When can a tax authority deny the right to deduct VAT? We explain the case law of the Court of Justice of the European Union, the concept of “could have known,” red flags in supply chains, and practical risks for businesses.
The right to deduct VAT is one of the fundamental principles of the value-added tax system. In practice, it is often taken for granted—if there is an invoice, the transaction has taken place, and both parties are VAT payers, the business owner expects the government to recognize the deduction.
However, developments in recent years show that this certainty is waning. Tax audits are increasingly focusing on cases where tax fraud occurs somewhere in the supply chain, even though the business owner may not have been aware of it and had no realistic way of detecting it.
Today, the tax authority bases its decisions on the case law of the Court of Justice of the European Union, according to which a VAT deduction may be denied only if the entrepreneur’s participation in tax fraud is proven. The basis is the so-called four-step test, which examines the existence of tax evasion, its fraudulent nature, the link between the transaction and the fraud, and, in particular, whether the business owner knew or could have known that by making the purchase, they were participating in the fraud.
It is precisely the concept of “could have known” that poses the greatest problem in practice. The entrepreneur’s due diligence is assessed very strictly and often retrospectively. The tax authority evaluates whether the entrepreneur reacted to unusual circumstances, so-called red flags, such as an unreasonable price, unclear business partners, informal communication, or the supplier’s lack of business history.
EU case law also emphasizes that entrepreneurs are not expected to act as investigators. They do not have to verify the entire supply chain or determine whether someone else has paid VAT. However, due diligence today means morethan just good faith—it includes reasonable verification of partners and proper documentation of transactions.
Prevention is therefore key for businesses. Watching for warning signs, making payments through registered bank accounts, and keeping basic records of transactions can determine whether they become collateral victims of someone else’s tax fraud.
