Tax evasion in the supply chain and its consequences
If a participant in a supply chain evades VAT, the other involved parties often have to fear for their VAT related benefits (cf. Streit/Echterfeld, DStR 2023, 1978). If the tax office believes that the other parties were aware of the VAT evasion, it will deny the input VAT deduction or other benefits (such as the zero-rating for intra-community supplies) and, in some cases, both. This applies even if the entrepreneur had no actual knowledge of the VAT evasion. It is sufficient that the entrepreneur should have known about the VAT fraud.
Origin of the Anti-Abuse Jurisprudence
The possibility of denying VAT related benefits was originally developed by the European Court of Justice (ECJ) to curb VAT fraud. Carousel fraud was a topical issue at the time this so-called abuse jurisprudence was developed. However, it remains highly relevant to this day. VAT carousel schemes alone cause tax losses amounting to tens of billions of euros every year. The importance of these cases is also reflected in the fact that a specially established authority, the European Public Prosecutor’s Office, now investigates cross-border cases. Among other things, this office specializes in combating VAT fraud.
Not infrequently, however, this strict approach in VAT law becomes the downfall of honest businesses.
Development of Anti-Abuse Jurisprudence
The ECJ first addressed the question of whether an entrepreneur could be denied input VAT deduction, because it should have known that its transaction was involved in a VAT fraud, in a 2006 judgement. The ECJ answered this in the affirmative (see ECJ judgment of 06.07.2006 – C-439/04 and C-440/04, Kittel and Recolta Recycling SPRL).
This is not considered an incorrect interpretation of the Directive to the detriment of the entrepreneur. Good faith is an implied prerequisite for exercising the right to deduct input VAT. The entrepreneur must take all measures that can reasonably be expected to avoid its involvement in VAT evasion (see ECJ judgment of 06.07.2006 – C-439/04 and C-440/04, Kittel and Recolta Recycling SPRL).
Prerequisites for the denial of input VAT deduction
A prerequisite for the denial of input VAT deduction is, firstly, that VAT fraud has occurred. In addition, there must be objective circumstances from which the entrepreneur should have drawn the conclusion of the presence of some form of tax evasion.
Definition of “tax fraud”
The ECJ defines the concept of tax fraud as an act of deception. This is any intentional act or omission that adversely affects the EU's own VAT resources (ECJ judgment of 14.10.2021 – C-360/20). In contrast, under sec. § 25f of the German VAT Act, mere non-payment of VAT is defined as fraud (referring to sec. 26a, 26c of the German VAT Act, see below). However, the ECJ has ruled otherwise. According to the ECJ, the mere non-payment of VAT is not considered to be fraud (ECJ judgment of 02.05.2018 – C-574/15, Scialdone).
Participation in tax fraud by purchasing fraudulent goods
If an entrepreneur purchases goods tainted by fraud, it is considered – from a VAT perspective – complicit in the fraud if it knew or should have known about it. Active promotion of the tax fraud or the attainment of an economic advantage is, according to the ECJ, not necessary (see ECJ judgment of 14.04.2021 – C-108/20 - HR/FA Wilmersdorf).
In recent years, a number of further decisions have refined the anti-abuse jurisprudence (see KMLZ VAT Newsletter 49 | 2022; KMLZ VAT Newsletter 47 | 2020). Accordingly, the requirements for denying input VAT deduction are that:
VAT fraud occurred somewhere in the supply chain – regardless of whether it happened at an earlier or later stage of the supply chain.
the entrepreneur knew or should have known about this fraud at the time of the transaction.
This “should have known” must be proven by the tax office based on objective criteria (German Federal Fiscal Court, judgement of 11.03.2020 – XI R 38/18; ECJ, judgement of 18.05.2017 – C-624/15 – Litdana UAB).
The question of when a taxpayer should have known about a tax fraud is a case-by-case decision. All judgments agree that the circumstances of the individual case are decisive. The assessment is left, in a first step, to the tax office and ultimately to the national courts, as part of an overall evaluation of the evidence that indicates a fraudulent transaction. The control measures taken by an entrepreneur must also be considered. It must be decided whether the entrepreneur has done everything necessary, on its part, to avoid its involvement in tax fraud. Only then can the entrepreneur rely on the granting of its VAT-related benefits. However, the requirement of a case-by-case decision makes it considerably more difficult for an entrepreneur to judge when, and to what extent, control measures are necessary (and which information is objectively sufficient to satisfy the entrepreneur that all is well). The tax authorities require that the entrepreneur must, in the case of any doubt, terminate the business relationship (sec. 25f.1 para. 4 sentence 4 of the German VAT Circular; German Federal Central Fiscal Court, letter of 15.06.2022 – III C 5 – S 7429 – B/21/10003 :001, BStBI. 2022, 1002). In practice, this often represents a very significant intervention.
Introduction of sec. 25f of the German VAT Act
It took some time before the German legislator took action and incorporated the anti-abuse case law into German law. For transactions carried out from 01.01.2020 onwards, the provisions of sec. 25f of the German VAT Act apply. Essentially, this regulation implements the established anti-abuse jurisprudence, but in certain aspects, it deviates somewhat from previous case law.
Sec. 25f of the German VAT Act provides a clearer definition of what the German legislator considers to be “tax fraud.” This refers not only to the evasion of VAT, but also to the non-payment of VAT, with reference to sec. 26a and 26c of the German VAT Act. Interestingly, the wording of sec. 25f of the German VAT Act does not cover the entrepreneur’s own VAT evasion. In this respect, however, the anti-abuse case law continues to apply which, at this point, is more far-reaching.
The provision also addresses the legal consequences. It contains a catalogue of VAT-related benefits that can or must be denied if the requirements are met. The following VAT-related benefits are affected:
Zero-rating for intra-community supplies
- Input VAT deduction from invoices by other entrepreneurs
Input VAT deduction from intra-community acquisitions
Input VAT deduction from reverse charge transactions
Input VAT deduction for the final purchaser in triangular intra-community transactions
The intra-community acquisition of the first purchaser in a triangular intra-community transaction is not considered as taxed
Interestingly, the wording does not cover input VAT deduction from import VAT incurred.
The provision must be interpreted in light of ECJ case law. Its scope is very wide. VAT-related benefits can also be denied beyond the actual VAT loss (ECJ, judgment of 24.11.2022 – C-596/21 – Finanzamt M; see KMLZ VAT Newsletter 49 | 2022).
What does the Federal Central Tax Office’s letter dated 15.06.2022 – III C 5 – S 7429 – b/21/10003 :001, BStBl. 2022, 1002 regulate?
The Federal Central Tax Office’s letter dated 15.06.2022 contains extensive explanations on the application of the anti-abuse case law in administrative practice. The most important points of the circular are as follows:
Burden of Proof: The Federal Central Tax Office acknowledges that the tax office must prove both the existence of tax evasion and the objective indications of bad faith. This aligns with the jurisprudence (see above).
- Bad Faith of Employees: An entrepreneur may be charged as being responsible for the bad faith of its employees pursuant to sec. 166 of the German Civil Code (BGB). Subsequently, the ECJ decided that, under certain circumstances, an entrepreneur may also be charged with the bad faith of general contractors appointed by it (see KMLZ VAT Newsletter 51 | 2022). In particular, breaches of due diligence are regarded as indicating the presence of bad faith. Here, too, the burden of proof lies with the tax office (see KMLZ VAT Newsletter 51 | 2022).
The Federal Central Tax Office confirms that entrepreneurs must take all measures reasonably required to avoid involvement in tax evasion. In the case of irregularities, entrepreneurs must investigate and, as a last resort, even terminate business relationships.
The Federal Central Tax Office lists various circumstances it considers to constitute irregularities, including frequent relocation of business addresses; deviation of company purpose from business activity; when the parties involved lack professional experience; payment methods that are unusual for the business; the offer of an unusually large quantity of goods; the lack of sufficient contact details etc.
Impact on entrepreneurs
The issue remains that the question of whether bad faith is present is always a nuanced individual decision. Advice to terminate a business relationship, in the case of doubt, often does not align with the economic reality of entrepreneurs. Still, this measure represents the last resort. However, it is important that entrepreneurs check their business partners and their individual businesses. The information provided must be plausible, and checks must be documented. The extent to which an entrepreneur must carry out these checks depends on the individual case. Parallel to this, internal contacts (especially in purchasing, logistics, and sales) should be made aware of these issues. The implemenantion of a Tax Compliance Management System is therefore important.
Generally important measures include:
Checking the commercial register; requesting copies of ID cards
Verification of addresses
Internet research and review of market-appropriate prices
Measures to minimise risk during ongoing business activities
During ongoing business activities, several measures are recommended to minimize liability risk:
Employee awareness training
Inspection of goods
Monitoring of payment methods
Verification when contact persons change
Control of the records of rendered supplies
In the case of irregularities, entrepreneurs should request:
Additional information
A clearance certificate from the tax office (although, according to current case law, it is only of limited evidentiary value)
If uncertainties cannot be resolved, then – according to the tax authorities and case law – the business relationship must be discontinued.
Next steps to take when tax benefits are denied
If the unfortunate situation has already arisen that the tax office has given notice that it intends to deny VAT-related benefits, a thorough examination of the facts is of enormous importance. As complex as this analysis may prove in practice, it is essential in order to avoid fiscal (and criminal) disadvantages.
It is important to focus on the question of what the entrepreneur ought to have known at the time of participating in the transaction. Hindsight is always 20/20, but a retrospective “should have known” is not sufficient. The tax office must provide objective indications showing that the entrepreneur should have already drawn the conclusion, at the time of participating in the transaction, that it was involved in a fraudulent supply chain.
Since sec. 25f of the German VAT Act often also involves criminal allegations, it is particularly advisable to seek professional advice as soon as possible, as a solution is needed for both fiscal and criminal law. Protracted legal disputes can sometimes be avoided through negotiations with the tax and criminal authorities.
