Select Committee on European Union Twentieth Report

CHAPTER 2: TACKLING MTIC FRAUD: ACTIONS TO DATE

Extended Verification and Joint & Several Liability

22.  The Paymaster General outlined HMRC's strategy to date for interrupting MTIC fraud in her written evidence (pp 47-8) and oral evidence (QQ 229, 232-236). Over 1500 HMRC staff are now employed on the MTIC strategy, at a cost of £95 million per year (p 66). The strategy dates back to September 2000 but has evolved over time. It started by using risk-based controls to identify, prevent and disrupt potentially bogus businesses and transactions. HMRC initially argued that purchases and sales in the supply chain were not part of any economic activity for VAT purposes and thus fell outside the scope of VAT. This meant that VAT purportedly paid to suppliers was not VAT which could be reclaimed. HMRC attempted to recoup the VAT charged, but never paid over by the missing trader, by refusing to repay the VAT reclaimed later in the supply chain, typically by the exporter of the goods. This approach was challenged by those denied refunds in the UK courts and ultimately the European Court of Justice (ECJ), in Bond House[19]: the Court ruled against HMRC's approach.

23.  The ECJ held that the transactions in question were supplies of goods or services for the purposes of the then Sixth Directive: as long as a transaction itself was not vitiated by VAT fraud, the right to deduct VAT paid could not be affected by the fact that there was a fraud elsewhere in the supply chain. However, the right to reclaim VAT was taken away where the trader knew or had any means of knowing that there was fraud within the supply chain. This judgment was released in January 2006 and, according to HMRC, is the reason for the very significant rise in carousel fraud in the early part of 2006, presumably because the fraudsters felt encouraged that VAT recovery could not be denied on "non-economic activity" grounds.

24.  HMRC's position was clarified in July 2006, with the judgment of the ECJ in Axel Kittel[20]. Following the decision in Bond House, the ECJ held that where it is ascertained, having regard to objective factors, that the trader knew or should have known that, by his purchase, he was participating in a transaction connected with VAT fraud, he can be refused his entitlement to the right to deduct VAT. However, the Court said that traders would not risk losing the right to deduct VAT paid where they "take every precaution which could reasonably be required of them to ensure that their transactions are not connected with fraud."[21]

25.  As a result of these cases, HMRC's approach in the past year has focused on a "means of knowledge" test involving extended verification; HMRC staff conduct lengthy and far-reaching enquiries into every constituent part of each transaction chain, examining whether frauds have occurred and whether other participants in the trail could have known of it. As HMRC explained, this is an extensive task as some chains involve over 600 companies (Q 321).

26.  But firms who are confident that they have never traded directly with fraudulent participants claim to have had VAT repayments withheld (pp 76, 108-9, 135-6, QQ 289-290). The Federation of Technological Industries and others told us that every participant in the grey markets for mobile phones and computer chips has had their VAT repayments withheld since spring 2006, and that the due diligence required by firms under the "means of knowledge" test appears to be imposing an increasing burden on legitimate businesses (QQ 288-289). HMRC disputed this claim, although they did indicate that up to 1500 firms are currently subject to extended verification and that some of these firms may not have been a complicit party to the fraud (Q 336). HMRC also said that traders facing bankruptcy can receive repayments while verification is ongoing, if security for the repayment is given, and that they take steps regularly to inform firms subject to extended verification of progress (QQ 322-323).

27.  HMRC's interpretation of the scope of the "means of knowledge" test has been considered by the UK courts[22] but its application is yet to be considered by the VAT and Duties Tribunal against the facts of a particular case. The Federation of Technological Industries told us that they planned to challenge the legality of HMRC's approach in a judicial review (Q 308).

28.  As things stand, HMRC has no option but to continue with extended verification; however they need to take real and substantive steps to ensure that their actions do not damage the innocent and are proportionate to the scale of the fraud. We note that, according to the Paymaster General, this approach has led to a "massive drop" in attempted MTIC fraud in 2006/07 (Q 231). This appears to justify their approach, however, the system of extended verification is an inefficient and unsustainable use of HMRC's resources, and does impose a significant burden on smaller firms.

29.  Under UK law, section 77A of the VAT Act 1994 entitles HMRC to issue a notice that persons in a supply chain may be joint and severally liable for VAT unpaid if HMRC has reasonable grounds to suspect that the VAT would go unpaid elsewhere in the supply chain. The provision only applies to certain goods[23] and only when the addressee knew or had reasonable grounds to suspect that VAT would go unpaid on the supply to which it is a party or earlier in the supply chain.[24] Although the sectors in which most of the MTIC fraud has occurred are already covered by the scope of section 77A, the powers have not been widely imposed by HMRC. Section 77A has been referred to, however, in warning letters issued by HMRC designed to deter companies from trading in a way which HMRC believes puts them at risk of becoming liable for unpaid VAT elsewhere in their transaction chains (Q 325).

30.  While the range of section 77A is limited to certain products, the ECJ rulings and the "means of knowledge" test can be applied to all exported goods. In practice the Government has already sought to extend the "joint and several liability" provisions to allow HMRC to apply these powers alongside the "means of knowledge" test.

Disruption of criminal activity

31.  HMRC has also taken steps to disrupt the activities of fraudulent traders. HMRC believe that a relatively small number—in "the low end of the hundreds"—of sophisticated criminal gangs are behind the fraud, and it is likely that most of these gangs are also involved in other criminal activity including money-laundering and smuggling (QQ 342-344). The Paymaster General told us that "thousands of accounts" at an offshore bank had been frozen following HMRC's investigations, and that accounts at other banks were being investigated (QQ 241-244)[25]. The Minister also stated that HMRC is working with the Serious and Organised Crime Agency and other police forces and were continuing to work towards prosecutions (Q 345). The Paymaster General has also visited Dubai to hold talks on fraud and recouping money from fraudsters' accounts in the United Arab Emirates (Q 224)[26].

32.  The Metropolitan Police Service coordinates Operation Grafton, a multi-agency initiative tackling organised crime in the Heathrow area, where many freight forwarders are based. It is possible that some freight forwarders may be facilitating MTIC fraud if they act as a conduit for goods which are being repeatedly imported and exported. We were told that Customs have the power to log the contents of consignments of mobile telephones in order to trace goods moving into and out of the country; this works for these products, currently used in the fraud, but may not be a useful measure as the fraud mutates into products without serial numbers.[27]

33.  HMRC is content that they have the right range of powers to tackle the criminal groups undertaking the fraudulent activity. We welcome work between Customs and other law enforcement agencies to target the criminals behind the frauds, although in so doing we note that this close cooperation is only needed because the crime is so easy to accomplish.

Cross-border co-operation

34.  While this work continues, HMRC's strategy has broadened to include co-operation with other EU Member States. The European Commission operates the VAT Information Exchange System, which can be used by exporters to verify that their customer in another Member State is registered for VAT and thus entitled to a zero-rated purchase. We were told by Commissioner Kovacs that the system is significantly under-used. In 2005, there were only 26,000 information exchanges, despite there being 35 million traders involved in intra-Community trade (Q 115). The Paymaster General told us that the November 2006 ECOFIN agreed there is a need for more rapid exchange of information and the UK is part of a working group looking at ways to improve the efficiency of the VAT Information Exchange System (p 64). Commissioner Kovacs also noted that the Commission has taken the first step towards developing proposals to clarify and strengthen the legal framework for operational assistance between countries (Q 115).[28]

35.  There is an absolute need for revenue bodies to work with law enforcement agencies within each Member States, and across borders. HMRC have taken a lead on this work by hosting a conference for European law enforcement agencies and tax authorities in February 2007 (QQ 225-226), and we would welcome increased coordination of links between customs authorities and law enforcement agencies, rather than a series of bilateral links.[29] This work must continue: the scale of this fraud demands cross-border co-operation between revenue authorities and law enforcement agencies. Concern about protection of data shared during joint work (Q 222) must be resolved.[30]

36.  As outlined in Figure 3, the reverse charge allows a VAT-registered firm selling goods to another VAT-registered firm not to charge VAT. The tax is only collected by a firm which is selling on the product to a final consumer or a non-VAT registered firm. Critics of the reverse charge have noted that this still creates the opportunity for a firm to become a missing trader, and suggest that the problem may be magnified: as tax has not been collected in stages along the consumption chain, all of the tax due on the product is concentrated in the last trader (pp 79, 108). On the other hand, there are fewer traders collecting the tax for the revenue authority to monitor. In addition, as VAT is not collected by any one trader in the chain depicted in Figure 1, there is no opportunity for trade carousels to develop.

37.  While all of the measures described thus far create, in the Paymaster General's words, "a severe downward pressure on the potential loss" (Q 248), they can only be a palliative and will not prevent the fraud from happening. In 2006 an application was made by the Government for a derogation to enable the introduction in the UK of a reverse charge accounting procedure for the goods most commonly used in MTIC frauds. Changes to the VAT system require the unanimous approval of the Council; after some negotiation with other Member States, who may have been concerned that the derogation would move fraud from the UK to their territories, the derogation was granted and the measure will come into force on 1 June 2007.[31] The Paymaster General explained the reasons for the delay were of a technical nature, with other Member States seeking reassurance that the proposal would truly be limited (Q 257).

38.  The limited reverse charge is not unprecedented. A "Special Accounting Scheme for Gold" was introduced in the UK in April 1993, and since January 2000, "investment" gold has not been subject to the standard VAT rules anywhere in the European Union. These measures were introduced to combat VAT fraud being undertaken using investment gold, and also to protect the City of London's requirements as a major trading centre of gold. The measures are now accepted and understood by participants in the gold markets.

Reverse Charge

FIGURE 3

A Reverse Charge accounting system

39.  For this change to the VAT system, HMRC have worked with the mobile telephone and computer chip industries to design the reverse charge in a way which minimises administrative costs (Q 311). HMRC are also educating industry about the changes to the accounting methods through a dedicated team of several hundred staff who work to educate the public of changes to the tax system (Q 315). We support their decision to apply a light touch to compliance activity in the first year of the charge, particularly as some witnesses have suggested that the transition time is not long enough (Q 311, pp 124, 238). We also support the decision to raise the de minimis level to £5000, as we received evidence noting the difficulties the proposed £1000 de minimis level would create for retailers and the charity sector (p 103).

40.  HMRC states that they now have the monitoring capability to detect the growth of fraud in other sectors before it gets out of control (Q 334), but recording fraud via monitoring is not the same as preventing it from occurring. It is generally accepted that the broad phenomenon of MTIC fraud is out of control; we expect it to continue to mutate into other sectors. The reverse charge is only a temporary solution.

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19   Cases C-354/03, C-355/03 and C-484/03. Optigen Ltd, Fulcrum Electronics Ltd and Bond House Systems Ltd v Commissioners of Customs & Excise [2006] ECR I-483. Back

20   Cases C-439/04 and C-440/04. Axel Kittel v Belgian State and Belgian State v Recolta Recycling SPRL [2006] ECR I-6161. Back

21   Ibid. Paragraph 51 Back

22   HMRC's interpretation of the scope and application of the "means of knowledge" test has been considered in Dragon Futures Limited (Decision of the VAT & Duties Tribunal dated 10 October 2006) and Just Fabulous (UK) Ltd, Evolution Export Trading Ltd and Greystone Trading Ltd; Brayfal Ltd (Judgment of Mr Justice Burton dated 15 March 2007). The VAT and Duties Tribunal's first hearing to consider the facts of a particular case (CallTel Telecom Ltd and Opto Telelinks (Europe) Ltd) was held in early May 2007. Back

23   Originally section 77A was limited to telephones, computers and their parts and accessories. The range of goods was extended by a Treasury Order of 21 March 2007 to include "certain sorts of electronic equipment, of a kind ordinarily owned by individuals and used by them for the purposes of leisure, amusement or entertainment", and to clarify the inclusion of satellite navigation systems. Back

24   The 2007 Finance Bill includes provisions to extend the circumstances in which HMRC may presume the business had reasonable grounds to suspect fraudulent activity in the supply chain. Back

25   In a joint operation with the authorities in the Netherlands, accounts at the First Curacao International Bank in the Dutch Antilles were frozen.  Back

26   During 2005/06, there were six successful prosecutions resulting in 18 convictions with sentences totalling 72 years imprisonment. HMRC also took action against 29 companies involved in MTIC fraud resulting in £9.4 million being recovered or frozen (HMRC Annual Report 2005-06). Ongoing prosecutions involve some £2.5 billion of VAT (HL Written Answer 27 March 2007 col 266). Back

27   Mobile telephones have unique IMEI identification numbers which are relatively difficult to change. We were told that other goods have no identifying marks and can be repackaged (Q 273, p 70) Back

28   COM(2006) 254 Back

29   HMRC have also participated in cross-border operations with colleagues overseas (Q 340). Back

30   This is an issue we have addressed in other reports, most recently in European Union Committee, 18th Report (2006-07): Prüm: an effective weapon against terrorism and crime? (HL 90) Back

31   OJ L109 (26 April 2007) p 42 Back