House of Lords - European Union

Select Committee on European Union Twentieth Report

STOPPING THE CAROUSEL: MISSING TRADER FRAUD IN THE EU

CHAPTER 1: THE DEVELOPMENT OF MISSING TRADER INTRA-COMMUNITY FRAUD[1]

1. Missing Trader Intra-Community (MTIC) Fraud is an exceptional crime. It is exceptional in its scope: HM Revenue & Customs (HMRC) believe approximately £3 billion was retained by fraudsters in the 2005/06 financial year. It is exceptional in its execution: a deliberate criminal act undertaken by criminal gangs whose activities have led to a distortion of the UK's trade figures. It is also exceptional in its design: because of the nature of the VAT system companies are able to collect tax on behalf of the government and simply fail to remit it to HMRC. It is a high profile, lucrative and systemic fraud, but one which requires a solution which will neither propel the problem into other Member States nor place an over-onerous burden on legitimate business.

2. Our concern about MTIC fraud is heightened by the fact that it occurs because of a fundamental flaw in the design of the VAT system. This is not the plain evasion and fraud—such as under-reporting or mis-reporting of sales, or failing to register with the tax authority—that is also seen in other tax regimes. There is no evidence that the VAT evasion rate is higher than that for other forms of taxation[2]: approximately 12% of the hypothetical VAT revenue is being lost each year, but a third of this loss is attributable to MTIC fraud.

VAT

3. Value Added Tax (VAT) has a key strength: the government effectively collects a proportion of the tax at each stage in the sales chain, rather than concentrating the potential revenue, and the risk of evasion, in the final seller. This "fractionated" nature is also VAT's principal weakness: many more transactions have to be logged and reported by traders, raising both the regulatory burden and the difficulty of monitoring compliance. In addition, the seller of an item is collecting the tax on behalf of the revenue authority, rather than the revenue authority collecting it directly from the taxpayer. This extra link in the chain increases the opportunity for fraud. A tax authority considering claims for VAT repayment has to maintain a balance between not being so restrictive that legitimate claims are denied and the tax effectively becomes a tax on production inputs, and not being so lax that fraud continues unchecked.

4. In the past forty years, VAT has been introduced in around 130 countries, including all OECD members other than the United States. Several European nations, including Denmark, France, Germany, the Netherlands and Sweden introduced the tax in the 1960s; the UK introduced VAT in 1973. The Council of Ministers adopted its First and Second VAT Directives[3] in 1967, which introduced a common VAT system across Europe. The Sixth VAT Directive[4], adopted in 1977, standardised the basis of the application of VAT on goods and services within the EU. The Sixth Directive has been amended and was replaced in 2006 by a recast text (the "Principal Directive").[5] Member States continue to operate derogations to allow them to apply a reduced rate or exempt classes of goods from VAT.

5. The abolition of barriers to internal trade in 1992 required further changes to the system of VAT applied to intra-Community trade. The Commission proposed a clearing house which would ensure that tax collected in the supplying Member State and deducted in the importing Member State would be passed to the latter Member State's revenue authority. This proposal was rejected by the Council of Ministers, who expressed concerns that the clearing house would not be practicable, not least because Member States would have no incentive to investigate their purchasers in order to collect tax which would be passed on to another Member State.

6. Instead, Member States adopted a system under which intra-Community transactions were zero-rated. An exporter would not charge VAT, but would be able to claim a refund of input VAT; a purchaser would not pay VAT, but would have to charge it on subsequent sales and remit the VAT income to its fiscal authority. Thus consumption is taxed in the importing country. Any changes to this system, and other fiscal matters, require unanimity. This, along with a lack of political will to make a major change, has led to the current system continuing largely unchanged, despite suggestions on its introduction that it would only operate until 1997.

MTIC Fraud

FIGURE 1

A Basic MTIC Fraud[6]

7. In MTIC fraud's most simple form, a trader collects tax on sales and then fails to remit it to the government, for example by engineering bankruptcy. In the past decade a more damaging form of this fraud has arisen in the European Union. It is not a fraud against the Community itself, and does not come about because of mismanagement by European institutions, but instead is an attack upon the measures Member States have introduced to promote cross-border trade in the Community. Growth in the fraud is driven by four factors:

(b) The zero rate of taxation on intra-Community cross-border trade, which allows purchasers of goods from other EU countries not to pay VAT on purchase, although they then charge VAT on sales as normal.

(c) At the same time, exporters of goods are still able to reclaim VAT they have paid to other traders, thus crystallising the loss as the revenue authority refunds a payment for which it had not received a remittance earlier in the transaction chain.

(d) The abolition of frontier formalities within the European Community which prevents Member States from operating procedures which could impede the free flow of goods within the Union. This means that the verification of the zero-rated goods imported could only be based on an audit of the traders' transaction records—a process which at present is normally only undertaken when VAT receipts are remitted, some time after the transactions.

8. In MTIC fraud's more virulent form, the first and fourth factors above are abused to trade repeatedly the same consignment of goods between companies set up for this specific purpose. It is this repeated cycling of goods which gives this version of the fraud its common name of Carousel Fraud.

9. Once the shell companies have been created, MTIC fraud is a relatively simple crime to commit, with the cycling of goods allowing continuing profit from one initial outlay[7]. While it is more lucrative on zero-rated intra-Community trade, it can also occur on trade from countries outside of the EU. In these cases, illustrated in figure two, goods enter the EU in one Member State with a final destination in a different Member State, and under the Community Transit rules they travel duty-free within the Union. Before reaching their supposed final destination, goods are diverted to smaller consignments and their true source masked. The Common Customs Tariff remains unpaid on these items.

FIGURE 2

An MTIC fraud including extra-Community trade[8]

10. We were told that cargo planes are chartered each week to carry electronic goods out of the EU as part of the extended carousel fraud outlined in Figure 2 (Q 277). This type of fraud is able to occur because of poor management and oversight of the Community Transit system by Member States.

11. The European Court of Auditors recently reported on the Community Transit system and found:

12. The Court of Auditors' Report makes several recommendations for improvement and the Commission is considering these.[10] The Paymaster General has told us that the Government will support these improvements when they are brought forward[11], and we recommend that Government works with other Member States to ensure that these changes are prioritised in order to attack the supply chain for this variant of MTIC Fraud.

Losses to MTIC Fraud

13. MTIC fraud occurs across the EU. Very few Member States publish estimates of the size of the problem but the European Commission believes that in some countries it has reached levels of up to 10% of VAT receipts.[12] Germany has recognised that the fraud is a significant problem; it estimated a reduction in revenues due to MTIC frauds of €4.5 billion in 2002.[13] The National Audit Office reported that Denmark and the Netherlands were often used by fraudsters as the location for apparently legitimate transactions in a larger chain in which the tax is being stolen in other Member States, such as the UK.[14]

14. In the UK, levels of MTIC fraud have risen since it was first identified and measured in the late 1990s. However, like any criminal activity its nature makes it difficult to measure, and we have been presented with a variety of different estimates of the size of the activity. HMRC's estimates of the size of MTIC fraud are contained in Table 1:

TABLE 1

MTIC Fraud estimates[15]

Year	Estimated size of MTIC fraud—HMRC
1999/2000	£1.5-£2.4bn
2000/1	£1.3-£2.5bn
2001/2	£1.7-£2.5bn
2002/3	£1.5-£2.3bn
2003/4	£1.1-£1.7bn
2004/5	£1.1-£1.9bn
2005/6[16]	£3.5-£4.75bn

15. HMRC produced two figures for 2005/6. One used the existing methodology and produced an estimate of the size of the fraud of £1.4-£2.4 billion, but this figure was not supported by operational indicators. Operational evidence instead suggests that the scale of attempted fraud in 2005/06 is £3.5-£4.75 billion. It is possible that the scale of the fraud in earlier years may also have been higher than estimated. The Paymaster General told us that she is confident that the size of the fraud recorded in 2006/07 will be lower than in previous years (Q 237).

16. Separate figures produced by the "Eurocanet" project[17] have been widely quoted in media coverage of MTIC fraud and were referred to by some witnesses. Their report[18] suggests that the UK lost £8.4 billion to the fraud in the year to June 2006. We do not agree with their analysis, which was based on inadequate information and did not justify the conclusions drawn. We believe HMRC's calculations are more realistic.

17. The majority of the frauds in recent years have centred on the mobile phone and computer chip sectors, although the subject of the fraud is beginning to diversify. Witnesses told us that cosmetics, "precious" metals and computer software were products that criminals were now targeting (Q 273, pp 70-1) and the Paymaster General also outlined a range of goods that were potential vehicles for fraud (p 66). The industries used by the criminals generally involve high value/low weight goods, or service industries, usually with few barriers to entry. Industries with a significant grey market are common targets.

BOX 1

Grey Market

A "grey market" normally refers to the flow of new goods through distribution channels other than those usually authorised or intended by the manufacturer. Goods are imported outside of the manufacturer's normal distribution channels, often in order to take advantage of different pricing policies in different jurisdictions, and normally sold on at a price below the manufacturer's recommended level. Some grey markets include goods traded entirely legitimately, for example when a manufacturer is looking to dispose of excess stock.

18. It is clear from the evidence we have received that a number of participants—often small businesses operating in the grey market—in the mobile telephone and computer chip sectors have been adversely affected by the Government's attempts to eradicate the fraud in their industry. Big businesses do not appear to have been affected, primarily because they trade directly with manufacturers and end users (Q 286).

19. Missing Trader Intra-Community Fraud is occurring on a substantial scale across the European Union. We agree with HMRC that this is an outright attack on the tax system (Q 224), and note that it precipitates other crimes, such as theft of consignments (p 68). We accept the evidence that the majority of the fraud is being undertaken by a small number of sophisticated criminal gangs (QQ 275-276, 341-344).

A need for further action?

20. In this report we consider the actions already taken by the Government to tackle MTIC fraud, including the planned introduction of a "reverse charge" mechanism for VAT in the mobile telephone and computer chip sectors from June 2007. We also examine whether further action will be necessary, either in the form of changes to administrative practice in the UK, or via a major change to the European VAT system which would require unanimous agreement of EU Member States. For each possible change, we will consider two tests: whether it would stop the fraud; and whether it appears that it would create insurmountable compliance costs for legitimate business.

21. We make this report for debate.

1 Missing Trader Intra-Community Fraud is popularly known as "Carousel Fraud": this term represents the practice on continual import and export of the same goods in a chain of transactions. See paragraphs 7 & 8. Back

2 Other forms of VAT evasion include non-registration and non-compliance by registered firms. Losses under other types of tax are also suggested to be between 10-15%. VAT fraud and evasion: what do we know and what can be done? Keen & Smith, National Tax Journal Vol LIX, No 4 December 2006 Back

3 67/227/EEC and 67/228/EEC Back

4 77/388/EEC Back

5 2006/112/EC Back

6 Adapted from VAT fraud and evasion: what do we know and what can be done? Keen & Smith, National Tax Journal Vol LIX, No 4 December 2006 Back

7 It is also suggested that in many cases of the fraud, the goods do not exist, or are only traded on paper (p 30). Back

8 Adapted from HM Revenue & Customs 2005-06 accounts-The Comptroller and Auditor General's Standard Report NAO, July 2006 Back

9 European Court of Auditors Special Report No 11/2006 on the Community transit system
OJ C44 (27 February 2007) p 1 Back