BLUE SPHERE GLOBAL LIMITED VAT
HIGH COURT WIN

HMRC POLICY OF EXTENDED VERIFICATION
IN DISARRAY

22 May 2009

Leading City lawyers Thomas Cooper successfully appealed the first instance decision of the VAT and Duties Tribunal (“the Tribunal”) refusing repayment of VAT input tax paid by Blue Sphere Global Limited to its supplier on the purchase of mobile telephones.

This appeal was, to use HMRC terminology, a “contra-trading” appeal relating to what is frequently known as carousel fraud.  The contra-trader in this instance was Blue Sphere’s supplier.  In contra-trading appeals there are numerous linear supply chains leading to the contra-trader, where the acquiring trader at the start of some, or all, of these “dirty” chains has imported the goods and then fraudulently failed to account for VAT on the subsequent sale.  Blue Sphere purchased mobile telephones from a contra-trader, which it then exported, in a “clean” supply chain.  It was common ground that there was no tax loss in this clean chain to which Blue Sphere was a direct party, as the VAT had been properly accounted for.  However, the effect of the clean chain is that the net input tax position of the contra-trader in the dirty chain is cancelled by the output VAT in the clean chain.  Therefore the input tax reclaim which the contra-trader had in the dirty chain had moved to Blue Sphere, as the exporter in the clean chain.  For HMRC to legitimately refuse repayment of Blue Sphere’s input tax it must prove that Blue Sphere knew, or ought to have known, of the fraud of the defaulters in the separate dirty chains or of the fraudulent concealment and conduct of the contra-trader.  These are significant evidential burdens which HMRC must satisfy in order to succeed in contra-trading appeals.

The Tribunal found at first instance that Blue Sphere’s transactions with its supplier were sufficient to connect it to the fraudulent evasion of VAT by the defaulting traders in the dirty supply chains.  It also found that Blue Sphere should have known of the fraudulent evasion of VAT in the dirty chains and therefore its right to repayment of VAT was refused.

High Court Appeal

The appeal of Blue Sphere to the Chancery Division of the High Court was heard by Sir Andrew Morritt, Chancellor of the High Court and Senior Chancery Judge.  It was argued for Blue Sphere that the Tribunal had erred in law by refusing its claim for repayment of VAT on the grounds that:

  1. there was no sufficient connection between the fraudulent evasion of VAT and the transactions carried out by Blue Sphere, but even if there was;

  2. Blue Sphere did not have the means of knowledge to justify a conclusion that it should have known of that connection.

In an important decision for Appellants and practitioners in this field the Judge made the following findings:

  1. The dirty and clean chains can be regarded as connected with one another and, if there is a connection in the relevant sense, it does not matter which transaction came first;

  2. Not all parties involved in either chain, although connected, should be liable for any tax loss.  The control mechanism lies in the need for either direct participation in the fraud or sufficient knowledge of the fraud;

  3. The burden of proof is on HMRC to prove that Blue Sphere ought to have known that by its purchases it was participating in transactions connected with the fraudulent evasion of VAT.  It is not for Blue Sphere to prove that it ought not;

  4. It was not sufficient to demonstrate that Blue Sphere was involved in transactions which “might” turn out to have undesirable associations;

  5. HMRC must prove that Blue Sphere ought to have known that the other transactions of its supplier involved the fraudulent evasion of VAT;

  6. An inescapable consequence of contra-trading is that HMRC must prove that the contra-trader was a party to a conspiracy also involving defaulting traders in the dirty supply chains.

Judgment

In reaching his decision the Judge relied on the findings of fact of the Tribunal that there was no conspiracy involving Blue Sphere or its supplier, that the transactions in the dirty chains occurred after the transactions in the clean chains, that Blue Sphere had not been manipulated by a third party and its supplier had been acquitted of fraud.  In the circumstances the relevant question became:

If Blue Sphere’s supplier did not know of the fraud when it happened and was not party to any arrangement that it should happen, how could Blue Sphere have known of any fraud before it happened?

In light of the above question it was found to be axiomatic that no amount of due diligence undertaken by Blue Sphere on its supplier, or customers, could have revealed the existence of a fraud before that fraud had actually occurred.  As Blue Sphere could not have known of the fraud there were no circumstances from which it could properly be concluded that it ought to have known of the fraud.  In the circumstances the Judge found that the Tribunal was wrong to conclude that Blue Sphere ought to have known that by its purchases from its supplier it was participating in transactions connected with the fraudulent evasion of VAT.  The appeal was allowed.

Implications

Practitioners in this area will be extremely pleased with the further clarification provided by the judgment in Blue Sphere, which supports the earlier judgment of Mr Justice Lewison in Livewire Telecom Limited.  The Blue Sphere decision reinforces the requirement for HMRC to prove a causal and evidential link between the exporter in the clean chain and the fraud or frauds.  It is not sufficient for HMRC to rely on Appellants general knowledge of carousel fraud in the industry as a whole.      

Notwithstanding the above the role of due diligence remains vital for Appellants and they must continue to exercise every reasonable check and precaution required of them.  It is also important for Appellants to take active steps to address any issues raised by due diligence and conduct any necessary further investigations.  However, it is clear from Blue Sphere that it must be possible for due diligence to uncover the fraud, or frauds, and thereby form the required causal link.   

The impact of the Blue Sphere judgment on HMRC should not be underestimated, with the government’s policy of subjecting all repayment claims of this nature to the process of extended verification suffering a devastating blow.  The Judge’s comments as to whether it is even appropriate for HMRC to impose a liability for tax on a taxpayer on the basis of ECJ decisions, to which effect has been given by a number of decisions in the Tribunal, will no doubt give HMRC serious cause for concern and this issue may well be the subject of argument in future appeals.

What is certain is that Blue Sphere has done severe damage to HMRC’s approach to these cases and Appellants involved in both contra and linear trading carousel fraud litigation will be very encouraged by this.  However, the complexity of these cases should not be underestimated and it remains absolutely vital that Appellants retain experienced practitioners to represent them in these appeals, otherwise they may severely prejudice their prospects of success.          

On a final note it is said that there are presently over 600 appeals of this nature in the first instance Tribunals, with many progressing to appeal before the High Court.  The potential cost to the Exchequer of meeting all of these repayment claims is estimated at anywhere from £4 billion to, in excess of, £8 billion.  This clearly represents a, potentially, massive financial burden for the government in times where the Exchequer is already seriously depleted.  No doubt this will be a cause for serious concern at the highest levels.   

If you would like to discuss any matters relating to the Blue Sphere decision please contact Nicholas Green or Mark Whelan on 020 7481 8851 / 07816 548 260.