Deducting VAT in EU VAT returns: complexity of rules; varying application by member states; partial deductibility; timings of deductions; and administrative obligations
In a crowded field of complexity, VAT deductibility is most challenging area of EU (and global!) compliance. The premise of VAT neutrality, businesses should not lose out in their role of unpaid tax collector for governments is most at risk when it comes to deductibility. Most efforts to unify EU VAT compliance (the doomed EU Single VAT return) fail as member states refuse to give up their control of deductibility rules. Attempts to One-Stop Shop OSS deductibility keep hitting resistance for the same reason.
This blog aims to explain how broad EU deductibility regime works and why complexity results in large cash flow losses on disallowed deductions in VAT returns.
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What is the right to deduct VAT?
The VAT right to deduction allows VAT registered operators, ‘taxable persons’, to reclaim VAT paid on goods and services acquired for business purposes. This is often termed input VAT; contrasting with out VAT which is the VAT the same businesses must charge and remit on their own sales transaction. This deduction of input VAT reduces the VAT payable, the output VAT, to tax authorities in the regular VAT return by the deductible amount.
VAT can be deducted from the following transactions:
- Domestic supplies of goods and services: VAT is deductible when paid on purchases used for activities giving rise to deduction in the same EU country.
- Intra-EU acquisitions: VAT is deductible on goods acquired from another EU country if the goods are used for activities eligible for deduction.
- Importation of goods: VAT is deductible on goods imported into an EU country if they are used for deductible activities.
Conditions for Deduction
VAT can only be deducted when the goods or services are used for:
- Taxed transactions of the taxable person
- Certain exempt transactions.
- Transactions conducted abroad that would allow for VAT deduction if performed domestically.
- Cross-border sales of new means of transport.
- Certain exempt financial transactions with customers outside the EU.
Partial or Full Deduction
- Full Deduction: Applies to VAT on goods and services used entirely for deductible activities.
- Proportional Deduction: Applied when direct attribution of expenses to deductible or non-deductible activities isn’t possible, such as with overheads. Restrictions may also limit deduction on certain expenditures.
Timing of Deduction
The right to deduct VAT arises when the deductible tax becomes chargeable, which usually occurs when:
- The supply of goods or services is made;
- The invoice for intra-EU acquisitions is issued; and
- Goods are imported.
This timing determines the VAT return period in which the business can claim the deduction, which may be before the input VAT payment is actually made
Specific Transactions and Conditions for Deduction
- Domestic Transactions: VAT is deductible if it is paid or due on purchases within the same EU country and used for activities eligible for deduction.
- Intra-EU Acquisitions: VAT is deductible on goods acquired from another EU country under conditions that the VAT is due and the goods are used for deductible activities.
- Importation of Goods: VAT paid or due on the importation of goods is deductible if these goods are used for deductible activities in the importing EU country.
These rules ensure that VAT is neutral for businesses, meaning it is not a cost for those purchasing goods and services for their business activities. However, specific conditions and restrictions, such as the need for proper documentation and compliance with local regulations, must be met to successfully claim deductions. The complexities of different member state regulations, varying VAT rates, and detailed rules for partial and full deduction add to the administrative burden for businesses, particularly those operating across multiple EU countries.
The right to deduct VAT applies to several types of transactions, each with specific conditions:
- Taxed Transactions of the Taxable Person (Article 168 VAT Directive): VAT on goods and services used for the taxed transactions of a taxable person in the same EU country can be deducted.
- Transactions Carried Out Abroad (Article 169(a) VAT Directive): VAT can be deducted for transactions related to economic activities conducted abroad, provided these would give rise to deduction if performed domestically.
- Exempt Transactions with the Right to Deduct (Article 169(b) VAT Directive):
- Includes intra-EU supplies of goods, services related to the importation of goods, exports, international transport services, and supplies to international bodies or customs warehouses.
- Only specific exempt domestic transactions listed in Article 169(b) are eligible for deduction.
- Certain Exempt Financial Transactions (Article 169(c) VAT Directive):
- Includes insurance, credit management, currency transactions, and dealings in securities.
- Deduction is allowed if the customer is outside the EU or the transactions relate directly to goods for export.
- Cross-Border Supplies of New Means of Transport (Article 172 VAT Directive):
- Any person making occasional supplies of new means of transport to another EU country can deduct VAT, with a ceiling on the deductible amount.
Proportional Deduction:
- Applies when goods or services are used for both deductible and non-deductible transactions.
- Only the proportion of VAT attributable to deductible transactions can be deducted (Article 173 VAT Directive).
- Three methods to apportion deductible VAT are prescribed, and EU countries can choose the method.
Restrictions on Deduction:
- VAT cannot be deducted for non-business expenditures such as luxuries or entertainment (Article 176 VAT Directive).
- General restrictions on VAT deduction for certain expenditures can be imposed with unanimous agreement from all EU countries.
- EU countries may exclude expenditure on some capital goods from deduction for economic reasons, or alternatively, tax self-manufactured or imported goods (Article 177 VAT Directive).
Proof for right to deduct VAT
A business can claim VAT deductions if certain conditions are met, which vary by transaction type.
- Invoices: For the supply of goods and services, a valid VAT invoice is needed. This can be challenging as each country as slight, but painful variations in requirements.
- Intra-EU acquisitions require an invoice and specific VAT return information, though exceptions exist.
- Import transactions need import documents.
- Rules for transactions treated as supplies, intra-EU acquisitions, and reverse-charge VAT are set by individual EU countries.
EU countries can also permit deductions even if standard conditions aren’t met, setting their own detailed rules (Articles 178, 180, 181 VAT Directive).
Making adjustments to deductions
Adjustments to VAT deductions are necessary when circumstances change after the initial deduction.
- if a purchase is canceled;
- a price reduction is obtained;
- a transaction remains unpaid;
- the final deductible proportion is calculated;
- or the capital goods scheme applies. An initial deduction must be adjusted if it is incorrect (Article 184, VAT Directive).
Adjustments are typically required for canceled purchases, price reductions, or other changes affecting the deduction calculation. However, no adjustment is needed for unpaid transactions or lost, stolen, or destroyed goods unless proof is provided. EU countries may mandate adjustments for unpaid transactions or theft (Article 185 VAT Directive).
Capital goods adjustments
Each EU country sets its own rules for making adjustments (Article 186 VAT Directive) for capital goods. The concept of capital goods is broadly equivalent to fixed assets used over several years, with adjustment legislation in Articles 187-191 of the VAT Directive.
Summary
Navigating the complexities of VAT deduction in the EU requires businesses to be diligent, well-informed, and adaptable. The variability in VAT rates and rules, coupled with stringent documentation requirements and the evolving nature of VAT laws, demands robust compliance frameworks and often expert guidance. Businesses must invest in proper training, systems, and professional advice to ensure they maximize their VAT deductions while avoiding costly mistakes and penalties.
