The relevance of incidental transactions for pro-rata deduction of input VAT under the VAT Directive

Abstract: The principle of fiscal neutrality is the essence of the EU VAT system. It aims at relieving taxable persons of the burden of VAT through the deduction mechanism provided for by the VAT Directive. In its another aspect, the principle is a means of reflecting the equal treatment of taxable persons. The equal treatment of taxable persons ensures that taxable persons in a comparable situation are not treated differently. Additionally, it seeks to guarantee the functioning of the internal market in the sense that there is a level playing field for taxable persons within the EU. The purpose of this paper is to investigate the rules governing partial VAT deductions, and more precisely the rules on incidental transactions adjusting the calculation of deductible proportion. The rules are analysed and assessed in the light of the objectives of the principle of fiscal neutrality. It follows from the principle of fiscal neutrality that the method of calculation must be as precise as possible. However, the turnover-based deduction method provided for by the VAT Directive inherently restricts the right to deduct disproportionately in certain situations. To offset the negative effects, incidental transactions are excluded from the calculation of the deductible proportion. The objective of the provisions on incidental transactions is thus to make the calculation method established in the VAT Directive compatible with the principle of fiscal neutrality. Incidental transactions are defined neither in the VAT Directive nor in the case-law of the CJEU. Based on the case-law, it can be summarised that incidental transactions are of an unusual nature and of secondary importance in relation to the normal activities of the taxable person. Moreover, incidental transactions may entail the use of the taxable business assets only to a very slight extent. The provisions on incidental transactions and the interpretations of the CJEU comply with the principle of fiscal neutrality to a large extent. Nevertheless, the criteria established by the CJEU are rather imprecise and leave certain questions open, which threaten the achievement of the objectives of the principle of fiscal neutrality as regards the right to deduct. Additionally, the unclear criteria for identifying incidental transactions lead to differing practices in the Member States, which means that the level of tax burden on taxable persons varies from Member State to Member State. This is an undesirable result in respect of the principle of fiscal neutrality seeking to ensure the equal treatment of taxable persons. Moreover, the existence of two systems in the VAT Directive for determining the deductible proportion of input VAT is problematic from the perspective of the equal treatment of taxable persons. The applicable deduction method adopted by a Member State determines whether there is an obligation for that Member State to take incidental transactions into account. To achieve the objectives of the principle of fiscal neutrality, more case-law and certain improvements in the legislation are necessary.