Fabian Barth discusses how the lower threshold that applies for involvement in VAT fraud, recently consolidated in Impact Contracting Solutions, can put even honest traders at risk of suffering severe financial consequences.
Under English law, one does not normally become a participant in a fraud without acting dishonestly. It may therefore come as a surprise to businesses that, with regard to VAT fraud, they may (for some purposes) be treated as an accessory on the mere basis that they ‘should have known’ better.
It is hence prudent for traders to develop awareness; how does one become an accessory in a VAT fraud? What are the potential consequences?
How does one become a participant in fraud under domestic law?
Under domestic law, a person is usually held responsible for participation in a fraud only if some dishonest conduct on their part is established. Assessing whether conduct was dishonest involves a two-stage test, established by the Supreme Court in Ivey v Genting Casinos [2017] UKSC 67. First, one ascertains the subjective state of mind that the person actually had. Second, one asks objectively whether an ordinary and honest person would regard such a mental state as dishonest.
The critical issue here is that the person’s actual knowledge and state of mind is the starting point. Somebody who genuinely develops no suspicion that they are involved in a fraud cannot have acted dishonestly, no matter how foolish or naïve they may appear to an objective and reasonable bystander. That is not to say that a person needs to know for certain that they are involved in a fraud. At the very least, one cannot be “wilfully shutting one's eyes to the obvious” (Baden v Société Générale [1983] BCLC 325). However, it remains the case that pure negligence is by no means sufficient for a finding of dishonesty (Megtian (in administration) v HMRC [2010] EWHC 18 (Ch) at [41] and [42]).
How did case law alter this test for certain VAT purposes?
To a businessperson or indeed anyone else who is used to the English law test, it would perhaps come as a great surprise when they are accused of being an accomplice in a VAT fraud conducted by a supplier or customer purely on the basis that they ‘should have known’.
Imagine the following scenario: Trader T has been an honest trader and taxpayer for some decades. HMRC establishes that T’s supplier F has committed VAT fraud. Now, HMRC claims that T was an accomplice in that fraud. Nobody accuses T of having known about F’s fraud, or that T wilfully shut her eyes to the obvious. All that HMRC can show is that T was negligent, in the sense that if only she had conducted more thorough due diligence of F, she likely would have found out what they were up to.
What would be unthinkable based on domestic law alone in other contexts is now well established law in the field of VAT. The reason is case law from the Court of Justice of the European Union (CJEU), which classifies anyone as an accessory to VAT fraud who ‘knew’ or ‘should have known’of such fraud.
In practice, it is the second limb of that test which may prove dangerous. Crucially, the fulfilment thereof does not require dishonesty at all (HMRC v Citibank NA [2017] EWCA Civ 1416, at [85]). Rather, it “incorporates a duty of due diligence in addition to honesty”, as the Court of Appeal recently emphasised in Impact Contracting Solutions Ltd v HMRC [2025] EWCA Civ 623 at [33].
It follows that a trader accused of being an accomplice in another person’s VAT fraud cannot defend themselves on the basis that nothing in the facts known to them gave reasons for a suspicion of fraud, if their due diligence processes, other inquiries or general vigilance fell below the standard that a reasonable trader would find it prudent to comply with.
What are the potential consequences?
If HMRC can establish that a taxpayer knew or should have known about their involvement in VAT fraud, the law adds two swords to the state’s armoury.
The first and by far most common one is the denial of input tax deduction. So, if a business has paid VAT to a supplier, who in turn committed VAT fraud, and the business should have known so, then HMRC can reclaim any input tax deducted, even where all other substantive and formal conditions were fulfilled. The practical effect is that a taxpayer in this situation is forced to repay to HMRC an amount of VAT they already paid to the fraudstersupplier. The legal basis for this is the CJEU case Kittel (C-439/04) [2005].
The second and more draconian penalty is the cancellation of a trader’s VAT registration. This power was established in the CJEUcase Ablessio (C-527/11) [2013]. It is not quite clear what such a cancellation legally means for a trader who would be obliged by VATA 1994 to be registered and pay VAT. Clearly, as a matter of law, it cannot have the effect of them being disallowed to continue trading. However, in practice, it may result in just that outcome, given that many potential suppliers and customers might refuse to engage with a business without a valid VAT ID.
How can businesses protect themselves?
The most potent prevention against becoming an accessory in a VAT fraud is the conduct of due diligence of business partners. The steps in the HMRC Manual on the VAT Fulfilment House Due Diligence Scheme (FHDDS40100) offer a good starting point and can be read across into other contexts too.
In Red Rose Payroll Ltd v HMRC [2025] UKFTT 878 (TC) the Tribunal at [69] relied on three shortcomings for finding that sufficient due diligence had not been conducted: (i) failure to properly identify the counterparty, its directors and shareholders; (ii) failure to identify who paid the invoice; and (iii) failure to make enquiries why an unrelated third party had remitted funds.
A lack of a valid VAT ID is also an obvious red flag (Tower Bridge GP Ltd v Revenue and Customs [2022] EWCA Civ 998 at [126]).
It is in any event important to bear in mind that there is no conclusive list of steps that will definitely suffice. A business should have known what they can reasonably find out from public sources (Harry Construction v HMRC [2025] UKFTT 799 (TC) at [14]), so it is prudent to ‘keep the radar active’, for example, regarding unusual conduct or negative press reporting.
How can businesses defend themselves?
Where a business is accused of involvement in VAT fraud and HMRC seeks to exercise Kittel or Ablessio powers on the basis that the trader ‘should have known’, the following is worth bearing in mind:
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It is not sufficient for HMRC to show that the business should have known that there might be fraud. Rather, HMRC must establish that the fraud was the only reasonable explanation for the circumstances that were, or should have been, in the taxpayer’s knowledge (Mobilx v HMRC [2010] EWCA Civ 517 at [60]).
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The burden of proof is on HMRC to show that the trader should have known better (Mobilx at [81]).
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Assertions of honesty on the taxpayer’s part, however, are not in and of themselves sufficient.
Accordingly, helpful potential starting points for a defence are: (i) that the facts which indicated fraud could not reasonably have been in the taxpayers’ knowledge; and (ii) that even where they could have been, there would have been a reasonable innocent explanation.
In a particularly useful decision in the First-tier Tribunal, it was even suggested that the absence of proper due diligence itself would not be enough for HMRC to show, even though it would have disclosed information indicating the other party’s fraud (Red Rose Payroll Ltd at [75]). If due diligence alone is not necessarily sufficient, its absence is not necessarily insufficient, so the FTT reasoned. That seems to be a non sequitur, but of course, it is a helpful judicial statement to employ where due diligence processes were insufficient.
Finally, all exercises of Kittel and Ablessio powers must be proportionate, so a final line of defence is to argue that it would be disproportionate in a specific case. In a Kittel case, input tax denial will rarely be disproportionate. But in Ablessio, a deregistration becomes more likely to turn disproportionate the larger the share of affected legitimate business, and the smaller the transactions tainted by fraud. Impact Contracting Solutions contains helpful further guidance in [68] to [71].
Practical tip
The key to not ‘accidentally’ being regarded as an accomplice in a VAT fraud on the basis that one ‘should have known’ better is the documentation of proper supplier and customer due diligence, as well as staying vigilant for any red flags. If one ends up accused nevertheless, a possible defence is to show that there was a reasonable, innocent explanation for whatever one knew or could have known.
