EU Court: VAT Profit Margin Scheme and Good Faith

When a German retailer of luxury watches and jewelry applied the special VAT profit margin scheme to its 2013 and 2014 tax filings, it assumed every transaction was fully compliant based on supplier invoices. However, a routine audit triggered a chain of reassessments that transformed a dispute over reseller accounting into a defining European Court of Justice (ECJ) case on procedural rights.

Background of the Case 

The retailer, referred to here as X, sells jewelry and watches as both a retailer and a wholesaler, particularly through online platforms. In its 2013 and 2014 tax returns, X applied Germany’s VAT profit margin scheme to certain watch transactions. Following a tax audit, the German tax authorities concluded that X had applied the scheme incorrectly because some of the watches were new and therefore did not qualify under the applicable rules.

The suppliers had incorrectly charged VAT under the profit margin scheme, and X was consequently considered ineligible to apply it when reselling those watches. The tax authorities therefore reassessed the transactions under the standard VAT regime, calculating VAT on the full selling price rather than on the profit margin. X’s objections were rejected, and its appeal before the German tax court was also dismissed.

X appealed to the German Federal Fiscal Court, arguing that requiring it to pursue a separate equitable relief procedure to establish whether it had reasonably relied on its suppliers’ invoices would undermine the principle of effectiveness under EU law. This principle requires national procedural rules to ensure that rights granted by EU law can be exercised effectively.

The Federal Fiscal Court explained that, under German law and established case law, a taxable person’s legitimate expectations can be considered during the tax assessment procedure only where legislation expressly permits it. The German VAT Law does not specifically protect a taxable person who acted in good faith when applying the profit margin scheme. Such protection can therefore be considered only through a separate equitable relief procedure.

The two procedures differ in their purpose and operation. During the tax assessment procedure, the tax authorities establish the relevant facts on their own initiative and consider all circumstances affecting the case, including those favorable to the taxable person. By contrast, the equitable relief procedure is generally initiated by the taxable person, who must present the grounds for relief. The tax authorities then exercise their discretion and issue a separate administrative decision on whether equitable considerations justify relief.

The Fiscal Court noted that, although German law allows the tax assessment and equitable relief procedures to be combined, the usual practice is to determine the taxable person’s VAT liability first and examine any request for equitable relief separately afterward. Because the Federal Fiscal Court doubted that this practice is compatible with the EU VAT Directive, it paused the proceedings and referred a question to the ECJ.

Main Questions from Request for Ruling

The key question was whether a reseller’s good faith can be examined during the ordinary VAT assessment, or only in a separate equitable relief procedure. Formally, the Federal Fiscal Court asked whether Article 314 of the EU VAT Directive, read in light of the principle of effectiveness, precludes a national practice under which a reseller’s good faith regarding its supplier’s correct application of the profit margin scheme can be examined only through a separate equitable relief procedure.

Applicable EU VAT Directive Article

The ECJ analyzed and interpreted Articles 313–315 of the EU VAT Directive, which establish the special VAT regime known as the profit margin scheme, applicable to qualifying resales of used goods, works of art, collectors’ items and antiques.

German National VAT Rules

Regarding the national VAT rules and regulations, the ECJ outlined Article 25a of the German VAT Law, which establishes the national rules for applying the profit margin scheme, as one of the key provisions for this case. Additionally, it interpreted Articles 63 and 227 of the German Fiscal Code, which provide separate mechanisms for equitable tax relief.

Importance of the Case for Taxable Persons

This case matters to taxable persons because it addresses how far they can rely on their suppliers’ VAT treatment under the profit margin scheme, which they usually cannot verify themselves. If the supplier’s treatment turns out to be wrong, the reseller may face reassessment on the full selling price rather than the margin, a much heavier VAT burden. 

The key issue is whether a good-faith taxable person’s legitimate expectations can be considered in the ordinary VAT assessment, or only through a separate, discretionary equitable relief procedure that the taxable person must initiate and justify. This affects legal certainty, the burden of proof, and the cost and speed of obtaining a remedy. It also tests the EU principle of effectiveness, making it relevant to any business that depends on its suppliers’ invoices.

Analysis of the Court's Findings

Admissibility

Before answering, the ECJ had to decide whether the request was admissible. The German Government argued that the ECJ did not need to answer because the watches were new rather than used goods. The ECJ noted that the watches’ possible newness does not, by itself, make the question inadmissible, and that interpreting EU law was necessary to resolve the dispute. It therefore found the request admissible and proceeded to examine the question.

The Profit Margin Scheme and Good Faith

The first thing the ECJ recalled was that the profit margin scheme is a special VAT regime that derogates from the general VAT rules established by the VAT Directive. It applies to qualifying resales of used goods, works of art, collectors’ items and antiques. 

Under Articles 314 and 315, an eligible reseller may calculate VAT only on the profit margin earned from reselling qualifying goods purchased from one of the specified categories of suppliers. The profit margin is the difference between the selling price and the purchase price, reduced by the VAT included in that margin.

Article 314 specifies both the categories of goods eligible for the scheme and the types of suppliers from whom those goods must be purchased. One key characteristic for suppliers is that they were unable to deduct input VAT on their purchase of the goods, meaning that the VAT cost was ultimately borne by them.

In X’s case, the invoices issued by its suppliers indicated that the profit margin scheme applied. However, following a tax audit, the German tax authorities concluded that the suppliers were not entitled to apply the scheme to the watches in question. They therefore determined that X could not use the scheme either, because the necessary conditions had not been satisfied.

As a general rule, national tax authorities and courts must, in principle, deny a taxable person the right to apply the profit margin scheme when the conditions are not met. This applies even if the supplier has already applied the scheme to its sale to the reseller. This is in accordance with the established principle that denying the scheme is particularly justified where objective evidence demonstrates that the taxable person’s claim to the scheme involves fraud or abuse.

More broadly, this reflects an EU-wide principle that taxable persons cannot rely on rights granted by EU law to justify fraudulent or abusive conduct.

According to the established case law, a taxable person may be denied the right to apply the profit margin scheme not only when they personally commit VAT fraud, but also when they knew or should have known that their transaction was connected to VAT fraud committed by their supplier or another business elsewhere in the supply chain.

Nonetheless, the tax authorities cannot automatically require resellers to investigate whether their suppliers have correctly fulfilled their VAT obligations, declared and paid the appropriate tax, or satisfied every condition for applying the profit margin scheme. Nor can they generally require resellers to obtain documents proving that no irregularities or fraud occurred earlier in the supply chain.

Ultimately, Article 314 protects a reseller who receives an invoice indicating that the profit margin scheme applies, even if a subsequent tax audit establishes that the supplier applied the scheme incorrectly. The reseller cannot be denied the scheme solely because of the supplier’s error. However, an important exception exists. The tax authorities may refuse the reseller access to the scheme if they establish that the reseller did not act in good faith or failed to take all reasonable measures available to ensure that the transaction did not involve VAT fraud.

Procedural Autonomy and Effectiveness

While the EU VAT Directive allows EU countries to take measures to ensure the correct application of the profit margin scheme and prevent VAT fraud, it does not prescribe exactly which substantive measures national authorities must adopt to achieve these objectives. Where EU legislation does not establish specific rules, EU countries have procedural autonomy to determine which authorities are responsible for combating VAT fraud and how taxable persons can enforce their rights under EU law. 

When doing so, EU countries must meet two fundamental principles. The principle of equivalence requires national procedural rules governing EU law rights to be no less favorable than those governing comparable situations under national law. The principle of effectiveness requires that national rules do not make exercising rights granted by EU law impossible or excessively difficult in practice.

The ECJ noted that it is up to the Federal Fiscal Court to assess whether the national procedures at issue comply with these principles, taking into account all the circumstances of the case. However, the ECJ provided guidance to help the national court make that assessment.

Assessing compliance with the principle of effectiveness requires considering how a national procedural rule operates in practice. It is not enough to examine the rule in isolation. Instead, the court must consider its place within the overall proceedings, the procedures followed before the national authorities and the specific circumstances of the case. Relevant considerations may include the protection of the taxable persons’ rights of defense, legal certainty and the proper conduct of proceedings.

Practical Disadvantages of the Separate Procedure

In X’s case, the Federal Fiscal Court identified several disadvantages for taxable persons who must establish their good faith through a separate equitable relief procedure rather than during the ordinary VAT assessment. These disadvantages include additional costs, longer proceedings, and differences in the requirements for presenting evidence.

Furthermore, the Fiscal Court noted that German law allows tax authorities to combine the tax assessment and equitable relief procedures under the relevant national provisions, but does not require them to do so. Because the two procedures are legally independent, courts may be required to dismiss a taxable person’s appeal against the VAT assessment even where they could have qualified for the profit margin scheme if their good faith had been examined and established.

As a result, taxable persons may have to bear the costs of challenging the VAT assessment even if they subsequently obtain relief through the separate equitable procedure.

Regarding the duration, the separation of the two procedures may extend the overall process by several years. The tax authorities may wait until the courts have issued a final decision on the VAT assessment, including any appeal to the Federal Fiscal Court, before examining whether the taxable persons acted in good faith. During this period, the taxable persons may be unable to obtain a decision on their good faith or effectively exercise their right to apply the profit margin scheme within a reasonable time.

Concerning rules governing the burden of proof, the ECJ stated that taxable persons who received an invoice indicating that the profit margin scheme applied are, in principle, entitled to use the scheme unless the tax authorities establish that they did not act in good faith or failed to take all reasonable measures available to ensure that the transaction was not connected to VAT fraud.

Court's Final Decision

The ECJ ruled that the EU VAT Directive, interpreted in light of the principle of effectiveness, precludes a national practice that prevents tax authorities from considering a reseller’s good faith during the ordinary VAT assessment procedure and allows it to be examined only through a separate equitable relief procedure.

Conclusion

This decision reinforces procedural fairness in EU tax administration. Resellers who receive invoices indicating that the profit margin scheme applies can now raise their good faith directly in the ordinary assessment, rather than waiting for a separate, lengthy procedure. By integrating the good faith assessment into the standard VAT audit, the ECJ saves taxable persons time and cost, strengthens legal certainty, and protects businesses that rely in good faith on supplier documentation.