Tamás Fehér

International tax structures fail more and more often due to the lack of real economic presence. These days both foreign and Hungarian tax authorities analyse in detail whether a legal entity has real economic nexus to the country where it was established. While tax investigations in the past primarily focused on corporate income tax reassessments, a recent decision of the Court of Justice of the European Union (“ECJ”) pointed out that the lack of real economic presence may also entail significant VAT consequences.

In order to mitigate their tax liabilities international organisations regularly establish group companies in favourable tax jurisdictions and channel income to these companies. While tax havens are one of the alternatives, Dutch holding companies, Luxembourg financial centres or even Hungarian intellectual property holdings are equally popular.

In the past it was sufficient merely to establish such “letterbox” companies and to interpose them in international structure without contributing any assets to them for their proper operation. The tax authorities of the adversely affected countries started, however, to require higher and higher substance in order to recognise the real economic presence of these companies in their country of establishment. By now it became common that tax authorities perform site inspections at such companies and often ask unpleasant questions, such as: “What is the qualification of the managing director of the company?”, “Does the managing director receive compensation and if so, in what amount?”, “Does the company have a separate office and if so, what is its size?”.

If the investigation comes to the conclusion that the company does not have a real economic presence in the country of its establishment, then the desired favourable tax position could be lost. The investigating tax authorities may reclassify these companies as their local taxpayers and assess taxes accordingly.

Real economic presence is now required for VAT purposes as well

In the past most of the assessments associated with the lack of real economic presence affected corporate income tax liability, only. In the wake of the recently published judgement of the ECJ in the Welmory case, however, the lack of real economic presence will increasingly lead to VAT shortfalls as well.

In the Welmory case a Polish company provided services to a Cypriot entity. According to the general rules concerning the supply of services, the parties determined the seat of the Cypriot entity as the place of supply and charged Cypriot VAT on the transaction by the reverse charge mechanism.

The Polish tax authority investigating in the case examined whether the recipient Cypriot company had actual activity in Cyprus and whether the service provided by the Polish company was related to such Cypriot activity. Since the tax authority could not establish real presence and activity in Cyprus, it came to the conclusion that the Cypriot entity had a fixed VAT establishment in Poland (at the seat of the Polish company providing the service) and that the services provided were related to this fixed establishment. As a result, the tax authority argued that the transaction was concluded between two companies which are both subject to Polish VAT and that the service provider should have charged Polish VAT in its invoices. Therefore, VAT shortfall was established for the service in Poland.

Although the ECJ did not make a final conclusion in the case and asked the referring court to explore further the facts of the case, the judgement still opens up the door for the tax authorities from now on, to make VAT assessments based on the lack of real economic presence. On the basis of this decision tax authorities may increasingly feel encouraged to conclude that a company’s fixed establishment for VAT purposes differs from the country of its seat and may assess VAT accordingly.


It is clear that the provision of real economic presence is becoming an important factor in international tax planning. While it is easy to hire a few local employees, to open an actual office or to reserve a local phone number, they will all increase the costs of the structure.
On the other hand, the Welmory case also highlights that taxpayers who make business with foreign special purpose companies need to act in a more careful manner. Regardless of its foreign tax number, the tax authority may establish that a foreign company has a fixed establishment in the country of the service provider. This will cause tax problems for those service providers who treat the service as intra-Community supply and fail therefore to charge local VAT on it.