Insight

VAT fraud - protecting your business

September 2016


So a business that is registered for VAT is effectively a tax collector. The registered business deducts VAT it has paid (input VAT) from VAT it has collected (output VAT) and passes the net amount to the tax authorities. Where output VAT is less than input VAT the business receives a refund from the tax authorities.

The system works but is vulnerable to fraud and abuse. EU law states clearly that a business that knows, or should know, a VAT transaction is fraudulent, is deemed a participant in the fraud. There are certain consequences to this. At worst it's a criminal offence but the business can lose its right to deduct input VAT and may have to repay earlier deductions.

Fraud and how it might occur

In recent years tax authorities have increasingly refused to allow deduction of input VAT when they have found indirect suppliers to be acting fraudulently. This can hit SMEs hard as it affects cash flow, and cash flow problems can threaten a business's very survival.

Let's first look at a typical and legitimate VAT transaction.

Business A

Business B

Business C

Consumer D

  • A acquires goods
  • A pays input VAT
  • A supplies goods to B
  • A charges output VAT and receives payment from B
  • B buys goods from A
  • B pays input VAT to A
  • B supplies goods to C
  • B charges output VAT and receives payment from C
  • C buys goods from B
  • C pays input VAT to B
  • C supplies goods to D
  • C charges output VAT and receives payment from D
  • D buys goods from C
  • D pays VAT to C


Businesses A, B and C can deduct input VAT.

Now let's look at what a fraudulent VAT transaction might look like.

Business A

Business B

Business C

Consumer D

  • A acquires goods illegally
  • A pays no input VAT
  • A supplies goods to B
  • A charges output VAT and receives payment from B
  • B buys goods from
    A
  • B pays input VAT to A
  • B supplies goods to C
  • B charges output VAT and receives payment from C
  • C buys goods from
    B
  • C pays input VAT to B
  • C supplies goods to D
  • C charges output VAT and receives payment from D
  • D buys goods from C
  • D pays input VAT to C


The question is: can Businesses B and C deduct input VAT that they have paid on the purchase of goods?

The legal view

Historically it was rare for businesses to verify the credentials of their direct suppliers. It is now standard practice, to help protect against losing the right to deduct input VAT. But this may not be enough to satisfy the authorities as they will often argue that, regardless of the VAT appearing on an invoice for the supplied goods, the entities in the VAT chain should have known about the fraud. So in this example, Business B and C should have known that Business A was committing VAT fraud.

This puts businesses in the unhappy position of having to prove innocence rather than the burden of proof resting with the tax authorities. Consequently, this decision has been tested at the European Court of Justice (ECJ).

The cases of Axel Kittel and Recolta Recycling SPRL

In these cases the Court did reaffirm the principle that where a business knew, or should have known, that VAT fraud was taking place, then the business can be assumed to be a participant in the fraud. This became known as the Kittel test.

The cases of Mahageben kft and Peter David

In these cases the Court found it unreasonable for tax authorities to expect businesses to carry out investigations on their behalf. Consequently, tax authorities should not remove the right to deduct input VAT unless they can show on the balance of probability that the business should have known fraud was taking place.

This knowledge test becomes one of not whether the business has explored every possible avenue to satisfy itself of the legality, but one of whether fraud is the only reasonable explanation.

Conclusion

In the past, the tax authorities' appetite for blocking deduction of input VAT may have been motivated by a reluctance to instigate time-consuming and expensive fraud investigations - it is far easier to recover the lost VAT by penalising those trying to deduct it.

This approach now appears to run contrary to ECJ judgements and the burden of proof has shifted to the tax authorities.

When deducting input VAT be vigilant. Be on your guard against transactions that appear suspicious and document everything.

Author: Dr Rafal Nawrot