What good faith really means in the case of VAT (part 2)

Przemysław POWIERZA
Tax Partner at RSM Poland

In today’s post I would like to continue the series on good faith concerning VAT we have addressed because of a very interesting ruling of the Provincial Administrative Court in Wrocław of 10 July 2018 file ref. no. I SA/Wr 256/18. You can read more about it in the previous post (part 1). Now I would like to focus on the prerequisites of good faith presented by both the Polish administrative courts and the Court of Justice of the European Union (CJEU).

Fraudsters and entities knowingly contributing to tax frauds often bring honest taxpayers into fraudulent transactions, as it makes it more difficult for tax authorities to uncover the illegal practice. Unfortunately, entities unaware of being involved in such transactions may suffer severe consequences. That is why it is so important to learn the principles of good faith. If the tax authority determines that the taxpayer acted in good faith, he is not going to be denied the right to VAT deduction, 0% VAT rate or the right of reimbursement. Good faith offers protection, but the lack of it does just the opposite: it has legal consequences as the taxpayer is denied these rights, which has been clearly pointed out by the Provincial Administrative Court in Wrocław in the discussed ruling. However, acting in good faith is also essential from the business perspective. Being subject to a tax audit itself generates high costs for the entrepreneur, namely staff involvement and hiring external advisors to handle such a procedure. What is more, surely no entrepreneur would like to spend their own money on paying someone else’s tax, and that is what may result from acting in bad faith. That is why it is better to be safe than sorry, and implement your own, individual procedures instead of crying over spilt milk later, as the proverb says.

Abuse or fraud?

Before I go on to discuss the prerequisites of good faith, I will give you a couple of words of introduction. One of the most crucial aspects concerning good faith is to define two basic concepts, i.e. the abuse of law and tax fraud. Why is it so crucial? First and foremost because before the authority accuses the taxpayer of not having acted in good faith, they must demonstrate clearly that the right to deduct the input tax is being denied due to the taxpayer’s involvement in a tax fraud, and not because of an abuse of tax law. Good faith pertains to being unintentionally involved in fraud, whereas abuse of law means that the regulations have either been intentionally or unintentionally breached. When deciding if a given action is an abuse or a fraud, totally different facts must be proven. An abuse of law shall be understood as a transaction aimed primarily at tax evasion. Hence it is about creating artificial structures that are not based on any economic and business premises. As opposed to a tax fraud, in the case of the abuse of law, the transaction objectively meets all the conditions of the supply of goods or the provision of services; the fact that a given transaction took place is not being challenged. In the case of the abuse of law, we are dealing with tax evasion, e.g. if the input tax is deducted on the basis of documents that misrepresent the actual transaction or tax is evaded (through the underreporting of income, applying lower rates or deliberate failure to pay the tax). Should the tax authority find that the transaction we have concluded was part of a fraud, in the next step they must demonstrate that you have been involved in this fraud intentionally. The fact that your contractor was identified as fraudulent cannot automatically lead to a conclusion that the taxpayer must have known about the fraud. On the basis of objective circumstances, the tax authority must demonstrate that the taxpayer knew or should have known that the transaction being the basis for deduction involved a crime committed by the vendor or another entity operating at either an earlier or a later stage of the supply chain. If this is demonstrated that the taxpayer knew about the fraud, the taxpayer will be denied the rights he has under VAT regulations, including the right to deduct the input tax.

What should officials be guided by when assessing that the taxpayer, in given factual circumstances, should have suspected that his contractor committed a fraud in a situation in which the goods have actually been supplied or services provided? What must be determined is whether the entrepreneur took all actions that can be reasonably expected from him in order to make sure that transactions he concludes are not a tax fraud. If the entrepreneur took all rational measures he had at his disposal in order to avoid being involved in a fraud, we may presume that such transaction was legal and there is no risk of being denied the right to deduct the input tax.

Honest merchant, what does this mean?

First of all, the essential prerequisite of good faith is the criterion of “merchant honesty”. We expect business entities to be professional and have the skills and expertise, be meticulous and reliable, and have prudence and foresight. It is also about knowing the legal regulations in place and how they affect the business you are in. When assessing good faith, the tax authority is going to investigate the following elements: how the taxpayer established cooperation, what it looked like, what were the circumstances of supplies and payments for supplies, and what were the prices of the supplied or purchased goods. This analysis should be performed with due consideration of a given industry and standards at that time. The fact that the contractor has an image much different from others in the industry and the transaction has circumstances are examples of legitimate concerns for the entrepreneur. All these elements could (and actually should) be formulated as clear technical steps, thus forming a tight verification procedure for every customer and main transactions.

What verification steps should be taken by a rational entrepreneur in his business activity? Unfortunately, there is no golden mean that could be applied in all situations. The rich case-law of the CJEU and Polish courts allows us to come up with a set of minimum activities that will ensure due diligence in contractor verification and choice. Each procedure should be defined on its own in order to make it as effective as possible. Below are verifications considered an absolute minimum:

• check if the customer is registered with the National Court Register/CEIDG and for VAT purposes;
• verify if persons concluding the contract/transaction are duly authorised to act for and on behalf of the contractor;
• document the transaction with a contract, order or any other confirmation of the terms and conditions;
• check the actual place of business: you need to check if this place has technical capacities required for the transaction, i.e. if the contractor has appropriate organisational and technical facilities e.g. warehouse/ storage yard for storing goods or means of transport (if the contractor is responsible for transporting goods);
• note if there is any company signboard in the company’s registered office;
• observe your in-house procedures: formulating specific rules of procedure in your company is one thing, but you cannot forget that they must be implemented and applied; in the discussed ruling, the court accused the company that their contractor verification system proved ineffective, despite being multi-stage and operational;
• cooperate with tried and tested, reliable contractors: transactions with a new contractor clearly involve greater risk, therefore it is advisable to be more cautious in such situations;
• pay for the goods only once they are supplied.

The above steps may differ (very much at times) depending on the industry you operate in.

There is one more reason why a safe VAT procedure should be tailor-made: something may be considered absolutely unusual in one case and perfectly normal in another. Does an offer to purchase fuel from a company trading food products always have to be suspicious? As a rule of thumb, yes; however, it may turn out that this company has a very extensive logistic base with the infrastructure for fuel distribution. If they found good suppliers or quality fuel, they may want to expand this line of business. After all, you cannot presume that there is a fraudulent intent there. Yet, every rational suspicion should (definitely) be verified, before you needlessly get into trouble …

Clearly, these are not all the guidelines you need to consider for due diligence and good faith. I will discuss the remaining ones in the next part of our series; therefore, I encourage you to follow our blog.