Richard Cornelisse

US VAT Introduction: Any Lessons To Be Learned From European VAT Fraud?

In Indirect Tax Strategic Plan, US VAT introduction on 07/03/2012 at 4:40 pm

By Richard Cornelisse and Kelvin Hulsebos

In the European VAT system one of the basic principles is that input VAT (VAT paid) can be off sett against output VAT (VAT charged). In case of a surplus of input VAT a refund of tax is claimed and often paid by the authorities.

Allowing businesses the opportunity to collect and retain large amounts of tax can leave the system open to fraud and manipulation by dishonest taxable persons.  VAT fraud is for a while a key issue for all European Member States.

VAT Fraud / Tax Evasion

In its most basic form, VAT fraud/tax evasion works as follows.

A taxable person charges an amount of VAT for its sales. The taxable person receives this VAT from its customer, but does not pass it on to the authorities. Further, to optimize the fraudster’s profit in such a scheme, the taxable person tries to purchase the goods (or services) without VAT (cross border transactions and use of 0% rate). It is also common that the same goods are sold multiple times to a third party, unaware of the fraud (hence the name “carousel fraud”). Sale of computer parts, mobile phones and recently CO2 emission trading have been areas of substantial VAT fraud.

Above are just examples and many forms of fraud/tax evasion are possible.

Estimated The Amounts Of Fraud

According to a PwC report: “11 percent of VAT revenue is lost annually through fraud – principally ‘missing trader’ or ‘carousel fraud’ – which equates to in the region of €100 billion.

‘Elvis’ Left The Building

The life cycle of the fraudulent business is often short.  The shop is closed before a tax audit takes place and the person really in charge has skipped town. Besides maybe the appointed ‘homeless guy’ as managing director the only real alternative left for the tax authorities is to try to collect the VAT from the customer.  However, if the customer can prove good faith this is not possible.

It Is All About “Good Faith”

What is good faith? Good faith has some subjective elements and is absent when the customer “knowns or ought have known”. To avoid joint liability the honest trader has to prove proper internal awareness: counterpart acceptance measures and the company’s control framework should include detective and preventive controls.

In practice, is this easy to prove?

From the benchmark findings of Blog February 23 follows:

  • Management and oversight of indirect taxes are characterized by weaknesses in governance, controls and processes
  • Significant majority is just beginning to implement global VAT/GST processes and controls or has processes established in a few key countries
  • Limited existence and quality of documented processes designed to manage VAT/GST across the entire business
  • 40% of sample population has policies in the Europe, Middle East and Africa (EMEA) region

Based on the above the following questions from earlier Blogs pop up. What is the risk appetite of the company in the worse case scenario? What is the VAT Throughput? What are risky transactions (being material or not)? What needs to be done to manage these transactions (SMART goals and KPIs)?

Counter measures to combat fraud

One of the solutions to combat fraud is to introduce a reverse charge mechanism between tax payers. This means that the buyer and not the seller is responsible for paying VAT via self-assessment. The seller does not charge an amount of VAT, but the buyer is required to report the VAT for its purchase as VAT due in its VAT return.  In the same VAT return, the buyer can recover this VAT as input (assume full right of VAT deduction). The fraud loophole is closed as parties no longer charge an amount of VAT.

This solution has been successfully implemented by a lot of EU member states (for VAT fraud with CO2 emission rights).  However, it would be a fundamental change of the European VAT system to carry this out for all supplies.

What about the US? Is this statement also applicable from an US VAT introduction perspective?  Is such a solution a huge change as well?

Relation to US VAT introduction

Although implementing of a reverse charge mechanism for all transactions in Europe would be a fundamental change of the VAT system, this might be a solution from an US VAT introduction perspective. An overall reverse charge mechanism might be less of a change to the US sales tax system than a ‘copy paste’ of the current European VAT system. See Also PwC’s Final Report To European Commission  2007.

How do you see this?

As VAT is a multi-stage tax an introduction would mean that the tax administration should overlook much more transactions.  More work means more resources. A new tax system means education and training.  More complexity means the need for supporting technology to timely track tax evasion/fraud/risks. Is this only applicable in the start up? Not really. Europe still faces most of these challenges.

From a law perspective it is important to find the right balance between avoiding VAT fraud, transfer risk (e.g. joint liable) and creating administrative burdens. As stated in Blog Of March 3 support for a VAT introduction will likely be lost when anti-fraud/tax evasion legislation causes disruption to daily business and is the cause effect of substantial implementation costs.

Richard Cornelisse is CEO of the KEY Group and worked previously as Big4 Partner in the Tax Performance Advisory and Indirect Tax Practice and blogs on Tax Function Effectiveness and Tax Control Framework developments.

Tax Management Consultancy welcomes your opinion on any of the issues raised, so feel free to join in the discussion on LinkedIn | Twitter | Facebook.

  1. One key learning point could be to make one single VAT juristiction for the entire US. one of the main “sources” of opportunities for fraud is the long process of reaching the final “EU market” for VAT purposes. This opens for the possibilities of fraud with VAT inside EU that utilizes the weaknesses of the temporary VAT setup that has now been working in its current form since 1993.

  2. Implementing a VAT in the USA would require a major reform to the US Revenue Authorities. Conceivably, the VAT could be collected by the State Revenue Authorities but inconsistencies in resourcing levels, application of the law and ‘turf wars’ could create major exposures to fraud and overall non-compliance. In reality the Federal IRS should be given the task to administer the VAT as VAT compliance systems could be built to interface with exiting income and employment tax systems to mitigate the scope for fraud. The major problem facing the IRS is that it is fundamentally an income tax organisation with very limited exposure to transaction taxes. I would think that, in the first instance, the IRS would need to recruit VAT operators from the pool of Sales and Use Tax staff in State Revenue Authorities supplemented by overseas recruitment (incidentally they will be competing for the same overseas pool with business and the professions). This will present a huge challenge and in the first few years of a US VAT it is possible that fraud and non-compliance on a significant scale may occur. From a tax structure point of view I agree that steps to eliminate carousel fraud will need to be taken first by allowing a settling in period before any concessions such as those within the EU are allowed within NAFTA.

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