Strict stance on input VAT deduction in tax evasion cases - ECJ-ruling "HR" (C-108/20)

The fact that the deduction of input VAT can be denied if the taxable person is involved in tax evasion is not new. However, in its decision of 14 April 2021 (C-108/20 involving the "HR" case), the ECJ (European Court of Justice) once again emphasizes that a mere "should have known" with regard to tax evasion is sufficient at a preliminary stage. This ruling means that taxable persons have considerable due diligence obligations.

In the case before the ECJ, HR operated a wholesale beverage business. HR purchased the beverages from P GmbH, which in turn was supplied by HR's husband. The husband did not issue invoices to P GmbH for these purchases. P GmbH wrongfully deducted input VAT for these purchases using fictitious invoices issued by one of its employees. After discovering this fact, the tax office not only denied the input VAT deduction by P GmbH but also by HR as it was part of the supply chain with its business in which the VAT evasion had been committed. HR brought an action before the tax court, which referred the case to the ECJ for a preliminary ruling. The question to be resolved was whether HR could be denied the input VAT deduction solely because she knew, or should have known, about the tax evasion at the previous stage in the supply chain or did HR have to be actively involved in the tax evasion for this to occur?

Active participation in tax evasion at the preliminary stage is not required

The ECJ held that previous case law had already clearly answered this question, and for this reason only ruled by order and did not issue a judgement. It referred, inter alia, to the judgments in the cases Kittel and Recolta Recycling (C-439/04 and C-440/04, July 6, 2006), Mahagében and Dávid (C-80/11 and C-142/11, June 21, 2012) and Glencore Agriculture Hungary, (C- 189/18, October 16, 2019). Accordingly, the deduction of input tax is to be denied not only if the taxpayer itself commits a tax evasion, but also if it knew, or should have known, that with its purchase it was participating in a transaction (even if this occurred at a previous stage) that was involved in VAT evasion. This must be established on the basis of objective circumstances - strict liability without such culpability would be excessive. However, it is not necessary to prove that the taxpayer actively promoted or abetted the tax evasion.

Tax authorities vague in their requirements

The tax administration took measures to clarify this case law in Section 15.2 (2) Sentences 5 and 6 of the administrative guidelines to the German VAT Code. These measures specify that  taxable persons do not lose the right to deduct input VAT if they have taken all the necessary precautions that can reasonably be required of them to ensure that their transactions are not involved in fraud. This requires that the taxable person neither knew of, nor could be expected to know of, the scam.

Recommendation: Tax Compliance Management System

The requirement that reasonably required actions must be taken is subject to a great deal of interpretation and, as a result, is fraught with uncertainty for business owners. Especially in the case of long supply chains, it is difficult to know about every previous link in the supply chain, and to what extent this can be "reasonably" required certainly depends on the individual case. In the ECJ case discussed here, it seems to have played a role that the tax evader was HR´s husband, even if he did not supply her directly. To avoid any possible complicity in such matters, we recommend that special attention be paid to internal control procedures in which the identity and integrity of new suppliers are checked – using the VAT ID and, if necessary, other sources. If doubts arise during this routine check, requires delving deeper by (for example) requesting the transmission protocols of preliminary VAT declarations.

Known suppliers who suddenly increase their trading volume also deserve special attention. Setting up such a tax compliance management system can help demonstrate to tax authorities that the required due diligence was done.

(Dated: May 10, 2021)