Tax myths in the German SME sector – part I: business entertainment and VAT

In day-to-day business, a number of tax-related myths continue to circulate. As is often the case with myths, they are usually based on misconceptions or incomplete knowledge. For small and medium-sized businesses in particular, this can create avoidable risks – whether in liquidity planning, during tax audits or when making structural business decisions.

In this article, we explain what the rules actually say.

Myth 1: “Business entertainment expenses are fully tax-deductible”

For many businesses, entertainment expenses are a relevant issue when it comes to taxation and the deductibility of costs. In principle, business entertainment expenses are operating expenses and may therefore be claimed for tax purposes, provided that the statutory requirements are met.

But what are those requirements?

1. There must be a business-related reason.
   The entertainment must be provided for an operational or commercial purpose, for example to maintain client relationships or in connection with contract negotiations.
2. The costs must be reasonable.
   They must not be disproportionately high in relation to the occasion.
3. A proper receipt must be available.
   This must be an appropriate, machine-generated entertainment receipt. If the gross invoice amount exceeds €250, the name and address of the entertaining business must also be shown on the receipt.
4. The relevant details must be recorded.
   The date, place, participants and specific business reason must be documented either on the receipt itself or on a related entertainment record.

As a general rule, only 70% of business-related entertainment expenses are tax-deductible.

There are, however, exceptions, including entertainment provided exclusively for internal business purposes and minor refreshments offered during training sessions.

But what do these terms mean in practice?

Internal business entertainment is provided solely for the benefit of the business, for example meals at a company event or other catering provided to employees.

Minor refreshments such as coffee, tea or biscuits made available to participants during training sessions may also be fully deductible.

Please note: A business entitled to deduct input VAT may generally claim 100% of the input VAT incurred on business-related entertainment expenses.

But what happens if entertainment expenses are not documented correctly?

Incomplete or incorrect information can quickly result in deductions being reduced during a tax audit. Businesses that regularly entertain clients or customers should therefore ensure that entertainment receipts are completed carefully.

Employees who frequently deal with clients and business contacts, such as members of management or sales teams, should also be informed of the documentation requirements. This helps ensure that entertainment expenses are recorded correctly and remain deductible.

Myth 2: “VAT is merely a pass-through item”

Another common tax myth in a business context relates to VAT. Many business owners take the view that VAT is simply a pass-through item.

In principle, this is correct. Businesses charge VAT to their customers and subsequently pay it to the tax authorities. At the same time, they may deduct the input VAT charged to them on business-related purchases.

However, this only applies where the relevant requirements are met.

From an accounting perspective, VAT collected from customers is a liability owed to the tax authorities, while input VAT paid by the business represents a claim against the tax authorities.

For businesses subject to the standard VAT regime, VAT is therefore generally economically neutral and may indeed be regarded as a pass-through item.

However, this is not always the case. In tax law, there are very few rules without exceptions. Under the statutory provisions, VAT is not necessarily just a pass-through item in the following situations:

1. The small-business scheme (section 19 UStG)
   Businesses with relatively low turnover are not required to charge VAT on their own supplies. However, they are generally not entitled to deduct input VAT.
2. VAT-exempt transactions
   Certain transactions are exempt from VAT by law. Examples include medical treatment in the field of human medicine under section 4 no. 14(a) UStG, insurance transactions and the letting of residential property. In these cases, input VAT paid by the business may become a genuine cost.
3. Transactions subject to the reverse-charge procedure (section 13b UStG)
   Under the reverse-charge procedure, the recipient of the service, rather than the supplier, is responsible for accounting for the VAT. This procedure applies only to certain business-to-business transactions, for example cross-border services within the EU or specific domestic sectors such as construction and cleaning services. As a result, invoices are issued without VAT.

4. VAT-exempt transactions with the right to deduct input VAT
   Under this form of exemption, input VAT on incoming invoices may still be reclaimed even though outgoing invoices do not include VAT.

This applies in particular to exports and intra-Community supplies.

Understanding and applying the rules correctly as a factor in commercial success

For businesses of every size, understanding and correctly applying VAT rules is not merely a matter of complying with the German VAT Act. It is also an important commercial consideration.

Errors in invoicing, missed deadlines and mistakes relating to input VAT deductions can have immediate financial consequences, particularly in an international context.

VAT errors can have a direct impact on liquidity, especially in larger businesses. They may also expose the company and those responsible to liability risks.

Conclusion: tax clarity creates commercial certainty

Tax myths often arise from assumptions that appear logical at first sight. In practice, however, the details are frequently decisive – particularly in tax matters.

Inadequate processes and incorrect documentation can cause financial damage and may also create liability risks.

Businesses should therefore structure their tax processes clearly in order to reduce risk, improve planning certainty and preserve commercial flexibility.

Tax myths for medium-sized businesses – part II

Part II of this series covers topics including:

• Invoice corrections
• Tax deadlines
• Common mistakes in practice
• Other common tax myths

FAQ – answers to frequently asked questions about tax myths – part I:

Are business entertainment expenses fully tax-deductible?

Business entertainment expenses incurred for commercial purposes are generally deductible as business expenses at a rate of only 70%. However, entertainment provided exclusively for internal business purposes, such as catering at a company event, may be fully deductible. The same may apply to minor refreshments such as coffee or biscuits provided during training sessions.

What information must an entertainment receipt contain?

An entertainment receipt must be a proper machine-generated receipt and must include the date, place, participants and the specific business reason for the entertainment. If the gross invoice amount exceeds €250, the name and address of the business providing the entertainment must also be stated.

Is VAT always merely a pass-through item for businesses?

No. Although VAT is generally economically neutral for businesses subject to the standard VAT regime, there are exceptions. These include small businesses applying the German small-business scheme, VAT-exempt supplies and transactions subject to the reverse-charge procedure.

What are the consequences of errors relating to entertainment expenses and VAT?

Incomplete receipts or incorrect invoices may result in a reduction or loss of the deduction for business expenses or input VAT. Businesses may also face additional tax liabilities, potentially affecting liquidity, and in some cases liability risks.

Image source: ©stock.adobe.com