VAT deduction disallowed due to supplier status

In most cases, a tax audit for VAT deduction is harmless on the face of it. The tax authority asks for basic documents and the taxpayer readily provides them. Routine… In practice, however, it happens disproportionately often that this seemingly innocuous introduction ends at the end of the day with a disallowance of the VAT deduction. And that puts some businesses down. Well, and in misaligned corporate structures, it can also put down the individuals behind the business.

Non-deduction of VAT in economic consequences

Imagine a trading company that purchases goods worth EUR 1 000 000 + VAT per year. It then sells these goods for EUR 1 100 000 + VAT. The gross margin is therefore EUR 100 000. The tax authority starts a tax audit for 24 calendar months and decides that the supplier could not have delivered the goods (for example because he did not have a warehouse). The tax office does not dispute that the goods never existed or were never delivered.

If the tax authorities were to disallow the company’s VAT deduction (i.e. EUR 400 000), this would be an amount far in excess of the company’s gross margin. Not taking into account the company’s other costs. Imagine that the company has bank loan financing for which the owner is the guarantor. If the tax authorities do not grant the VAT deduction, the company can only seek justice in court. In the meantime, however, this claim by the tax authorities for EUR 400 000 + penalty will most likely become enforceable. The bank may repay the loan and the company, including its owner, may end up in bankruptcy, without the court ruling on the merits of the case.

There is no doubt that the tax authorities in Slovakia must make decisions lawfully. And what is this lawful decision-making in the case of supplier status will be the subject of this article.

The person named on the invoice when deducting VAT

The wording of the Slovak VAT Act is largely dependent on the EU VAT Directive. Both legislations require two basic conditions to be met for VAT to be deductible: (i) formal conditions and (ii) the fulfilment of substantive conditions.

Under the substantive conditions, it must be shown that the supply actually took place. In practice, however, we encounter a kind of derivative of this condition, which is applied relatively often by Slovak tax administrators. They often require that the supplier (i.e. the person named on the invoice) actually made the supply or was able to make it. It is not sufficient that it is obvious that the supply has taken place. There is a big difference.

Problematic person in the chain and impact on VAT deduction

The tax administration’s interpretation of the construction “thesupplier supplied” or “was able to supply” has the potential to expose the taxpayer significantly. The tax administration will start to question whether the substantive condition has been met and you may be denied the right to deduct input VAT if it finds that there is an entity in the supply chain that:

• according to the financial administration, the transaction could not be carried out objectively (e.g. it has no employees or no warehouses);
• is non-contact;
• has not filed tax returns or control statements; or
• did not have employees, etc.

The person named on the invoice did not make the delivery

Under the EU VAT Directive, any person who includes VAT on an invoice is liable to pay it. This requirement of the Directive is implemented in the Slovak VAT Act in § 69 (5). This means that an entity that has not incurred the obligation to pay VAT is obliged to pay the VAT stated on the invoice to the state budget.

However, the problem arises with the customer. The customer is not entitled to deduct VAT on the input VAT applied in this way. The customer is only entitled to deduct VAT if the supplier has actually incurred the tax liability. In this case, however, the supplier has not incurred the liability and the customer cannot argue that (i) the VAT has been paid by the supplier; and (ii) the VAT has also been paid by the customer by way of output VAT.

This view is supported by the judgments of the Court of Justice of the EU (“CJEU“), which have been relatively uncompromising in this regard. They separate out such supplies and do not take into account that input VAT has been paid by the supplier. The right to deduct VAT only arises if the supplier has also incurred the tax liability, i.e. the supplier has actually supplied the service or goods (or has been able to supply them, which appears to have been very material in recent years). And these facts are subject to verification during VAT tax control.

Non-deduction of VAT due to tax fraud

It follows from the case law of the CJEU that participation in tax fraud must be supported by objective facts on the basis of which it can be justified that the taxpayer knew or should have known that he or she was participating in the fraudulent conduct. These have been formulated in several judgments of the CJEU and have given rise to the so-called Axel Kittel test. The test consists of four questions. All four questions must be answered in the affirmative in order for the administrator to deny the taxpayer the right to deduct VAT.

(i) Did the taxable transactions under consideration give rise to tax evasion?

(ii) If so, is this tax evasion the result of fraudulent conduct?

(iii) If the tax evasion is the result of fraudulent conduct, have the taxable transactions of the taxpayer associated with that conduct been assessed?

(iv) If the taxable transactions under assessment involved fraudulent conduct, did the taxpayer know or could and should have known about it?

The first three questions are aimed at establishing objective facts. The tax administration must therefore prove, and therefore bear the burden of proof, that there has been fraudulent conduct involving tax evasion. At the same time, it must prove that the transaction under examination is part of a fraudulent practice. The fourth point (the so-called knowledge test) then becomes crucial. This is to show whether the party knew or should have known or should have known of the fraudulent conduct.

Back to the person on the invoice and CJEU case law and the link to tax fraud

The CJEU’s ruling in Case C-610/19 Vikingo Fővállalkozó Kft (the “Vikingo ruling“) also deals with the denial of the right to deduct VAT on the grounds that the supply was not made by the declared supplier.

The case concerned a situation where the Hungarian company Vikingo, a wholesale candy business, purchased food packaging machines for its products from the supplier Freest. The supplier bought these machines from another subcontractor, who in turn bought them from another subcontractor. Vikingo deducted input VAT on the invoices from the supplier Freest, whereas, according to the CJEU, there was no doubt that the machines actually existed and were put into operation.

The tax office did not recognise the VAT deduction in question during the audit, namely mainly because the directors of the companies in the supply chain did not confirm the supply. The tax office concluded that the supply was made by an unknown person and not by the person on the invoice. A very similar conclusion to the one we see in Slovak decision-making practice.

The CJEU gave the following answer to the Hungarian court: the EU VAT Directive, in conjunction with the principles of fiscal neutrality, efficiency and proportionality, must be interpreted as precluding a national practice under which a tax authority refuses a taxable person the right to deduct value added tax paid on the acquisition of goods supplied to him on the ground that

• first, the invoices relating to those purchases cannot be considered reliable because, first, the person who drew up the invoice was unable to produce or deliver the goods in question because of a lack of the necessary material and human resources, i.e. those goods were in fact acquired from another person whose identity has not been established;
• secondly, national accounting legislation has not been complied with;
• third, the supply chain leading to the purchases in question was not economically justified;
• and fourthly, there were irregularities in some of the previous transactions that were part of this supply chain

Such a refusal of the right to deduct VAT shall only be possible where it is established to the requisite legal standard that the taxable person actively participated in the tax fraud or knew or ought to have known that the transactions in question were part of a tax fraud committed by the person who drew up the invoice or by any other entity upstream in the supply chain. However, that fact must be verified by the tax authorities.

This means that if it is proved that the goods have been supplied, the facts cannot be considered that (i) the chain of transactions leading to those supplies does not appear to be rational or reasonably justifiable from an economic point of view; or (ii) any of the participants in that chain has failed to fulfil its tax obligations, shall be sufficient to conclude that there has been tax evasion. The tax authority has the legal burden of establishing in each particular case, on the basis of the objective circumstances, that the taxable person has committed tax fraud or that he knew or should have known that the transaction in question was part of a tax fraud committed by the person who issued the invoice or by another entity involved in the supply chain of goods or services.

So what about the burden of proof?

The CJEU is and should be an important legislative well for Slovak tax administrators. This is especially the case where the VAT Act does not give a clear answer. In the context of the topic of this article, therefore, another CJEU judgment is interesting. In another recent case, the CJEU dealt with the assessment of the denial of the right to deduct VAT in the context of the taxpayer’s obligation to act prudently when choosing his business partner.

The CJEU notes that a prudent person may, depending on the circumstances of the case, consider it his duty to find out information about the other party from whom he intends to acquire goods or services in order to identify its reliability. However, the tax authorities may not, in general, require the taxable person claiming a VAT deduction to verify that the person who issued the invoice relating to the goods and services on the basis of which the VAT deduction is claimed is the person who issued the invoice relating to the goods and services on the basis of which the VAT deduction is claimed:

• meets the conditions of a taxable person;
• it had the goods in question and was able to supply them; and
• it has fulfilled its obligation to file a tax return and pay VAT,

to ascertain whether there have been any illegalities or tax fraud on the part of the taxpayer’s business partners.

In principle, it is for the administrative authorities to carry out the necessary checks on taxable persons in order to detect illegalities and VAT fraud and to impose penalties on the taxable person who has committed such illegalities and tax fraud. The burden of proof in these circumstances must therefore be borne by the tax administrator.

The reality of tax controls in proving eligibility for VAT deduction:

The performance of tax administration, and thus also the performance of tax control, is subject to compliance with the basic principles of tax administration formulated in the Tax Code. These principles should always be followed by the tax administrator. For the purposes of the fair exercise of tax control, the following principles are particularly relevant:

• take into account not only their own interests but also those of the taxpayer;
• to act at all times in accordance with generally binding legal regulations, while protecting the interests of the state and municipalities, but at the same time taking care to preserve the rights and legally protected interests of tax subjects and other persons;
• evaluate the evidence according to its discretion, each piece of evidence individually and all the evidence in its context, taking into account everything that has come to light in the administration of the tax. However, the content of the phrase ‘at its discretion’ does not mean that the tax administrator is entitled to take into account arbitrarily, and sometimes arbitrarily, only that evidence which is to the tax administrator’s satisfaction. The tax administrator should reflect on each piece of evidence, realistically assess and evaluate it and rationally state why it does not take any piece of evidence into account.

In practice, however, tax administrators relatively often not only fail to respect these basic principles of tax administration, but also fail to follow the established case law of the CJEU (e.g. the Axel Kittel test or the Vikingo ruling).

In addition, the tax administrators apply the provision of Art. 6 of the Tax Code, arguing for a kind of tax advantage. However, it is objectively not possible to obtain such an advantage if the tax subject pays the output VAT.

So what (and more) should tax administrators observe when performing tax administration (i.e. also tax audits)?

The judgments of the CJEU also show that the EU VAT Directive should be interpreted in conjunction with the principles of tax neutrality and proportionality. Under these principles, a customer cannot be denied the right to deduct VAT on the grounds that invoices cannot be regarded as reliable simply because:

• the person named on the invoice was unable to deliver the goods due to lack of material and personnel resources, and therefore the delivery had to be made by another person;
• national accounting law has not been complied with or the supply chain has not been economically justified; or
• there have been some discrepancies in the previous stages of trade.

What should be done to increase the likelihood of success in defending a VAT deduction claim?

In the reality of tax audits, the tax authorities will relatively often refuse a VAT deduction as soon as an entity in the queue fails to comply with its reporting or levy obligations. However, these are not necessarily known to the taxpayer. Although the tax administration publishes a number of lists on its website which might indicate that a problematic entity is likely to be involved, these lists are updated with time delays. Thus, at the time of the contaminated transaction, the problematic entity may not be on any of the lists at all.

For these reasons we recommend:

• Have documented communication with the business partner to the maximum extent possible;
• Also have the existence of the delivery documented to the maximum extent possible, including photo documentation or email communication where appropriate;
• Do not do business with business entities that have a record of amounts owed to a public authority;
• Be vigilant with newly established business partners;
• Be vigilant with business partners with minimal capital;
• Be vigilant with business partners who do not have employees but possibly show high turnover;

In practice, it may happen that the tax administrator questions the personnel capacity of the supplier and places the burden of proof on the audited tax entity. The taxpayer should thus demonstrate how the supplier was able to carry out the supplies in question. In some cases, the tax authority’s argumentative position may be inferred from its requirement for the tax entity to have even a detailed overview of the employees/suppliers of the business partner, including the content of their contractual agreements.

Based also on the established case law of the CJEU, we are of the opinion that the audited tax entity cannot be required to prove facts which are completely outside its sphere of influence and which it cannot, either because of legal obstacles or because of the factual state of the case, ascertain and verify.

But will this be enough to justify the VAT deduction?

If the taxpayer had everything recorded in writing, including printed websites of the Social Insurance Institution, the relevant health insurance companies, the register of accounts, the commercial register and/or the lists of the tax administration, would this be sufficient to prove the right to deduct VAT and to do so in good faith?

Unfortunately, there is no uniform and unambiguous answer to this. In recent practice, we have seen a case where the taxpayer had several relevant facts necessary to defend its VAT position covered. For example, it required confirmation from the supplier in the contract that it had staff capacity. The taxable person had a lot of relevant supporting documentation for each transaction and was as cooperative as possible in the tax proceedings. In addition, it was a reputable foreign company. The result of the tax audit was a report of approximately 100 pages, on the basis of which the tax administration issued a decision confirming the existence of the supplies, but criticising the tax entity for the fact that the supplier was unable to carry out the supplies due to a failure to demonstrate staff capacity.

But this is against EU law and needs to be legally defensible. Not only subsequently in a tax dispute against the tax directorate or in court, but also preventively by building a more sophisticated corporate structure.

Further consequences of the non-recognition of a VAT deduction

If a taxpayer is denied an input VAT deduction, he automatically becomes an unreliable taxpayer for the tax administration in subsequent tax proceedings. This has further consequences, such as shorter deadlines, reluctance of the tax administration to accept certain claims, a higher probability of tax audits and a negative perception in the eyes of business partners. At the same time, applying the logic of the tax administrator, such business partners should no longer want to do business with the tax entity because they expose themselves to tax risks.

We believe that the approach of tax administrators in Slovakia will fundamentally change. Otherwise, routine tax audits may be liquidating for less prudent entrepreneurs. And more prudent entrepreneurs must make significant efforts at prevention. Prevention not only in terms of obtaining sufficient documentation to demonstrate good faith conduct, but especially in terms of legally structuring the business in a way that protects valuable assets/business streams from these risks. In our experience, business transfers abroad are common. Of course this is only possible in certain cases.

We thus provide our clients not only with representation before tax authorities, but also with a comprehensive set-up of their business with a view to preventive prevention of materialisation of the risks in question. On several occasions we have assisted clients in the legal transfer of assets from the company in the event that the company was already “overwhelmed” by a number of tax audits.

If you are interested in this topic, please do not hesitate to contact us.