Do you lose your VAT deduction in case of VAT fraud further up in the supply chain?

VAT deduction depends on correct purchase invoice and the fact that these relate to actual supplies of goods or services. But what about your VAT deduction when the supplier of your supplier (or even further up the supply chain) commits fraud. Do you then also lose your VAT deduction?

Question of a Hungarian judge

Vikingo, a Hungarian company buys machines from another Hungarian company (Freest Kft). Before the actual supply of the machines, the company orders an additional number of machines. According to the contractual provision Freest would buy these machines from another company, which in its turn buys these from again another company. Vikingo wants to deduct the VAT on its purchases.

It is certain that the machines are occupied at the premises of Vikingo, but the tax authorities found that the invoices, which were formally correct, and other supporting documents did not show that the economic transactions mentioned on the invoices were actually performed.
The Hungarian tax authorities established that the content of these invoices was countered by statements on the supply and origin by the issuer of the invoices and by directors of the companies earlier on in the supply chain. The Hungarian tax authorities decided that content of the invoices was untrustworthy (despite the fact that each of the directors acknowledged that the supply and use of the machines actually took place).

After a number of local judgments, the question was passed to the European Court of Justice (case C-610/19, 3 September 2020). The question of the Hungarian judge is whether the tax authorities in case of fraud can 'reconstruct' the supply chain if it's not economically appropriate of when a transaction is not justified or properly established.
Can in such a case the VAT deduction be disallowed irrespective of the fact whether or not the VAT payer was aware or should have been aware of the fraud.

European case law

The most important applicable rules were already discussed in previous judgments of the European Court of Justice. Briefly:

When both the formal and material conditions for VAT deduction are met by the VAT payer, the VAT deduction cannot be refused.

The material condition is only fulfilled in case the supply of goods or services actually took place.

The fact that earlier of later in the supply chain the VAT due was paid to the Treasury or not, does not have any impact on the right to deduct VAT in the hands of the said VAT payer.

The Court already ruled in the past that the proof for the material condition (the fact that the goods or services were actually supplied) is a national matter. The tax authorities will determine how this evidence should be provided.

But in this case, it is added that the fact that the said goods were not supplied by the issuer of the invoices nor his subcontractor, since they do not have sufficient personnel and material means, is not sufficient to decide that the goods were not supplied.
It is e.g. perfectly possible that the supplier conceals information or used other subcontractors.

Further it is established case law that if a VAT payer is aware (or should be aware) of fraud, the VAT deduction can be disallowed. It does not matter whether or not this fraud is part of VAT fraud by another entrepreneur in an earlier or later stage of the supply chain.

Implausible invoices

The Hungarian tax authorities rejected the invoices because they were implausible. The tax authorities were of the opinion that the supplier had insufficient personal and material means to produce and supply these machines. Based hereon, they concluded that in reality these goods were bought from an unknown person.
The tax authorities also invoked other arguments: the national bookkeeping rules were not respected, there would have been irregularities with previous transactions in the supply chain, ...

The Court decided that in this case the VAT deduction could not be disallowed, only because the invoices were implausible.
According to the Court, in order to reject the VAT deduction, it should be demonstrated that the VAT payer was actively involved in the fraud or should have known that the transactions were part of fraud by the issuer of the invoices or any other market participant which intervened in an earlier stage of the supply chain.

This decision is important: the professional customer of services or goods can deduct the VAT paid, even when further up in the supply chain fraud is committed. The tax authorities can only disallow the VAT deduction if it is properly demonstrated that the buyer participated or was aware or should have been aware.