It was reported on 7 September 2010 that HMRC have identified the first cases of attempted VAT fraud in the wholesale gas and power markets. All markets in high value taxable goods are potential targets for fraudsters especially those where physical possession of the goods being sold is not required.

Risk for UK Businesses – denial of input tax

This is a significant risk for businesses operating in markets that have not previously been targeted by fraudsters. HMRC is entitled to refuse a claim to entitlement to repayment or credit for input VAT where the business should have known that it was participating in a transaction connected with VAT fraud. As a result, a business which has no involvement in or knowledge of a fraud, and has not traded directly with the fraudster, may suffer a very significant and damaging financial hit.

Structural flaw in VAT system of accounting

VAT is a charge on consumers and is intended to be neutral for traders. Missing trader, or MTIC (missing trader intra-community), fraud takes advantage of a structural flaw in the system of accounting for value added tax. UK Importers are required to account for output VAT to HMRC on purchases by UK traders. UK Exporters are able to reclaim input VAT suffered on purchases from UK traders but are not required to account for VAT in respect of the goods exported. If goods that are imported to the UK are subsequently exported by a different person, the overall UK VAT position should be largely neutral. But owing to differences between VAT accounting periods for different traders, and the fact that VAT is self-assessed, HMRC may find that they have paid input VAT to an exporter long before they have discovered that the importer of the same goods has failed to account to HMRC for the VAT charged on its sales in the UK.

Markets already affected by Missing Trader Fraud

Missing trader fraud first proliferated in markets for mobile phones and computer chips. HMRC’s response to the fraud in those markets was to introduce a specific provision which caused all persons in the chain to become jointly and severally liable of the missing VAT. The Last year the government was forced to take action to prevent missing trader fraud in the market for carbon credits. In that case HMRC’s response was to treat supplies in carbon credits as zero rated supplies. As the problem lies in the structure of the tax and fraud can be perpetrated in all markets, each time the opportunities for fraud in a particular market have been closed down, the fraudsters have moved on to a new market.

Transactions connected with VAT Fraud

A transaction will be connected with VAT fraud if the goods supplied under the contract in question were imported to the UK by a “missing trader” who has failed to account to HMRC for output VAT, ie where the transaction is part of a “dirty” chain of transaction. For example, traders of goods that are involved in a “carousel fraud”, where the same goods are repeatedly imported and exported, are all part of a “dirty” chain and will all be carrying out transactions “connected with” fraud. But a transaction will also be “connected with” VAT fraud if it is part of a “clean” chain of transactions running parallel but in the opposite direction to the dirty chain (so-called “contra-trading”), where the aim of those participating in the fraud is to ensure that no participant in the dirty chain is in a net reclaim position with respect to VAT.

Burden of proof on HMRC but taxpayer must take reasonable steps to identify VAT fraud

In May of this year, the Court of Appeal confirmed that it was for HMRC to show that a person should have known that he was participating in a transaction connected with VAT fraud (in Mobilx Ltd v HMRC [2010] EWCA Civ 517). The Court of Appeal decided that, “if a taxpayer has the means at his disposal of knowing that by his purchase he is participating in a transaction connected with fraudulent evasion of VAT he loses his right to deduct”. This clearly puts the onus on traders to take every reasonable step at their disposal to identify indicators of VAT fraud.

The Court of Appeal said that the responsibility to use the means of knowledge at one’s disposal extends beyond the requirement to carry out due diligence. The Court of Appeal said, “even if a trader has asked appropriate questions, he is not entitled to ignore the circumstances in which his transactions take place”.

Input deduction denied if the only reasonable explanation for the circumstances is fraud

HMRC argued that the test of knowledge should be that a trader should have known that it was more likely that not that a transaction was connected with fraud. The Court of Appeal disagreed, and said that HMRC was entitled to deny a deduction for input VAT only where the trader could be regarded as a “participant” in a fraud. Moses LJ, who gave the unanimous decision of the Court of Appeal, said, “a trader may be regarded as a participant where he should have known that the only reasonable explanation for the circumstances in which his purchase took place was that it was a transaction connected with such fraudulent evasion”.

Intelligent due diligence

When it becomes known that fraudsters are targeting a particular market, the importance of the processes and controls employed by participants in that market to identify trading patterns associated with VAT fraud increases.

What can businesses do to protect themselves against the risk of being unwittingly implicated in a VAT fraud and denied a deduction by HMRC? As mentioned above, due diligence is important, but it is also important to examine the circumstances of each transaction or series of transaction. HMRC’s published VAT Notice 726 contains a list of factors to be considered and checks that might be appropriate.

Most businesses find it easier to implement new due diligence checks and procedures than to focus collective thinking on circumstances of particular transactions that might indicate a risk of VAT fraud. Often it requires a change of culture and needs to be led by senior management. Specific training may also be required for those who are in the best position to detect suspicious trading activity. Flags that might be used by businesses as indicators of increased risk of VAT fraud include:

  1.  Arrival of a new trader in an established market;
  2.  A pattern of increasing size and/or frequency of transactions; and
  3.  Prospective suppliers and purchasers of the same goods approaching the business at the same time.

HMRC are in the best position to identify emerging patterns of fraudulent trading, and we would recommend that businesses actively involve HMRC in their risk mitigation strategy, for example businesses may consider:

  1.  Taking advantage of HMRC’s VAT validation service;
  2.  Asking HMRC for comments on Know Your Client procedures;
  3.  Reporting unusually large transactions for a particular market participant to HMRC; and
  4. Inviting HMRC to share information on patterns of fraudulent activity and on any particular names in the market who are suspected of being involved in missing trader fraud.