Kittel v Belgian State (C-439/04), and Recolta Recycling (C-440/04)

The authority behind every MTIC and VAT fraud input tax denial in the United Kingdom. Kittel draws the line between the innocent trader, whose right to deduct is protected, and the trader who knew or should have known that his purchase was connected with fraud, who loses it, whether or not he profited and whether or not he was dishonest.

Why This Case Dominates VAT Fraud Litigation

The Kittel principle is the mechanism by which HMRC denies input tax to businesses that were not themselves the fraudsters. It is the foundation of every missing trader intra-community (MTIC), and carousel fraud denial, and it has since spread far beyond electronics and carbon credits into labour supply, construction, telecoms, fuel and scrap metal. A Kittel denial is not a penalty and requires no dishonesty on the taxpayer’s part, only that the taxpayer should have known. That is what makes it so dangerous, and so widely used.

Although the United Kingdom has left the European Union, Kittel remains part of retained and assimilated law and continues to be applied by the tribunals and courts in its domestic form as developed in Mobilx.

The Facts of the Two Joined Cases

Case C-439/04: Kittel (the guilty trader)

Computime Belgium SA traded in computer components. It purchased goods in Belgium and resold them, principally to customers in other Member States. Its supplies formed part of a classic carousel: a chain in which one participant (the “missing trader”) charged VAT on its sales, went missing without accounting for it to the tax authority, while traders further down the chain reclaimed the corresponding input tax. The Belgian authorities found that Computime knew it was participating in that arrangement. Mr Axel Kittel acted in the proceedings as the administrator in the company’s insolvency.

Case C-440/04: Recolta Recycling (the innocent trader)

Recolta Recycling SPRL bought sixteen luxury vehicles from a Mr Ailliaud, who had himself acquired them from another company. Recolta then sold them on for export. Mr Ailliaud never paid the VAT he had charged. Critically, the Belgian court found that Recolta had no knowledge whatever of the fraud and no reason to suspect it.

The Belgian State nevertheless sought to deny Recolta its input tax deduction, relying on a rule of Belgian civil law: a contract with an unlawful cause is void ab initio, and if there was no valid contract there was no supply and therefore nothing to deduct.

The Questions Referred

1. Where a supply is made to a taxable person who contracted in good faith without knowledge of fraud committed by the seller, does the nullity of the contract under national law deprive that person of the right to deduct?
2. Is the answer different where the nullity arises from fraudulent evasion of VAT specifically, rather than some other unlawful cause?
3. What is the position where the taxable person did know, or should have known, that by his purchase he was participating in a transaction connected with fraud?

The Legal Framework and the Prior Authority

The relevant provisions were Articles 2(1), 4(1), and (2), and 17(2)(a) of the Sixth VAT Directive (77/388/EEC), now Articles 2, 9 and 168 of the Principal VAT Directive (2006/112/EC), and in domestic law ss24–26 VATA 1994.

Optigen Ltd, Fulcrum Electronics Ltd and Bond House Systems Ltd (C-354/03, C-355/03 and C-484/03)

Decided six months before Kittel, this is the indispensable companion. The Court held that whether a transaction constitutes a supply for consideration by a taxable person acting as such is to be determined by reference to objective criteria, considering the transaction in isolation. The fraudulent intention of another participant elsewhere in the chain, of which the trader is unaware, does not alter that character. An innocent trader’s right to deduct therefore survives, and is not affected by whether VAT was paid at some other point in the chain.

Optigen gave the innocent trader almost complete protection. Kittel then supplied the limiting principle.

Halifax plc v Customs and Excise Commissioners (C-255/02)

Decided in February 2006, Halifax established that Community law cannot be relied on for abusive ends and that transactions whose essential aim is a tax advantage contrary to the purpose of the provisions may be redefined. Kittel draws on the same underlying principle (that the Directive’s rights are not available to those who invoke them fraudulently or abusively), but the two doctrines are distinct and should not be conflated. Halifax is about artificiality; Kittel is about connection with fraud.

Federation of Technological Industries (C-384/04)

Also decided in 2006, this case upheld domestic joint and several liability provisions against traders who knew or had reasonable grounds to suspect that VAT would go unpaid, while insisting that such measures respect legal certainty and proportionality. It supplies the proportionality frame within which Kittel operates.

The Ruling, the Operative Principle

The operative part

The Court answered the questions in two limbs.

First limb. The innocent trader is protected. Where a supply is made to a taxable person who did not and could not know that the transaction concerned was connected with fraud committed by the seller, Article 17 of the Sixth Directive precludes a rule of national law under which the nullity of the contract of sale, by virtue of a civil law provision rendering the contract void as contrary to public policy for unlawful basis attributable to the seller, causes that taxable person to lose the right to deduct. It is immaterial whether the nullity results from evasion of VAT or from some other fraud.

Second limb: the knowing or negligent trader is not. Where it is ascertained, having regard to objective factors, that the supply is to a taxable person who knew or should have known that, by his purchase, he was participating in a transaction connected with fraudulent evasion of VAT, it is for the national court to refuse that taxable person entitlement to the right to deduct.

The reasoning that supports it

Two propositions in the recitals carry the weight of the principle:

• The accomplice rationale. A taxable person who knew or should have known that by his purchase he was taking part in a transaction connected with fraudulent evasion of VAT must be regarded, for the purposes of the Directive, as a participant in that fraud, irrespective of whether or not he profited from the resale of the goods. In such a situation the taxable person aids the perpetrators of the fraud and becomes their accomplice.
• The due diligence guarantee. Traders who take every precaution which could reasonably be required of them to ensure that their transactions are not connected with fraud must be able to rely on the legality of those transactions without the risk of losing their right to deduct input VAT.

The second of these is the practitioner’s foothold. It converts due diligence from a matter of good commercial hygiene into a legal defence, and it is the reason contemporaneous, documented checking is the single most valuable evidence in a Kittel appeal.

Passages Beyond the Ruling, and What They Have Been Used For

• “Irrespective of whether or not he profited.” Not required by the questions referred, but heavily relied on by HMRC to defeat the common submission that a trader earning an ordinary commercial margin cannot have been a participant. The absence of an abnormal profit is evidentially relevant but not an answer.
• “Becomes their accomplice.” Language of complicity in a judgment about a civil right of deduction. It is rhetorical rather than operative, a Kittel denial requires no dishonesty and is not a finding of criminality, but it is regularly deployed to colour the tribunal’s view of a “should have known” case. Advisers should be alert to the distinction and press it.
• The precautions passage. The Court did not define what precautions are “reasonably required”, and deliberately left that to national courts. Two decades of UK litigation have been spent filling that gap.

How Kittel Was Domesticated: Mobilx and After

Mobilx Ltd (in administration) v HMRC [2010] EWCA Civ 517

The single most important UK authority on Kittel. Moses LJ made four points that govern every case:

1. The test is not “means of knowledge”. HMRC had argued for a broader test based on whether the trader had the means of knowing. The Court rejected it. The question is whether the trader knew or should have known.
2. “Should have known” has a demanding meaning. A trader should have known where the only reasonable explanation for the circumstances in which the transaction took place was that it was connected to fraud. It is not enough that the trader should have known there was a risk of fraud, or that fraud was more likely than not.
3. The connection must be to fraudulent evasion of VAT, not merely to some general irregularity or to a fraud of another kind.
4. The tribunal must look at the totality of the circumstances, but must not substitute an impressionistic conclusion for the statutory question.

The supporting line of authority

• Red 12 Trading Ltd v HMRC [2009] EWHC 2563 (Ch). Christopher Clarke J held that individual transactions must be viewed in the context of the whole, and that a tribunal is entitled to look at the surrounding circumstances rather than examining each deal in isolation. Frequently cited by HMRC.
• Megtian Ltd (in administration) v HMRC [2010] EWHC 18 (Ch). Briggs J distinguished between different types of orchestrated fraud and held that a trader need not know the precise mechanics; it is enough that the trader should have known of a connection to fraudulent evasion.
• Fonecomp Ltd v HMRC [2015] EWCA Civ 39. Confirms that the trader need not know the identity of the defaulting trader or the details of the fraudulent scheme. Knowledge that the transaction is connected to a fraud suffices.
• Davis & Dann Ltd v HMRC [2016] EWCA Civ 142. A rare taxpayer success in the Court of Appeal, emphasising that the tribunal must stand back and consider the totality rather than accumulating individual adverse indicators, and that the commercial reality of the trade matters.
• Italmoda (C-131/13, C-163/13 and C-164/13). The CJEU extended the principle beyond deduction to the exemption and refund of VAT on intra-Community supplies, and held that national authorities must refuse those rights even in the absence of specific implementing provisions.

Burden and Standard of Proof

The burden of proving that the taxpayer knew or should have known rests squarely on HMRC, to the ordinary civil standard of the balance of probabilities. HMRC must prove three things:

1. that there was a fraudulent evasion of VAT somewhere in the chain;
2. that the appellant’s transactions were connected to that evasion; and
3. that the appellant knew or should have known of that connection.

Each limb is separately contestable. In practice the first two are often established by HMRC’s deal chain analysis, and the contest is on the third. But the first limb should never be conceded: HMRC must actually prove the defaulter’s fraud, and deal chain evidence is sometimes thinner than the schedule makes it look.

Practitioner Application

Defending a Kittel denial

• Interrogate the deal chains. Ask for the underlying evidence of the alleged defaulter’s fraud, not just HMRC’s summary schedule. Missing links, assumed connections and reliance on other traders’ unproven conduct are all attackable.
• Build the contemporaneous due diligence record. The Kittel guarantee protects the trader who took every precaution reasonably required. What matters is what was done at the time and recorded (VAT number verification, company searches, trading history, insurance, inspection of goods, credit checks), not what could have been done in hindsight.
• Hold HMRC to the Mobilx standard. HMRC officers frequently plead a case that amounts to “the appellant should have been suspicious”. That is not the test. The only reasonable explanation for the circumstances must have been a connection with fraud.
• Use Davis & Dann. Where HMRC’s case is a list of individually minor features, argue that the tribunal must stand back and assess the totality, including the genuine commercial rationale for the trade.
• Watch for the extended verification trap. HMRC frequently withholds repayment during extended verification for long periods. Consider whether the delay is itself challengeable, and the cash flow consequences for the business, at an early stage.
• Separate Kittel from penalties and PLNs. A Kittel denial is not a penalty and carries no behaviour finding. If HMRC also seeks a Schedule 24 penalty or a personal liability notice against a director, those require separate proof of deliberate conduct and should be resisted independently.

Frequently Asked Questions