How to protect your business from HMRC input VAT claim refusals: the Kittel threat

Whilst taxpayers have the fundamental right to deduct input tax, HMRC can, in particular circumstances, refuse the taxpayer this right if it can prove that the taxpayer knew or should have known that their transactions were connected to fraud.

In the past year, we understand that there has been a significant increase in clients across different sectors receiving correspondence from HMRC to deny the recovery of input tax on the above purported basis.  

It is crucial to understand the seriousness of the matter and potential reputational and financial impact it could have on the business if it is not dealt with properly.

What is the “Kittel” principle? 

Pre-2006, it was an established principle that a taxable person's right to deduct input tax would be lost when their transactions relate to VAT fraud carried out by the taxable person. In 2006, the European Court of Justice (ECJ), in the cases of Axel Kittel v Belgium and Belgium v Ricotta Recycling [2008] STC 1537, clarified that input tax may also be denied where the person knew or should have known that the transaction on which the tax is claimed is connected with the fraudulent evasion of VAT conducted by another party. This is known as the “Kittel principle”. Failing to understand and comply with this principle could lead to severe financial and legal consequences, potentially jeopardising the financial and reputational stability of taxpayers.

How does HMRC apply the Kittel principle in practice? 

The Kittel principle grants HMRC extensive powers to combat perceived VAT fraud across supply chains, with a particular focus on traders.  In fact, HMRC's VAT Fraud Manual dedicates 22 separate sections to 'The Kittel principle intervention', outlining how its staff should implement the legislation.

It is crucial to understand that the taxpayer does not have to be the one committing the alleged fraud. The Kittel principle extends its reach to those who should have known that their purchase was connected with fraudulent evasion of VAT. This means that the fraud could have been committed by a distinctly separate trader somewhere earlier in the supply chain, and HMRC is seeking to deny input tax on transactions within the chain. 

Unlike situations where a taxpayer is making a claim for input VAT, the burden of proof where input VAT has been denied in these circumstances is on HMRC to show that the test has been met, that the tax loss has occurred, and that it was a result of fraud.

It is accepted that the phrase 'known or should have known' should not be read to mean the same thing; instead, they demonstrate two different states of mind. In simpler terms, Justice Briggs in Megtian Ltd (in administration) v CRC [2010] STC 840 said that “a person who knows that a transaction in which they participate is connected with fraudulent tax evasion is a participant in that fraud. That person has a dishonest state of mind. By contrast, a person who merely ought to have known of the relevant connection is not dishonest but has a state of mind broadly equivalent to negligence.”

Further, the Upper Tribunal in Davis and Dann Ltd v CRC [2014] STC 39 stated that “This test presents a high hurdle for HMRC... it is not enough that the circumstances of the taxpayer's transactions might reasonably lead him to suspect a connection with fraud; nor is it enough that the taxpayer should have known that it was more likely than not that his purchase was connected to fraud… He should have known that the transactions in which he was so involved were connected to fraud; he should have known that they were so connected because that is the only reasonable explanation that can be given in the circumstances of the transaction” (emphasis added).

In the absence of any clear evidence of direct involvement with fraud, these principles may only apply if a trader should have known that the only reasonable explanation for the transactions in which they were involved was that they were connected with fraud. 

HMRC will also review taxpayers' general awareness of fraud, including knowledge of fraud related to the market in which they traded at the time of the transactions. General awareness can encompass media coverage of VAT fraud, industry discussions, membership in a trade organisation that has addressed VAT fraud, or participation in activities supporting legal action against HMRC's anti-fraud measures.

HMRC will also examine contrived features of the transaction chain and the taxpayer's failure to consider negative indicators during due diligence and risk assessment. It is helpful to know that the company's inadequate due diligence procedures should not be the only evidence that it knew or should have known that it was involved in the fraudulent evasion of VAT.

If a taxpayer is found to have known or should have known that a transaction was fraudulent, HMRC can impose various penalties. These penalties can be significant, ranging from a fixed amount to a percentage of the VAT due, and can be issued at the time of the Kittel decision or years later.

In certain circumstances, HMRC also has the power to hold those involved in the company's management personally liable for these penalties.

What to do if HMRC issues an enquiry based on the Kittel principle?

Upon receiving a Kittel decision letter from HMRC, swift action is not just advisable; it is crucial. Failing to address HMRC correspondence promptly could lead to significant harm to your business. Therefore, seeking specialist advice without delay is of utmost importance, underlining the need for immediate and expert response in such situations.

We have seen circumstances where HMRC have been unwilling to provide details of the transactions that are allegedly connected with fraud until a few rounds of correspondence have taken place.  In some circumstances, we are aware that HMRC have taken the decision not to share key information and documents until the matter has entered Tribunal litigation; causing additional (and unnecessary) expense.

What can you do to protect yourself?

Assessing the circumstances surrounding a transaction is crucial before engaging in it. This involves conducting thorough due diligence. A robust due diligence process is the most effective way to safeguard against a Kittel notice from HMRC, providing taxpayers with the necessary information to make informed decisions.  

Knowing who is in your supply chain is not enough; regular due diligence is also necessary. This can also include having a third party review your current policies and procedures to see if there’s any areas for improvements.

It's important to keep up-to-date and accurate records of your due diligence and act on any intelligence uncovered. This documentation will indicate your efforts to prevent VAT fraud, should the need arise. 

As a wider point, considering any uncharacteristic or unusual behaviours on the part of the parties involved in the transactions and any behaviours inconsistent with usual market practice in your relevant sector would be prudent. Credit checks are not necessarily valuable for evidence of VAT fraud and should not be relied upon in this instance.

In short, this is an area of growing concern for UK businesses.  Many of those being denied input VAT have no involvement in any fraud (and are completely unaware of it) but this could lead them to incur significant time and fees in defending their position against HMRC without early intervention.

Position going forward

Should there be a change in government in the upcoming election, Labour has also promised to close the tax gap which currently stands at c.£40bn. Labour propose to do this by relentlessly pursuing money that is owed to HMRC, with a plan to make sure people pay the correct tax in the first place and directly tackle tax avoidance and evasion.  

It is therefore likely that going forward, HMRC will continue to increase investigations in this area, which means it could be harder than ever to recover input VAT without having a sensible plan in place should HMRC take a closer look.

Further information

If you have any questions or concerns about the topics raised in this blog, please contact Waqar Shah and Krishna Mahajan.

Further information is also available on our Tax Law and HMRC webpages. 

 

About the authors

Waqar Shah is a Partner in the Dispute Resolution department, focusing on the resolution of complex tax matters. He acts for high net worth individuals and corporate clients across all sectors in respect of HMRC disputes and investigations across the full range of taxes. This typically includes VAT disputes, employment tax matters (including 'IR35'/off-payroll working), customs/excise duty issues, and tax fraud investigations.

Krishna Mahajan is an Associate in the Dispute Resolution department, who specialises in litigation and resolution of complex tax matters. She has extensive experience in tax and trust litigation including working on Codes of Practice 8 and 9, cross-jurisdictional schemes with UK tax implications, settling EBTs and film finance schemes with HMRC, and concluding long standing HMRC enquiries. Krishna assists agents and companies who have made R&D claims that are being investigated, including COP8s and lengthy information requests under Schedule 36 of Finance Act 2008. Krishna is studying to become a qualified member of the Association of Tax Technicians.

Melissa Joseph is a Trainee Solicitor in the Dispute Resolution department.