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

 

 

Tax inspection: what are the rules of play?

Sooner or later all entrepreneurs are confronted with an inspection by the Tax Authority. This inspection may not only focus on the entrepreneur’s liability to pay tax, but also that of a third party (e.g. his customer or supplier). The Tax Authority has several possibilities for inspecting an entrepreneur. For example, the inspector may conduct an audit, visit the company or carry out an on-site observation. Experience shows that the Tax Authority is currently inspecting entrepreneurs’ balance sheet item, turnover tax. The strategy applied by the Tax Authority indicates that this inspection primarily focuses on investigating an entrepreneur’s culpability. That should set off the entrepreneur’s alarm bells immediately. What are our rights and obligations during a Tax inspection? Is the entrepreneur obliged to cooperate in establishing his/her culpability? I deal with these topics in this blog.

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Various inspection possibilities

The tax inspector has several possibilities for conducting an inspection on an entrepreneur. Firstly, the inspector may conduct an audit. The purpose of an audit is usually to inspect the entrepreneur’s tax returns and administration. The inspector may opt to audit a specific period or specific components of the tax returns and/or administration. The inspector usually spends (part of) a day at the entrepreneurs place of business to conduct the inspection. The inspector may also ask the entrepreneur questions during the inspection. The inspector also uses this inspection, for example, for the (latest) examination of an entrepreneur’s balance sheet item, turnover tax.

Another possibility is that the inspector wants to gain insight into the entrepreneur’s company and business procedures. In most cases, the inspector will visit the entrepreneur’s business premises.

The inspector may also carry out an on-site observation. The inspector does this to establish with his/her own eyes what actually takes place within the company on a day-to-day basis. The inspector does not give advance notice of this visit and it can therefore be labelled a ‘surprise visit.’ This strategy is frequently applied in hotel and catering establishments.

Finally, the inspector may conduct a so-called third-party investigation. This third-party investigation may focus on the taxation of the entrepreneur him/herself or that of a third party (e.g. one of the entrepreneur’s suppliers or customers). In the latter case, the entrepreneur will be confronted with a third-party inspection. In the first case, a third party, one of the entrepreneur’s customers or suppliers, will be confronted with an inspection by the inspector.

An entrepreneur has rights and obligations with respect to all of these inspections conducted by the Tax Authority. It is important to bear that in mind, so that no information can be provided involuntarily that the inspector may use against the entrepreneur later on.

Obligations

The point of departure for an entrepreneur’s obligations is the obligation to file a tax return in Articles 6 to 10 inclusive of the General Tax Act (hereafter referred to as: AWR). These are also called the primary obligations. In the majority of cases the primary obligations will not be addressed during a tax inspection, but rather the additional obligations of Articles 47-56 of the AWR. The most familiar additional obligations are: the obligation to provide information (AWR, Article 47) and the obligation to keep records and the obligation to retain (AWR, Articles 52 and 53).

Obligation to provide information (AWR, Article 47)

The obligation to provide information means that the entrepreneur is obliged to answer the inspector’s questions that are relevant for the imposition of taxes. This seems straightforward enough, however, in practice, it is not quite as straightforward as it seems. The inspector may, for example, only inquire about the facts and not the entrepreneur’s opinion. The inspector is not allowed to ask the question ‘Was trade in clothes the source of income?’ Instead, the inspector asks the entrepreneur to qualify certain facts (source of income). The inspector is allowed to ask ‘Have you purchased or sold clothes?’ This could be followed with: If yes, ‘for how much did you purchase or sell the clothes?’ etc., etc.

Another obstacle that may arise is the question how should the entrepreneur respond if the question is relevant for imposing taxes as well as for imposing a punitive fine. Any entrepreneur would, of course, be quick to say that they are not obliged to cooperate in their own conviction. But can he or is he entitled to do so? Unfortunately not. The entrepreneur is obliged to answer the so-called ‘mixed’ question. The only restriction is that the inspector is not allowed to use the answer to substantiate the fine. The entrepreneur is only entitled to invoke his/her right to remain silent on questions that are directly related to the imposition of a fine.

Under Article 47 of the AWR, the entrepreneur is also obliged to allow the inspector to examine the accounts, documents and other data carriers at its request. This obligation does not, however, entitle the inspector to an unlimited right to inspect. I discuss this in more detail under the entrepreneurs ‘rights.

Obligation to keep records and obligation to retain (AWR, Articles 52 and 53)

The entrepreneur’s obligations to keep and retain records are laid down in Article 52 of the AWR. Article 53 of the AWR subsequently stipulates that the entrepreneur is obliged to allow the inspector to examine his/her administration for the purpose of his/her own taxation and/or that of a third party.

The obligation to keep records enables the inspector to easily check that the entrepreneur complies with his/her rights and obligations for the tax levy. How the administration has to be set up and what it should include is not provided for in the legislation. What exactly should be included in the entrepreneur’s administration depends on the nature and size of the business. The administration may include:

  • cash transactions and receipts;
  • financial statements, like purchase and sales ledger;
  • incoming invoices and copies of outgoing invoices;
  • bank statements;
  • contracts, agreements and other arrangements;
  • agendas and appointment books;
  • correspondence.

The obligation to retain – in short – means that the entrepreneur is obliged to retain the administration for 7 years. Data on immovable property (deed of sale and civil-law notary invoice) are even subject to a retention period of 9 years.

Rights

In addition to the abovementioned obligations, the entrepreneur also has a number of rights. While the obligations are clearly set out in Articles 47-56 of the AWR, the entrepreneur’s rights are mainly to be found in the case law and the general principles of sound administration.

The most significant right that will spring to everyone’s mind is the right to remain silent. In tax audits, an entrepreneur can avail of this right sporadically. As already explained, an entrepreneur is obliged to answer the inspector’s questions. The entrepreneur is only entitled to invoke his/her right to remain silent on questions that are directly related to the imposition of a fine. The inspector shall caution the entrepreneur before asking a question that is directly related to a fine, so that the entrepreneur knows that he/she is not obliged to answer.

As already mentioned, the inspector assesses entrepreneurs’ balance sheet item for turnover tax. The inspector has drawn up a contingency plan for this inspection. According to this contingency plan the inspection of the balance sheet item, turnover tax, that is conducted at the entrepreneurs place of business is really only to establish the entrepreneur’s culpability (the liability). It is also noted in the contingency plan that, depending on the outcome of the inspection, a fine will be imposed on the entrepreneur. It can be deduced from this that if the inspector asks the entrepreneur any questions during the examination of the balance sheet time, turnover tax, these questions will only be pertinent the (possible) imposition of a fine. Consequently the entrepreneur is entitled to invoke his right to remain silent during this inspection.

Another right that the entrepreneur has is in fact a ban that the inspection has, namely the ban on browsing and/or the ban on fishing expeditions. The inspector may not, for instance, take it on himself to open or enter filing rooms looking for documents that may be interesting for tax purposes. The inspector will have to ask the entrepreneur have a specific document. Nor may the inspector sit behind the entrepreneur’s computer to look for documents that may be interesting for tax purposes. On the contrary, the inspector may ask to link his computer to the entrepreneur’s computer to facilitate the transfer of data.

In most cases, the entrepreneur will avail of the services of an accountant, tax consultant, civil-law notary and/or lawyer. Lawyers and civil-law notaries have a legally arranged right to non-disclosure (AWR, Article 53a). If the entrepreneur has received any correspondence and/or advice from a lawyer and/or civil-law notary (the latter is subject to some restrictions), the inspector is not at liberty to ask for these to be made available for inspection. Not even if the entrepreneur has included this correspondence and/or advice in his administration. This does not apply in the case of accountants and tax consultants. The do not have a legally arranged right to non-disclosure. Nonetheless, the inspector may not request that correspondence and/or advice from the accountant or tax consultant is made available to him for inspection if the object of that request is to advise the entrepreneur about his tax position. The fair play principle precludes the inspector from requesting to inspect.

It is important for an entrepreneur to take stock of these rights. During an inspection, the inspector is usually extremely eager to obtain as much information as possible. The accusation that the inspector is quick to make is that entrepreneurs look for loopholes in the law. The inspector understands what it is to be human. The inspector often treads the borderline between what may and may not be asked into order to obtain as much information as possible. So, be on your guard!

Conclusion

The abovementioned is a brief outline of the various types of inspections that may be conducted by the Tax Authority. I also briefly discussed the obligations and rights that an entrepreneur has during such an inspection. It is important that an entrepreneur is aware of these, so that he does not involuntarily provide information to the inspector that can be used against him later. This situation may arise when the inspector is examining the entrepreneur’s turnover tax balance sheet item. The contingency plan drawn up for such inspections shows that the only reason for conducting the inspection is to determine the culpability of the entrepreneur. This means that the entrepreneur is entitled to invoke his right to remain silent. If he does not do this and voluntarily provides information to the inspection, the inspector may use that information against him to substantiate the fine. For more information on this subject, please refer to the Tax Inspection guide, which you will find here.

Mr. M.H.W.N. (Marloes) Lammers