT on the recharged retention costs or severance payments.

The VAT treatment of the was therefore not in dispute between the parties. 

Following an external audit, the tax office came to the conclusion that not only the administrative and qualification costs, but also the retention costs and severance payments were subject to VAT. The tax office considered the payments received from the former employer for the retention costs and severance payments to be gross amounts, from which it deducted the VAT (see Sec. 10 para 1 sent. 2 Value added tax Act (“UStG”, Umsatzsteuergesetz)).

The VAT calculated in this way was therefore subsequently claimed. The transfer company contested this with its action before the Court.

The Court ruled that the costs of remanence received by the transfer company were to be treated as remuneration subject to VAT for a service subject to VAT.

The service provided by the transfer company would consist of taking over the employment relationships, which would release the former employer from its previous obligations (e.g. payment of wages, granting of holidays, continuation of a company pension scheme). The transfer of the retention costs is also not a transitory item for the transfer company. Such an item presupposes that there is a direct legal relationship between two parties and that the employer is only interposed as a paying agent. Contractually, however, there was a direct contractual relationship between the transfer company and the former employers, which resulted in the costs being categorised as remuneration.

The situation is different for severance costs that employees receive as compensation for the loss of their job. The Court ruled that these payments were not remuneration for a service subject to VAT. The severance payments are made from the original employment relationship, which is why the transfer company merely acts as a paying agent.

Significance of the judgement for practice

I. Basic question: How do you categorise the cost blocks for VAT purposes?

In particular, it is questionable whether qualification and remanence costs actually constitute remuneration for a service subject to sales tax. In addition to some voices in the literature, the Bavarian tax authorities have apparently also (previously) argued that remanence costs are not taxable.

Do you still have to follow the legal assessment of the Court in your own tax returns? - The answer is no.

Taxable persons are free to continue to treat these costs in invoices as non-taxable remuneration. To the best of our knowledge, there is currently neither a federal or state decree published in the Federal Tax Gazette Part I nor a decision of the Federal Fiscal Court published in the Federal Tax Gazette Part II on the treatment of costs for former employers when using transfer companies. However, the view "deviating" from the Federal Fiscal Court judgement should be explained to the tax office when submitting the relevant VAT return or declaration. On the other hand, there should in principle be no obligation to notify or correct declarations that have already been submitted in accordance with Sec. 153 General Tax Code (“AO”, Abgabenordnung)); however, this should be agreed with a tax advisor.

II. Contractual arrangements must be reviewed

When drafting the contracts, a precise distinction should be made between the different cost items and their tax treatment. In our practical experience, this is the only way to ensure correct implementation.

III. Final cost burden due to VAT possible for existing employers

If the judgement of the Court is followed, the VAT to be invoiced by the transfer company may lead to a final cost burden for some former employers who are not (fully) entitled to deduct input tax. 

This particularly affects existing employers who provide (partially) VAT-exempt services, meaning that they are either not entitled to deduct input tax at all or only have a low input tax key (Sec. 15 para. 4UStG). These include banks, financial service providers, insurance companies, property companies, hospital companies and operators of retirement homes.

In such cases in particular, it may make sense to deviate from the legal opinion of the Court at this stage. When drafting the contract, care should be taken to ensure that provisions are made for the event that the judgement of the Court is confirmed or if the tax authorities take up the case. This would have to be examined on a case-by-case basis.

IV. Subsequent apportionment of VAT to the former employer

If qualification and remanence costs were previously treated as remuneration not subject to VAT and the VAT treatment is addressed in the tax audit of the transfer company, this also has an impact on the former employer.

The transfer company will then regularly demand the "missing" VAT from the former employer. Whether such an additional claim is possible under civil law depends on whether a gross or net price agreement was made in the relevant contract. 

V. Keeping an eye on liquidity

In their financial planning, former employers should not lose sight of the fact that the subsequent payment of VAT to the transfer company on the basis of a net price agreement can lead to considerable liquidity disadvantages at times, depending on the scope of the payments despite an input tax deduction. 

This is due to the fact that VAT refunds are only paid out after approval by the tax authorities (Sec. 168 sent. 2 AO), which often takes at least 3 to 4 weeks to process.

What to do now?

The article has shown that the VAT issues explained must be kept in mind. This concerns the areas of contract design, communication with the tax office, but also any subsequent reversal. The involvement of a tax advisor should be essential here.

Note: The legal clarification has not yet been finalised. An appeal has been lodged against the judgement of the Court, meaning that the final decision now lies with the Federal Fiscal Court, which is conducting the pending proceedings under case no. V R 10/23. As soon as there are any new developments, we will publish an update for you.

***

The above information is for information purposes only and does not replace legal or tax advice.

Our research assistant Freeke Tasman contributed to the preparation of this article.