Knew or should have known… A review of MTIC or Carousel fraud cases

The English Courts and Tribunals have held that the right of a taxable person to deduct input VAT in respect of certain transactions cannot be affected by the fact that, in the chain of supply of which those transactions form part, without that taxable person knowing or having any means of knowing, another prior or subsequent transaction is vitiated by VAT fraud. This decision was extended by the ECJ in the case of Kittel, where it was held that:

“where it is ascertained, having regard to objective factors, that the supply is to a taxable person who knew or should have known that, by his purchase, he was participating in a transaction connected with fraudulent evasion of value added tax, it is for the national court to refuse that taxable person entitlement to the right to deduct”.

This principle has been upheld in the European Court of Human Rights.

Means of knowledge

The question of whether a person has “means of knowing” that VAT fraud is involved in a chain of transaction in which he is involved was considered in detail in the case of Dragon Futures. The tribunal concluded:

“(1)     The taxable person must be judged by both the level of actual knowledge and the actions taken, or not taken, to acquire knowledge at the time of entry into the commitment that gives rise to the input tax. Hindsight cannot be used. There may be questions in individual cases about the time of entry into the commitment. The taxpoint of a transaction may depend on how the transaction is carried out (for example, where payment precedes delivery).

(2)     The taxable person must make a proportionate response to information actually known that indicates fraud. That knowledge is not restricted to the immediate context of the supplier or purchaser of relevant goods to or from the taxable person. It includes knowledge of fraud “in the market” for the goods in question, as well as knowledge in the public domain or otherwise actually known of fraud by a specific trader. It includes information about all known counterparties in the web of transactions of which the contract forms part, and counterparties that can be identified on proportionate enquiry made within the limits imposed by market confidentiality.

(3)     The taxable person must take proportionate steps to use all means reasonably available to increase actual knowledge. For example, in these appeals, the tribunal saw the use of: checks on the validity of value added tax registration numbers; checks on customs stamps on goods going through a customs inspection; checks with and about individual suppliers and customers, including checks with national registration institutions; checks with credit agencies and inspection agencies, including checks on the IMEI numbers of telephones; use of appropriate terms of contract. Where an initial enquiry gives rise to information suggesting the need for further enquiry, the test is reapplied to assess the need for that further enquiry. What is proportionate and reasonable is a matter of fact, and involves balancing actual cost and the opportunity cost of personal effort against risk.

(4)     The taxable person, in making these checks, does not have to act to a higher standard of proof than that applied to the underlying claim. If disputed facts are determined by reference to the balance of probabilities, then that is also the standard by which the steps taken by a taxable person should be judged. A taxable person cannot be expected to take steps to ensure a transaction is clear of fraud beyond all reasonable doubt. That would be disproportionate. If, on what the taxable person knows after taking into account all actual knowledge and having made all proportionate enquiries, the better view is that there is probably no fraud connected with the transaction, then the taxable person has met the required standard.

(5)     Whether the steps taken by a taxable person to avoid being connected with fraud are proportionate in an individual case must be a question of fact taking all the circumstances into account. There can be no presumption that because there is fraud in a chain of transactions then that fraud is known, or should have been known, to all others in that chain.

(6)     Finally, the concern requiring investigation is with fraud on the public revenue through the value added tax system, not with other forms of fraud such as fraud on a foreign trader.”

In short, the question to be asked is:

“Has the taxable person, at the time of entering a transaction involving payment of value added tax by or to that person, and taking into account the actual knowledge of the taxable person at that time (including knowledge acquired from any enquiry or investigation), taken all proportionate steps available to it to ensure that, on the balance of probabilities, no aspect of the transaction is connected with any other party involved in, or any other transaction involving, fraud on the public revenue through the value added tax system?”

This question can be further divided in to four essential elements. The answer to each of these must be yes, for HMRC’s case to succeed:

(i)    Is there a VAT loss?

(ii)   If so, did this loss result from a fraudulent evasion?

(iii)   If so, were the transactions the subject of the appeal connected with that evasion?

(iv)   If so, should the appellant have known that its purchases were connected with a fraudulent evasion of VAT?

In the case of Our Communications, the tribunal held that the appellant had:

“taken all available proportionate steps to ensure on the balance of probabilities that there was no connection with persons or transactions involved in VAT fraud”.

The appellant was no doubt assisted by its assurance officer’s agreement that there was little more which appellant could have done to verify the validity of the transactions in question. In addition, the tribunal agreed that it was difficult, if not impossible, for the appellant to verify the validity of distance links in the chain:

“[the appellant] is not HMRC’s insurer as to the payment of VAT by someone far away in the chain. Otherwise why would joint and several liability provisions be needed? OCL only needs to act reasonably and proportionately in considering the integrity of the chain. It has done so and we so find.”

Input tax on transactions indirectly connected with fraudulent transactions

In the case of  Just Fabulous, the High Court was required to consider a development of MTIC fraud, known as contra-trading. Since HMRC were able to refuse an input tax claim on the part of an exporter who was knowingly involved in MTIC fraud, the exporter would buy further goods from another EU member state, which he would then sell to a “new trader” in the UK. Thus the exporter would offset his input tax claim against the VAT due on the domestic sale. The “new trader” would, it was argued, then be entitled to recover input tax on his purchase on the basis that that transaction did not form part of a transaction chain which involved fraud. The High Court, however, rejected that argument, holding that HMRC were entitled to refuse to make repayment in respect of returns which were indirectly connected with fraudulent transactions. If HMRC could show that the transactions were what they claimed them to be, they would have an arguable case that a trader who, knowingly or with means of knowledge, engaged in conduct designed to conceal or avoid the consequences of discovery of a fraud should be in no better position than the perpetrator of the fraud.

Similarly, in Olympia Technology, the High Court held that the tribunal’s finding (that HMRC had to show that the taxable person knew (or ought to have known) of both the missing trader’s fraud and also the contra-trader’s involvement in that fraud) was, in the circumstances, too high a legal test. In the case where the contra-trader had himself been a dishonest co-conspirator it need not be shown that the taxable person knew or ought to have known of the missing trader’s default. It was sufficient if he knew or ought to have known of the contra-trader’s dishonesty. In a case where the contra-trader had not been dishonest, it was sufficient if the taxable person knew or ought to have known of the missing trader’s default. Accordingly, the tribunal had misstated the legal test, and had been “wrong to water down the requirement that the taxable person must take every precaution reasonably required”. The case was remitted to the tribunal, which reconsidered the case taking into account the “inherent probability” of fraud. It allowed the appeal in principle with regard to seven transactions but dismissed it with regard to eight transactions.

In Blue Sphere, however, the High Court, in allowing the taxpayer’s appeal, considered that the burden was on HMRC to prove that the taxpayer ought to have known that by its purchases it had been participating in transactions connected with fraudulent evasion of VAT. Further, it was not sufficient to demonstrate that the taxpayer had been involved in transactions which “might” turn out to have undesirable associations. The relevant knowledge was that the taxpayer ought to have known that by its purchases it had been participating in transactions which had been connected with the fraudulent evasion of VAT; that such transactions might be so connected was not enough. Similar considerations applied to the formulation of the case for HMRC. Their contention that the taxpayer ought to have known of the connection between its transactions and the fraudulent evasion of VAT by the defaulting traders in the “dirty” chain was not enough. HMRC had to prove that the taxpayer ought to have known that those other transactions had involved the fraudulent evasion of VAT. At the time the taxpayer had entered into the “clean” chain there had been no such “dirty” chain of which it could have known, nor had the occurrence of such “dirty” chain been inevitable in the sense of being pre-planned.

The current state of jurisprudence with regard to “knowledge or means of knowledge” was summed up by Lewison J in Olympia Technology, and reproduced in Quality Export as follows:

(a)     it is disproportionate and contrary to Community law to require a person who is a careful and honest trader to assume liability for the frauds of others;

(b)     it is also disproportionate to hold a taxable person liable for fraudulent acts of third parties over whom he has no influence;

(c)     a trader who does take every precaution that could reasonably be required of him, and does not realise that he is participating in VAT fraud, must be entitled to rely on the legality of his own transaction;

(d)     a person who knew or should have known that by his purchase he was taking part in a transaction connected with the fraudulent evasion of VAT is to be treated in the same way as a person who fraudulently exercises the right to deduct;

(e)     it is not contrary to Community law to require a supplier to take every step that could reasonably be required of him to satisfy himself that the transaction which he is effecting does not result in his participation in tax evasion;

(f)     likewise a taxable person can be expected to act with all due diligence and care; and

(g)     whether a taxable person knew or should have known that he was participating in a transaction connected with the fraudulent evasion of VAT must be determined having regard to objective facts or factors.

The Court of Appeal decision in Mobilx and Kittel

The appeal to the Court of Appeal drew together two questions which had been raised following the decision of the ECJ in Kittel, namely:

(a)     what did the Court mean when it said that input tax could be denied where the taxable person “should have known” that, by his purchase, he was participating in a transaction connected with the fraudulent evasion of VAT? and

(b)     is it sufficient that the taxpayer knew or should have known that it was more likely than not that his purchase was connected to fraud or must it be established that he knew or should have known that the transactions in which he was involved were connected to fraud?

In relation to (a), the Court considered that Kittel was a development of the “means of knowledge” principle in Optigen:

“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, not as a penalty for negligence, but because the objective criteria for the scope of that right are not met. It profits nothing to contend that, in domestic law, complicity in fraud denotes a more culpable state of mind than carelessness, in the light of the principle in Kittel. A trader who fails to deploy means of knowledge available to him does not satisfy the objective criteria which must be met before his right to deduct arises…A trader who decides to participate in a transaction connected to fraudulent evasion, despite knowledge of that connection, is making an informed choice; he knows where he stands and knows before he enters into the transaction that if found out, he will not be entitled to deduct input tax. The extension of that principle to a taxable person who has the means of knowledge but chooses not to deploy it, similarly, does not infringe that principle [of legal certainty]. If he has the means of knowledge available and chooses not to deploy it he knows that, if found out, he will not be entitled to deduct. If he chooses to ignore obvious inferences from the facts and circumstances in which he has been trading, he will not be entitled to deduct.”

In relation to (b), the Court held that it was insufficient for HMRC to demonstrate that there was a risk of a fraudulent connection:

“If HMRC was right and it was sufficient to show that the trader should have known that he was running a risk that his purchase was connected with fraud, the principle of legal certainty would, in my view, be infringed. A trader who knows or could have known no more than that there was a risk of fraud will find it difficult to gauge the extent of the risk; nor will he be able to foresee whether the circumstances are such that it will be asserted against him that the risk of fraud was so great that he should not have entered into the transaction. In short, he will not be in a position to know before he enters into the transaction that, if he does so, he will not be entitled to deduct input VAT. The principle of legal certainty will be infringed…It must be remembered that the approach of the court in Kittel was to enlarge the category of participants. A trader who should have known that he was running the risk that by his purchase he might be taking part in a transaction connected with fraudulent evasion of VAT, cannot be regarded as a participant in that fraud. The highest it could be put is that he was running the risk that he might be a participant. That is not the approach of the Court in Kittel, nor is it the language it used. In those circumstances, I am of the view that it must be established that the trader knew or should have known that by his purchase he was taking part in such a transaction”.

However, it would appear that a point arises where the risk of involvement in a fraudulent transaction becomes so high as to be a virtual certainty:

“The true principle to be derived from Kittel does not extend to circumstances in which a taxable person should have known that by his purchase it was more likely than not that his transaction was connected with fraudulent evasion. But 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.”

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