Innocent businesses who have suffered through the Revenue’s clampdown on VAT fraud in the mobile handset and computer chip markets have been vindicated by the European Court of Justice.
The ECJ has reversed two decisions of the UK VAT Tribunal dating from 2003. They have ruled that the right to reclaim VAT paid by a business to its supplier is not invalidated by the existence of a prior or subsequent fraudulent transaction in the same goods by unconnected third parties.
Sounds complicated? It is. But basically the VATman has been withholding more than £800m of VAT claimed by businesses, saying that they are entitled to do so where there may have been VAT fraud by unconnected third parties who dealt with the goods several transactions earlier or later in the supply chain – irrespective of the fact that the businesses seeking the reclaim had no knowledge and no means of knowing of the fraud.
It seems some blameless traders have been forced out of business by this policy and others have been pushed into liquidation, despite spending thousands on due diligence to help HMRC combat fraud.
The situation arose following a crackdown on VAT fraud by rogue companies. Legitimate mobile phone traders were unfairly caught up in the moves against ‘carousel’ frauds – which involved mobile phones purchased VAT-free from an EU member state and then sold on through a continuous circle of trading companies, with VAT repayments claimed back from HM Revenue at each stage.
At the heart of the scam there were fraudulent VAT trading companies set up for the purpose of whipping up as much business as possible in a short time, and then disappearing without accounting for the VAT repayments they received. It is estimated that the cost to the taxpayer of these scams ran into billions.
Hartley Foster, tax investigations expert at global law firm DLA Piper, says the crackdown effectively clobbered a lot of innocent and legitimate trade. “In order to combat this type of fraud HMRC [HM Revenue and Customs] prevented companies trading mobile phones from claiming back VAT in the way most businesses do. It was comparatively easy for innocent companies to be caught up in the carousel and so legitimate businesses lost money as a result.”
It was this policy that was successfully challenged in the European courts. HMRC tried to argue that it was justified in withholding VAT because the fraud committed elsewhere in the supply chain means that none of the transactions in the chain constitutes proper economic activity; and therefore the transactions are not actually within the VAT system.
The Advocate-General, a Court-appointed officer who provides a legal opinion to assist the Court, pointed out just how daft this was – this approach “would produce the incongruous result of an entire supply chain falling outside the Sixth Directive merely because one trader in the chain failed to account for VAT to the tax authorities” (the EC’s Sixth Directive governs VAT in member states).
“Such an outcome is particularly puzzling,” he added, “since it would mean that, as a result of a trader’s failure to account for VAT, he would in fact be under no obligation to pay VAT in the first place.”
It also seems that HMRC deliberately chose not to prosecute those who were known to be the orchestrators of the carousel frauds. Instead they decided to take action against companies which are acknowledged to be innocent participants. “This is likely to form the basis of a significant number of claims by innocent companies whose trade was damaged”, says Foster. “The amount at stake here is likely to be even greater than the VAT reclaims.”
DLA Piper is acting for a significant number of companies affected by HMRC’s approach, and the law firm is attempting to obtain a group litigation order on their behalf.
So is Jason Collins, tax litigation partner in UK law firm McGrigors, who has also been representing a number of affected businesses. He said: “The Court’s ruling confirms the position that innocent businesses have maintained all along. Those businesses will now want to consider whether they may be entitled to damages from Customs.”
James Bullock, head of tax litigation at McGrigors, called the ECJ’s decision “a victory for business and a victory for common sense”.
“Nobody disputes that a fraud has been perpetrated against the UK Government. HMRC, as custodians of the VAT system, are best equipped to put an end to that fraud by dealing with the fraudsters. But in recent years they have focussed their resource not on tracking down and prosecuting fraudsters but on forcing innocent and unwitting businesses to shoulder the financial burden of the fraud.
“This diversion of resource from investigation has been disastrous and has allowed the fraudsters to stay at least one step ahead of the game.”