In VAT law, the distinction between the supply of goods and the supply of services may at first seem like a technical detail. In practice, however, incorrect classification can have significant tax implications, both for contractors and for clients. A case currently pending before the Federal Fiscal Court concerning the manufacture of beverages demonstrates how contentious this issue is, even in seemingly straightforward circumstances.
Two types of service with different rules
In principle, the Value Added Tax Act recognises only two types of taxable transactions: supplies and other services. The supply of goods and the provision of services are special forms, both of which arise when a third party’s item is worked on or processed, thereby combining elements of both a supply and a service.
The key question is which of these two types of supply ultimately applies. This determines the place of supply, the tax liability and, in some circumstances, the application of tax exemptions or special rules such as the reverse-charge mechanism, under which the recipient of the supply is liable for VAT rather than the supplier.
The key distinguishing feature
Under Section 3(4) of the Value Added Tax Act, a supply of work and materials is deemed to exist where the materials procured by the trader themselves characterise the entire transaction. For tax purposes, it is then to be treated as a supply. If, on the other hand, the materials procured by the trader are used merely as ingredients or ancillary items in a primarily manual or manufacturing activity, this constitutes a service involving the performance of a specific task, which is classified as an ‘other service’.
In a nutshell: anyone who primarily supplies materials and also processes them is providing a supply of materials and work. Anyone who mainly provides their labour and expertise and uses their own materials only to a limited extent is providing a service.
The current case: is water a principal or secondary ingredient?
The Saxony-Anhalt Finance Court had to consider a case involving a company that manufactured drinks. The manufacturer sourced the water for production itself, whilst the client supplied the remaining ingredients. The point at issue was whether the water should be regarded as the defining main ingredient or merely as a secondary ingredient.
The Finance Court ruled on the matter in its judgement of 21 November 2024 (case number 2 K 458/21). However, following an appeal by the claimant, the Federal Fiscal Court granted leave to appeal (BFH, decision of 29 July 2026, case number V B 43/25). Germany’s highest tax court will therefore have to clarify, as a matter of principle, from whose perspective the issue is to be assessed: from the perspective of the business recipient or the non-business end consumer.
Why drawing the line is so difficult in practice
Although the law provides a clear framework, there is often considerable leeway when it comes to the specific assessment. Particularly in the case of mixed construction, repair and fabrication services, where materials are supplied by the client – either in full or in part – the following issues are frequently the subject of dispute:
- Is this a single service at all, or do the individual parts need to be assessed separately?
- Are third-party items actually being processed or manufactured?
- Do the fabrics sourced independently play a defining role in terms of quality, or do they merely play a minor role?
What does this mean for business owners?
Anyone who provides or commissions services involving both materials and labour should not leave the classification for VAT purposes to chance. Errors in classification can lead to the wrong tax rate being applied, the place of supply being incorrectly determined, or the reverse-charge mechanism being overlooked. In all these cases, there is a risk of having to make additional payments and pay interest.
The forthcoming Federal Fiscal Court (BFH) ruling will provide greater legal certainty in this area. Until then, it is advisable to seek tax advice at an early stage in such cases.
Source: Haufe: Tax
This article was created with the help of AI and has been editorially reviewed.
