Kittel principle: quantum of disallowance

The CJEU has held that a taxpayer who fails to carry out reasonable checks to ensure that a transaction is not connected with fraud can be denied the right to deduct all VAT charged (under the Kittel principle), not merely the amount of VAT which the tax authority lost due to the fraud: A v Finanzamt M (Case C-596/21).

The Court has held that the objective of ensuring that taxpayers do not facilitate tax evasion (either by knowing involvement in a fraudulent supply chain or by failing to carry out appropriate due diligence checks) is sufficient for the right to deduct input VAT to be lost entirely where tax evasion occurs.

Background

The decision concerns a tripartite arrangement between three parties:

• C (the owner),
• W (the intermediary); and
• A (the purchaser and relevant taxpayer in this case).

C sold a car to A. A thought they were buying the car from W and not from C. This was because C was pretending to be W (with W’s knowledge and consent). The rationale for C’s conduct is unclear in the decision.

In terms of the invoicing chain, C issued W with an invoice for €52,000 plus VAT for the supply and W sent A (via C) an invoice for €64,000 plus VAT. C accounted for the VAT on their invoice but W did not account for any VAT on their invoice.

A settled the invoice including the VAT and made a claim to deduct the VAT as input VAT. The German tax authorities rejected that claim on the basis that A knew, or should have known, that the transaction was part of a fraudulent supply chain.

On appeal, the German referring court considered that in view of the occurrence of a number of events which it describes as ‘abnormal’, A ought to have checked the identity of the other contracting party. It is unclear what these events were which in the view of the referring court should have triggered this check.

That check would have enabled it to find in the view of the referring court, first, that C had deliberately concealed his identity, which could have had no purpose other than to evade VAT due in respect of the sale of the vehicle, and, second, that W did not intend to discharge his tax obligations.

However, the Court decided to refer to the CJEU the question of the quantum of the disallowance of input VAT in these circumstances. It noted that the amount subject to the fraud was only €2,000, the difference between the VAT on the invoices issued by C and W. In such circumstances, it considered that the deduction of input VAT should be refused only in so far as it proves necessary to compensate for the loss of tax revenue by fraudulent conduct.

Decision of the CJEU

In the first place, the CJEU confirmed that the Kittel principle applied equally where a second purchaser of goods (A) knew or ought to have been aware of the existence of VAT fraud by the original seller (C), even if the first seller (W) was also aware. The Kittel principle applies to any fraud in the supply chain, not simply fraud committed by the direct seller to the relevant taxpayer.

As regards the amount of input VAT to be denied, the Court held that, since lack of knowledge of fraud constitutes an implied condition of the right to deduct, a taxable person who does not satisfy that condition must be refused the right to deduct in its entirety.

That conclusion was reinforced by the objective being pursued, which is to require taxable persons to carry out reasonable due diligence in order to satisfy themselves that they are not participating in tax evasion. This objective would not be effectively achieved if the right to deduct were only limited to the sums fraudulently withheld. Indeed the court noted that the right to deduct could be deprived even without a risk of loss of tax revenue.

Comment

The decision of the Court reinforces the importance of taxpayers ensuring that they carry out appropriate due diligence in relation to their supply chain. Any fraudulent activity in that supply chain can limit their rights to deduct input VAT if they should have been aware of it and the amount at risk is not simply the amount of VAT fraudulently lost to the public purse, but the full amount of input VAT incurred by the taxpayer.

Unfortunately the specific “abnormal” events which in the view of the referring court should have triggered additional due diligence are not discussed in the decision. Whilst the decision leaves it for the referring court to determine whether the taxpayer knew or should have known about the fraud, the questions which naturally arise are whether the taxpayer simply had not carried out standard due diligence checks or whether the events referred to triggered an enhanced level of due diligence that should have been undertaken.

In particular, understanding the necessary criteria to know that W did not intend to discharge their tax obligations seems a relatively high bar. In the absence of a clear history of VAT fraud or a lack of a registration number, it seems difficult to understand how a taxpayer can know that a counterparty will not account for the relevant VAT in their new VAT return or how commercially a relevant payment could still be made without a split payment model whereby the VAT is paid directly to the tax authorities.

The significant impact of an input tax block for businesses against a relatively low bar for tax authorities to cross that the business “should” have known about fraud, creates an ongoing risk for tax departments that needs to be managed as part of the tax risk control framework.

This doesn’t just apply to tax though. Quite apart from the financial implications of failing to carry out appropriate due diligence, there may also be reputational consequences where businesses are inadvertently (but carelessly) involved in a fraudulent supply chain. With ESG considerations becoming increasingly significant for businesses generally, it is ever more important for due diligence procedures to be as robust as possible.