VAT fraud in the emissions and energy trading sectorMay 6, 2011
The largest VAT fraud in the EU is referred to as “carousel fraud” or, to give it its full name, missing trader intra-community (MTIC) fraud.
MTIC fraud is a hot topic both within the EU and for other jurisdictions considering implementing a new VAT system or reforming current systems. This type of VAT fraud is growing at an alarming rate — in quantity, the industries affected by it and, especially over the course of the last two years, in its overall level of sophistication.
Today it is beginning to affect the credibility of markets themselves and, because of the staggering figures involved, the accuracy of EU Member States’ trade statistics. Estimates vary concerning the actual level of VAT losses, with figures ranging up to €100billion (1) per annum across the EU Member States.
In this article, we discuss the characteristics of this type of fraud and present a number of key leading practices — applicable to all businesses — which can be followed to reduce the risk of falling prey to such a fraud.
VAT fraud has become an established industry in itself and is spreading toward the commodity trading world. New and innovative forms of fraud are constantly under development.
Historically, this type of fraud has been restricted to specific industries and selected products — mobile phones in the telecoms sector and central processing units (CPUs) in information and communication technologies (ICT) trading being perpetually popular items.
We have also seen it spread into newer areas in the telecoms and ICT sectors, especially high value and easily tradable services such as software, licensing, data provision and exploitation of data lines.
However, with last year’s rapid spread to other more unconventional areas, such as emissions trading, it seems that MTIC VAT fraud has now also infiltrated previously unaffected industries, even reputable and regulated ones, such as the gas and electricity market (2).
This article aims to explain the basic forms of MTIC fraud, summarizes developments and addresses some of the key issues that businesses are struggling with:
- The spread of MTIC VAT fraud into previously unaffected areas of emissions and energy trading
- The growing sophistication of MTIC fraud — including how to recognize fraudsters and detect whether you may become part of a fraudulent chain of transactions
- The risks to companies acting in good faith that find themselves within a fraudulent chain
- How companies can protect themselves against the indirect tax risks involved — such as not being able to recover input VAT claims or being held jointly liable for VAT
- Assessing which preventive and detective measures, controls and counterparty procedures make sense in view of the regulatory framework
MTIC fraud — basic form
In its most basic form, MTIC fraud works on the following basis:
- Company B acquires goods cross-border VAT-free from its supplier, Company A.
- B then charges local VAT for a domestic supply to its customer, Company C, and although B charges and receives this VAT from C, Company B never remits and accounts to the tax administration for the VAT paid by Company C.
- But Company C of course recovers the VAT it paid to Company B from the tax administration through its periodical VAT return.
- Therefore, the tax administration and the country for which it is collecting revenue eventually loses the VAT that Company B never remits.
- Typically, Company B then disappears and thus becomes the “missing trader.”
The following illustration (3) shows a typical MTIC fraud structure involving two Member States (Germany and France), so that the missing trader, Company B in the illustration, can purchase goods (mobile phones in this example) VAT-free and is able to collect VAT from its customer, Company C in the illustration, without paying the VAT to the tax authorities.
Court cases decided at the European Court of Justice (ECJ), such as Axel Kittel, deal with some of the issues arising from MTIC fraud, such as whether the other parties in the supply chain may be held jointly liable for the VAT loss and the possibility of the tax administration denying input tax deduction when a party in a fraudulent chain is not acting in good faith and “knew or should have known” (4) that it is part of such a chain.
Although MTIC fraud was traditionally limited to the supply of goods (e.g., computer parts such as CPUs and mobile phones), there is nothing to stop this type of fraud, in principle, being conducted using supplies of services subject to the reverse charge when purchased cross-border — which, under the new main place of supply rule, involves almost all B2B services.
The most recent sophisticated forms of this fraud are based on the intangible nature of certain tradable products, such as emission rights, which are services that are more difficult to track and which do not require the same level of VAT reporting as normal supplies of goods.
The penetration of MTIC VAT fraud in 2009 into emissions trading
The first rumors of a new form of suspected VAT MTIC fraud began to circulate around March 2009.
The trade in CO2 emission rights such as EU Emissions Allowances (EUAs), Certified Emissions Reductions (CERs) and Emission Reduction Units (ERUs) (usually referred to as “carbon credits” whether or not Kyotobased) is subject to VAT.
A reverse-charge mechanism applies if the credits are sold by an EU supplier to a customer in another EU Member State. A VAT carousel can be set up by purchasing carbon credits abroad (no VAT applied, but reverse charged) and selling these rights domestically on the local market with local VAT.
The VAT is charged and collected from the customer, but is not paid to the tax administration.
Using (electronic) marketplaces for carbon credits, such as French exchange Bluenext or Dutch/UK-based exchange Climex, fraudsters can generate massive trade volumes and pocket substantial amounts of VAT.
In combination with the usual way in which invoices are raised — the exchange sends credit invoices to its suppliers — it adds another layer of complexity for tax authorities to detect this type of fraud as the fraudsters do not even have to issue their own invoices.
Initially this new form of VAT MTIC fraud involving carbon credits appeared particularly in relation to carbon spot-market trades on Bluenext exchange and was identified by a huge rise in trading volumes from October 2008 to May 2009, when trading volumes reached an unprecedented high of 186 million.
As a result of the unexplained rise in volumes, the Bluenext platform was closed for a number of days in early June.
On 8 June 2009, a VAT exemption was introduced for all domestic trades in carbon rights in France (5).
Eventually, the whole EU carbon credit market was hit by the fraud. After measures to exempt the domestic trade from VAT were taken in France, a number of other countries followed with specific anti-fraud measures, including the introduction of a domestic reverse charge or a VAT zero rate.
This occurred in the Netherlands, the UK, Germany, Denmark, Spain and Luxembourg. After these measures were applied, traded volumes fell back to normal levels again.
However, once again, there are rumors of new fraudulent activity in the trading of nonKyoto carbon credits and similar climate change related tradable rights, such as green certificates and origin certificates.
On the legislative side, the EU is also working on some new initiatives. In December 2010, the Council adopted a regulation involving the creation of Eurofisc, a network of national officials to detect and combat new cases of cross-border VAT fraud.
Additionally in December 2010, the Commission presented its Green Paper on the future of VAT (6).
Needless to say, MTIC is one of the major issues addressed in the Green Paper. The Commission is, for example, also contemplating the possibility that the customer pays the VAT charged to him by the supplier directly to the tax authorities.
However, it will take years before such drastic measures resulting from the Green Paper will be adopted. In the meantime, traders will have to take their own counter measures to avoid becoming part of a fraudulent supply chain. These measures are discussed in further detail below.
Spread of MTIC fraud in other trading areas such as energy trade
The cross-border trade in gas and electricity currently shows similar characteristics and circumstances for VAT fraud as the cross-border trade in emissions.
Since the change of the VAT rules for cross-border trade in gas and electricity in 2005 (which remain goods for VAT purposes), VAT application has moved more toward the concept of the place of supply for services rather than goods.
In other words, the supply is subject to VAT where the customer is established, with a reverse charge if the supplier is established outside the EU country of the customer.
In fact, the situation is potentially even more attractive to fraudsters, as, with the introduction of the VAT package in 2010, energy is one of the few products that can be traded cross-border without having to be listed in an EU sales listing (in principle, intra-EU supplies of all other goods and services must be listed).
The graphic below page shows how sophisticated fraudsters make use of the gas and electricity market and may set up a structure suitable for MTIC VAT fraud.
Evidence that this type of activity is currently occurring in the market is supported by various indications throughout the EU.
For example, the Czech energy company ČEZ announced that it suspects that VAT fraud is on the rise in the country’s power market and has stopped trading with some smaller companies.
ČEZ became suspicious when these companies wanted to trade large volumes that did not correspond to their potential end-user demand.
Also in the Netherlands, some of the known fraudulent emissions-trading counterparts have tried to penetrate the power market by trying to register with the transmission system operator (TSO) and the electricity exchange, who had already taken preventive measures.
Indications from the UK
Most notably, there are clear indications of the spread toward commodity and particularly the gas and electricity market in the UK.
The UK tax administration (HMRC)’s fraud investigation team has alerted UK energy traders to the possible risk of MTIC fraud in this market (7).
HMRC has indicated that oil could also be used as a commodity to perpetrate MTIC fraud.
New estimates, which take into account mutations in the fraud, show that attempted MTIC fraud in this area has now risen significantly HMRC stresses the need for an adapted and specific due diligence process and has invited traders in the UK to validate the VAT details of any new or potential customers or suppliers.
In the announcement, HMRC especially stressed the importance of having sufficient controls aimed at creating awareness and the need for specific preventive and detective controls for VAT in this area (called by HMRC “reasonable checks on future transactions in accordance with Section 6 of Notice 726”).
A customer validation process also exists whereby copies of documents can be sent to HMRC in relation to new or potential customers or suppliers for validation.
Documentation includes the VAT certificate, letter of introduction, certificate of incorporation, the name of the new or potential client, their VAT registration number, contact numbers and details of the directors and (or) responsible members, bank sort code and account number.
Measures and controls
CO2 emissions trading fraud and current developments in electricity and gas trading have shown that anti-fraud measures must be constantly undertaken, in advance of fraudster networks being set up.
Once these networks are in place, they typically act very fast and it is often difficult to detect and stop them. The most significant risk to many companies is unwittingly becoming part of a fraudulent chain and thereby being held jointly liable for missing VAT revenue that disappears further up or down the chain.
EU VAT case law and the recent EU Commission Directives include rather subjective elements such as “good faith” and “known or should have known,” which play an important role in indicating culpability.
Regular controls are usually not sufficient to adequately protect a company against fraudsters — as such, basic controls are exactly what fraudsters aim for and exploit in order to go on undetected for long periods of time.
Due to the complexity and growing sophistication of MTIC frauds, a more tailored approach is required, involving implementation of specific VAT risk management measures in order to avoid becoming drawn into the fraud and (or) being held jointly liable.
HMRC suggests paying attention to a series of indicators that could raise suspicion about counterparties, such as:
- Newly established or recently incorporated companies with no financial or trading history
- Unusually exhaustive efforts to appear as trustworthy as possible such as registration with the exchange, company auditors and most especially regarding their VAT status — such as extensive mention of VAT information, VAT numbers, auditors and so on, homepages, contracts and invoices
- Individuals with prior history, connections or links to high value traditional carousel fraud goods such as mobile phones, CPUs and other computer parts
- Established commodity trading companies that have recently been bought by owners without ties to emissions or energy trading
- New companies managed by individuals without energy trading or emissions knowledge and exchange traders who have recently hired and are recruiting specialists from the energy sector
- Companies whose business or economic model is not suitable for or compatible with the energy or emissions trading sector
- Companies and individuals who make extensive enquiries about the VAT treatment and surrounding issues such as VAT Information Exchange System (VIES) checks and statistical information in respect of trade in energy or emissions
- Inexplicable increases and large positions in trading volume as compared to market demand especially compared with “smaller” traders
- Unusual trading activity, behavior, out of the ordinary margins and commissions compared to normal market behavior
- Trading counterparts who conduct business from out of the ordinary locations, short-term lease offices and facilities without actual trading floors and normal amenities
What the tax function can do
The typical measures implemented to reduce risk in this area apply equally to companies outside of the energy business.
Trading companies dealing with various types of emissions and similar tradable rights, electricity and gas, oil and other susceptible commodities should start by creating awareness and set up customized counterparty acceptance measures as well as using detection and prevention tools, preferably as part of an overall risk management approach.
The challenge, of course, is to cause as little disruption to daily business as possible and to embed reasonable and practical measures into the trading environment.
Typical measures may include:
- Creating awareness through brainstorming sessions with the tax team, risk managers, controllers and especially traders to discuss what is occurring in the market and throughout the EU with respect to VAT carousel fraud and the recent spread to other products (such as emissions, oil, electricity and gas)
- Enable preventive measures and discover potentially risky counterparts and risky areas with respect to VAT carousel fraud, typically aimed at emissions trading and energy trading
- Setup of specific counterparty acceptance policies aimed at tackling potentially risky clients with respect to VAT carousel fraud
- Review the current counterparty population and conduct a risk assessment of current trades (both accounts receivable and accounts payable) for possible joint liability (accounts receivable invoices) or possible denial of deduction of input VAT (accounts payable invoices) as a result of deals with potentially fraudulent counterparts
- Prepare for investigations by tax administrations related to VAT carousel fraud and (or) third-party information requests, determine to what extent the organization should cooperate and what the penalty and liability risks are
- Incorporate extra focus on MTIC fraud in M&A strategy and due diligence
- Take preventive measures and adopt VAT checks, e.g., via the VIES system and cooperation with fraud investigation authorities
At the end of the day, common sense plays an important role in all processes, as will your overall tax risk management policy.
It is vital to build an awareness of VAT MTIC fraud into the organization, not only within the back office (finance, tax and internal controls) but also at the front office and with traders and management.
Fraudsters rely upon the exploitation of the most straightforward, basic and default procedures.
In combination with the growing sophistication applied and the intangibility of some of the products — which make it hard to physically trace transaction flows — this has become a very complex type of fraud to battle.
Considering the growing amounts, volumes and risk involved, it is, however, becoming one of the most important tax risks to consider in the trading environment.
This article was originally published in the Ernst & Young Tax Indirect tax briefing which can be accessed using the link below:
- “A tax net full of holes — VAT fraud in the European Union,” The Economist, 13 May 2006.
- Information provided by the electricity and gas exchanges and the Special Investigations team of Her Majesty’s Revenue and Customs in the UK.
- Public report by the international VAT Association of March 2007 for the EU Commission.
- Paragraph 62, Axel Kittel ECJ decision (case C-439/04).
- French Ministry of Finance Instruction of 10 June, 2009, 3L-1-09.
- EU Commission’s Consultation on the “Green paper on the future of VAT — Towards a simpler, more robust and efficient VAT system,” which is available on http://ec.europa.eu/taxation_customs/resources/documents/common/consultations/tax/future_vat/com(2010)695_en.pdf
- Alert letter of HMRC Specialist Investigations of July 2010 following the Alert of the Serious Organised Crime Agency of June 2010.