Tackling MTIC Fraud — Knowledge is Key

Paul Grimwood of HM Revenue & Customs' VAT Fraud Policy Team explains how the Department's strategy to tackle MTIC fraud is developing

Six months have now passed since HMRC last wrote an article on missing trader intra-community (MTIC) VAT fraud for The Tax Journal (see Bond House ECJ decision, Issue 823, 6 February 2006). Much has happened during this period and now seems to be a good opportunity to explain how HMRC's strategy to tackle MTIC fraud is developing.

The European Court of Justice (ECJ) has been busy. Following the Bond House and others decision on 12 January 2006, the Halifax and others decision came out on 21 February; the Advocate-General gave his Opinion in the Kittel and Recolta case on 14 March; the ECJ handed down its decision in the FTI and others case on 11 May (where the legal vires for joint and several liability was confirmed and security clarified); and most recently the decision of the ECJ in the Kittel case came out on 6 July 2006. What has developed out of all of these cases is the 'knew or should have known' test — which I comment on in more detail later.

Without wanting to appear flippant, it has to be said that the fraudsters have been busy too. Whilst our last published fraud estimate for 2004/05 (between £1.12 and £1.90 billion) was 30% below the peak in 2001–02, operational indicators show an increase in MTIC fraud activity during this year. This suggests that there is increased transaction activity involving goods the subject of MTIC fraud and with no apparent commercial or economic explanation for that increase. Therefore we have to assume there is an increase in MTIC activity. We have strengthened our strategy in response and tackling MTIC VAT fraud remains HMRC's top priority.

Often the peaks and troughs of MTIC fraud activity are reactions to Court cases or to HMRC's operational activity. For example, MTIC activity mirrors national and European Court cases with an adverse case (to HMRC) resulting in the increased confidence of fraudsters, whilst an adverse case (to fraudsters) deflates that confidence. Furthermore, our increased verification of repayment claims has resulted in attempts to further contrive and disguise very complex transaction chains with the increased occurrence during the past year of 'contra-trading' or 'off-setting' deals.

'Contra-trading' all centres round one trader that acts both as an acquirer of goods into the UK in one chain of transactions and as an exporter (broker) in a separate chain. As an acquirer, this trader 'accounts' for output tax when it sells the goods to a different broker. As this different broker sells the goods outside the UK it makes a repayment claim. On the surface the transaction chain appears not to have a tax loss. This is because, in the chain where this same trader acts as a broker, it too makes a repayment claim — and this is where the tax loss is crystallised.

The reality of this analysis has recently been confirmed by the finding of 'how to' documents detailing this type of transaction chain arrangement. It is clearly an elaborate and complex scheme to defraud the revenue and one which HMRC is determined to tackle.

HMRC has also been busy supporting the Revenue and Customs Prosecution Office in its criminal cases. During 2005/06 there were ten successful cases involving many £millions, resulting in 33 convictions and sentences totalling 162 years' imprisonment.

In the 2006 Budget, three anti-fraud measures were introduced — this time with no legal challenge. There has also been a significant re-deployment of resources to ensure that HMRC could increase the level of verification activity in respect of repayment claims received from those suspected of trading in contrived transaction chains that are tainted by MTIC fraud.

As a result of our increased verification activity there has been a sizeable increase in pre-action protocol correspondence and (at the time of writing) some six applications for judicial review. Whilst HMRC accepts that this is a proper (and the only) course for traders to take where a decision has yet to be made about the veracity of an input tax claim, it does, ironically, take away the very resources that are examining the claims and ultimately slows down the verification and decision-making process.

I guess that there will be no sympathy for the position HMRC finds itself in. In turn, HMRC makes no apology for carrying out the verifications of these extremely large repayment claims, as doing so is a key element of HMRC's strategy to tackle MTIC fraud.

So why are so many of HMRC's resources (now over 800 staff) aimed at this? HMRC is entitled and required, as part of its responsibilities for the care and management of VAT, to make all reasonable enquiries into claims, including testing the information given in support of the claim, prior to making payment. Over 170,000 claims to VAT tax credits were verified prior to repayment in 2005/06. It is unsurprising that a significant minority of these claims relate to supplies of mobile phones and computer chips, and other sectors which are known to be seriously affected by MTIC fraud, and often involve claims which total many £millions per month.

As I have already mentioned, the need for continued verification activity is confirmed by operational indicators which suggest that there is increased and more complex MTIC fraud activity. Our work is a necessary and proportionate response to the threat that organisations 'wittingly' continue to trade in transaction chains that commence with a significant tax loss caused by traders who have no intention or means of paying the tax due, or who are otherwise involved in transactions that are part of an overall scheme to defraud the revenue.

One of the conclusions of a verification might be to deny the claim because there is evidence to suggest that the claimant 'knew or should have known' that its transactions formed part of an overall scheme to defraud the revenue. This argument has developed out of the decision of the ECJ in the Bond House and others and, more recently, in the case of Kittel.

What the ECJ decided in Bond House was that the wholly innocent trader caught up in a MTIC fraud is entitled to recovery of its input tax; by contrast, in HMRC's view, the trader who has knowledge or the means of knowledge is not entitled to input tax recovery. HMRC's understanding of this decision has now been bolstered by the decision of the ECJ in Kittel.

This latest ruling confirms HMRC's position in verifying suspect VAT repayment claims and denying the repayment where there is objective evidence the trader concerned knew or should have known that its transactions formed part of an overall scheme to defraud the revenue. If the trader should have known that it was connected to a fraud in this way, the national court should refuse entitlement to the right to deduct.

With all this verification going on, it is interesting to note some common features that have been found. Unsurprisingly, the overwhelming majority of transactions do lead directly or indirectly back to a tax loss. The 'profits' through the transaction chain add up to that tax loss at the start; each trader has the exact same mark-up irrespective of the quantity it buys; a buyer is always found for the exact same number and type of phones and often pays for them even before the seller has bought the stock. There are also more and more instances of goods not existing, or goods supposedly supplied that have not gone on general sale (manufacturers of the fraudsters' goods of choice are certainly proving extremely helpful in this regard).

Is all this normal commercial practice?

This calls into question some traders' due diligence checks — checks that are so often described to HMRC officers as being 'extremely thorough'. What does it say about a trader's knowledge of, for example, the telecommunications industry when it is offered thousands of the latest mobile phone that has not even been released by the manufacturer? How difficult is it to find that out? How reliable can the documentation provided to and by the trader really be? What about the credibility of the contracting parties? It would appear that, regardless of the apparently strict controls and alleged due diligence undertaken by traders, there is sometimes little more than the creation of a paper trail of very limited value, with matters not apparently followed up when discrepancies or lacunas appear.

The flip side to this is perhaps a trader's checks do show up problems but a blind eye is turned and the deal is completed no matter what.

In their article Non-Economic Activity — RIP (The Tax Journal, Issue 848, 31 July 2006), Jason Collins and Ben Cooper helpfully interpreted 'connected with' from the Kittel decision — this wide interpretation is one HMRC concurs with. However, they do go on to question how HMRC can establish 'should have known' against 'an innocent trader'. It is difficult to see how repetitive carousels can actually occur without contrived transactions taking place. The transactions have to be orchestrated in terms of the price and the people to whom the goods must be sold and these hardly seem 'normal' business transactions. Whilst there is no allegation of guilty knowledge of fraud on behalf of many of the businesses in MTIC chains, it is difficult to see how everybody can be entirely innocent or unwittingly involved.

It will be very interesting to see what happens when the reverse charge takes effect. The latest position is that the European Commission has indicated support for the UK's request for a derogation but is yet to put forward a formal proposal in writing to other Member States. Since the Government announced it was applying for a derogation for a reverse charge earlier this year, we have seen a sudden and unexplained increase in the 'market', particularly for mobile phones and computer chips. With the reverse charge removing the VAT element from transaction chains, HMRC hopes this will create a level and fair playing field, where stolen tax and invalid repayment claims are not needed to oil any legitimate market.

MTIC — RIP? HMRC is looking out for a shift by the fraudsters to trading in other goods and is ready to crack down quickly where that is identified.