Financial MarketsPublic Sector
Is a correction of the deducted tax credit necessary? What does the Court of Justice of the EU say?
This piece was written in due course following the CJEU judgment in May 2023.
On 1 January 2024, changes to the Bulgarian Value Added Tax Act (VAT Act) came into force, in particular Article 80(2), which harmonises Bulgarian with European legislation in accordance with the Court’s judgment. Thus, cases such as the one described here should no longer arise.
Consult us about your tax obligations by emailing us at: ivanova@ynglegal.com.
Introduction
In May 2023, the Court of Justice of the European Union (CJEU) issued a landmark decision (Decision of 04.05.2023 in Case C-127/22) in the field of the right to deduct tax credit, clarifying questions of practical importance. The Court’s decision concerns the need for a correction of the initially determined amount for deduction in cases of goods being defective, subsequently sold as waste, or destroyed.
The tax credit allows registered persons under the VAT law to deduct from their tax obligations the tax paid on taxable supplies of goods and services. One of the conditions for exercising this right is for the goods or services to be subject of subsequent taxable supplies. Often, certain goods need to be declared defective after the tax credit has already been deducted.
After the process of declaring the goods defective is completed, a decision regarding their subsequent treatment should be made. In some cases, the defective goods are subject to destruction, which practically excludes the possibility of them being the subject of subsequent taxable supplies. However, it is not excluded that the goods may be sold as waste.
Many businesses have raised the question of whether they should return the deducted tax credit to the budget in cases where the defective goods have been destroyed or have become the subject of a subsequent taxable supply but as waste. This question now has a clear and categorical answer. It was initially prompted by the incompatibility of the national regulations regarding the correction of deducted tax credit with European rules. We have paid special attention to the collision between the provisions of Council Directive 2006/112 (the “Directive”) and the provisions of the VAT Act.
The dispute in the context of which the preliminary question was made
The dispute concerns a tax-related issue that arose between the Appeals and Tax Insurance Practice Directorate (ODOP) of the National Revenue Agency (NRA) and “BTK” EAD – a Bulgarian company providing telecommunications services. In the course of its activities, the company acquired various long-term assets through taxable supplies.
After availing itself of its right to deduct input tax credit, between October 2014 and December 2017, the company disposed of various goods that had become unfit for use or sale due to wear and tear or defects. It is important to note that some of the goods were sold as waste, while others were destroyed. Subsequently, the company made corrections to the utilized VAT credit based on Article 79, paragraph 3 of the Value Added Tax Act (VATA) (in its version effective until December 31, 2016) and Article 79, paragraph 1 of the VATA (in its version effective until January 1, 2017).
These provisions provide for the refund of the deducted tax credit (in full or in part) in case of destruction, disposal, or identification of shortages of goods. The corrections were made by issuing protocols under Article 117 of the VATA and reflecting them in the respective monthly VAT returns.
On January 18, 2019, BTK submitted a request to the NRA for the refund of the returned tax credit, maintaining that there was a discrepancy between the provisions of the VATA and the Directive. The request was rejected by the NRA, leading BTK to file an appeal with the Sofia City Administrative Court (SAC). In its appeal, the company argued that the dispute was purely legal and is related to the question whether the VATA requires the correction of the utilized tax credit in cases of destruction or disposal of goods when duly proven or confirmed, in violation of the Directive.
The appeal was dismissed, with SAC stating that our national legislation (Article 80, paragraph 2 of the VATA) lists exceptions where no corrections are made under Article 79 of the VATA, including the disposal of goods, but under additional conditions. The company appealed SAC’s decision to the Supreme Administrative Court (SAC), which stopped the proceedings and referred a preliminary question to the Court of Justice of the European Union (CJEU).
Where does the problem stem from?
The root of the problem lies in the contradiction between the provisions of Article 78 and subsequent articles of the VATA, regulating the matter, and the European rules on correction of deducted tax credit provided for in Directive 2006/112.
What does Directive 2006/112 provide for?
The fundamental possibility of adjusting the initially determined amount for deduction is provided for in Article 184 of the Directive. Article 185 clarifies that the correction is made in cases where there is a change in the factors used to determine the deduction amount after the preparation of the VAT return. Article 185, paragraph 2, provides that in cases of destruction, loss, or theft of goods, duly proven or confirmed, the utilized tax credit is not subject to refund, regardless of the change in factors. The Directive grants Member States the freedom to establish detailed rules for the application of Articles 184 and 185 and to adapt their national legislation according to the requirements of the Directive.
What does Bulgarian legislation provide for?
In Bulgaria’s legislation, the regulation of the matter is in Articles 79 and subsequent articles of the VAT Act. Contrary to Article 185, paragraph 2 of the Directive, Article 79, paragraph 1 of the VAT Act provides that in cases of destruction, loss, and disposal of goods, taxable persons must refund the deducted tax credit.
Article 80, paragraph 2 of the VAT Act (in its version effective from January 1, 2017) regulates the exceptions to this rule. It specifies that there is no obligation to refund the utilized tax credit only when destruction, loss, or disposal are caused by any of the events listed in the provision. For example, taxable persons are not obligated to refund the tax credit when destruction is caused by force majeure (item 1) or accidents or disasters (item 2).
Analysis of Article 185, paragraph 2 of the Directive and Article 80, paragraph 2 of the VAT Act shows that there is a collision between them. The VAT Act provides that as a rule, in cases of destruction, loss, and disposal of goods, the tax credit should be refunded. Only in cases where they are caused by the events listed in Article 80, paragraph 2, there is an exception to the rule, and the utilized tax credit is not subject to correction and refund. On the other hand, the Directive regulates that as a rule, destruction, loss, or disposal of goods does not require the refund of the utilized tax credit, without considering the specific events that led to them.
This contradiction leads to significant practical problems for many businesses, which are obligated to refund the utilized tax credit.
The interpretation by the Court of Justice of the European Union (CJEU)
The interpretation by the CJEU resolves the disputed points and provides a clear answer to the questions posed. The CJEU comments on two hypotheses, which differ depending on how defective goods, for which the taxable person has determined cannot be realized due to physical wear or damage, have been treated. In the first hypothesis, the goods were destroyed after being declared defective, while in the second, they were sold as waste under a taxable supply.
The first question relates to the interpretation of Article 185, paragraph 1 of the Directive. The CJEU is expected to clarify whether there is a “change in the factors” used to determine the deductible tax credit when the declaration of defective goods is followed by a sale of those goods as waste subject to VAT.
According to the CJEU, such a hypothesis should not be considered a “change in the factors” within the meaning of Article 185 of the Directive. It specifies that one of the conditions allowing for the deduction of tax credit is met—the goods have become the subject of a subsequent taxable supply in form of a waste. According to the decision, it is irrelevant that the sale of waste does not relate to the usual economic activity of the taxable person.
The second, third, and fourth questions are considered together by the CJEU. With them, the referring jurisdiction essentially seeks to establish the following:
Whether there is a “change in the factors” used to determine the deductible amount when the declaration of defective goods is followed by their voluntary destruction?
If the answer to the previous question is affirmative, then the CJEU is asked to clarify whether the declaration of defective goods in such circumstances constitutes “destruction” or “loss” within the meaning of Article 185, paragraph 2 of the Directive, even though it is not an event beyond the control of the taxable person, and which could not have been foreseen and prevented by the latter.
The Court of Justice of the European Union specifies that destruction and spoilage should undoubtedly be classified as “changes in the factors” within the meaning of Article 185 of the Directive, insofar as they lead to the impossibility of using the goods for subsequent taxable supplies. On the other hand, they fall within the scope of Article 185, paragraph 2 of the Directive, which lists hypothesis where no adjustment and repayment of input tax credit is required. Therefore, no correction should be made in this case either.
However, there are two additional requirements that must be met to conclude that destruction falls within the scope of Article 185, paragraph 2 of the Directive. Firstly, the destruction must be properly proven. In addition, the destruction must be result of a decision taken beforehand by the taxable person to destroy the goods due to the impossibility of using them for their usual economic activity.
The CJEU also pays attention to the terms “destruction” and “spoilage”, highlighting the differences between them and clarifying that the spoilage of an item could not result from the voluntary action of its owner or possessor, whereas this is not ruled out in the case of destruction. In the dispute between ODOP and BTK destruction is present, as the existence of the goods has been terminated as a result of actions by the taxable person.
The decision also addresses the second question, which essentially seeks to establish whether destruction must be beyond the control of the taxable person in order for Article 185, paragraph 2 of the Directive to apply. The CJEU clarifies that from the text of the provision, it cannot be inferred that destruction must necessarily result from an event beyond the control of the taxable person.
Considering the above, according to the CJEU, there is no need to repay the input tax credit when the scrapping of the goods is followed by their voluntary destruction, provided that the destruction is properly proven or confirmed and there is no longer any benefit from the goods in economic activity.
Additional notes
It is important to recall that directives are acts of EU law that give Member States freedom in their choice of form and means to achieve the objectives set out in them. It is precisely in this sense that Article 186 of the Directive provides Member States with the freedom to determine detailed rules for the application of Articles 184 and 185.
However, they must refrain from introducing rules that contradict those in the Directive or are more restrictive than them. In this regard, in its decision, the CJEU explicitly notes that the Directive does not allow provisions of national legislation that provide for the correction of deducted VAT in cases where the scrapping of goods is followed by their subsequent sale as waste, destruction, or disposal.
Practical consequences of the CJEU decision
The commented decision poses a challenge to the Bulgarian legislative authority to undertake legislative changes through which the VAT Act will be brought into compliance with the interpretation provided by the CJEU. We expect changes in the VAT Act to put an end to the existing practical problem. In the meantime, taxable persons who have made adjustments to deducted tax credit have the opportunity to request a refund of the returned tax, citing the commented decision, as it is binding on Bulgarian courts.
Assistant attorney Iveta Ivanova consults on various legal topics, she prepares opinions and contracts.
