VAT’s mechanics are founded upon three fundamental and quite simple axes:
- It is charged along each of the stages of the commercial circuit, by any taxable person.
- It may be deducted, by any given taxable person.
- It must always be incurred by the final consumer.
We have to notice that VAT’s mechanics create a rational correlation between the amount of VAT to be deducted and the amount of VAT actually charged by any taxable person.
In what concerns people that only carry out activities subject and not exempted from VAT, such correlation may be described as follows: taxable people may deduct the amount of VAT charged by its suppliers (“input” VAT)up until the full amount of VAT that it has charged to its clients (“output” VAT), in a given tax period.
However, grains of sand in the cogs tend to appear, when such a logical correspondence is to be applied to the so-called “mix taxable persons” (i.e., taxable persons that simultaneously conduct transactions, which are subject to VAT, and transactions that benefit from a tax exemption or that are outside VAT’s scope).
Firstly, mix taxable persons must mandatorily use the “direct attribution of input tax”[i].
This method can be summarized as follows:
- VAT that has been charged by suppliers on the acquisition of goods/services to be used in an activity subject to VAT may be wholly deducted;
- VAT levied on the acquisition of goods/services to be used in an activity benefiting from a VAT exemption or that are outside its scope, may not be deducted.
However, if the goods/services are to be used concurrently in both activities (subject and exempted/outside the scope), mix taxable persons must consequently use the so-called “pro-rata” deduction method[ii].
This method establishes a proportion of deductible VAT (which underlines/accentuates the inherent correlation between “input” and “output” VAT).
Such proportion is to be determined as follows:
(AT / TTA) x 100 = “Pro-Rata”
AT: Annual turnover concerning activities, carried out by a given mix taxable person, subject to VAT.
TTA: Total turnover amount (i.e., the sum of the activities carried out by the mix taxable person subject to VAT, with those that benefit from an exemption or which are not within its scope) [iii].
The “pro-rata” determined at the end of each year shall (provisionally) apply to the VAT charged in every acquisition of goods/services simultaneously used in activities subject to taxation and activities benefiting from an exemption/outside the scope, in the following year.
This will allow the mix taxable person to determine the precise amount of VAT that it will be entitled to deduct, at acquisition.
However, by the end of this (subsequent) year, it is mandatory to make an adjustment of the total amount of VAT that was deducted (given that the definitive “pro-rata” to be applied in this following year must take into account the effective turnover of such year).
This adjustment is a logical consequence of the VAT’s mechanics.
Still, there is another type of adjustment that, apart from stemming from the nature of the tax itself (i.e., its mechanics), seems to provide an immune boost, against tax avoidance schemes.
Article 187 of the VAT Directive prescribes a need to an adjustment in what concerns VAT paid in the acquisition of capital goods, on a period of five full years starting from the time at which the goods are first used (for immovable property, acquired as capital goods, the adjustment period may be extended up to 20 years).
This particular adjustment will be based on “variations in the deduction entitlement” in subsequent years, taking into account the year in which the goods were acquired, manufactured or used for the first time.
In order to fully comprehend this type of adjustment, consider the hypothesis of a mix taxable person acquiring, in 2017, an industrial machine in order to be indistinctively/simultaneously used to exempt activities and taxable activities, having paid €1.000 of VAT.
The definitive “pro-rata” of that year was of €67%. Therefore, a total amount of €670 was deducted [€1.000 x 0,67].
In the following years, the mix taxable person had the following definitive “pro-ratas”
| year + 1 | year + 2 | year + 3 | year + 4 |
| 65% | 63% | 60% | 70% |
Considering that the “variation of deduction”, established by the Member State, is of 5 percentage points, we must conclude that in year + 3 there would have to be an adjustment, to be paid to the national tax authorities, of €14:
€1.000 x 0,60 = €600
€600 – €670 = € -70
– €70 / 5 = – €14
This example allows us to reach the following conclusion: even though this specific adjustment is a direct consequence of the general mechanics of VAT, it actually deters a specific category of tax avoidance constructions.
In fact, mix taxable persons would be tempted to acquire a given capital good in a year where they would estimate that they would carry out a substantial amount of transactions subject to VAT and an insubstantial amount of exempted/outside the scope transactions.
This would allow them to benefit from a significantly higher “pro-rata”, in comparison to other normal/regular years (i.e., enabling a higher percentage of “input” VAT to be deducted).
By establishing these “variations” in deduction, such tax avoidance transactions will simply cease to exist. Which might, consequentially, allows us to consider the anti-tax avoidance predisposition of the referred adjustment mechanism (i.e., an anti-tax avoidance tool, of a non-normative/non-judicial nature).
Pedro Costa Monteiro
January 2023
To keep track of EU Law and ECJ case law:
[i] Nº. 38 of ECJ “Abbey National plc vs. Commissioners of Customs & Excise” (case C-408/98), judgement of 22 February 2001 [ECLI:EU:C:2001:110].
[ii] In accordance with the caselaw of the Court, Member States have the possibility to use other methods and criteria appropriate to determine the precise amount of VAT to be deducted by a mix taxable person, so long as they are consistent with the principles underlying the common system of VAT, such as the affectation method used by certain jurisdictions, and that is fundamentally sustained in objective criteria – please refer to number 34 of ECJ “Securenta Göttinger Immobilienanlaen und Vermögensmanagement AG vs. Finanzamt Göttingen” (case C-437/06), judgement of the 13 March 2008 [ECLI:EU:C:2008:166]. However, and for reasons of simplification, we shall only analyse, in this article, the “pro-rata” deduction method.
[iii] Please notice that, in accordance with paragraph 2 of Article 174 of the VAT Directive, it will not be included in the “pro-rata” formula, amongst others: (i) the amount of turnover attributable to supplies of capital goods used by the taxable person for the purposes of his business; (ii) the amount of turnover attributable to incidental real estate and financial transactions; and (iii) the amount of turnover related to the granting and negotiation of credit, or credit guarantees, deposit and current accounts, payments, transfers, cheques and other negotiable instruments, negotiation of currency, transactions with shares, interests in companies or associations, and management of special investment funds (as far as these last transactions are incidental).