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.

Businessman trapped on mousetrap on white background.

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.

Conclusion

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.

Nick van den Hoek, Attorney at law

 

 

Infringement of privacy or defence rights: exclusion of evidence in tax proceedings based on European law (WebMindLicenses)

Supreme Court directly overstepped by webcam girls? 

The European Court issued the seemingly ground-breaking WebMindLicenses ruling on exclusion of evidence in tax proceedings as the result of an infringement of European law (Union Law). While this case ‘only’ concerns the infringement of privacy and the use of evidence from an ongoing criminal proceeding, the consequences extend beyond the defence rights. For example, the provision of evidence in a tax proceeding obtained by force, which is subsequently used for evidence for a fine or punishment – despite the right to remain silent and the related right to not have to cooperate in your own conviction. Moreover, the Court is of the opinion that infringement not only has consequences for imposing fines, but also for determining the tax levy. 

toetsenbord stethoscoop

Lifejasmin.com’s privacy

The WebMindLicenses ruling of 17 December 2015 concerns the webcam girls from the website Livejasmin.com. The case essentially concerns the question whether, for the turnover tax, the ‘erotic interactive visual services’ were transferred to Portugal as the result of a license that was issued, or whether this had still been granted from within Hungary. Intercepted telephone conversations and seized emails from an ongoing case were used as evidence in the tax case. The question has been raised in the criminal proceedings whether this information was obtained illegally. The question at hand for the European Court: if the evidence was obtained illegally in the criminal proceedings and this had not yet been established, can that evidence be used in tax a proceeding?

European fundamental rights

Before the European Court deals with the question as to whether evidence for the tax proceedings should be excluded from this case, the broader context of the guaranteed rights will be defined within the broader context of the Union Law. In particular, reference is made to the Charter of Fundamental Rights of the European Union (the Charter), for which the EU has also published Explanatory Notes. Many of the human rights from the ECHR, such as the right to privacy and the right to a fair hearing, are incorporated into European law. Restrictions or infringements on these rights may only be made by law and must be necessary for recognised objectives of general interest, such as the prevention of fraud. That means that the restriction (of privacy, etc.) should be able to have the desired effect and not extend beyond that which is strictly necessary.

Exclusion of evidence

The European Court tests in three steps:

  1. Has the evidence in the criminal proceedings been illegally (without judicial authorisation) obtained
  2. Does the use of same by the tax authority constitute an inadmissible restriction on the defence rights because a less serious infringement could have sufficed
  3. In the case of infringement, will an ‘effective remedy’ be offered, either
    1. because testing may establish whether the Charter rights have been safeguarded;
    2. or the evidence will be excluded from use in the tax proceedings.

By doing this, the European Court is once more setting down markers in the area of privacy, after the method of exchanging information between countries had already been denounced in the Smaranda Bara ruling in October 2015.

Supreme Court directly overstepped by webcam girls?

Last year, the highest court of the Netherlands ruled that ‘illegal (criminal) evidence’ should not only be excluded in tax proceedings, but not even as evidence for the fine. The Supreme Court holds firm to its line set out in 1992 on the use of illegally obtained criminal evidence in a tax proceeding:

“The use of such evidence by the inspector is only prohibited if it is obtained in a manner that is so contrary to that which can be expected of a reasonably acting government, that this use has to be deemed inadmissible under all circumstances.”

Due to this strict rule from the Supreme Court, it boils down in practice that in many cases illegally obtained criminal evidence may be used in a tax proceeding. Advocate General Wattel also pleaded in favour last year for the tax penalty law to comply with the more flexible manner in which illegally obtained evidence is dealt with in criminal law. The Supreme Court rejected this advice, and ruled in its judgement of 20 March 2015 that the “such contradictory criterion” cited above still applies.

The European Court has since thwarted that and declared exclusion of evidence in the new standard, in each case where a matter of illegally obtained criminal evidence exists through infringement of the right to privacy. The Court does not limit this ruling to any fine, be also declares it applicable to determining the tax liability. The consequence when (the court determines that) the requirement laid down is not satisfied, is that the evidence will have to be excluded for the tax levy which, without sufficient other evidence, will have to result in the tax assessment being rendered void.

Other defence rights 

This judgement forms, in the first instance, a powerful argument for respecting privacy. Of course, any criminal investigation may infringe on the privacy of suspects and that does not automatically lead to exclusion of evidence. However, if a boundary is reached, as is the case here because no advance permission was granted by any court before telephones and emails were intercepted, unless, and this is subsequently what the national court concerns, it can be verified later on whether the confiscation was legal, necessary and did not extend beyond ‘effective’.

But there is more. The European Court does not only refer to the Charter for the right to privacy, but emphasises that all rights included therein weigh just as heavily as their counterparts in the Human Rights Treaty of 1950 (ECHR). For the question ‘and then?’: what is the sanction if an unreasonable infringement on the (privacy) right is determined in one of the preceding steps, the Court refers to the ‘rights of defence’ in article 47 of the Charter, which refers to the right to a fair hearing as (also) guaranteed in ECHR, Article 6.1.

Evidence provided by force

The right to a fair hearing includes, among other things, the right to remain silent and the right to not have to cooperate in your own conviction. In some respects, there is a large area of tension between these guaranteed rights and in other respects the tax obligations to acquire information. The ruling of the Supreme Court on the issue as to when forced information may be used for a fine, does not yet seem to be fully ECHR-proof.

The portal to the European Court, through which Tribunals, Courts and the Supreme Court submit (preliminary) questions on the interpretation of Union Law, is perhaps more interesting in these cases than filing an appeal with the ECHR. The latter Court may only become involved in the final stage when, after years, the Supreme Court has ruled – and, moreover, only for the fine. The European Court can come into the picture much faster and, moreover, also rule on the usability of evidence for the tax levy.

Restriction to ‘European’ cases

An observation that has to be made is that the European Court only deals with European cases, which means that there has to be a link to Union Law. That link can be made in various ways. For example, the turnover tax is regarded as a ‘European tax’ and an appeal can be made to, for instance, the Charter in cases concerning VAT. It is justifiable that the rights from the Charter are so fundamental and generally applicable that they should apply in any proceeding. However, according to the Supreme Court, this does not apply for a purely Dutch case concerning VAT. Each (EU) country still has its own income tax legislation, so that there is no link with Union Law – unless. Such an ‘unless’ crops up, for example, in discussions on tax evaders. Because the European freedom to save money in another country is utilised, the legal protection that the European Court offers in such matters comes into play.

The fact that guarantees for one type of tax may well not apply for the other types, does not, however, show a comprehensible distinction. This creates a strange situation in that for some taxes there is more legal protection than for others.