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VAT - Whose liability is it anyway (revisited)?

Indirect Tax Matters December 2019

In a previous edition of this newsletter, we explored the increasing trend of tax authorities pursuing innocent third parties for VAT evaded by fraudsters, or seeking to deny them input deduction merely because they were involved in the supply chain at some point. We now revisit this topic to take account of some recent case-law in this area.

In September 2019, the European Commission estimated that the ‘VAT gap’ i.e. the difference between the estimated VAT revenues that EU Member States expect to receive and the amount of VAT actually collected amounted to €137 billion in 2017. This figure represents more than just fraud and evasion as it also includes VAT lost due to, for example, insolvencies, bankruptcies, and administrative errors. 

A concerning trend across Europe

VAT fraud can be perpetrated in a number of ways and can be complex in nature but it generally involves a fraudster charging VAT on supplies at some stage in a supply chain and then absconding with the VAT without ever paying over the VAT collected to the tax authorities.

In an effort to close the ‘VAT gap’, there is a concerning approach which has been adopted by some tax authorities in Europe. The practice of pursuing innocent third parties for VAT evaded by fraudsters, or seeking to deny them input deduction merely because they were involved in the supply chain at some point. 

The Court of Justice of the European Union (‘CJEU’) has previously observed that it breaches several well-established principles of EU law namely legal certainty, fiscal neutrality and proportionality. It is also fundamentally flawed as it is counterproductive. If fraudsters know that tax authorities will seek to hold unwitting third parties responsible then it will only fuel fraudulent activity. As the CJEU noted in Teleos and Others (C-409/04) ‘a regime imposing the entire responsibility for the payment of VAT on suppliers, regardless of whether or not they were involved in the fraud does not necessarily safeguard the harmonised VAT system from evasion’.

In several cases, the CJEU has held that the practice of seeking to deny input deduction to innocent third parties is incompatible with EU law.

In recent times, the UK has introduced a number of measures in this regard including legislation which seeks to hold marketplaces jointly and severally liable for an overseas’ seller’s unpaid UK VAT liabilities. This course of action is not merely intended to combat deliberate fraud, it is also designed to recoup the VAT which should have been charged by non-established businesses which either blatantly ignore or fail to recognise that the VAT registration thresholds only apply to locally established businesses. Interestingly, on 9 October 2019, the European Commission issued a formal notice to Germany in respect of its new rules which see marketplaces as being jointly and severally liable for goods being sold by traders in certain circumstances. The European Commission holds the view that the German measures are inefficient, disproportionate and hinder the free access to the German market.

CJEU case-law

This area has given rise to a body of case-law including numerous referrals to the CJEU with a common theme of tax authorities unsuccessfully seeking to preserve their public exchequers at the expense of innocent and unwitting parties.

In the joined cases of Optigen Ltd (C-354/03), Fulcrum Electronics Ltd (C-355/03) and Bond House (C-484/03), Her Majesty's Revenue and Customs sought to deny input deduction to taxpayers who were not involved in fraud, had no knowledge of fraud and did not act recklessly, on the basis that other parties within the overall supply chains had acted fraudulently.

The CJEU has repeatedly held that VAT applies to each transaction within a supply chain so each transaction must be regarded on its own merits and cannot be altered by earlier or subsequent events. Any attempt to deprive a legitimate business, that did not know or ought to have known that a fraud was being perpetrated, of its right to input deduction has been held to have no foundation in EU law. In this context, the CJEU has consistently held that the right to input deduction is an integral part of the common VAT system and, in principle, may not be limited.

In the joined cases of Kittel (C-439/04) and Recolta Recycling SPRL (C-440/04), the CJEU ruled that a legitimate business’s right to input deduction cannot be denied where it ‘did not and could not know’ that fraudulent activity occurred at a different stage in the supply chain. However, the CJEU found that a national court could seek to deny input deduction where a business ‘knew or should have known that, by his purchase, he was participating in a transaction connected with fraudulent evasion of value added tax’. The CJEU arrived at a similar ruling in the case of Mecsek-Gabona Kft (C‑273/11).

Clearly, willing participants or those recklessly facilitating fraud should not be entitled to VAT input deduction. More difficult is establishing what constitutes a means of knowing that fraud was present at a different stage in the supply chain but the CJEU made some interesting observations in the joined cases of Mahagében kft (C-80/11) and Péter Dávid (C-142/11). The CJEU noted that ‘when there are indications pointing to an infringement or fraud, a reasonable trader could, depending on the circumstances of the case, be obliged to make enquiries about another trader from whom he intends to purchase goods or services in order to ascertain the latter’s trustworthiness.’ This would seem to suggest that in the absence of factors indicating that fraud is present in a supply chain, a legitimate business is not obliged to carry out extensive due diligence checks. The CJEU reiterated this position in the case of PPUH Stehcemp (C-277/14), a case which is good authority for some types of due diligence checks.

In the case of Altic (C-329/18), the Latvian tax authorities had sought to deny input deduction to Altic on the basis that it would have known about the existence of fraudulent activity in the supply chain if had undertook checks required by food regulations. On 3 October 2019, the CJEU held that complying with those food regulation checks are ‘not relevant for the purpose of determining whether the taxable person knew or should have known that he was involved in a transaction involving VAT fraud’. Accordingly, the arguments advanced by the Latvian tax authorities in an attempt to deny input deduction to Altic had no basis in EU law.

The CJEU (in the joined cases of Mahagében kft (C-80/11) and Péter Dávid (C-142/11)) also found that it is the responsibility of tax authorities to carry out the necessary inspections of businesses in order to detect VAT fraud and those authorities cannot transfer their own investigative tasks to legitimate businesses. It would be both astonishing and deeply disturbing if the CJEU had stated otherwise. The CJEU reiterated this point in the case of PPUH Stehcemp (C-277/14).

The case of Teleos and Others (C-409/04) involved the zero-rated supply of mobile phones from the UK to other EU countries for which the purchaser was responsible for arranging transportation. The purchaser provided the suppliers with false documentation stating that the mobile phones had left the UK when, in fact, they remained in the UK.

The suppliers acted in good faith, made detailed inquiries about the parties involved, had no reason to doubt the authenticity of the documentation provided, were not party to any fraud and were entirely unware that the mobile phones had not left the UK. Despite this, Her Majesty's Revenue and Customs pursued them for several million pounds of UK VAT.

The CJEU found that where a supplier had acted in good faith, took every reasonable measure to ensure it was not involved in fraud and fulfilled its obligations regarding the intra-Community supply for which the purchaser was contractually obliged to arrange for transportation, it was the purchaser who should be held liable for the VAT due – not the supplier.

The CJEU reiterated the position as set out in a body of other case-law that it is necessary for a legitimate business to be aware of its tax obligations before concluding a transaction. Furthermore, the CJEU stated that it would be contrary to the well-established principle of legal certainty and leave suppliers in an ‘uncertain situation’ if an EU Member State could ‘subsequently require’ a supplier to ‘account for the VAT on that supply, where it transpires that, because of the purchaser’s fraud, of which the supplier had and could have had no knowledge, the goods concerned did not actually leave the territory of the Member State of supply.’ The CJEU also held that the principle of fiscal neutrality – which precludes treating similar supplies in competition with each other from being treated differently for VAT purposes – would also be infringed.

The CJEU also reiterated its position with regard to the principle of proportionality. It held that while Member States can adopt measures to protect their public exchequers, such measures must go no further than necessary for that purpose and should not operate to the detriment of EU law. The CJEU confirmed that any distribution of risk between a supplier and the tax authorities, following the perpetration of fraud by a third party, must be compatible with the principle of proportionality i.e. there cannot be a disproportionate response to the risk of fraud which places an unjust burden on legitimate businesses.

In the case of Unitel (C-653/18), which concerned the exportation of mobile phones from Poland to Ukraine, the CJEU held on 17 October 2019 that the supplier, who was an innocent party, was entitled to benefit from the zero-rating of its supplies even though fraud was committed by another party. The CJEU stressed that it ‘would clearly be disproportionate to hold a taxable person liable for the shortfall in tax caused by fraudulent acts of third parties over which he has no influence whatsoever’.

Ireland’s current position

As the CJEU pronounces on principles which must be used in interpreting the European VAT Directive (‘the Directive’), and the Directive is supposed to underlie the VAT law of all EU jurisdictions, decisions of the CJEU are relevant for VAT in each Member State. As a result, with regard to the application of this case-law in Ireland, we can ignore the fact that the questions in the cases referenced above were not posed to the CJEU by the national courts in Ireland.

Businesses in Ireland can take comfort in the fact that there is no evidence to suggest that the approach adopted by some taxation authorities in Europe has migrated to Ireland. Ireland’s current position is principally set out in Section 108C of the Value-Added Tax Consolidation Act 2010 (‘VATCA 2010’) and guidance published by Revenue.

Finance Act 2014 saw the introduction of Section 108C VATCA 2010 which seeks to impose joint and several liability for VAT evaded by fraudsters on third parties involved in the supply chain where a third party ‘knows that, or is reckless as to whether or not’ that supply is ‘connected to the fraudulent evasion’ of VAT. The wording of this piece of legislation is consistent with the tests established in the body of case-law referenced above. While there is no guidance currently available as to what Revenue believes constitutes ‘reckless’ behaviour, taking the ordinary meaning of that word results in a far less onerous burden being placed upon legitimate businesses than other EU tax authorities have sought to impose on taxpayers in their jurisdictions.

Revenue’s published guidance entitled ‘How to protect your business from becoming involved in VAT fraud.’, which was last reviewed by Revenue in November 2018, also outlines some of the tests established by the CJEU.

Revenue expect legitimate businesses to assess the integrity of their supply chains, customers, suppliers and goods within those supply chains on an ongoing basis. Failure to do so may lead to Revenue seeking to deny a business input deduction or hold it accountable for VAT evaded by a fraudster.

Revenue outline a number of useful examples of considerations or checks a legitimate business could have or undertake for trading partners and transactions it enters into to protect itself from becoming involved in VAT fraud. Such checks will prompt taxpayers to consider the legitimacy of its suppliers and the commercial viability of transactions. They will also serve to protect a business from not only VAT fraud but the associated financial loss with fraud in general.

There is no suggestion that Revenue would consider a business to be acting recklessly if did not perform all of the checks outlined in its guidance. In our view, to do so would place an unrealistic administrative burden on legitimate taxpayers. For example, as part of carrying out due diligence tests when establishing a trading relationship with a new supplier or customer, it is suggested that a legitimate business could visit their prospective trading partner’s premises, obtain signed letters of introduction on headed paper, obtain trade references, follow through on those trade references to ensure they are genuine and also to carry out credit checks. Clearly, it may not be feasible to carry out that level of due diligence in all instances.

Although the current guidance does not make reference to some of the more recent findings of the CJEU, there is nothing to suggest that the current approach by Revenue is not in keeping with the CJEU’s recent findings.

Concluding remarks

No one is disputing that VAT fraud and non-compliance are not serious issues. There can be no protection afforded to fraudsters or accomplices to fraud but seeking to hold innocent third parties accountable is clearly not the answer. Instead, tax authorities should use the far-reaching range of powers prescribed by law to combat VAT fraud. Such powers include the ability to audit businesses, refuse VAT registrations, exchange information with authorities in other jurisdictions on a real-time basis and extend the use of the reverse charge mechanism etc.

Finally, to address the question posed by the article’s title - VAT – Whose liability is it anyway? – it may not be yours but that seems increasingly unlikely to dissuade some tax authorities from not pursuing you for it. Undoubtedly, in the years to come, if tax authorities continue to attempt to shift the financial cost of VAT fraud to innocent third parties, disputes will continue to arise and courts will be asked to rule on such matters.

Should you have any queries on this article’s contents or would like our assistance with dealing with any taxation dispute, please feel free to contact us.

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