‘Was aware or should have been aware of fraud‘ is the magical formula by which the Dutch Tax Authority is trying to tackle VAT fraud. For the VAT zero rate (on deliveries within the EU) or the right to deduct input tax to be refused, it is enough that the businessperson ‘should have been aware’ that their suppliers or customers (who are often in other countries) committed VAT fraud. A retrospective levy (usually 21%) because you failed to be properly aware 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 can charge 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 customer acts in the capacity of tax subject;
- There is a question of transferred power to dispose of a goods item as the owner; and
- The goods have been (physically) relocated (to the other member state).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 tax subject’, i.e. that the supplier can be required to act in good faith and to do everything that can be reasonably demanded of him to ensure that he, in the action he undertakes, does not involve himself in tax fraud. The latter is also referred to as ‘prudent business management’.
In addition, the ECJ determined that no other criteria, in addition to these three, can be set for the ability to apply to 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 tax subject him/herself (‘for example, by presenting a false 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 Kittel ruling
The ruling in the Kittel case was a groundbreaking one. This was because, in that ruling, the ECJ determined that:
“A tax subject who knew, or should have been aware, that he participated, by virtue of his purchase, in a transaction that formed part of VAT fraud (…), must therefore also be regarded as a participant in this fraud, regardless of whether he profits from selling the goods on.”
After this ruling, it is no longer necessary for the relevant tax subject to have committed fraud for the zero rate or the right to deduct input tax to be refused. It is enough that he ‘was aware or should have been aware’ of fraud ‘in the chain’. With this, the ECJ has attempted to give the European tax authorities more resources to combat VAT fraud. Because a retrospective levy in the Netherlands, imposed on goods supplied to a business in another member state, does not detract from the tax status of the acquisition in the other country, Prof. Van Hilten spoke in her speech 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 is retrospectively found that a business in Europe has supplied goods at 0% VAT, while according to the Tax Authority it should have reported the possibility of fraud on the part of the customer, it can have a retrospective levy imposed on it at the prevailing rate (usually 21% in the Netherlands). The question arises as to whether this amounts to a punishment (of the ‘lax’ 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 applicable. These criteria are as follows:
- The qualification according to international law
- The nature of the offence
- The nature and heaviness of the sanction
In later jurisprudence, the ECHR has indicated that it regards the second and third criteria in the Engel case 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 culpability if a person ‘was aware or should have been aware 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 the third ‘Engel’ criterion, the nature and heaviness of the sanction, an important point is that VAT is intended to tax consumption and should therefore not be an imposition on businesses. A retrospective levy of 21% can therefore only be intended as a ‘deterrent’. The deterrent function of sanctions also plays a central role in criminal law. With respect to the ‘heaviness 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 penalised. Finally, I refer to the overkill at ‘chain level’ which the ‘was aware or should have been aware’ approach incorporates. 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 sanction is involved.
The Italmoda and Stehcemp rulings
Regarding the answer to the question of whether a penalty is involved if the business, which should have been aware 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 it in its ruling on the Italmoda case. In section 61, the Court determined that there was no question of a 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 been notionally traded (‘on paper’). 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 Authority can demonstrate that the tax subject ‘was aware or should have been aware’ of the fraud. In this connection, the Court of Justice does speak of a penalty:
“49. On the other hand, if the material and formal criteria, set out in the Sixth directive, for the entitlement to and exercise of the right to deduct input tax are met, it is not compatible with the regulation of the right to deduct input tax, as established in this directive, to penalise by refusing this right a tax subject who was not aware and could not have been aware that the action in question formed part of fraudulent activity by the supplier (…)”
Risk liability under criminal law
It is clear that everything hinged on the awareness of the tax subject. A person who was not aware (and ‘could not have been aware’) 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 was aware, or should have been aware, that he participated in fraud but did not himself commit fraud. Although there is no excuse for penalising when there is no prior legal basis for imposing a penalty, it is still possible to have (some) understanding of this if there is a question of ‘being aware’ of fraud. However, with the phrase ‘should have been aware’ it appears that a risk liability under criminal law 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 been aware’ in relation to VAT fraud, the Court of Justice appears to assume gross culpability. This is because it opted not to deduce the ‘awareness’ from the lack of diligence (as with conditional intent), but to create a separate category for the purpose (‘should have been aware’) 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 inspector to primarily become a public prosecutor in cases of VAT fraud, because the court adjudicating tax affairs can reach a penalty verdict under more flexible conditions. Of course, it is already the case that the 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 in isolation from this (simply to penalise).
Incidentally, an identical deliberation to that in the Stehcemp case can be found in section 47 of the ruling on the Mahagében case.
With the European jurisprudence concerning a tax subject who ‘was aware or should have been aware that he participated in fraud’, VAT can be retrospectively levied on businesses that did not exercise due diligence when supplying goods within the EU. Viewed from various perspectives, this possibility for retrospective levies, developed in jurisprudence, bears great similarity to penalisation. This is also apparent after comparison with the criteria developed by the ECHR for this purpose. The conclusion that penalisation is involved conflicts with Article 7 for the European Convention on Human Rights because a retrospective levy on an ‘undiligent’ businessperson who ‘was aware or should have been aware’ 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 speak of penalisation in this connection. The conclusion that a retrospective VAT levy constitutes a penalty is even more alarming in cases where the businessperson was not aware of fraud but ‘should have been aware’ of it. In these cases, there is no intent to defraud that can justify a penalty.