The relationship between deduction and refund in a VAT system

How does the right to a refund come into being? There are chiefly two reasons: one is related to the export of the goods and services. Most countries define the jurisdictional reach of their VAT under the destination principle93 _{by which exports are free of tax} (zero rated). By this means, it brings out the excess input VAT. The other cause is related to registered taxable persons making sales taxable in the domestic market, which could not occur frequently, but still may take place occasionally, such as the substantial input credits generated by capital purchases or an increase of inventory to expand a business. One of the treatments of the excess tax paid is to enable the taxpayer to reclaim the difference from the tax authorities, that is, the right to a refund. We can see that both the processes (deduction and refund) in VAT grant the taxpayer a

92 _{In case that there is an excess of the input tax, taxpayer could carry forward to the successive tax}

period or to make a refund according to the national VAT system. Article 183 of VAT Directive 2006:“Where, for a given tax period, the amount of deductions exceeds the amount of VAT due, the Member States may, in accordance with conditions which they shall determine, either make a refund or carry the excess forward to the following period.”

93 _{A country with a VAT must define the jurisdictional reach of the tax, usually there are two}

choices—the origin principle and the destination principle. Under the former principle, the tax shall be imposed by the country from which it is exported; under the latter one, the tax is charged by the import country.

“right” enforceable against the taxation authority. However, there are differences. I use VAT “refund” to mean one of the measures to deal with the excess amount of input VAT. In the EU VAT system there also exists the right to a refund in the situation that businesses operate in countries in which they are not established or registered (i.e. nonresident businesses)94_.

The VAT taxpayers of different legal systems might enjoy the following rights in the procedure to determine their tax liability: the right of deduction, the right to carry forward the excess deductible amount, the right to a refund, on the condition that they fulfill the relevant requirements95_{. Among these, the right of deduction is definitely} the most important one as it was the first to emerge and lays the foundation for the development of subsequent tax positions related to the excess deductible. In fact, without the correct exercise of this right, the subsequent tax positions and rights could not come into being: in this way, the right of deduction affects the right of refund in VAT96_{. And the two rights belong to two different phases of a VAT system: the phase} of the determination of the tax due and the phase for the treatment of the over-amount VAT deductible, both phases consist of the process for the recovery of VAT deductible. To make this clear, we should first appreciate the significance of the right of deduction. In the first place, from the aspect of the taxpayer, regardless of the enforcement mechanisms and the purposes of the tax itself, the deduction is considered as a tax credit; in the second place, it is understood that the deduction was the pivot of the structure of VAT, it is been so qualified just because it is a right strictly related to the determination of the tax due (and the pursuit of neutrality) and

94 _{Producers under this circumstance can incur significant amounts of VAT on expenses paid in those}

countries. In principle, non-resident businesses should be able to recover some or all of the VAT incurred, thereby reducing their costs. As Article 170 states: “All taxable persons who, within the meaning of Article 1 of Directive 79/1072/EEC, Article 1 of Directive 86/560/EEC and Article 171 of this Directive, are not established in the Member State in which they purchase goods and services or import goods subject to VAT shall be entitled to obtain a refund of that VAT in so far as the goods and services are used for the purposes of the following... And Article 171 regulates the specific in which the taxable person should be entitled the right to refund VAT.”

95 _{According to Article 183 of the VAT Directive 2006, a taxable person whose input VAT exceeds his}

output VAT is entitled to a refund of the excess from his national treasury. However, Member States may decide to carry forward the excess to the next taxable period and offset it against tax due in that period.

96 _{For further information, see M. Basilavecchia,Situazioni creditorie del contribuente e attuazione del}

independently configurable only in the manner and within the time prescribed by law. It is clear that the deduction may (but does not certainly) give rise to a right to claim a credit (here meaning the right to a refund of the excess input VAT deductible) only after having performed (in the terms and in the manner prescribed by law) its function in the internal procedure of calculating VAT due.

The difference described above could lead to a consideration that, in the mechanism of VAT, the right to a refund (arising from the existence of an excess credit) and the right of deduction are not legal arrangements which could be used in an alternative way. The right of deduction is not a real right;97 _{however, the deduction has a} necessary function in a tax with VAT purposes 98_{and, as such, is not replaceable by} any other legal arrangement: the mechanical application of VAT requires immediate neutralization of input tax paid in the upstream and such an effect can only be achieved with the provision of the right of deduction which can ensure an immediate and full deduction99_{. It is indeed such an effect that would be inhibited if the right to a} refund (not the right to deduct) applied: the taxpayer would be obliged to make a financial outlay and suffer the burden of the tax until reimbursement of the sums from the taxation authority.

In contrast, the right to a refund is not irreplaceable; according to Article 183 of the VAT Directive 2006, each state can decide how to promote the recovery of the excess subject to the condition of neutrality. With innumerable variations, there are two basic methods by which VAT systems provide for the recovery of excess input VAT: immediate refund or carried forward. Under the latter, normally the taxpayer recovers against future VAT liability, but if there is no future VAT, it is recovered either by offsetting other tax liability or turn back to the former method—refund of the excess credits.

97 _{See the description in part (2) The deduction – a “right” of taxpayer, which enables a taxpayer as a}

“creditor”.

98_{“A tax with VAT purposes” is not informative in this thesis.}

99 _{The immediate and full deduction of the input tax is an important feature of the right to deduct,}

In summary, the right of deduction and the right to a refund are two separate rights belonging to two respective stages—the procedure of the determination of the tax due and the procedure of the recovery of the over-amount input VAT deductible—in a VAT system although they are strictly related to each other. In general, the proper exercise of the right of deduction precedes the successive positions of a deductible credit, as a pre-condition to the right to a refund. The conclusion, which also forms a difference between the two rights, is that the right of deduction is so crucial to the well-functioning VAT that it could not be replaced by any other mechanisms. Meanwhile, the right to a refund is just one optional method to make the recovery of the excess deductible which is decided by the process of deduction, and may not be a preferred choice of the legislatures and tax authorities in some states because of the risk of fraud and the negative cash flow associated with it.