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EU VAT fraud part 3

Tax criminals employ a number of intricate schemes, some of which have been discovered and prosecuted. This third instalment in a five-part series looks at how the schemes work and at estimates of how much they are costing EU governments.

VAT fraud takes many different forms. ‘Black economy’ transactions are common as are straightforward frauds such as filling false claims and making unauthorised deductions. There are, however, a couple types of fraud that prey on the weaknesses of the transitional-systems’ treatment of cross-border trade. Although they are quantitatively less important than within-nation fraud, they attract a lot of attention. Tax fraud caused by EU leaders’ inability to cooperate makes much more exciting news than old-fashioned tax cheats (modulo elected officials and rock stars).

VAT fraud – ‘Missing trader’ and ‘Carousel’ frauds

The transitional system unintentionally disrupted part of the VAT system’s powerful self-enforcing mechanism. When a €1m shipment of cell phones leaves Germany, the German government writes the exporter a cheque for all the VAT paid on the supplies the exporter purchased – a cheque that could easily amount to €150,000. The importing company in, say, France, is responsible for collecting the 22% French VAT on the full value of its onward sales of the phone. Suppose the French firm charges a 10% mark-up and sells the phones for €1.1m in France. In doing so, it collects €242,000 of VAT from its customer. The €242,000 are supposed to be handed over to the French tax authorities, but the importing company can take the money and run by going bankrupt before the French tax authorities come calling. This is called the ‘missing trader’ fraud; the VAT has been paid to a company that has gone missing.

Notice that the German tax rebate in this example was not critical in qualitative terms, only quantitative terms. The same sort of missing trader fraud could (and does) go on inside Germany, but for domestic cases, the missing trader would have already paid VAT on their supplies, so the fraudster’s net gain would only be the VAT on its slice of the value-added chain. The importing company in our example, by contrast, paid no VAT on its supplies; in essence it collects the VAT due on all previous stages of production. Under the transitional system, the first trader in France takes over the role that used to be played by the uniformed officials in the border posts before 1993. This delegation of tax-collecting authority is the ultimate source of the incentives to commit VAT fraud. Since it is also one of the main advantages of the VAT, even a near-perfect VAT system in a near-perfect world would be subject to some fraud.

The so-called ‘carousel fraud’ takes the missing trader fraud to a higher level. An international gang of white-collar criminals owns the exporting firm in Germany and the UK company that went out of business. It also owns the UK-based firm that bought the goods from the now-missing trader. This second UK company proceeds to export the goods to Germany and receives a large cheque from Her Majesty’s Revenue and Customs to compensate it for the VAT that it paid to the missing trader. The gang then sells the goods to another German-based company that it owns, so the goods acquire a German VAT liability that the German VAT authorities will rebate when the goods are once again exported to Britain. In this manner, the goods turn around and around like a carousel. It works especially well in nations where it is quick and easy to set up new firms. A 1998 Commission estimate suggested that the average amount involved in detected carousel frauds was €2m per case.

This example is only the simplest possible one. Real criminals are using far more devious and complex schemes to outwit VAT tax collectors in a classic ‘cops-and-robbers’ sequence of criminal innovations and official reaction. For example, these scams increasingly involve services whose delivery is hard to verify, as well as third-nations. One scam that has been prosecuted involves the carousel goods being exported to Dubai so as to break the trail of invoices. Cell phones and computer chips, with their high-value-to-weight ratio, were used in many of the schemes prosecuted to date.

How big is the problem?

As early as the mid-1990s, problems of VAT fraud were recognised. Measures were taken to improve the system, but these were akin to treating a broken leg with antibiotics – it might have done some good, but it didn’t address the core problem. A European Commission report to the Council and European Parliament in 2000 used unusually blunt language:

“The transitional VAT arrangements have been in place for more than 6 years. During this period, one would have expected that the implementing problems should have been solved and that the system should be running smoothly. However, this does not appear to be the case. The 6 years appear to have given the fraudsters time to appreciate the possibilities offered by the transitional VAT arrangements to make money, while, generally speaking, Member States have not met the challenge posed by fraud. …There are indications that the level of serious fraud in intra-Community trade is growing.”

As always with illegal activity, especially white-collar crime like this, it is hard to estimate the losses. Tax authorities in EU member states are reluctant to estimate the losses. Austria and Germany, who recently asked the Commission for permission to deviate from the ‘transitional system,’ provided estimates as part of their requests. Austria gauged its overall losses at 4.4% of VAT revenue, but did not have an estimate of the proportion of this which was due to missing trader and carousel fraud. Germany estimated that the missing-trader type frauds cost it 2% of its VAT receipts. The British Institute for Fiscal Studies reports that VAT fraud cost the Exchequer £12.4 billion in the 2005-2006 fiscal year (14.5% of the potential VAT take), but missing trader and carousel frauds account for less than a quarter of this. A 2007 report by the International VAT Association provides the widely-quoted estimate of €100 billion. In April 2007, the Commission informally estimated the loss from all VAT fraud at up to €250 billion annually, basing this figure on ‘received wisdom’ estimates in the public finance literature that tax-fraud amounts to between 2% and 2.5% of GDP.

An entirely different approach to estimating the problem comes from trade data. In today’s borderless Europe, trade statistics are gathered by VAT authorities. The claims for export rebates are the source of the export figures, and the reported imports are the source of import statistics. If cross-border fraud occurs, especially of the false-export type, it may show up as a mismatch between exports reported by the exporting country’s VAT authority and imports reported by the importing nation’s VAT authority. This gap is huge – so large in the case of the UK that it had to restate its national accounts in 2003. The revisions involved upward adjustments to imports of £11.1 billion in 2002 (about 5% of total imports).

In short, we are talking real money. The fraud due to a lack of coordination among EU members costs member states about as much as the EU itself -- the entire 2006 EU budget was only €120 billion. The next instalment presents a way to organising thinking on the various solutions to the problem.


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