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INSIGHT: Covid-19—Protecting Your Business from VAT Fraud

March 27, 2020, 7:00 AM

As businesses are feeling the impact of unprecedented coronavirus (Covid-19) measures, governments are turning to emergency support packages. Like in other crises, value-added tax (VAT) is an important fiscal tool of choice when responding to the economic downturn. Measures include rate cuts, accelerated refunds and extensions of payment deadlines.

As a result of the crisis and the measures that governments and businesses are taking, an increase in fraud, VAT fraud included, becomes apparent. The main reason for this is the lack of sufficient controls.

Bona fide businesses can become impacted if they become an unwitting party to a VAT fraud. Sophisticated fraud schemes try to lure bona fide businesses into their chain of transactions. If these bona fide businesses cannot demonstrate that they have taken the necessary precautions, they may end up paying for it.

This article discusses why businesses, especially as the Covid-19 crisis worsens, should ensure that they are diligent in the conduct of their operations and what actions they can take to protect themselves from becoming unwittingly involved in unlawful transactions.

VAT Fraud: What is it and How Can it Impact Businesses that are Lawful?

Since the late 1960s, when the decision was made to adopt VAT as the common form of sales tax in the European Economic Community (now the European Union), VAT has grown as a stable source of income, not only for EU member states, but also for many other countries. The domestic and international neutrality properties have encouraged the further spread of VAT around the world. Today, VAT is a key source of revenue in over 160 countries worldwide. It raises approximately 20% of worldwide tax revenue.

From the beginning there have been concerns around fraud and abuse. The VAT system offers distinctive opportunities for evasion and fraud, especially through abuse of the credit and refund mechanism. With the introduction of the single market in the EU in 1993, when internal border controls were abolished, fraud opportunities were created.

The European Commission has made several attempts to reduce fraud and to gain insight into the volume of missed VAT income due to tax fraud, tax evasion and tax avoidance—as well as bankruptcies, financial insolvencies and miscalculations. As for any type of tax fraud an exact estimate of the revenue loss is hard to make, but research estimates that the so-called VAT gap of all 28 member states amounts to 137.5 billion euros ($148 billion). This is the overall difference between the expected VAT income and actual VAT collected.

It happens that bona fide businesses also become involved in fraud transactions. In fact they may unconsciously be lured into the chain, as part of the criminal master plan, just to disguise the artificial character. If bona fide businesses get involved the consequences can be far-reaching, even if the transactions in which the business is involved are not unlawful themselves. Within the EU in particular, businesses could lose their entitlement to:

  • claim a VAT input credit; and
  • apply the zero-rate for cross-border transactions within the EU.

Also, under the circumstances they may be held jointly and severally liable for the VAT debt incurred.

Authorities will apply the principles established in these cases, having regard to objective factors, that a business knew or ought to have known that it was taking part in a (chain of) transaction(s) connected with VAT fraud, and did not take every reasonable step within their power to prevent this.

In Times of Crisis, Businesses Should be Extra Careful

The current crisis and its predecessor, the financial crisis, are different in certain ways. One is caused by a pandemic and the other by failures in the set up of the financial system. At the same time, they have something in common offering a platform for fraudsters: the level of control is not sufficient.

Right at the time of the outbreak of the 2008 crisis, caused by systemic failures in the financial system, VAT fraud with carbon rights developed on a large scale. Respectable and well-known financial institutions, who bought carbon credits at a discounted price, claimed back VAT that was charged but never paid to the tax authorities.

While the focus is on the crisis, businesses in survival mode tend to have less of an eye on matters that are—although important—not urgent. In addition to that, businesses may implement drastic changes, without ensuring that robust procedures are put in place and staff are adequately instructed. These are all circumstances under which businesses are vulnerable. Fraudsters will take advantage of the crisis that, like any other crisis, in a way always comes unexpectedly and takes society by surprise.

At the same time, we see that governments are taking measures to accommodate businesses from a cash flow perspective. As an example, businesses are given the option to postpone their VAT payments and VAT refunds are accelerated by the tax authorities. Measures like these will invite fraudsters to take advantage.

How Should Businesses Protect Themselves from These Risks?

Now is the time for businesses to reflect on their fraud risk management and review its robustness, but how should bona fide businesses protect themselves from being an unwitting party to VAT fraud? This will be anything but simple, as VAT fraud can be (highly) sophisticated and requires a certain amount of effort with continuous monitoring from businesses. However, a best practice can be found with the implementation and use of a tax control framework.

A tax control framework is an internal control instrument—and part of an overarching business control framework—aimed at the tax function within a business. The importance of a tax control framework lies in its ability to provide a verifiable assurance that enables businesses to be fully aware and “in control” of all the positions and issues that need to be disclosed with all its external and internal stakeholders. If well-designed, it can help businesses to identify, assess, understand and undertake the appropriate respond to mitigate the impact of (potential) risks.

As part of a tax control framework, it is good business practice to undertake (a thorough) due diligence when entering into a business transaction—especially with unknown parties. When done on an ongoing basis, businesses will be able to assess and guarantee (to the extent it is reasonably possible) the integrity of their supply chain, including their suppliers, customers and goods within it.

Businesses should ensure that appropriate checks are undertaken and recorded. The actions listed below, for instance, can help businesses to protect their business from VAT fraud risks.

  • Obtain a copy of the articles of incorporation/deed of formation.
  • Obtain an (certified) extract from the Chamber of Commerce.
  • Obtain a copy of the VAT registration certificate, if applicable.
  • Verify VAT registration details via VIES (VAT Information Exchange System).
  • Carry out a (thorough) web search (e.g. via Google).
  • Obtain some form of written and trade references—and verify their legitimacy.
  • Obtain credit checks and other background checks from independent third parties.
  • Obtain copies of supplier’s bank details to ensure that the information provided is consistent with other copies obtained.
  • Visit supplier’s business every now and then.

Another part of the tax control framework is a continuous review of the business’s VAT position. Can any changes in patterns (such as unexpected high amounts of recoverable VAT) be explained?

Warning Signs

It is important for businesses to follow up on any warning signs. They should be particularly alert to practices that deviate from normal commercial practices within their sector. To minimize their risk, they should, in addition to the due diligence checks, consider:

  • the nature of the supply;
  • payment arrangements and conditions; and
  • details of the movement of goods involved.

If a transaction looks too good to be true, it probably is. Businesses will need to undertake the necessary steps to establish the bona fides of the transaction concerned and the trading partners involved.

In order to assess the legitimacy of supplier businesses could, for instance, check:

  • what the supplier’s history of trade looks like;
  • whether a deal is offered that carries commercial risk for them; and
  • whether high value deals are offered along with formal contractual arrangements.

In order to assess the commercial viability of the transaction businesses could, for instance, check:

  • whether products as described and in quantities offered are available in their market;
  • whether the method used in negotiating prices differs from what is common practice in the sector; and
  • whether there is any commercial justification for the request for third party payments.

Jan Sanders is a VAT Partner and Ibrahim Ahmed is a VAT Adviser at PKF Netherlands.

This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.