El Supervisor Europeo de Protección de Datos (SEPD)

In an invoice-credit method VAT, the right to deduct64 _{input VAT incurred for the} purposes of the business is a fundamental feature of VAT, as it is this that prevents VAT from being a cascade tax. The soul of a perfect VAT is to obtain both neutrality (the internal character in itself) and efficiency (the external requirement of the market). This implies the following two aspects in a desired VAT system: (1) the scope of VAT should be as wide as possible, to cover all business transactions; and (2) a systematic right to deduct input VAT with the least possible restriction.

These two aspects are not mutually exclusive, but closely connected; the latter especially is normally affected by the former. In the context of the EU, in the process of harmonization to achieve a common and definitive VAT regime in Europe the above two aspects are the substantial and unavoidable issues to be resolved. The harmonization of the right to deduct input VAT is an element of VAT harmonization and is also an independent area that requires special arrangements.

3.2.1 The current legislation

In the context of European VAT, the right to deduct input VAT should be understood from two perspectives: (1) the harmonization of the domestic refund system of the Member States; (2) the establishment of an intra-Community and international refund system. The latter is a natural corollary of the former, which is the subject of the VAT

63 _{For a detailed description of the definitive system, see Ogley,Principles of Value Added Tax, chapter}

8, and de la Feria,The EU VAT System and the Internal Market, chapter 2, pp. 80-88.

64 _{A VAT registered business can recover VAT it has been charged by deduct amount against VAT on its}

own sales, as long as the expenditure represents a business expense and the relative legal requirements are fulfilled.

Directive 2006. Accordingly, the following are the main Directives related to the right to deduct input VAT at present:

- Council Directive 2006/112/EC of 28 November 2006 “on the common system of value added tax”65 _{(i.e., the VAT Directive 2006). Under Title X, “Deductions”, the} basic principles and mechanisms are regulated, but a large space of discretion is left to the Member States, especially in Chapter 3, “Restrictions on the right of deduction”66_. - the Eighth Directive “on taxable persons not established in the territory of the Member State of refund”, which was replaced by Council Directive 2008/9/EC of 2010 for intra-Community VAT refunds; and,

- the Thirteenth Directive “on taxable persons not established in the territory of the Community” for international VAT refunds.

With reference to China, a united country, the right of deduction in a domestic VAT system is most relevant to this thesis. In practice, many serious problems arise from the latter two Directives, especially the procedure regulated in the Eighth Directive. The origin of these problems is the various deduction mechanisms functioning in different Member States.

3.2.2 The main problems remained in the harmonization of the right of deduction in EU VAT

The current EU VAT system is the result of the compromise of policy in its not too long history of harmonization, and is far from the most desirable outcome. At the same time, new challenges arise with the development of the modern economy, from both new transaction methods and deepening globalization.

The main difficulty or defect in the current procedure for harmonization of the right of

65 _{It brings together the various provisions into one piece of legislation, so gives a clearer overview of}

EU VAT legislation currently in force.

66 _{The internal features of the right to deduct are: integral, global and immediate deductibility of input}

VAT. The restrictions are against the basic principles in general. These limits result from the initial version of the Second and then Sixth VAT Directive which included restrictions of a temporary nature, until permanent provisions are adopted, which was the aim of the Twelfth Directive, which was never agreed and was withdrawn in 1996.

deduction is insufficient harmonization which is generated from both the inadequate coordination of VAT as a whole and the large discretionary space enjoyed by the Member States. From the perspective of the harmonization of VAT as a whole, the scope of VAT and the exemption system is obviously linked to the failure of proper functioning of the right to deduct input VAT.

More specifically, in the first place the scope of the VAT system remains substantially restricted because of the exclusion of certain activities, such as those of states, regional and local government authorities and other bodies governed by public law. This situation has attracted much attention from both academia and the Commission67_. Second, exemptions for certain activities, classified either as a policy choice (exemptions for certain activities in the public interest) or a technical choice (exemptions of financial services and insurance services), which also excludes the right of deduction, is also one of the reasons for the current situation.

Against the background of the modern economy, the exemptions for certain activities in the public interest may no longer be justified and they may cause serious distortions. Calls to move certain exempted areas as much as possible to full taxation are gaining more and more support. With regard to the exemptions for the financial and insurance services, great efforts were made in the past68 _{to include them within the scope of full} taxation, no agreement was reached, however, mainly because of the complexity and difficulties in their application.

From the perspective of the deduction mechanism per se in the VAT system, the main question is the regulation related to the restriction of the right of deduction, which is regulated in Article 176 of VAT Directive 2006:

67 _{Amending these provisions was on the work program of the Commission in 2000 (EU Commission,}

Communication: A Strategy to improve the operation of VAT System within the context of the Internal Market, COM (2000) 348 of June 7, 2000), reiterated in 2003 (EU Commission, Communication: Review and update of VAT strategy priorities, COM (2003) 614 of October 20, 2003) and is there again in the White Paper but without any result up to now.

68 _{A remarkable effort was made by Satya Poddar’s study, in which, the cash-flow approach was}

recommended and tested, the results of the test were shared with the Commission, who published the Report giving a detailed description of a modified form of the cash flow system of VAT (The TCAADD Report) in 1996. For further information, see Poddar Satya, “VAT on Financial Services, Searching for a Workable Alternative”, mimeo 2008.

The Council, acting unanimously on a proposal from the Commission, shall determine the expenditure in respect of which VAT shall not be deductible. VAT shall in no circumstances be deductible in respect of expenditure which is not strictly business expenditure, such as that on luxuries, amusements or entertainment.

Pending the entry into force of the provisions referred to in the first paragraph, Member States may retain all the exclusions provided for under their national laws at 1 January 1979 or, in the case of the Member States which acceded to the Community after that date, on the date of their accession.

Two types of difficulties exist with the above provision. One is the vagueness of the scope of the “expenditure which is not strictly business expenditure” expressed in the first paragraph. This results in a very diverse implementation in Member States and causes many distortions instead of harmonization. The second is the restrictions to some certain activities remaining in the Member States which are permitted by the “standstill” clause in the second paragraph, mainly for cars, business travel, accommodation, food and drink. There is a dilemma here, as on the one hand, it is not possible to abolish all the restrictions completely, otherwise the risk of tax fraud would be greatly increased. On the other hand, the harmonization to achieve a unique standard or a unified list to be put in force in the Member States is also impossible. Notwithstanding all the problems and difficulties inherent in making a change, a review of the complex and divergent rules on the right of deduction is necessary for a further harmonization of the tax and to better ensure the neutrality of the tax as well. Especially for the present situation—new economic models brought by the development of technology—it is both a challenge for the current VAT system and an opportunity for its reform.