The Value Added Tax (VAT) right to deduction refers to a taxable person’s right to claim from tax authorities the VAT they paid on the goods and services they acquired. It works by subtracting the deductible amount from the VAT payable to tax authorities in the regular VAT return.
VAT can be deducted on the following transactions:
- Domestic supplies of goods or services and transactions treated as such
- Intra-EU acquisitions of goods and transactions treated as such
- Importation of goods
In addition, only VAT due on goods or services used for the following activities can be deducted:
- the taxed transactions of the taxable person
- certain exempt transactions
- transactions carried out abroad if the same transactions would give rise to VAT deduction domestically
- cross-border supplies of new means of transport
- certain exempt financial transactions with customers established outside the EU
Partial or full deduction
Full deduction applies to VAT due on goods and services used for activities giving rise to the VAT deduction. VAT due on goods or services used for activities not giving rise for deduction may not be deducted.
Proportional deduction applies in cases where direct attribution of expenditure either to activities where there is no right of deduction or to activities where there is a right of deduction (e.g. in respect of overheads) is not possible.
In addition, restrictions on deduction apply on certain types of expenditure.
When does the right to deduct arise?
The right to deduct arises when the deductible tax becomes chargeable (Article 167 VAT Directive). This timing determines in which VAT return period the business may claim the VAT deduction. This may often be before payment of the input VAT is made.
The basic rule is that VAT becomes chargeable:
- when the supply of goods or services is made
- for intra-EU acquisition on issue of the invoice
- for importation of goods, when the goods are imported
For more detailed information, see Chargeable event and chargeability.
The ‘cash accounting’ scheme is a special scheme that EU countries may put in place for certain transactions or taxable persons. It allows the supplier to declare VAT in the tax period in which the payment for the supplies of goods or services is received.
When a taxable person is under this scheme, VAT becomes chargeable and is due by the supplier to the tax administration only once they have received the payment. Consequently, the customer can only deduct the VAT when the payment is made to the supplier.
For the customer to know when his/her VAT becomes deductible, the supplier should mention on the invoice that he/she is using the ‘Cash accounting’ scheme (Article 226(7a)).
Additionally, EU countries may provide that, when a taxable person is under the ‘cash accounting’ scheme, that person can only deduct the VAT charged to them on the supplies of goods or services received when the invoice is paid (Article 167a). This does not affect their supplier, who has to declare and pay VAT in accordance with the general rules.
Transactions on which VAT is deductible
Domestic supplies of goods and services and transactions treated as such
| Type of transaction on which VAT is deductible | Conditions for deduction |
|---|---|
| Domestic supply of goods and services Article 168(a) VAT Directive |
|
| Transactions treated as a supply of goods and services Article 168(b) VAT Directive |
|
Intra-EU acquisition of goods and transactions treated as such
| Type of transaction on which VAT is deductible | Conditions for deduction |
|---|---|
| Intra-EU acquisition of goods Article 168(c) VAT Directive |
|
| Transactions treated as EU acquisitions Article 168(d) VAT Directive |
|
Importation of goods
| Type of transaction on which VAT is deductible | Conditions for deduction |
|---|---|
| Importation of goods Article 168(e) VAT Directive |
|
Transactions giving rise to deduct
Taxed transactions of the taxable person
| Type of transaction giving rise to deduct | Conditions for deduction |
|---|---|
| Taxed transactions of the taxable person Article 168 VAT Directive | Goods and services are used for the taxed transactions of the taxable person in the same EU country. |
Certain transactions carried out abroad
| Type of transaction giving rise to deduct | Conditions for deduction |
|---|---|
| Certain transactions carried out abroad Article 169(a) VAT Directive | Transactions are related with any economic activity of the taxable person:
|
Transactions exempt with the right to deduct
| Type of transaction giving rise to deduct | Conditions for deduction |
|---|---|
Exempt transactions (Article 169(b) VAT Directive) such as:
| Only domestic VAT exempt transactions listed in Article 169(b) of the VAT Directive are eligible. |
Certain exempt financial transactions
| Type of transaction giving rise to deduct | Conditions for deduction |
|---|---|
Exempt transactions (Article 135(1), (a) to (f), VAT Directive) such as:
| Only VAT exempt transactions listed in Article 169(c) VAT Directive are eligible and only when one of the two conditions are met:
|
Deductions for cross-border supplies of new means of transport
| Type of transaction giving rise to deduct | Conditions for deduction |
|---|---|
| Cross-border supplies of new means of transport Article 172 VAT Directive |
|
Proportional deduction
Proportional deduction of input VAT applies whenever a taxable person (business) carries out both transactions in respect of which VAT is deductible (taxed supplies) and those in respect of which it is not (most exempt supplies, for example).
According to Article 173(1) of the VAT Directive, in the case of goods or services used by a taxable person both for transactions in respect of which VAT is deductible and for transactions in respect of which VAT is not deductible, only such proportion of the VAT as is attributable to the former transactions shall be deductible.
Article 173(2) of the VAT Directive prescribes three methods that may be used to apportion the deductible VAT and leaves the choice of method to each EU country. EU countries are not required to choose one method to the exclusion of the others.
Under all three methods, where the amount of non-deductible VAT turns out to be very small compared to the deductible amount, EU countries may choose to allow it to be equated to nil and hence allow full deduction.
An EU country may authorise the business to determine a proportion for each sector of its business, if it already keeps separate books of account for each sector, or require the business to keep separate books of account for each sector of its business and to determine a proportion for each sector.
An EU country may authorise or require the business to deduct or not to deduct on the basis of the actual use to which all or part of the goods or services are put in respect of a specific transaction.
The deductible proportion is calculated as a fraction, of which:
- the numerator is the total VAT-exclusive annual turnover attributable to transactions qualifying for VAT deduction and
- the denominator is the total VAT-exclusive annual turnover attributable to both transactions qualifying for VAT deduction and transactions not qualifying for VAT deduction.
EU countries may choose whether or not to require subsidies (other than those directly linked to the price of supply) to be included in the denominator.
There are amounts that must be excluded from the calculation. These are amounts of turnover attributable to:
- supplies of capital goods used by the business for business purposes (however, in EU countries where no adjustment is made for capital goods (see Deductions: Adjustment for capital goods), disposals of capital goods may be included in the calculation);
- incidental transactions with immovable property and incidental financial transactions; and
- incidental exempt financial transactions, listed in points (b) to (g) of Article 135(1), VAT Directive.
As the rules imply, the deductible proportion is calculated once a year. A provisional proportion, based on the previous year’s transactions may be used initially, and an adjustment is then made when the final proportion is known in the following year.
Where there are no or insufficient transactions in the previous year on which to base the provisional proportion, the business can use its own forecasts to estimate it, with the approval of the national tax authorities.
EU countries that had different rules in place on 1 January 1979 may retain their own rules and countries joining the European Union after that date may retain the rules they had at their date of accession.
(Article 175, VAT Directive)
It must be fixed as a percentage and rounded up to a figure not greater than the next whole number.
Example
A business, B Co, has a VAT-exclusive turnover of EUR 70 000 from transactions qualifying for deduction and EUR 50 000 from transactions not so qualifying. It has also sold capital goods for a total of EUR 12 000*.
Its deductible proportion is: 70 000 / (70 000 + 50 000) = 58.33%
This may be rounded up to no more than 59%.
* B Co’s EU country excludes the value of capital goods from the calculation of the deductible proportion.
Restrictions on deduction
There are essentially only two global restrictions on the right of a taxable person (business) to deduct the VAT incurred on goods and services purchased or acquired. In no circumstances may VAT be deducted in respect of expenditure that is not strictly business expenditure.
Examples of expenditure that is not strictly expenditure (Article 176 VAT Directive) are expenditure on luxuries, amusements or entertainment.
With the unanimous agreement of all EU countries, a general restriction, is set to be imposed on the deduction of VAT for certain specified types of expenditure.
Until such time, EU countries may retain exclusions that were in place on 1 January 1979 (or as at their date of joining the EU, if later).
EU countries may, subject to consultation of the VAT Committee, totally or partly exclude expenditure on some or all capital goods from the right to deduct, for cyclical economic reasons.
Instead of denying deductions, EU countries may instead tax goods the business manufactures itself or purchases within the EU or imports from third countries, but not more heavily than they tax the acquisition of similar goods.
(Article 177 VAT Directive)
Evidence and procedures for deduction
A taxable person (business) may only exercise his right to deduction if he satisfies certain conditions. The precise nature of the evidence or conditions depends on the nature of the transaction on which the deduction is being claimed.
| The deduction is claimed for VAT on: | Evidence/conditions required |
|---|---|
| Supply of goods and services | Business must hold a valid VAT invoice. |
| Transactions treated as a supply of goods or services | Rules are laid down by the individual EU country. |
| Intra-EU acquisitions of goods | Business must hold a valid VAT invoice and provide the information required in its VAT return. However, EU countries may choose to override this rule and allow businesses to make the deduction even where they do not hold a valid VAT invoice. |
| Transactions treated as intra-EU acquisitions | Rules are laid down by the individual EU country. |
| Imported goods | Business must hold an import document naming it as the consignee or importer and stating the amount of VAT due or enabling that amount to be calculated. |
| Reverse-charge VAT | Rules are laid down by the individual EU country. |
(Articles 178 and 181 VAT Directive)
Regardless of the above, EU countries have the authority to allow businesses to make a deduction in cases where they have not been able to comply with the requirements above and/or with the method of making deductions. The EU country concerned will set its own detailed rules for this.
(Article 180 VAT Directive)
How and when deductions are made
Taxable persons (businesses) make good their right to deduct input VAT when making their VAT return for the relevant period by:
- subtracting the input VAT for which the right of deduction has arisen in that period
- from the total amount of VAT due by them in that period.
(Article 179 VAT Directive)
See how and when to make VAT returns
See when VAT is due - VAT Chargeability
Exception for occasional transactions – EU countries may choose to require that persons whom they regard as taxable persons because they carry out occasional supplies of:
- buildings prior to their first occupation and of the land on which they stand or
- building land
to exercise their right of deduction only when they make the supply (Article 179 VAT Directive).
When deductible VAT is more than VAT due – If the amount of VAT a business may deduct in any period is greater than the amount of VAT due from that business in the same period, EU countries may either:
- make a refund of the excess or
- carry the excess forward to the next period.
They may, however, also refuse to refund or carry forward an excess if it is insignificant (Article 183 VAT Directive).
Adjustments of deductions
There are occasions when the circumstances underlying the deduction change after a deduction (‘the initial deduction’) has been made, so that it is no longer correct. This may be because:
- the purchase on which the VAT was payable is cancelled
- a price reduction is subsequently obtained for a purchase
- a transaction remains totally or partially unpaid
- where proportional deduction applies, the final deductible proportion is calculated
- the capital goods scheme applies.
When to make adjustments – An initial deduction must be adjusted where it is higher or lower than the deduction to which the taxable person (business) is entitled (Article 184, VAT Directive).
This is particularly the case where purchases are cancelled, price reductions are obtained or there is some other change in the factors used to calculate the deduction.
However, no adjustment may be made for transactions remaining totally or partially unpaid or where goods purchased are destroyed, lost or stolen (subject to proper proof or confirmation).
Nevertheless, EU countries may require an adjustment where:
- transactions remain totally or partially unpaid or
- in the case of theft.
(Article 185 VAT Directive)
Procedure for adjustments – Every EU country provides national rules for making adjustments (Article 186 VAT Directive).
Adjustments for capital goods
The VAT Directive does not contain a definition for ‘capital goods’ - this is left to EU countries themselves.
However, the concept is broadly speaking equivalent to a fixed asset, the use of which is likely to extend over several years (at least five is the implication), typically, immovable property or expensive computer equipment, and is unlikely to be limited to one specific business or non-business purpose.
The legislation for the capital-goods adjustment is found in Articles 187-191 of the VAT Directive.
An adjustment must be made whenever, during the ‘adjustment period’, the degree of use of the goods for the purpose of making taxable (taxed/exempt) transactions alters.
Adjustments for capital goods need not be made, therefore, when the business makes only transactions that are taxed or exempt with right of deduction or only transactions that are exempt without right of deduction or non-taxable.
It will therefore apply to businesses who make proportional deductions at any time during the adjustment period.
The normal adjustment period is five years, starting with the year in which the goods are acquired or manufactured. Alternatively, EU countries may start counting this period from the date on which the goods are first used.
In the case of immovable property, EU countries may extend this period up to a maximum of 20 years.
The adjustment is made annually during the adjustment period. However, if the degree of entitlement to the deduction (calculated as for proportional deductions generally) is the same in any year as in the first year for which the deduction is claimed, no adjustment need be made.
The adjustment in any one year is given by the formula: (VAT on original acquisition / number of years in the adjustment period) x (difference in entitlement percentage)
Example
A business who makes both taxed and exempt transactions purchases a computer installation at a price of EUR 200 000 for his factory. The VAT on the purchase is EUR 40 000. The adjustment period is 5 years.
In Year 1, the degree of use for taxed transactions is 60%. In Year 2, it is 56%; in Year 3 it is 65%; in Year 4 60% and in Year 5, 58%.
Deductions and adjustments are as follows:
Year 1 - 40 000 x 60% = 24 000 original deduction
Year 2 - (40 000/5) x (60% - 56%) = 320 due to national tax authorities
Year 3 - (40 000/5) x (65% - 60%) = 400 deduction
Year 4 - No adjustment, as the entitlement percentage (60%) is the same
Year 5 - 40 000/5) x (60% - 58%) = 160 due to national tax authorities
What happens if capital goods are sold or transferred during their adjustment period?
There is only one adjustment period. If the transferee (new business owner) acquires the goods while that period is still running, it must make the adjustment only once in respect of all the time the period still has to run. If the supply to it was taxed, the business' original deduction (initial entitlement percentage) is 100%. If the supply is exempt, theinitial entitlement percentage is zero.
In applying the adjustment scheme for capital goods, EU countries may choose to:
- adopt their own definition of capital goods
- specify the amount of VAT to be used in the adjustment calculation
- take measures to prevent the obtaining of an unjustified advantage
- make administrative simplifications
Normally, yes. EU countries may choose not to operate it under the following conditions:
- the practical effects of applying the scheme is negligible;
- it takes into account overall impact of VAT and the need of administrative simplification;
- it ensures that there is no distortion of competition as a result;
- consults the VAT Committee in advance.