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VAT Fraud and the ‘Should Have Known’ Test: What Every UK Business Needs to Understand

For many UK businesses, fraud is something you expect to find in extreme circumstances — a deliberate lie, an intent to deceive, or a rogue actor within an organisation. Under most areas of English law, you are not considered a participant in fraud unless you’ve acted dishonestly. But when it comes to VAT fraud, the rules are different — and dangerously so.

Under case law rooted in European legal principles, HMRC can treat a business as an accessory to VAT fraud even where there is no evidence of dishonesty. The threshold is much lower: you may be penalised if you “should have known” that fraud was involved, regardless of your intentions.

This principle, and the legal powers it supports, can have severe financial and reputational consequences for businesses — particularly those trading in supply chains vulnerable to missing trader or carousel fraud.

In this article, we outline:

  • How the ‘should have known’ test works
  • What the legal consequences are
  • How businesses can protect themselves
  • What to do if HMRC challenges your VAT position

Fraud and Dishonesty in English Law

Under traditional domestic law, a business can only be considered to have participated in fraud if dishonesty is proven. The test for dishonesty, as clarified in Ivey v Genting Casinos [2017] UKSC 67, has two stages:

  1. Subjective: What did the person actually believe at the time?

  2. Objective: Would an ordinary honest person consider that belief dishonest?

In practice, this means that if a business director genuinely had no reason to suspect wrongdoing — even if they were careless or naïve — they wouldn’t be treated as having acted dishonestly. Negligence alone isn’t enough.

But that standard doesn’t apply in VAT fraud cases.

The ‘Should Have Known’ Test: VAT’s Unique Legal Trap

In the area of VAT law, EU case law continues to shape domestic rules even after Brexit, particularly in supply chain fraud cases.

Two key principles arise from Court of Justice of the European Union (CJEU) judgments:

  1. A business is treated as a knowing participant in VAT fraud if it “knew or should have known” of the fraud.

  2. This applies even where the business has acted honestly — what matters is whether their conduct fell below the level of due diligence expected of a reasonable trader.

The UK courts have since accepted and applied these principles, as confirmed in key judgments such as:

  • HMRC v Citibank NA [2017] EWCA Civ 1416

  • Impact Contracting Solutions Ltd v HMRC [2025] EWCA Civ 623

This approach puts a duty of vigilance on businesses — failure to spot fraud risks or red flags, even inadvertently, can be enough to lose VAT entitlements or face other penalties.

What Are the Consequences?

If HMRC concludes that a business “should have known” it was connected to VAT fraud, two serious consequences follow.

1. Denial of Input VAT (Kittel Principle)

Based on Kittel v Belgium (C-439/04), HMRC can deny input tax deduction even where:

  • VAT invoices are valid
  • The VAT was properly paid to the supplier
  • The taxpayer was unaware of any fraud

If HMRC can show that fraud existed in the supply chain and that your business should have known, they can require you to repay the VAT. This can result in large, unexpected liabilities, especially in high-volume, low-margin industries.

2. Cancellation of VAT Registration (Ablessio Principle)

In more extreme cases, HMRC may cancel a business’s VAT registration under the principles from Ablessio (C-527/11).

The legal effect of this is unclear, as UK law requires VAT-eligible businesses to be registered. However, in practice, deregistration can:

  • Disrupt trading relationships
  • Damage commercial reputation
  • Restrict ability to recover input tax
  • Prevent participation in B2B supply chains that require valid VAT IDs

While relatively rare, the Ablessio power gives HMRC a strong deterrent tool against businesses failing to meet their due diligence obligations.

How Can Businesses Protect Themselves?

The best defence is prevention. HMRC expects businesses to carry out adequate due diligence on their suppliers, customers, and transactions.

Although no checklist is foolproof, good practice includes:

1. Know Your Counterparty

  • Identify the business name, VAT number, and company registration number
  • Verify the identity of directors and shareholders
  • Use public records (e.g., Companies House) to verify legitimacy

2. Trace the Payment Trail

  • Understand who pays you and who you pay
  • Investigate payments made by third parties or unrelated entities
  • Be cautious of discrepancies in bank details or payment instructions

3. Check VAT Registration

  • Confirm the counterparty’s VAT ID is valid and active
  • Be cautious of parties not registered for VAT when they should be

This point was highlighted in Tower Bridge GP Ltd v HMRC [2022] EWCA Civ 998.

4. Stay Alert to Commercial Red Flags

  • Unusually low prices
  • Pressure to pay in cash
  • High-volume transactions from newly formed companies
  • Negative press coverage or adverse history

As highlighted in Harry Construction v HMRC [2025] UKFTT 799, businesses are expected to act on what they could have reasonably discovered.

Defending Against ‘Should Have Known’ Allegations

If HMRC challenges your VAT position based on the ‘should have known’ test, there are key legal points to raise:

1. The Burden Is on HMRC

HMRC must prove that fraud was the only reasonable explanation for the circumstances your business knew or should have known about.

This was reaffirmed in Mobilx v HMRC [2010] EWCA Civ 517, at [60] and [81].

2. A Lack of Due Diligence Is Not Always Enough

While insufficient due diligence is often cited by HMRC, the absence of checks does not automatically equal complicity.

In Red Rose Payroll Ltd v HMRC [2025] UKFTT 878, the Tribunal held that while the business’s checks were lacking, that alone did not prove they should have known about the fraud.

This gives businesses some ground where record-keeping may not be perfect but no red flags were apparent.

3. Proportionality

Even if HMRC can establish the ‘should have known’ threshold, they must act proportionately in applying penalties or sanctions.

In Ablessio cases, cancelling a VAT registration may be disproportionate if:

  • Only a small fraction of transactions were affected
  • The majority of the business is legitimate
  • The impact of deregistration would be commercially devastating

This was discussed further in Impact Contracting Solutions [2025] EWCA Civ 623 at [68]–[71].

Key Takeaways for UK Businesses

  • You don’t need to be dishonest to be implicated in VAT fraud — lack of due diligence can be enough.
  • HMRC can deny input VAT or cancel your registration if you “should have known” about fraudulent activity.
  • The legal standard is high: HMRC must prove fraud was the only reasonable explanation.
  • Businesses should implement clear due diligence processes and maintain documentation.
  • If challenged, seek advice immediately — legal and procedural arguments may apply.

If you’re unsure whether your current VAT compliance or supplier checks are sufficient, or you’ve received correspondence from HMRC relating to Kittel or Ablessio actions, contact Merranti Accounting for specialist support. Our team can help assess your position, strengthen your defences, and engage with HMRC on your behalf.

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