Under current practice the Tax and Customs Administration (NAV) fines taxpayers that are caught with a VAT shortfall even if the budget has sustained no losses. An opinion recently published by the Advocate General of the European Court of Justice could spell the end for this extremely unfair and much criticised procedure.

The VAT treatment of certain transactions can often be problematic, and it is by no means uncommon for the parties in the transaction to end up misinterpreting – together and in good faith – the relevant provisions of the VAT Act. The parties may, by mistake, treat a transaction that is subject to a reverse charge as a regular transaction, or vice versa.

As long as the parties are acting prudently and in good faith, the budget suffers no losses at all: one taxable entity pays the VAT into the budget, the other deducts it. Ultimately, the outcome of all this for the budget is the same as if the parties had not charged VAT under the rules of reverse charging. Indeed, the budget often actually does better in terms of cash flow, as the company charging the VAT may be required to pay the VAT into the budget before the other party is able to recover it (either through a VAT deduction or a VAT reclaim).

The tax authority, however, comes down hard on taxable entities that make such mistake on VAT treatment. Where the tax authority finds a VAT shortfall, it regularly imposes a 50% tax fine, regardless of whether the budget suffered any overall loss as a result. What’s more, this practice was recently given the green light by the Supreme Court in a recent ruling.

The Farkas case

Recently, however, the Advocate General of the European Court of Justice also gave its opinion on the issues described above in a Hungarian case (the Farkas case). The parties of the transaction in question applied direct VAT, whereas NAV believes they should have applied a reverse charge. As usual, NAV fined the party that unlawfully reclaimed the VAT. Giving its opinion on the case, however, the Advocate General declared that NAV breached Community law by imposing a fine even though there was not even a suspicion of tax fraud between the parties.

The opinion of the Advocate General is the starting point for the European Court of Justice, which rarely arrives at a decision that deviates from the position taken by the Advocate General. Another reason that the European Court of Justice is likely to share the Advocate General’s opinion in this case is that it fits in seamless with the decisions brought by the court in similar cases.

But what happens to the paid-in VAT?

If the Advocate General’s motion is accepted, this will resolve the onerous situation in which the tax authority imposes fines on the basis of VAT that has already been paid to the state, and which is being used by the state. A question that commonly arises, however, is: if NAV finds a tax shortfall at the buyer and doesn’t permit deduction of the VAT charged by the seller, will the seller be able to reclaim the excess tax paid to the tax authority in error?

While the answer to this question is, in theory, yes, technical obstacles often come into play. First of all, a prerequisite for reclaiming paid-in VAT is a corrected invoice. But if the taxable entity that issued the original invoice no longer exists, or exists but now trades under a different tax number, it is technically impossible to correct the invoice. The reclaiming of the paid-in VAT could also be prevented if the tax authority has already audited the accounts of the taxable entity concerned for the tax year in question, as a self-revision is only possible in respect of a period that has not been closed with a tax authority audit. And large taxpayers are audited regularly by NAV, so they can easily lose the opportunity to reclaim the VAT, essentially paying the same tax twice in the course of a transaction.

And even if the paid-in VAT is reclaimable, it’s still not certain whether the contract concluded between the parties makes it possible for the party that lost out to oblige its counterparty to refund the reclaimable part of the VAT to it. In such case the tax laws are of no assistance; everything depends on the careful wording of the contract between the two parties.