Knew or should have known of vat fraud

Combating VAT (turnover tax) fraud has been on the agenda of the European member states, including the Netherlands, for several years. Many rulings have been issued in recent years in particular by the Court of Justice of the European Union concerning the consequences of committing tax fraud. The line pursued in these rulings appears to be as good as complete now. In short, a taxable person is not entitled to invoke the right to deduction of input tax, apply the zero rate or obtain a refund if he knew or should have known of fraud elsewhere in the chain. In pursuing this line, the discussion on fraud cases will focus on the question of whether the taxable person knew or should have known of the fraud. I will discuss this in more detail below.

Turnover tax levy

The Turnover Tax Act 1968 states that a tax is levied on all goods and services that are for sale in the Netherlands. Entrepreneurs charge the turnover tax (more commonly known as VAT) to the final buyer of the product or service. Often, before a product is purchased by the end consumer, it has gone through several links in the chain of entrepreneurs. ‘Something’ is added at each of those links by each of those entrepreneurs.

Every entrepreneur in the chain must charge VAT to his buyer (entrepreneur or consumer). The entrepreneurs in this chain collect the VAT from their buyers and pay this VAT to the Tax Authorities. On the other hand, the entrepreneur may then deduct the VAT charged to him. This ensures that the VAT levy between the entrepreneurs in the chain is tax-neutral and payment of the VAT ultimately rests with the end consumer. This is the person that ‘consumes’ the product or the service.

Example of a chain

Nederlands	Engels
Leverancier grondstof	Raw materials supplier
Producent van grondstof naar mobiele telefoon	Raw material to mobile phone manufacturers
Groothandel mobiele telefoons	Mobile telephone wholesaler
Winkel/verkoper mobiele telefoons	Mobile phone shop/retailer
Consument die de mobiele telefoon koopt	Consumer that purchases the mobile phone

The chain from entrepreneur to consumer does not have to play out only in the Netherlands. In practice, the chain regularly extends across Europe and the world. For example, the suppliers of the raw materials and the manufacturer are located in Italy and the wholesaler, retailer and consumer are in the Netherlands.

The assumption then is also that the VAT chain between the entrepreneurs VAT neutral. To facilitate this, intracommunity supplies and acquisitions of goods was incorporated into the VAT levy. The entrepreneur that supplies goods intra-communally to another entrepreneur (for example, the manufacturer to the wholesaler in the aforementioned chain example) does not have to charge VAT, but can deduct the VAT charged to him (with the purchase of the raw materials from the supplier) in advance. The VAT levy on the supply of the mobile phones is therefore actually moved from the manufacturer to the wholesaler in the example. The wholesaler then charges VAT to the shop/retailer. That link may also take place via the system of intra-community supplies and acquisitions.

What constitutes fraud?

The turnover tax system makes certain that VAT is susceptible to fraud. After all, the advance tax deduction is in no way linked to the payment of the relevant turnover tax. There is therefore a chance that, for example, the wholesaler does not declare the intra-community acquisition of the mobile phones, charge the shop/retailer VAT, and then does not pay that VAT to the Tax Authorities. In that case, there is a flaw in the VAT levy. The wholesaler has received the VAT, but does not declare it. This creates a financial advantage for him. In order to actually gain that advantage, the wholesaler disappears. This is often solved in the chain by establishing a new wholesaler, often with the same goal.

This type of fraud is generally called ‘carrousel fraud.’ There is no fixed definition for the concept ‘carrousel fraud,’ but various descriptions can be found. The core [1] of these descriptions is always that there is an invoice flow (real or not) that corresponds with trade transactions with at least one of the parties involved charging VAT in their own country, while he knows that he will not be declaring that amount on his tax return. The VAT that this party does not pay to the Tax Authorities will, however, be deducted by his buyer.

To match the description of a ‘carrousel fraud,’ it is no longer relevant that the goods go full circle (‘carrousel’). The crucial factor is that one party charges VAT, knowing that he is not going to declare it to the Tax Authorities and that his buyer will deduct the VAT that was charged to him. This seems to open the way for the case law that has been mainly set by the Court of Justice of the European Union to ensure that carrousel fraud cases also apply to all types of VAT fraud.

Apparently, the financial benefits of VAT fraud are lucrative enough that people are engaging in this on a large scale. This means that significant amounts of VAT cannot be collected. This is a cause of frustration for the European Union and the member states and they want to do their utmost to quash this type of fraud. This, however, may not involve taking rash action. The ‘good’ entrepreneurs should not have to suffer because of the ‘bad’ entrepreneurs’ actions. But what makes you a good entrepreneur? And when does the case law of the Court of Justice of the European Union apply to your ‘VAT fraud’?

Knew or should have known?

To determine if someone is a ‘good’ or a ‘bad’ entrepreneur, it must first be established if the entrepreneur in question is himself a fraud. If it is determined that this is indeed the case, this entrepreneur will, in fact, lose all this rights. As follows from the following paragraph, this entrepreneur will not be entitled to his right to deduct input tax in advance, to apply zero rate or a refund for number acquisition. However, it is usually not the ‘bad’ entrepreneurs that end up suffering the consequences of VAT fraud. These ‘bad’ entrepreneurs’ business is often set up with the goal of committing VAT fraud and making (a lot of) money before disappearing into the sunset. The chances of the Tax Authorities catching this ‘bad’ entrepreneur and recouping the wrongfully collected monies (or unpaid taxes) are therefore minimal.

It is therefore primarily ‘good’ entrepreneurs that have to deal with the adverse consequences of VAT fraud. The only way to avoid these adverse consequences is if the entrepreneur in question did not know and could also not have known of the VAT fraud.

These concepts of ‘knew’ or ‘should have known’ are not clear at a glance. Although the first concept, ‘knew,’ is clearer than the second, ‘should have known,’ it will have to be established what the knowledge of the entrepreneur was, using the facts and circumstances.

In the past, I made a comparison with ‘knew’ or ‘should have known,’ as it is used in the criminal and penalty law. For the ‘knew’ concept, a connection could be sought with the concept of ‘intent’. Intent is when someone knowingly and intentionally commits a finable or punishable offence. In other words, if someone consciously undertakes a specific action. If we apply this to VAT fraud, this means that the entrepreneur in question knows that VAT fraud is being committed, but that he nevertheless continues to participate in that transaction or in that chain in full awareness. In practice, it will not be this situation that gives rise to discussion between the parties, but the question of when a business owner ‘should have known’ of the VAT fraud in the chain.

For the explanation of ‘should have known,’ a connection may be sought with the concept ‘gross negligence’ from the penalty and criminal laws. Gross negligence is when the party involved did not want the relevant consequence, but it can be blamed on his negligence, carelessness, or neglect that the consequence has occurred. It can be deduced from this that a ‘good’ entrepreneur must be attentive and must act with due care. To comply with this, the entrepreneur has a certain obligation to investigate. This obligation to investigate means that an entrepreneur must do everything that may reasonably be expected of him to ensure that his actions are not part of a fraud chain (Court of Justice, Mahagében, 21 June 2012, joined cases no. C-80/11 and C-142/11 (Peter David).

Consequences of knowing of fraud?

It must be assessed for each taxable action whether the entrepreneur ‘knew or should have known’ that VAT fraud was being committed (Court of Justice, Optigen, 12 January 2006, joined cases C-354/03, C-355/03 and C-484/03). Within a chain, this may cause the entrepreneurs to be treated differently. One entrepreneur may have acted in good faith (did not know and also could not have known) and another entrepreneur may have known or should have known of the fraud.

If it is established that an entrepreneur knew or should have known of the VAT fraud, this will have significant consequences. It follows from the Italmoda ruling that in that case an entrepreneur is not entitled to the right to deduction of input tax, to apply the zero rate and/or obtain a refund for number acquisitions. These penalties even occur if the national legislation does not provide for this option. The Supreme Court even explicitly takes this into consideration in the ruling of 18 March 2016, no. 11/02825, ECLI:NL:HR:2016:442 (see ground for the decision 2.1 and 2.2).

If the entrepreneur has already exercised his right to deduction of input tax in the turnover tax return, he will receive an additional assessment to pay back the amount wrongfully deducted in advance to the Tax Authorities.

1. The other possibility is that the entrepreneur exported the goods to another country with the application of the zero rate. If the entrepreneur can be charged with knowing about the VAT fraud, he will not be permitted to apply the zero rate, despite that the conditions ((i) right to dispose of the goods has been transferred, (ii) the goods are physically moved from one Member State to another and (iii) the goods have been supplied to an entrepreneur who has declared this as intra-community acquisition) have been fulfilled. The Court of Justice therefore rules that not all conditions have been fulfilled. The word ‘all’ refers to the fact that no VAT fraud must be committed. In this case, the entrepreneur will receive an additional assessment for turnover tax, in which the goods and/or services are taxed for VAT at the rate of 6% or 21%.
2. Finally, there is the option to refuse a refund for number acquisition. In that case the entrepreneur has paid the VAT, but he is not entitled to a VAT refund.

The Court of Justice is of the opinion that VAT fraud must not pay off and that every effort should be made to combat and prevent such fraud. Should such fraud occur anyway, this may and should be dealt with severely, according to the recent case law of the Court of Justice. That this may possibly result in a breach of the fiscal neutrality in the VAT, the principles of legal certainty or the legitimate expectations is not important. Those principles, according to the Court of Justice, can and must be put aside if a taxable person knew or should have known of the VAT fraud in one of the links of his chain and in doing so jeopardised the proper functioning of the common VAT system.

At this time, there is still on-going discussion as to whether the Tax Authorities can handle all three possibilities for one taxable person simultaneously, i.e. refuse the deduction of input tax and the zero rate and the refund. If the Tax Authorities were allowed to apply all three options alongside each other, this would create a double or triple tax. This cannot and could not have been the intention of the Court of Justice’ ruling. After all, the entrepreneur will then be ‘punished’ twice or thrice. The entrepreneur, for example, does not get deduction of input tax for the same goods and moreover, instead of being able to apply the zero rate, has to pay 6% or 21% VAT to the Tax Authorities. That would be a double charge.

The basic premise should therefore be that the Tax Authorities must choose from the three options. The Tax Authorities must refuse either the deduction of input tax, or refuse to apply the zero rate or refuse to grant the refund. That this should be the point of departure also follows from the way in which the Court of Justice has formulated the answer to the stated prejudicial questions. In answering these questions, the Court of Justice includes “refusal of the right to deduction, exemption or refund of the tax on the added value” (underlining ML). By using the word ‘or,’ the Court of Justice shows that a choice must be made from the three options.

This reading/explanation of the Court of Justice’s ruling on the decision to be made is also shared by A-G Ettema in her conclusion of 1 February 2016.

Scope of ‘knew or should have known’

I have already explained that ‘knew or should have known’ of the VAT fraud has considerable consequences for an entrepreneur. The entrepreneur may lose his right to deduct input tax or to apply the zero rate. But can this case law of the Court of Justice be applied one on one in every situation? I wonder.

What if a tax consultant or a lawyer assists a foreign entrepreneur in a Dutch VAT fraud case. This tax consultant or lawyer will send a bill to the entrepreneur in question. It is likely that the service provider knew or should have known of the possible fraud being committed by his client. After all, the service provider will have received procedural documents with an explanation of the suspicion (if it is a criminal case) or the corrections by the Tax Authorities (if it concerns a fiscal correction and a fine). Can the service provider still be ‘careless’ in his declaration in applying the zero rate and send it to his client? Can the service provider be confronted with the refusal to deduct input tax for, e.g. the paper that the declaration is printed on, or the pen he used for his signature?

The Court of Justice has not given a definite answer to these questions yet. The procedures that have been presented to the Court increasingly looking like ‘genuine’ cases of fraud. The inspector and also the prosecutor, like to quote the phrase, ‘Surely it could not be that…’. I think that phrase equally applies to this. Surely it could not be that a service provider is confronted with the case law of the Court of Justice in the area of VAT fraud and therefore loses his right to apply the zero rate or to deduct input tax because he provided legal representation to an entrepreneur who is suspected of/confronted with VAT fraud.

Conclusion

 VAT fraud is a cause of frustration to both the European Union and the member states. With assistance of the Court of Justice, every possible effort is being made to reduce VAT fraud and, in the best-case scenario, to prevent it. Although a distinction is made here between ‘good’ and ‘bad’ entrepreneurs, this distinction is very flimsy. Only an entrepreneur who did not know or could not have known that VAT fraud was taking place will be immune from this problem.

 It is therefore also important that even if entrepreneur is doing everything right himself, but he does know or should have known that one of the links in his chain is committing VAT fraud, the entrepreneur will not get off scot free. He knows or should know of fraud and can therefore also be confronted with the adverse consequences, namely:

• refusal of the application of the zero rate, in which case the entrepreneur still has to pay the regular rate of 6% or 21% to the Tax Authorities, or
• refusal of the right to deduction of input tax, in which case the entrepreneur must pay back VAT deducted in advance, or
• refusal of the refund for number acquisition, in which case the entrepreneur has paid the VAT but does not have it refunded.

Due to this hard line in the case law, the core of the discussion with the Tax Authorities in VAT fraud cases will increasingly focus on the question of whether the entrepreneur ‘knew or should have known’ of the VAT fraud. So far, these concepts have not been given sound definitions, so there is room for the entrepreneur to escape the adverse consequences of VAT fraud in his chain.

[1] Dr. R.A. Wolf, LLM, Carrouselfraude, Fiscaal Wetenschappelijke Reeks (Carrousel Fraud, Fiscal Science Series), no. 15, SDU publishers, chapter 3.