Carousel Fraud: An Aspiring Lawyer’s Guide to Tax
A series introducing law students to the real world of tax.
A study by the EU Parliament in October 2018 named carousel fraud as the most harmful form of cross-border VAT fraud, estimating annual losses at around €50 billion. Before delving into how the fraud functions, it is essential to understand the tax on goods and services, and also the difference between cakes and biscuits.
Tax, but the government pays you
Value Added Tax (VAT) is a crucial source of government revenue in over 160 countries worldwide. As a consumption tax, VAT is levied on an amount added to goods and services at each stage of production and distribution.
An indirect tax, VAT is collected by businesses on behalf of the government and ultimately paid by the consumer. Crucially, businesses reclaim from HM Revenue and Customs (HMRC) the VAT they paid when they bought their goods and services.
For example, a construction company buys materials for a new project, spending £10,000 plus a 20% VAT (£2,000). When this company invoices another business for the construction work, totalling £8,000 plus 20% VAT (£1,600), it can offset the £2,000 VAT paid on materials against the £1,600 collected. The construction company will reclaim $400 from HMRC.
So, in certain transactions, HMRC refunds VAT tax to traders.
Are Jaffa Cakes cakes?
Another feature of VAT that enables the carousel fraud is the 0% VAT, best illustrated by the identity crisis concerning Jaffa Cakes.
Generally, consumers pay 0% VAT on necessities or stable foods such as cakes. Biscuits covered with chocolate, however, are deemed luxurious and are thus subject to a 20% VAT. What about Jaffa Cakes?
In United Biscuits [1991], a court confirmed that Jaffa Cakes stay cakes for VAT purposes because they harden rather than soften when stale.
Crucially, the 0% VAT (or VAT exemption) applies also to cross-border transactions in the European Union.
Now we are in a position to appreciate the carousel fraud, or less excitingly, the missing trader intra-community fraud.
Merry-go-round the missing trader
The carousal fraud takes advantage of VAT exemption and its refundability.
Fraudsters exploit the VAT system by importing 0% VAT goods from one country and selling them at VAT-inclusive prices within another, then not paying back the collected VAT to the government. The goods are often sold repeatedly through multiple companies in different countries, creating a complex trading cycle that makes it difficult to find the stage at which the payable VAT went missing.
Suppose a pre-Brexit UK-based trader, Amy, buys £100,000 worth mobile phones from a trader in Germany. Amy pays no VAT to the German seller. Amy then sells the phones to (UK-based) Bob for £125,000, plus 20% VAT of £25,000. Amy then has £150,000, £25,000 of which is the profit on the sale.
Suppose, then, Bob sells the phones to (UK-based) Chuck for £200,000, plus 20% VAT of £40,000. Chuck pays £240,000 to Bob. (The cycle could go to confuse HMRC but let us suppose it ends here.) Lastly, Chuck sells the phones to a Greek trader £300,000, charging no VAT.
If Amy, Bob, and Chuck are honest traders, they would need to pay HMRC the VAT they collected minus the VAT they paid. But they are not. In fact, they are one criminal entity.
Amy simply disappears and never pays HMRC the £25,000 VAT she collected. Bob has collected £40,000 from Chuck and paid £25,000 to Amy, so Bob pays HMRC £15,000. Chuck has paid £40,000 in VAT to Bob but collected no VAT from the Greek trader, so he reclaims £40,000 from HMRC.
If the Greek trader is a co-conspirator, the phones would go back to Amy and the carousel keeps on running.
In the end, the trio has reclaimed £25,000 from HMRC via circle of fraudulent transactions. Because HMRC has difficult connecting Chuck to Amy the missing trader, carousel frauds often go undetected.
Legal and social issues
The central legal issue is: when can tax authorities refuse repayments to honest traders suspected of the fraud, i.e., the Chucks?
The legal question carries significant social impact as allowing too much such payment means significant loss in tax revenue. For instance, in HMRC v. Livewire Telecom Ltd [2009], HMRC failed to prove that Livewire had actual knowledge of the fraudulent transactions and was ordered to refund more than £2m to Livewire.
Courts need to draw the line between traders accidentally engaged in the carousal transactions and traders who ought to know their involvement. In Mobilx Ltd and others v HMRC [2010], the court of appeal confirmed that the test was: whether the traders ought to have known that the transactions were more likely than not to relate to fraud.
Law firm involvement
In addition to representing companies accused of VAT fraud and assisting HMRC in prosecution, law firms perform the following tasks.
Preventive Advisory: Law firms advise companies on compliance with VAT regulations to prevent unintentional breaches that could be interpreted as fraudulent. This includes guidance on proper VAT documentation, invoicing, and the reporting system.
M&A Due Diligence: Law firms conduct due diligence to uncover any past VAT non-compliance that could pose legal and financial risks, mitigating future liabilities arising from inherited VAT issues.
Investigation Assistance: When VAT fraud is suspected, law firms collaborate with forensic experts to investigate anomalies in financial records via internal audits.
Recovery Actions: In cases where VAT fraud has been confirmed and losses incurred, law firms may also be involved in recovery actions to reclaim defrauded amounts. This involves legal proceedings against fraudulent parties or claims through insurance.
Article by David Zheng
For more articles in the tax law series:
M&A Tax: How does M&A save companies billions in tax?
Transfer Pricing: What is transfer pricing, and how does it minimise tax burdens?
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