On 21 June 2012 and on 6 September 2012, the Court of Justice of the European Union (CJEU) issued two judgments on cases concerning the tax authorities' obligation relating to the deduction of VAT. The judgment states that allowing the deduction of VAT paid for the purchased products and services is an essential base of the European VAT system. Therefore, generally, the right to deduct shall not be limited. To limit this right, the tax authority has to prove, based on objective criteria, that the taxpayer knew or ought to have known that the transaction is related to a fraud.
The CJEU recently issued two judgments in relation to the practice of the Hungarian National Tax Authority (NAV) in the joint cases C-80/11 and C-142/11, and case no. C-324/11. In these cases, the NAV prohibited the parties to deduct VAT paid for the products and services they purchased and used for their economic activity. The prohibition was justified each time irregularities are committed by the seller of the product or the service provider.
In case no. C-80/11, the seller did not declare all of its assets to the tax authority; therefore, officially, it did not possess enough product to fulfill its obligations towards the taxpayer. In case no. C-324/11, where the taxpayer provided construction works to third parties, one of its subcontractors failed to declare its employees; therefore, the subcontractor did not pay any tax or contribution which was due in relation to their employment.
The NAV argued that due to these irregularities, it cannot be proven whether the transactions actually occurred the way they are described on the invoices; therefore, it did not allow the buyers to deduct the VAT they paid in relation to the purchased products and services.
The CJEU reasoned in its judgment that the NAV shall prove, based on objective evidence, that the party requesting the deduction of VAT was aware of the fraud. Pursuant to Section 273 of the VAT Directive (Council Directive 2006/112/EC), the member states have the right to adopt measures to prevent tax evasion and ensure the fulfillment of tax obligations. However, these measures shall not exceed the level necessary to achieve these goals.
Although the taxpayer has to act with due care during the transactions, the tax authority shall not as a general rule require the taxpayer to verify whether its business partner fulfills its obligations in relation to taxes, such as paying taxes or declaring employees. Based on the jurisdiction of the CJEU, a taxpayer who acted with due care shall not have to bear the risk of the prohibition of the deduction.
Based on the VAT Directive, the requirement of the deduction of VAT is that the purchased products or services shall be used in connection with the taxpayer's taxable activity. The deduction cannot be prohibited only because of the fact that a taxpayer's business partner did not act in line with the VAT regulations. However, if the tax authority proves that the taxpayer knew or ought to have known that the transaction is part of a fraud, the taxpayer shall be considered a co-conspirator of the fraud, regardless of the fact that it made profit or not during the transaction. In this case, the deduction of VAT must be prohibited.
The CJEU shifted the burden of proof between the taxpayers and the tax authority. Although it underlined the importance of the prevention of tax evasion, the CJEU required the tax authority to prove that the party requesting VAT deduction was aware of the fraud related to the transaction. Therefore, the CJEU slightly limited the requirements of acting in due care, as the CJEU does not require taxpayers to verify all the aspects of the business partners' taxpaying activities. This detailed control shall be conducted, generally, by the tax authorities.
As the CJEU stated, it is the tax authority's duty to control whether the taxpayers are fulfilling their obligations related to the payment of taxes. The tax authority shall not pass on this duty to the taxpayers by envisaging the possibility of the prevention of the tax deduction.
These judgments will probably have a significant impact on the practice of the NAV (and other tax authorities), as the CJEU obliges the tax authority to prove the bad faith of the taxpayer, when prohibiting the deduction of VAT.