Bleeding Central Europe through VAT scams

Value-added tax (VAT) is the cornerstone of public finance in every European country. It is easy to calculate and easy to collect. And, until the creation of the Single Market, it was also extremely difficult to avoid paying. Now, as goods move freely between countries, national authorities are struggling to keep track of how much is owed to them. Worse still, the complexity of intra-community rules is used by fraudsters to set up schemes that serve a single purpose – to defraud governments of money.

Foto: Creative Commons/ Leo Marco


This is a challenge for any EU country. However, the VAT gap (the difference between the money theoretically owed to government and the cash actually collected) is now particularly pronounced in a number of the EU new member states, including most of the Visegrad group.

The godfathers are not the only problem

Sometimes, the scams and the scammers make for a colorful spectacle. In Slovakia, the most notorious fraudster is a heavily-moustached former policeman, Mikuláš Vareha. For a number of years he was the uncrowned tycoon of a small impoverished region centred roughly around the Slovak part of the Tokaj wine-producing area. After he was finally nabbed, reporters in the courtroom listened with glee to the descriptions of the highly improbable trades for which he claimed VAT refunds from the government. The prosecution insisted that most of these trades, such as selling tons of insects allegedly collected in the forest as pheasant food, were completely fictitious.

Incredibly, this fraudster managed to enjoy a relatively lavish lifestyle for several years. He felt so invincible he even boasted about his exploits on Youtube.

This is vaguely reminiscent of the UK gangs, which, at the height of that country’s carousel fraud epidemic in the mid-2000s, bought mansions, flew helicopters and generally enjoyed a flashy lifestyle. Yet, VAT fraud is no TV show. The few exotic cases hide the real size of the problem and the sophistication of many fraudsters who are careful to keep a low profile. In fact, coming back to the Slovak case, the few cases that the authorities have so far uncovered cannot account for more than a miniscule part of the VAT gap.

How big is the gap?

The most recent authoritative analysis of the VAT tax-gap was made by the Polish institute CASE and partners and presented by the European Commission in September 2013. The analysis shows the VAT gap. This is the difference between tax revenue as it should be collected taking into account tax rules and the economy’s performance on the one hand, and the actually collected amount on the other (Table 1: the EU figure in the table does not include Cyprus, for which there is incomplete data).

Table 1 Source: New study confirms billions lost in VAT gap (European Commission press release)

VAT gap as % of GDP 2011 VAT gap as % of GDP 2000-2011
Czech Republic 2.7 2.1
Hungary 3.7 3.0
Poland 1.5 1.1
Slovakia 4.0 2.9
EU 26 total 1.5 1.2
EU 26 average 2.1 1.6

The study shows that of the V4 countries only Poland has relatively satisfactory rates of VAT collection. In contrast, Slovakia and Hungary are doing very badly (as the underlying study shows, their VAT gaps are among the worst in the EU). The Czech Republic is somewhere in the middle.

In many cases, VAT is uncollected simply because companies have gone more or less legitimately bankrupt. Consequently, they have not forwarded the VAT they collected to the government. Even this is a case for concern, however, as a properly administered and efficient VAT collection mechanism would prevent this from happening. But, and this is even more important, it is impossible for such a large gap to arise purely through bankruptcies. Much of it is due to either tax evasion or other types of tax fraud.

Tax evasion (as opposed to tax avoidance) means illegally not paying taxes. In the case of VAT this often happens because transactions are not registered. A plumber is paid cash-in-hand for a job without issuing a receipt. A retailer sells an item without using the cash register. In this case, the government is defrauded of its revenue.

The more serious cases of tax fraud, however, involve defrauding the government of VAT reimbursements. This means not just not giving the government its due arising out of activities that would take place anyway, but devising activities with the aim of taking money from the government.

From missing trader to carousel fraud

The value-added tax is one of the great French 20th century inventions. It was first introduced in that country in 1954. Since then, VAT has spread to all European countries and many beyond.

Economically, VAT is a rather fair tax that falls ultimately on consumption, but is applied proportionately through the production process. For the government, it has a particularly appealing feature: the tax is collected by the businesses themselves, and simply passed on to the government.

However, ever since the Single Market was completed in 1992, national tax authorities have also found that this system is prone to fraud. Since the EU has free movement of goods but national VAT systems, there is no way of charging VAT on goods and services as they cross borders. Instead, goods and service are imported free of VAT. When they are exported, the exporter is reimbursed the full VAT by the government.

This gives rise to a very simple type of fraud called “acquisition fraud”. A company imports goods, which are VAT-free, and then sells them onto another company, charging it VAT. Then, instead of passing the VAT onto the government, the company disappears.

The only good news is that acquisition fraud is relatively inefficient. First, one must find a counter-party willing to actually buy the imported goods. Second, following the sale and non-payment of VAT, the company closes its doors and the whole fraud ends.

A more effective type of fraud is one called “carousel fraud”. Here, the fraudster controls a chain of companies. After the goods pass through the chain, they are re-exported. The last company in the chain claims a full VAT refund while, in the meantime, the first company in the chain disappears without passing on the VAT. The whole chain is controlled by one group, and the non-payment is its profit.

The goods can then be re-imported, using a different company to start the chain and the whole process is repeated. Sometimes, the transfer happens physically and a truck is moved across borders. However, often it is possible to simply bill the transactions to goods that have just been sitting in a warehouse.

Carousel fraud often happens with goods that are sold in a dynamic, exploding market, where the movement of goods is difficult for the authorities to track. We witnessed this in the mid-2000s, when the most popular conduit for carousel fraud was mobile phones. They still often feature in VAT scams. However, the fraud can be committed with any type of good and almost any service.

A simple carousel fraud is still a relatively straightforward operation. The more sophisticated fraudsters create overlapping flows of goods in a group of practices known as contra-trading. The overlapping transactions can effectively hide the chains used to commit fraud.

All of these different types of fraud are known in EU-speak as Missing Trader Intra-Community (MTIC) fraud. MTIC fraud has exploded in the past decade. In the UK at its peak, the UK government estimated it was losing up to £1.5 billion a year from VAT scams and some put the figure much higher.

Scamming the V4 taxpayer: from scrap metal to sugar

What is the situation in V4 countries? The Polish government is increasingly concerned with the scale of VAT fraud in the country, which involves mobile phones, but also various scrap metal and steel products (easy to hide in Poland’s lively metals trade).

Polish authorities reacted by introducing a so-called reverse-charge system on VAT payments for steel products. Reverse-charge means that the VAT is only billed to the final customer. It was first introduced on a larger scale by the UK government in 2007 to counter the heavy carousel fraud in mobile phones and similar goods at the time. Until recently, imposing reverse-charge VAT had to be approved by the European Commission. However, since July this year, the rules have been eased and national governments are relatively free to impose the mechanism.

Hungary heavily trades in agricultural produce, particularly grain, and this is where a lot of VAT fraud apparently happens. According to some estimates, the government loses around a billion euro a year through carousel fraud. In the Hungarian case, the fraudsters are particularly attracted by its 27% VAT rate, the EU’s highest. The higher the VAT, the higher the profit for the fraudster who absconds with it.

The most high-profile cases in Hungary involved the Europol-assisted January arrests of a gang operating among Hungary, the Czech Republic and Slovakia, stealing VAT on the back of their scrap metal trade. Another high-profile case involved a reimbursement claim for a whopping 12.7 billion forints (€43 million) on a fake sugar deal in June.

The Hungarian government is taking counter-measures. Three years ago it introduced a strict trade partner liability for VAT fraud. Under this arrangement, the authorities could force a company to pay the VAT on behalf of a trading partner, if the authorities can demonstrate that the company in question might have made it easier for the fraudster by improperly filling out paperwork relating to a deal. This is a relatively popular measure used in various forms in other countries, but it is often controversial. The Hungarian law was challenged at the European Court of Justice, which ruled against it, requiring the law to be amended. In another bid to narrow down the room for fraud, the authorities started conducting more physical inspections of goods moving across borders.

The Czech Republic is one of the few countries where VAT collection has actually improved since 2008. The government has been countering VAT fraud relatively aggressively, although not without controversy. It introduced its own version of trade partner VAT liability in 2011. Further, it had planned to introduce a register of “unreliable trading partners” this year, meaning that a company doing business with a subject on the list would be fully liable for any VAT non-payment. But following protests, the government decided not to impose this until the start of 2014. At any rate, the law is being challenged in the courts. Despite the government’s hawkishness, VAT fraud does take place. For example there were several schemes using carbon permit trading (which has recently become a favored fraud method in several countries). For many years, politicians have also considered imposing the blanket use of electronic cash registers (in existence in neighbouring Slovakia), but the heavy administrative impact on businesses has always incited strong lobbying against it.

Slovakia has the biggest VAT problem of the V4. To put this in perspective: if the VAT gap came down to “just” the 1.5 % of GDP that constitutes the EU average, the country would be able to balance its budget. In June 2012, the government did adopt a program for fighting tax fraud with a list of measures. In particular, it toughened requirements for the certification of cash registers (these can be manipulated to delete transactions). The government also changed legislation to require all business transaction over €5,000 to be non-cash. The tax authorities received the power to require suspect companies to put down a cash guarantee.  And as of January 2014, companies will be required to electronically register deals so that the government has near real-time data on VAT flows.

Yet, for a recent article in the local economic weekly Trend, the Slovak authorities freely admitted that they were seriously understaffed and simply could not physically check all suspicious activity even if they wanted to. Recently, and with great fanfare, the government assigned six prosecutors to deal with cases involving tax fraud.

The Slovak government also introduced a “VAT lottery”. Shoppers are encouraged to collect receipts and have them registered for a draw. The idea is that this will encourage people to demand receipts and also that traders will be discouraged for giving out false receipts. The value of this initiative is doubtful, however. The gambling-keen can simply use supermarket receipts to enter the draw while continuing with business as usual, e.g. being charged less by a craftsman or a taxi driver if the transaction is “receiptless”.

Investing in fighting fraud is worth it

The EU has several initiatives to help combat MTIC fraud. Eurocanet is a platform for data-sharing and information requests that should help investigators look into suspicious trade flows across borders. Hercules is a training program to disseminate information and train experts from national authorities. The VAT Information Exchange System allows member states to forward to each other queries regarding companies, and also allows quick checks by companies on any trading partners’ basic registration data.

There is much more in the pipeline as part of the European Commission’s consultations on anti-tax evasion policies. Rules on VAT registration requirements have recently been brought more into harmony. The EU is also creating a network of public officials from member states that should be engaged in close cooperation on tax matters (Eurofisc). Earlier this year, the European Economic and Social Committee proposed a Quick Reaction Mechanism that would allow member states to ask the European Commission for a temporary exemption from EU law where this is needed to fight tax fraud on a serious scale.

These initiatives are useful, but they can at best assist, not replace, the effort required of national authorities to improve tax collection and fight fraud. What can national authorities do on their end? The usual first reaction is to take administrative and technology-based measures: require the extensive use of more sophisticated cash registers (cash registers with fiscal memory, strictly certified); implement reverse charges where possible; impose shared tax liability for trading partners; create registers of unreliable companies; require non-cash transactions; move VAT-forwarding time as close as possible to deal settlement; create an online, real-time database of taxable activities.

A combination of these measures, if properly implemented, can help enormously. Of course, policy design is key. If bad, then these measures can become excessively burdensome for business. Also, it should be noted that some of these measures don’t necessarily deal with fraud, they just change the way different jurisdictions are used for different kinds of transactions.

To properly address VAT fraud, the government must operate at three levels. First, it needs to be able to analyze the available data to see that something is wrong and identify the risk areas. Macroeconomic models help assess the scale of any overall tax gap. Analysis of the flows of goods and services into the country versus VAT reimbursements on goods and services flowing out can help indicate where something might be wrong.

Secondly, efforts to uncover VAT fraud must be backed up by investigative capacities. Especially in the more sophisticated types of VAT fraud, it is often not possible to clearly identify that a fraud is occurring simply by following the goods, rather it is necessary to follow the people organizing the fraud with the use of police techniques.

This is also necessary for the reason that, thirdly, combating VAT fraud requires securing evidence that can lead to effective prosecution and conviction. This is no trivial matter. Many types of VAT fraud are difficult to prove. And vice versa, incorrect procedure can lead to harassment and even convictions of companies that are not really guilty. It is especially tempting for the authorities to abuse shared liability and prosecute a company that might be guilty of administrative mishaps but otherwise is conducting an honest business, whereas the real fraudster has disappeared.

Finally, when it comes to taxation in general, VAT fraud is just one, even though probably the most serious, of the problems. When it comes to personal income tax, the type of oversight seen in Western countries is missing in the East. Wealthy Germans, Brits or Italians need to be able to prove they have spent the customary half a year in Monaco, Andorra, Switzerland or whichever tax haven they have declared as their fiscal home.

This gets even more serious in the US. Many wealthy foreigners who have tried to be trendy and buy a New York apartment or a Florida house have discovered the authorities mercilessly tax them if they overstay their allowed non-domicile term (which is roughly three months, but the rules are more complex than that).

Conclusion

VAT fraud is often a very difficult governance challenge that needs to be tackled by building sophisticated capacities. Conservative paper-checking will have only a limited effect.

And, as always with tax issues, it’s not just about taxes. If entrepreneurs face cumbersome bureaucracy, chaotic legislation and a weak rule of law, they will not play by the rules either. If the government does not strive to make the notional social compact with citizens work, the majority of the society will be apathetic about fraud. So, more repression and more administrative counter-measures will not help. If we really want to get rid of tax gaps, improving overall governance should be our goal.

Juraj Draxler

Juraj Draxler

is Associate Research Fellow at the Brussels-based think-thank CEPS, and lecturer at the Anglo-American University, Prague. He has authored and co-authored several reports contracted by the European Commission on social policy and labour market regulation.