Examination of Witnesses (Questions 300
- 308)
TUESDAY 27 FEBRUARY 2007
MS ANGELA
O'HARA, MR
FRED HOWARTH
AND DR
MICHAEL CHEETHAM
Q300 Lord Kerr of Kinlochard:
If it was a requirement that anybody trading in mobile telephones
kept records of IMEI numbers—
Dr Cheetham: It is a requirement.
Q301 Lord Kerr of Kinlochard:—then
would that not make the fraud rather difficult? If the same number
appeared twice in a company's books one might conclude that something
circular was going on. If it was a requirement to keep the records
and, lo and behold a company had not kept records, one might suspect
that something fraudulent was going on. Is this not a step that
we should take?
Dr Cheetham: First, it is a requirement now.
As I said about the ever-extending list of things to do, it is
a requirement, but the fraudsters will simply either change the
bar codes and forge the bar codes. What happened when Customs
alleged that is the mobile phone trade tried to get from Nokia
and from Motorola a list of bar codes to verify these were genuine
bar codes, and Motorola and Nokia refused to release them.
Q302 Lord Kerr of Kinlochard:
Let me stop you there. If there are problems like that with a
measure of the kind we are talking about, surely it would be a
good idea to tackle these problems? In principle, a requirement
to maintain true records of IMEI numbers would be an effective
check.
Dr Cheetham: It would, but it is a requirement
now and companies I know are doing this and are not seeing the
same things going round. Also fraudsters will simply move into
high tec products like memory chips, for example, and they do
not have bar codes on them.
Q303 Lord Kerr of Kinlochard:
I just wanted to check on the facts. Now, I have heard six different
solutions to this problem in the course of this inquiry and one
of them, very interestingly, Dr Cheetham has brought out in his
written evidence and today. I would just like to check from all
three witnesses, please, the six routes that I will try to summarise.
I would like to have your judgment, Mr Howarth, of their effectiveness
in dealing with missing trader fraud and of the collateral damage
or extra cost they would impose on the industry: your judgment
against these two parameters. Solution one, what the Government
is trying to do, a reverse charge system limited to this sector,
with improved co-operation and information exchange, with continental
services. The downside of this is the migration of risk into some
other commodity. Clearly there is no real problem of interference
and extra cost for this sector of the industry but, the solution
might not be 100 per cent effective. Secondly, an origin system
like the original origin system. Cost of change from destination
to origin system right across the board enormous, but mainly a
one-off transitional cost, with possibly a continuing cost in
terms of the need for a giant clearing-house. Third, Dr Cheetham's
variant on that where you would have a base or medium rate charged.
I guess this would, indeed, reduce the incidence of fraud, in
this country, but you would be running up against fiscal sovereignty
concerns because, de facto, you would, commodity by commodity,
be introducing a minimum rate of VAT across the European Union,
so quite big issues would be raised. Fourth, another variant which
we understand is under consideration in the Commission would be
to have a system whereby national fiscal authorities charge the
rate of VAT in the country of destination, which would still require
a clearing-house system but it would be internal to 27 revenue
services. Fifth, there is some form of a technological solution.
You, Dr Cheetham, have spoken about a realtime trade logging database.
I guess that would have quite a big transitional cost but I do
not know very much about it, and I would be interested to hear
what you have to say. Lastly, we have, I suppose, a trusted third
party solution of some kind. So that seems to me to be the range
of solutions and I would like you to consider them against the
two criteria, please: effectiveness against fraud and interference
with legitimate trade, and the industry. Could I ask for an answer
from all three witnesses?
Mr Howarth: Taking reverse charge first, reverse
charge removes the fraud from the wholesale trading of the commodity.
There is no VAT charged anywhere down the line and when it is
exported there is no VAT to reclaim, so the fraud has gone away.
The impact on the retail side of the equation is difficult for
me to judge, not being involved in retail, but on the surface
it would appear that we are moving the burden from the exporter
currently to potential retail fraud, so I would say maybe that
would be moving the problem from one area to another, although
maybe not in such a big way. On the origin system and self-clearing,
this is very difficult because these introduce a cross-border
taxation system and the very concept of the European Union is
freedom of trade. If there are different rates of cross border
taxation then the normal entrepreneur will be looking for the
sharpest edge, which country to go and trade from, and if I can
make an extra 1 or 2 per cent profit by trading from France rather
than from the UK then I will go and trade in France. It would
be a commercial decision and I would be a fool not to. One would
have to discuss those problems with tax experts and economists
to see whether or not they are viable and whether or not they
in themselves were open to other fraudulent activities which are
there. The realtime logging database option goes back to 2003,
when almost everybody within the trade was directly sending their
trades down to Redhill—in a non technological manner, granted,
but the details of the trade from virtually everybody in the chain
would be sent down to Redhill. So if somebody was offering a company
stock the supplier of the stock would submit that offer down to
Redhill with full company details, full details of the trade,
where they were buying from, who they were selling to, and they
waited for the response. Similarly, by the time it comes up the
chain to the exporter, the exporter would submit the trade. On
many occasions traders were informed that there was a discrepancy
somewhere down the chain. They were always very careful not to
reveal how far down the chain or where in the chain the problem
was under data protection, but there was a problem. From my experience
and my knowledge of the industry, if a trader was advised of that
then they would take that advice and would not continue with the
trade. That, due to lack of resources on HMRC's part, was withdrawn
in early 2004 and no matter how much information you presented
HMRC at Redhill all you would get back was that the VAT number
was valid, and we do not see this as an authority to trade disclaimer.
The logging database takes that a stage further in as much as
it is a technological approach, and I cannot really comment on
it in greater detail but on the surface I would say there is a
possibility of a timing problem in that whilst you are still allowing
people at one end of the chain to accumulate VAT over a three
month period with a further month to account for that and a further
month before they realise it has not been accounted for, so the
trader at the beginning of the chain has five months to keep the
logging database up to date, then you would get the same arguments
that Redhill threw at us—today the chain is valid, today
the stock is there, today everything seems fine, but in three
or four or five months' time it may have vanished. That is the
problem; you are giving the people at the beginning of the supply
chains, the fraudsters, the opportunity to manipulate the system
for such a long period of time. On the third party trusted with
the VAT payments, we examined this about two and a half/three
years ago and it could well be that that has come on as a result
of this examination. We were trying to look at it from a commercial
point of view within the FTI to see whether or not it was a service
we could develop and offer to trade and get approval from HMRC
to introduce third party trusted facilities whereby the VAT was
paid into account A and I traded with the trader in account B,
with all the VAT ending up in A and getting paid back and at the
end of the day it could not go missing. This was seen as requiring
data protection and could not be run commercially by the normal
industry; it would have to be a government body that ran it, and
there is an awful lot of money involved with the interest, et
cetera, and all that came into it. I do not think the solution
is limited to these five because I think what we have is an overall
problem that is not being dealt with. We are not using joint and
several liability; we are not improving our verification process.
We are disrupting verification and new registrations with making
it harder to get registered. If I was opening a florist today
I would try and trade below the threshold because as soon as I
see the threshold I have the dilemma of can I keep my florist
shop running for another six to twelve to eighteen weeks while
HMRC decide if I can get a VAT number, and if they decide at the
end of it that I cannot have a VAT number how do I account for
my trading in the meantime? So it is a very disruptive approach
they are using as opposed to co-operating with industry and with
businesses and developing a verification process and a monitoring
process to make sure that new registrations, new companies, toe
the line and follow the rules, that the rules are laid down and
they know where they are going and have certainty that if they
carry out their actions in one way this will happen and if they
go down another path, that will happen. At the moment there is
no legal certainty. We do not know what will happen. If I go out
and buy phones today and sell them I do not know if I can claim
my VAT, and that is the problem.
Ms O'Hara: In order to eliminate fraud you do
require wholesale changes to the VAT system. Of all of the measures
the reverse charge would seem the one that would be the most effective
because it reduces VAT completely, but you would have to extend
it further than just selected trade on computer chips and phones.
Our business and that of all of the other mobile operators is
very complicated, so all of this is quite complex particularly
if you try and put limitations around a set of rules, for example
business customers can walk into our retail stores, so what do
you do if they are buying a phone or buying a phone in a contract?
Wholesale change of the VAT rules is very complex to adopt, and
of all of the solutions the reverse charge, extending it much
broader to more business-to-business supplies, would seem to be
something that would eliminate the fraud completely. Obviously
that is very difficult to achieve, particularly to reach agreement
at EU level as well, so I think there should be some more immediate
measures, certainly around the joint and several liability and
a more targeted approach by Customs, with them using their resources
to validate repayments quickly. There should be a domestic short-term
measure whilst they look for more long-term measures to tackle
this or similar fraud. Concerning the origin system, or the flat-rate
system or destination system, I have had various conversations
at EU level and certainly any suggestion of an origin system is
rebutted. You will never get agreement on a single VAT rate and
clearly, if we have different VAT rates, then businesses will
want to locate themselves in the lowest rate and supply from that
location, which I think is understandable, so harmonisation is
not somewhere we will get to realistically. On a flat-rate origin
system, again, I think there are quite a lot of complications
around that. If you are talking about having a flat rate for cross-border
trade then you have a distortion between domestic trade and cross-border
trade, and there are a lot of complications within larger businesses.
When you drill down to the level of detail these changes would
take a significant amount of time, not the eight weeks which it
has been suggested Customs would allow for businesses to implement
changes. Using a destination system, where you are charging VAT
at the destination, again, this needs to be well thought out.
Is this just for cross-border trade, or just selected products?
My concern there would be I am not sure that some of our billing
systems, which are very large lumbering beasts, could accommodate
27 different VAT rates, so the cost of making changes could be
astronomical and run into many millions. Added to that, it requires
businesses to understand what the standard rates are, what the
reduced rates are, what all the different rules are in the different
countries, as well as potentially being subject to audit by 27
countries which is quite a large requirement, so I cannot see
that we would necessarily favour that. In terms of a realtime
logging database I do not have enough information about that,
but anything that has a technology solution can be simple and
easy to implement or might be quite costly to tie into our systems,
so without a proper interrogation I could not really comment but
I do always have some concerns when people talk about technology
systems because we have very complex technology for the whole
of our system, so it might be easier or it might be something
quite costly that would take perhaps 18 months to two years to
implement. Using a trusted third party, again, does not feel like
it is really addressing the fraud, and it feels like an expensive
option. Where we are shipping in vast sums of handsets through
our system how much would we reasonably have to pay out to control
when the fraud actually takes place far later down the supply
chain?
Q304 Chairman:
Dr Cheetham, is there anything you want to add to your colleagues'
remarks?
Dr Cheetham: As my Lord Chairman may be aware,
the reverse charge was applied for by three Member States at the
same time. Germany and Austria wanted it on a very broad spectrum
of product with the capacity to expand it on to whatever they
felt like; the UK went in with a very narrow request, mainly chips
and phones and some other high value IT goods, and the UK succeeded.
But what the UK was really doing with reverse charging, and doing
it on its own, was saying: We are going to wash our hands of the
problem, we are not going to have VAT on these products, and therefore
the fraud will continue on with the other Member States. But it
creates three new frauds. Firstly, it creates an end-seller fraud,
so you will have companies selling, say, on the Internet; they
have bought from the supply chain VAT-free; sold on the Internet
to the public and collected the VAT and do not pay the VAT across,
so it will shift the fraud from one end of the chain to the other
and, secondly, it will create end-user fraud where people will
pretend to be VAT-registered in order to get goods VAT-free when
they are not. Both of those frauds will be on a much smaller scale
than the carousel fraud we see nowadays, but what the UK is really
asking to do is to be able to supply every other Member State
with VAT-free goods and feed the fraud in that country, so the
goods may go from a fraud in France through the UK to a fraud
in Germany, but because of something called triangulation, which
you may or may not know about, that allows the goods to go direct
from France across the border, which may take 10 minutes, and
the paperwork and the money go through the UK. So a fraud will
happen in France, then Germany, then Italy, and all the time the
paperwork will be handled by the UK and the UK will put its hands
up and say: "We do not have a problem, we do not have VAT".
We are not losing VAT but we will be inflicting fraud on other
Member States. Also, reverse charging is already limited to this
scope of goods. You cannot keep going back to the European Union
and asking for a new product to be added. On an origin system
and flat-rate system, I think if you chose perhaps a median rate
of 18 per cent that would be in the UK only half a per cent difference,
and in countries where it is 22 per cent it is only a 4 per cent
difference and I think that would be acceptable and would not
have an effect on trade. It would certainly eliminate the fraud.
On the self-clearing origin system—well, I have proposed
that in my written evidence and I think that is a good idea. Looking
outward from England we see a level playing field. Everybody charges
us 17.5 per cent. The only problem I see is the computer systems
would have to carry all these different rates of VAT. The logging
database is my solution to the system as it is now. Obviously
my two colleagues here have not had a chance to see the system
but we have written a website and it is very simple. It has only
about eight fields in the database; it is written and up and running
and I demonstrated it to Customs a few weeks ago, and it will
eliminate the fraud at the first deal. What happens is you do
not pay VAT to anybody in front of you unless they give you a
valid invoice with a valid VAT log number on it which is generated
from a website or by the telephone. What Customs would have to
do is shift their resources which are now used for destroying
legitimate companies to policing the system.
Q305 Lord Kerr of Kinlochard:
So this would be an IT way of getting back to the 2002 situation
that you spoke to us about?
Dr Cheetham: Yes. It is the first deal. Because
you do not pay VAT until you get this valid number and the log
number goes down the chain and you get a new one at each stage
of the chain, then the only way that the fraudster can sell his
goods in the UK is to go right at the start of the system on to
the Internet, or by telephone, or even by text message, and get
a log number—
Q306 Lord Kerr of Kinlochard:
Yes, I grasp the concept. What about the last solution, the idea
of the trusted third party?
Dr Cheetham: Can I just say something extra
which is important about the VAT logging system? Because of the
FTI's case and their success in the European Court of Justice,
one of the things the European court said they could do is require
a security guarantee. That means you can ask a company to deposit
VAT or its equivalent. With my VAT logging system what you do
is when the system pops up on Customs computer they go to the
company and say: "OK, we require that VAT to be deposited
with us—first deal". Now, missing traders usually have
to make a loss and, therefore, they would not be able to deposit
that number so you turn off the logging system and that company
can no longer trade. So you run that system, you make them deposit
the VAT, and under the security guarantee rules the missing trader
will not be able to operate and it will eliminate it. The factoring
system is very similar. In my system, because you are using a
security guarantee to get the VAT off them, Customs hold the VAT.
If you introduce a factoring company they are going to make charges
and so on. It is far better that Customs take the VAT live off
the missing trader and when they have the VAT they will let them
do the next one and so on down the line.
Lord Kerr of Kinlochard: I am very grateful.
Lord Steinberg: Finally, I am sure I
and all my colleagues here hate the idea of genuine traders being
squeezed to go out of business because they are not getting their
VAT refunds, but how many criminal gangs do you estimate are doing
these frauds in a sophisticated way, and what do you believe the
best way of stopping them is?
Q307 Chairman:
I recall a figure of around 15-20.
Mr Howarth: I could not begin to estimate. I
have no knowledge whatever.
Dr Cheetham: These people are right at the other
end of the chain, so we have no idea. It is Customs job to police
the industry, not ours.
Ms O'Hara: I think it is a fair point. We need
more targeted measures, specifically at fraudsters, so better
exchange of information would be good certainly, and also trying
to give legitimate businesses some sort of certainty. When measures
were introduced Vodafone said: "We have put together what
we think are reasonable checks, can you confirm whether or not
you think they are reasonable?" And they said: "No,
we are not in a position to know whether or not it is reasonable".
So when a large business does not have that certainty it must
be very difficult for small businesses to trade in that environment.
Q308 Chairman:
Mr Howarth, could you provide us an update on the FTI's planned
judicial review of HMRC's actions?
Mr Howarth: Yes, certainly. Back in May 2006
we were getting reports from members and non members within the
trade, because we had conversation within the trade in general,
that their VAT repayments were being withheld; they were getting
various comments from the local HMRC officers, and the normal
cycle had been broken. We were not overly concerned at this stage
because on a selected approach this had happened back in 2003-04,
where selected traders had experienced these difficulties in a
very small, minor way. By June 2006 we realised from the number
of inquiries we were getting that almost 100 per cent of anyone
we had spoken to had not had a repayment since March, so by June
March was held up and a lot of them had been told that March had
been subjected to extended verification and any work done in April
would probably be held up as well, so we realised there was a
problem there. Some of the larger companies and one or two of
the smaller ones began legal action, and again the FTI was in
conversation with these people and advising them and providing
information where we could. The JR route is not a straightforward
process in any way, shape or form; it is highly complex and very
expensive; but several of the cases during October managed to
get a hearing date, not for the JR but for an application for
interim relief under the JR. It was a way of getting in front
of a judge to try and get some of the information. What has happened
without exception so far is that every time a JR has appeared
before a judge it has not been heard. Now, despite what was said
back on 6 February I would say there have been 14 JRs, three of
which are still pending, and only just, and the other 11 have
all received negative decisions before the JR was heard. So before
all of the information and evidence has been gathered, all the
witness statements, all the statements of claim which have been
assembled over several months for each of these companies gets
heard by a judge, plus the judicial review of the activities of
the HMRC, they were all stopped. One way or another every one
of the JRs that has gone forward has been stopped. The FTI took
advice whether or not we could launch an action which could not
be stopped because we do not have any trading to have a decision
made upon. It is not: "We would like you to stop verifying
our claims" that we are asking; it is the legality of what
they are doing that we would like reviewing. I said there were
still three JRs pending; these three have gone through the initial
stages of the paperwork being examined by the judges, who have
gone through oral submissions to determine whether or not they
will get permission to go forward into what is called a full substantive
hearing. There are three companies destined for a full substantive
hearing next week in front of three separate judges with three
separate legal teams on the trader's part and three on the part
of HMRC. Yesterday, HMRC put forward a motion to have those three
JRs set aside, so although they have gone through all this and
they are trying to get some judicial control over HMRC's activities,
HMRC's lawyers are now asking the judge to set those JRs aside
on the basis that there is a tribunal hearing in April which might
affect those JRs. Now, the tribunal hearing is about a trader
who traded in a certain manner and has had his repayment disallowed;
the judicial reviews are not about having it disallowed but about
HMRC's activities, but they are trying to move the goalposts again
and not have the case heard. So on 6 February, when the question
was asked whether HMRC's activities are legal or are they acting
lawfully, it may be ill-advised but the response that they are
not acting illegally is incorrect. The FTI have it on good authority,
and we have spent the best part of three months going through
the legality of what HMRC are doing and the basis upon which they
are doing it. The JR we are bringing forward is well supported
from within the industry by traders who quite honestly cannot
afford to support us but they are finding means and ways of doing
so. The JR says that what HMRC are doing with extended verification
is unlawful in that they are rolling up into one a verification
process which has legality and case history which says that this
is what you can do for this period of time that has been accepted
by the High Courts with an investigative process, so they are
not just verifying our claims, although they call it verification;
they are investigating and withholding the payments from these
trading companies until they have finished their investigations
and that is what we are saying is unlawful. Similarly the basis
upon which they are carrying out this investigation is an error
in the law. It is a misinterpretation of the Kittel case.
There is Optigen and Bond House and the FTI
which quite clearly from the ECJ specify what the "knowledge"
is, what the "means of the knowledge" is and where it
starts, stops and ends. HMRC have decided to interpret Kittel
as saying that it has no start point, it has no end point, if
you have knowledge of any sort of fraud within the industry, whether
you are involved or not, then you are guilty. So in quick summary
that is the case. It is about to be launched and, hopefully, we
can move it forward.
Chairman: Thank you, Mr Howarth, Ms O'Hara
and Dr Cheetham for giving this Committee the benefit of your
very extensive experience in this most complex of issues.
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