How ‘knew or should have known’ of vat fraud leads to criminal punishment

‘Knew or should have known’ is the magical formula by which the Dutch Tax Authorities are trying to tackle VAT fraud. For the zero rate (on deliveries within the EU) or the right to deduct input tax to be refused, it is sufficient that the taxable person ‘should have known’ that their suppliers or buyers (who are often in other countries) committed VAT fraud. A retrospective levy (usually of 21%) because you have failed to properly inform yourself feels pretty much like a penalty. This is problematic because these grounds for a retrospective levy are not regulated by law, and hence conflict with the principle of ‘no penalty without law’. This blog explains how this state of affairs came to exist.

Criteria for zero rate / deduction of input tax

The VAT system is arranged in such a way that a business supplying goods to a business in another EU Member State charges 0% VAT (the zero rate). In addition, although the business supplying the goods does not charge VAT, it does have the right to deduct input tax. In its ruling on the VSTR case, the European Court of Justice (ECJ) determined (in section 30) that three criteria are applicable here:

• The buyer acts in the capacity of taxable person;
• There is a transfer of power to dispose of goods as owner; and
• The goods have been (physically) relocated (to another Member State).

In addition, the ECJ determined that no other criteria but these three can be set for the ability to apply the zero rate and the right to deduct input tax. However, in the ruling on the Halifax case, the ECJ determined that if tax fraud is committed by the taxable person him/herself (‘for example, by presenting a false tax return or drawing up false invoices’), then these criteria are not met (and thus there is no right to apply the zero rate or deduct input tax).

The ECJ does not explain which criterion has not been met in the event of fraud. This may have to do with the ECJ’s determination in section 52 of the VSTR ruling concerning the ‘capacity of taxable person’, i.e. that the supplier is required to act in good faith and to take every measure which can reasonably be required of him to ensure that the transaction that he effects does not lead to his participation in tax fraud. The latter is also referred to as ‘prudent business management’.

The Kittel ruling

The ruling in the Kittel case was ground breaking. This because, in that ruling, the ECJ determined that:

“In the same way, a taxable person who knew or should have known that, by his purchase, he was taking part in a transaction connected with fraudulent evasion of VAT (…), must be regarded as a participant in that fraud, irrespective of whether or not he profited by the resale of the goods.”

Due to this ruling, it is no longer necessary for the relevant taxable person to have committed fraud for the zero rate or the right to deduct input tax to be refused. It is sufficient that he ‘knew or should have known of fraud in the chain of deliveries’ he was involved in. With this, the ECJ has tried to give the European tax authorities more resources to combat VAT fraud. Because a retrospective levy in the Netherlands does not affect the taxability of the acquisition in the other country, Prof. Van Hilten spoke in her oration of 24 November 2016 of a ‘ghost tax’ which has the effect of disrupting competition.

Is a retrospective levy of 21% a penalty?

If it turns out that a business in Europe has supplied goods at 0% VAT, while according to the Tax Authorities it should have noticed the possibility of fraud on the part of the buyer, a retrospective levy can be imposed at the applicable rate (usually 21% in the Netherlands). The question arises as to whether this amounts to criminal punishment (of the negligent business). This is relevant because, pursuant to Article 7 of the European Convention on Human Rights, no penalty can be imposed unless the deed was already an offence under law (which is not the case here). In the landmark ruling on the case Engel versus The Netherlands, the European Court of Human Rights (ECHR) formulated three criteria on the basis of which the Court judges whether a penal sanction is applied. These criteria are as follows:

1. The qualification according to international law
2. The nature of the offence
3. The nature and the degree of severity of the penalty

In later jurisprudence, the ECHR has indicated that it regards the second and third criteria in the Engel ruling as of particular importance. In relation to the second ‘Engel’ criterion, the Court of Justice’s comment in the Kittel ruling concerning the nature of ‘knowing or should have known’ of fraud is significant:

“57    In such a situation the tax subject is, after all, aiding the fraudsters and he becomes their accomplice.

58     An interpretation of this type counteracts fraudulent activities by making it more difficult to accomplish them.”

In relation to the third ‘Engel’ criterion, the nature and the degree of severity of the penalty, it is important to notice that VAT is intended to tax consumption and should therefore not be imposed on businesses. A retrospective levy of 21% can therefore only be intended as a ‘deterrent’. The deterrent function of penalties also plays a central role in criminal law. With respect to the ‘degree of severity of the penalty’, it is also relevant that the refusal of both the zero rate and the right to deduct input tax means that the business is de facto doubly punished. Finally, I refer to the overkill at ‘chain level’ which the ‘knew or should have known’ approach entails. In this way, in fact, retrospective levies can be imposed on several (if not all) businesses, so that more VAT is levied in total than was lost due to the fraud. In my opinion, this overkill underlines the punitive nature of the extrajudicial facility to impose retrospective levies on ‘participation in fraud’. Judging by the ‘Engel’ criteria, the conclusion is that there can be little doubt as to whether a punitive penalty is involved.

The italmoda and stehcemp rulings

Regarding the answer to the question whether criminal punishment is involved if the business, which knew or should have known of fraud on another’s part, is refused the zero rate or the right to deduct input tax, the ECJ gives varying signals. For example, the Court denied this in its ruling on the Italmoda case. In section 61, the Court determined that there was no penalty, because the refusal of the right to deduct input tax ‘is purely the consequence of the omission of the criteria required for this in the relevant stipulations of the Sixth directive’ (as mentioned previously). This approach is appealing in cases where the goods have only fictionally been traded. The reasoning appears to be “no ‘real’ trade/deliveries, so no deduction”.

In its (later) ruling on the Stehcemp case, the key issue was the right to deduct VAT input tax on invoices from a non-existing (fraudulent) business. The Court of Justice ruled that the assertion that the supplier was fraudulent does not detract from the right to deduct input tax, and that this changes only if the Tax Authorities can demonstrate that the taxable person ‘knew or should have known’ of the fraud. In this context, the Court of Justice does speak of a penalty:

“49. By contrast, where the material and formal conditions laid down by the Sixth Directive for the creation and exercise of that right are met, it is incompatible with the rules governing the right to deduct under that directive to impose a penalty, in the form of refusing that right to a taxable person who did not know, and could not have known, that the transaction concerned was connected with fraud committed by the supplier, or that another transaction forming part of the chain of supply prior or subsequent to that transaction carried out by the taxable person was vitiated by VAT fraud (…)”

Criminal risk liability

It is clear that everything hinges on the knowledge of the taxable person. A person who did not know (and ‘could not have known’) of the fraud cannot be penalised with refusal of deduction of input tax. A contrario, one may infer from this that a penalty can be imposed, in the form of refusal of the right to deduct input tax, on someone who knew or should have known, that he participated in fraud but did not himself commit fraud. Although there is no excuse for penalising if there is no prior legal basis for imposing a penalty, it is still possible to have (some) appreciation of this if there is a question of ‘knowing’ of fraud. However, with the phrase ‘should have known’, it appears that a criminal risk liability has arisen in the approach of the Court of Justice. This contrasts with the requirement in Dutch criminal law that intent must be proven for a fraud conviction, with conditional intention being the lower limit. For that, it is sufficient that the person involved consciously accepted the significant likelihood that a certain consequence will ensue, from which it can be objectively ascertained that the suspect (apparently) intended to commit the proscribed action. By contrast, with the phrase ‘should have known’ in relation to VAT fraud, the Court of Justice appears to assume gross negligence. This is because it opted not to deduce the ‘knowing’ from the lack of diligence (as with conditional intent), but to create a separate category for the purpose (‘should have known’) which deserves the same consequence (a retrospective levy of 21%). In the Netherlands, gross culpability is not sufficient for a criminal conviction in cases of suspected fraud. And there’s the rub. The possibility exists that this will cause the tax inspector to primarily become a public prosecutor in cases of VAT fraud, because the court dealing with tax affairs can reach a penalising verdict under more flexible conditions. Of course, it is already the case that the tax inspector can impose penal fines, with the subtle difference that such fines are linked to (a percentage of) the tax that was falsely unpaid and cannot be imposed without a tax assessment (only to penalise).

An identical paragraph to the one in the Stehcemp case can be found in section 47 of the ruling on the Mahagében case.

Conclusie

With the European jurisprudence concerning a taxable person who ‘knew or should have known that he participated in fraud’, VAT can be retrospectively levied on businesses that did not act carefully in supplying goods within the EU. Viewed from various perspectives, this possibility for retrospective levies, developed in jurisprudence, bears great similarity to criminal punishment. This is also apparent after comparison with the criteria developed by the ECHR for this purpose. The conclusion that criminal punishment is involved conflicts with Article 7 for the European Convention on Human Rights because a retrospective levy on a ‘negligent’ taxable person who ‘knew or should have known’ has no legal basis and, furthermore, is not explicitly regulated in the European VAT directive. In the Italmoda case, the Court of Justice denies that penalisation comes into play in cases where the ‘relevant criteria’ for the right to deduct input tax are not met. In its rulings on the Stehcemp and Mahagében cases, the Court of Justice does mention criminal punishment in this context. The conclusion that a retrospective VAT levy constitutes criminal punishment is even more alarming in cases where the taxable person did not know of fraud but ‘should have known’ of it. In these cases, there is no intent to defraud that can justify criminal punishment.