When EU officials established the Emissions Trading Scheme in 2005 to help meet emission reduction requirements under the Kyoto Protocol, tax fraud was the furthest thing from their minds.
Under the ETS, companies in industries like utilities and manufacturing were given limits on how much carbon dioxide they could emit each year. Companies that emitted less than their annual allowance could sell those credits on the market. Companies that exceeded their limits could buy these carbon credits to reduce their emissions and help them meet their targets.
The purpose of this cap-and-trade system was to reduce greenhouse gas emissions by creating a financial incentive for companies to reduce their emissions below allowable limits so they could sell the extra credits. When setting up the system, EU officials agreed that value-added tax (VAT) would be charged on emission trading between parties within the same country, but not on cross-border trading within the EU.
It was a longstanding policy on certain goods to encourage trade among EU member states. Little did they know they had opened the door to a unique form of organized crime — carousel fraud. Elements of fraud
Carousel fraud occurs when a crime ringleader sets up a company (a so-called “missing trader”) that buys goods from suppliers in other countries VAT free, sells them to domestic customers with VAT, then pockets the VAT rather than remitting it to local tax authorities.
Since a missing trader’s objective is to collect as much VAT as possible within a short period, it prefers goods that are expensive and easily transported. From 2006 to 2007, for example, the UK treasury lost billions on carousel fraud involving mobile phones repeatedly bought and sold by organized crime rings with multi-country networks.
After pocketing thousands, sometimes millions, in unpaid VAT, the missing trader disappears. In many cases, the domestic customer that bought the product from the missing trader is also part of the scam. It resells the product to a bogus company in another country, then files for a VAT refund from local tax authorities. That bogus company then sells the product back to the missing trader, and round and round it goes.
Meanwhile, treasuries throughout Europe are losing money not only through tax evasion, but by repaying VAT it never received. A new-and-improved fraud
In the past two years, carbon credits have fallen victim to this type of fraud. A new and largely unregulated market, emissions trading is even more attractive to these criminals because there’s nothing to ship. Carbon credits are bought and sold electronically with the click of a mouse.
In carbon credit fraud, the ringleader sets up a company that registers to trade carbon credits within the ETS. It then buys carbon credits from companies in other EU countries VAT free, sells them to domestic companies with 15 to 25 percent VAT and keeps all the money. The domestic company then trades them to a party in another country and files to reclaim the VAT.
Because these traders are only interested in generating as much trading as possible to get the VAT, they don’t mind buying at high prices and selling at low prices. Their willingness to offer very attractive prices to domestic buyers undercuts the market.
“This kind of trade is hurting bona fide emission traders because missing traders are willing to conclude transactions at a loss,” says Redmar Wolf, a tax partner in Baker & McKenzie’s Amsterdam office. “With that pricing policy, they generate huge trade volume in the blink of an eye.” Government action
In June 2009, France shut down BlueNext, its carbon trading exchange, for two days because of suspected VAT fraud. The volume of carbon trading on BlueNext had risen from 27.2 million tons of carbon to 186 tons in just six months. To stop the fraud, French authorities eliminated VAT on carbon trades
The following month, the Netherlands and the UK also changed their VAT policies after noticing trading surges on their carbon exchanges, Climex in Amsterdam and Climate Spot Exchange in London. Spain, Belgium and Norway also followed suit.
Since then, government authorities have launched investigations across Europe, conducting raids in the UK, Germany, Spain, Norway, Denmark, Belgium, Finland, Netherlands, Portugal, Czech Republic and Cyprus. By May 2010, 62 people had been arrested for carbon-trading fraud.
European authorities estimate that countries across Europe have lost USD 7 billion to carbon trading fraud. Given the severity of the losses, the European Commission adopted a directive
allowing EU members to adopt a “reverse charge” mechanism for carbon trading.
Under a reverse charge, the customer pays the VAT directly to tax authorities. Thus, there is nothing for missing traders to pocket. EU members, however, are not required to adopt this mechanism, so the crime rings could simply move to countries that haven’t implemented it. Challenges ahead
For legitimate emissions traders, VAT fraud will continue to pose significant challenges. Under the European Court of Justice’s Kittel decision, VAT cannot be refunded to a party that knows or should have known its transaction was linked to VAT fraud.
Thus, if a legitimate trader conducts cross-border trades that were later discovered to be part of a crime ring, tax authorities could deny them VAT refunds. It’s also possible that tax authorities will challenge VAT-refunds paid out during the heyday of carbon carousels.
To protect themselves from tax claims, traders must conduct “Know Your Client” checks on trade counterparties to demonstrate they’ve taken all reasonable measures to avoid fraudulent trading activities.
Baker & McKenzie, one of the first law firm to realize what was happening in the carbon markets, is well-versed in the hallmarks of VAT fraud and helping clients implement the checks that various tax authorities recommend to avoid getting caught in the web of carbon trading fraud.
“We are working with tax officials and the bona fide traders to stamp out this VAT fraud,” Wolf says. “Whether the authorities are able to stop it will determine the future of Europe’s cap-and-trade model.”