On 12 January 2006 the European Court of Justice ruled in favour of the taxpayer. First it held that transactions forming part of a chain of supply, which are not themselves vitiated by value added tax (VAT) fraud, constitute supplies of goods or services and an economic activity within the meaning of Articles 2(1), 4 and 5(1) of Sixth Council Directive. Second, it concluded that the right of that person to deduct input value VAT cannot be affected by the fact that in the chain of supply of which those transactions form part, another prior or subsequent transaction is vitiated by VAT fraud, without that taxable person knowing or having any means of knowing.
The Court's reasoning was as follows:
- According to Article 4(1) of the Sixth Directive any person who independently carries out in any place any economic activity is considered to be a taxable person, whatever the purpose or results of that activity.
- An obligation on the tax authorities to take account, in order to determine whether a given transaction constitutes a supply by a taxable person acting as such and an economic activity, of the intention of a trader other than the taxable person concerned involved in the same chain of supply and/or the possible fraudulent nature of another transaction in the chain, prior or subsequent to the transaction carried out by that taxable person, of which that taxable person had no knowledge and no means of knowledge, would a fortiori be contrary to the objectives of the Directive.
- Each transaction must therefore be regarded on its own merits and the character of a particular transaction in the chain cannot be altered by earlier or subsequent events.
- As regards the argument of the United Kingdom Government that unlawful transactions fall outside the scope of VAT, that case-law concerns products which by their very nature and because of their special characteristics may not be marketed or incorporated into economic channels. Second, it is settled case-law that the principle of fiscal neutrality prevents there being any general distinction as between lawful and unlawful transactions. Consequently, the mere fact that conduct amounts to an offence is not sufficient to justify exemption from VAT. That exemption applies only in specific situations where, owing to the special characteristics of certain products or certain services, any competition between a lawful economic sector and an unlawful sector is precluded.
- It follows that transactions such as these, which are not themselves vitiated by VAT fraud, constitute supplies of goods or services effected by a taxable person acting as such and an economic activity within the meaning of Articles 2(1), 4 and 5(1) of the Sixth Directive, where they fulfill the objective criteria on which the definitions of those terms are based, regardless of the intention of a trader other than the taxable person concerned involved in the same chain of supply and/or the possible fraudulent nature of another transaction in the chain, prior or subsequent to the transaction carried out by that taxable person, of which that taxable person had no knowledge and no means of knowledge. Nor can the right to deduct input VAT of a taxable person who carries out such transactions be affected by the fact that in the chain of supply of which those transactions form part another prior or subsequent transaction is vitiated by VAT fraud, without that taxable person knowing or having any means of knowing.
- The right to deduct provided for in Article 17 et seq. of the Sixth Directive is an integral part of the VAT scheme and in principle may not be limited. It must be exercised immediately in respect of all the taxes charged on transactions relating to inputs. The question whether the VAT on the earlier or later sale of the goods concerned to the end-user has or has not been paid to the public purse is irrelevant to the right of the taxable person to deduct input VAT.