For many business owners, the logic around VAT seems straightforward.
You receive a properly issued invoice, you pay it, you record it in your books, and you deduct the VAT. From a commercial perspective, the transaction is complete.
However, in today’s European tax environment, this assumption is increasingly risky. Across the EU, tax authorities and courts have developed a consistent principle: the right to deduct VAT depends not only on the invoice, but also on the taxpayer’s business diligence.
This means your company’s tax position may be affected by the conduct of your supplier—even when you had no intention of participating in any wrongdoing.
The foundation of VAT deduction rights
Under EU VAT law, the right to deduct input VAT is a core principle of the system. VAT is meant to be neutral for businesses. Each company charges VAT on its sales and deducts VAT on its purchases, so the tax ultimately falls on the end consumer.
In theory, this means that if you:
- receive a valid invoice,
- pay the supplier,
- and use the goods or services for taxable business activities,
you should be entitled to deduct the VAT.
But over the past two decades, a series of court decisions across the EU has introduced an important limitation to this principle.
The “knew or should have known” test
According to the established case law of the Court of Justice of the European Union, the right to deduct VAT may be denied if it is proven that the taxpayer:
knew or should have known that the transaction was connected to tax evasion.
This test has become one of the most important concepts in VAT audits across Europe.
It creates a shift in responsibility. Instead of focusing only on whether the invoice is formally correct, tax authorities now examine the business behavior of the taxpayer.
In other words, the key question is no longer:
“Was the invoice valid?”
but rather:
“Did the company act with reasonable care when entering the transaction?”
A typical real-life scenario
Consider a common situation.
A company hires a subcontractor to perform services. The subcontractor issues an invoice that looks perfectly normal. The price is competitive, the documentation seems complete, and the work is delivered as agreed.
The company:
- receives the invoice,
- pays it,
- records it in its accounting,
- and deducts the VAT.
Months or even years later, the tax authority audits the subcontractor. During the audit, it turns out that:
- the subcontractor never paid the VAT,
- or the company was part of a fraudulent supply chain,
- or it had no real business activity behind the invoices.
The tax authority then looks at the subcontractor’s customers—including your company.
At this point, the focus of the audit shifts. The question is no longer what the supplier did. The question becomes:
Should your company have recognised the risk?
If the authority concludes that the answer is yes, the consequences can be serious.
Possible consequences for the buyer
If the VAT deduction is denied, the buyer may face:
- repayment of the deducted VAT,
- late-payment interest,
- tax penalties,
- and in some cases, extended audit periods.
These consequences may apply even if:
- the service was actually delivered,
- the invoice was formally correct,
- and the buyer had no intention to commit fraud.
From a legal perspective, the deduction is denied not because the transaction did not happen, but because the buyer failed to act with sufficient business diligence.
What does “should have known” mean in practice?
This is the most critical and also the most uncertain part of the rule.
Tax authorities do not need to prove that the buyer intentionally participated in tax evasion. It is enough to show that the company ignored obvious warning signs.
Typical red flags include:
- prices significantly below market level,
- newly established suppliers with no track record,
- companies without real offices, staff, or equipment,
- unclear or inconsistent contract terms,
- unusual payment arrangements,
- frequent changes in suppliers,
- lack of communication or documentation.
None of these factors alone automatically prove wrongdoing. But when several of them appear together, the tax authority may argue that a reasonable business should have identified the risk.
The growing importance of business substance
In recent years, tax authorities across the EU have moved toward a substance-over-form approach. This means they focus on the economic reality of transactions, not just their formal appearance.
For businesses, this has two important consequences.
First, a formally correct invoice is no longer enough to guarantee VAT deduction.
Second, the internal processes of the company—how suppliers are selected, how transactions are documented, how risks are evaluated—have become central elements in tax audits.
This is why proper, structured tax optimization today is not simply about reducing the tax burden. It is about building business structures and transaction flows that are commercially logical, well documented, and defensible under scrutiny.
The role of due diligence in supplier selection
To protect the right to deduct VAT, companies should be able to demonstrate that they took reasonable steps before entering into a business relationship.
Basic supplier due diligence may include:
- verifying the supplier’s VAT number,
- checking company registration details,
- reviewing the company’s business activity,
- confirming the existence of offices, staff, or equipment,
- evaluating whether the price is in line with the market,
- documenting the commercial reason for choosing that supplier.
These steps do not need to be overly complex or expensive. In most cases, simple checks and proper documentation can significantly strengthen the company’s position in an audit.
Documentation: your strongest defence
In VAT disputes, documentation often determines the outcome.
Companies that can provide:
- contracts,
- correspondence,
- performance reports,
- delivery confirmations,
- payment records,
- and internal approval documents
are in a much stronger position than those that rely solely on the invoice.
The tax authority does not expect businesses to act as investigators. But it does expect them to behave like reasonable, prudent commercial operators.
Cross-border risks are even higher
The risk becomes more complex in cross-border transactions, where different countries apply the same EU principles in slightly different ways.
In such cases:
- the supplier may be located in another jurisdiction,
- the buyer may have limited information about the partner,
- and language, legal, or cultural differences may reduce transparency.
This makes coordinated accounting, legal, and tax review even more important when operating internationally.
So, are you liable if your supplier didn’t pay VAT?
In most cases, the answer is:
You are not automatically liable—but you must prove that you acted with due care.
If your company can demonstrate that it:
- selected the supplier for legitimate business reasons,
- performed basic checks,
- documented the transaction properly,
- and had no reason to suspect fraud,
then the VAT deduction is far more likely to be upheld.
If, however, the company cannot show these elements, the tax authority may conclude that it “should have known” about the risk.
The practical lesson for businesses
VAT compliance is no longer just about correct invoices and accurate bookkeeping. It is about the quality of business decisions and the processes behind them.
The companies that are best protected in VAT audits are those that:
- treat partner selection as a documented process,
- align their accounting and tax strategies,
- and build structures that reflect genuine economic activity.
Because in today’s tax environment, when the authority asks,
“Your supplier didn’t pay VAT. Are you liable?”
the answer will depend not only on the supplier’s behavior—but on what your company can prove about its own.