Digging deep into Europe’s VAT rules

March 8, 2013

What are the EU principles governing VAT deduction for businesses that supply VATable and VAT-exempt goods, and how are the rules applied?

EU businesses supplying VATable and VATexempt goods and services do not generally recover all the VAT paid on business costs and overheads. However, the amount of input-VAT individual taxpayers can recover varies depending on location and VAT-recovery calculation method. This article examines the EU VAT deduction principles for partially exempt taxpayers and the practical application of the rules in selected member states.

Taxable businesses must collect VAT from final consumers and report and remit it to local tax authorities. VAT paid on purchases and expenditure (input-VAT) can be deducted from VAT payable (in principle). Thus, businesses only pay VAT on value added.

However, this concept is not applicable to businesses involved in VAT-exempt activities. From a VAT perspective, these businesses are treated as final consumers, since the VAT they pay on purchases and expenditure is irrecoverable.

Businesses engaged in both taxable and exempt transactions play a dual role:

  • They collect VAT on taxable transactions on behalf of governments
  • They are treated as the final consumer for exempt transactions

The EU VAT Directive allows businesses to deduct input-VAT related to taxable transactions or certain exempt transactions. Therefore, input-VAT related to exempt transactions not specifically mentioned in Article 169 is non-deductible.

Any input-VAT that cannot be directly attributed to taxable or exempt transactions is normally referred to as residual VAT. Business can only deduct input-VAT related to taxable transactions.

This is calculated on a pro rata basis where the nominator is total taxable transactions and the denominator is taxable and exempt transactions. However, EU member states may:

  • Allow businesses with suitable records to compute a sector-specific pro rata
  • Oblige a business to compute a sector-specific pro rata and keep sector-specific records
  • Allow or oblige a business to make the input-VAT deduction based on the use made of all or part of supplies received
  • Allow or oblige a business to apply the pro rata to all purchases and expenditure used for business purposes
  • Apply a de minimis rule to non-deductible VAT

The EU VAT Directive aims to harmonize VAT within the EU, but member states have some individual leeway. The Directive does not currently contain any rules regarding input-VAT deduction on revenue generated outside the country of establishment.

However, the Crédit Lyonnais case currently before the Court of Justice of the European Union (CJEU) may provide clarity on this issue. Crédit Lyonnais sought to include the value of loan interest provided by the head office to non-EU branches in its pro rata calculation.

Arguing that the head office and branches are the same legal entity, French tax authorities refused to allow the inclusion. The CJEU’s verdict will have far-reaching implications for VAT recovery for business sectors where full VAT recovery is impossible.

EU member states: current positions


  • Applies a stepped pro rata system where input-VAT related to taxable supplies is fully deductible, but non-deductible from exempt supplies. The deductible portion of the residual VAT must be estimated.
  • Turnover-based value estimation is only permitted in the absence of another allocation method.
  • In April 2005, the German Government issued new guidance on this issue for banks.
    • A specific pro rata applies to each business sector. Banks can apply a modified turnover pro rata where a margin is considered, rather than actual interest.
    • For a bank’s own equity business, a fictitious margin instead of equity values is acceptable.
    • Various methodologies are acceptable, but all taxpayer actions must be economically justifiable
    • Taxpayers are bound by their chosen methodology – switching for VAT benefit is unacceptable.

United Kingdom

  • Applies a “standard method” as per UK VAT regulations for calculating deductible input tax for all UK businesses.
  • A proportion of input tax incurred for both taxable and exempt supplies is attributed to taxable supplies.
  • If a “fair and reasonable” input tax recovery is not given by the standard method, businesses can seek approval to use a special method that separates the residual input tax between different areas or sectors. Normally, a sector-based method is appropriate because there are different business activities that use costs differently. Therefore, bigger businesses are more likely to find a sector-based method appropriate.

The Netherlands

  • VAT incurred on goods and services is initially attributed to either VATable or VAT-exempt activities. Where VAT cannot be directly attributed a turnover-based pro rata calculation is used. However, different VAT-recovery methodology is acceptable if it is more accurate.
  • Currently, no specific guidance on accounting for foreign branch turnover; however, in practice the tax authorities have allowed it to be included.
  • Dutch branches of foreign companies should apply a pro rata calculation separate from the foreign company’s calculation. Where the branch receives income only from its head office this doesn’t apply; instead the head office’s VAT recovery rate should be applied for the recovery of Dutch VAT.


  • Taxpayer activities involving both taxable and exempt transactions require pro rata-calculated VAT deduction, even if goods and services are exclusively attributable to taxable transactions.
  • However, an alternative regime using specific pro rata calculation and record-keeping specific to each business segment is available. Insufficiently related goods and services must be apportioned according to objective criteria.
  • Under the “36 bis” regime, available to companies carrying out mainly exempt activities, invoicing and recording VAT-exempt transactions is not required. In exchange, companies cannot deduct VAT on goods and services purchased and imported, regardless of their pro rata.

The full version of this article is available in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.10 MB)

Questions or comments? Contact T Magazine and Ernst & Young

EY refers to one or more of the member firms of Ernst & Young Global Limited (EYG), a UK private company limited by guarantee. EYG is the principal governance entity of the global EY organization and does not provide any service to clients. Services are provided by EYG member firms. Each of EYG and its member firms is a separate legal entity and has no liability for another such entity's acts or omissions. Certain content on this site may have been prepared by one or more EYG member firms.