Under the Kittel principle HMRC can refuse a business’s claim to deduct input tax, or to zero rate a supply, where the transaction was connected with fraudulent evasion of VAT and the business knew or should have known of that connection, even if it did not profit from the fraud. The courts have held that “should have known” means the only reasonable explanation for the circumstances of the deal was fraud, and since 16 November 2017 a penalty of 30% of the VAT at stake can follow a denial.

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What is missing trader fraud?

VAT Notice 726, paragraph 2.3, describes missing trader fraud as a scheme in which a missing or defaulting trader deliberately fails to pay the VAT on taxable supplies made in the UK. The goods or services may pass through several intermediaries before reaching an end user or a customer outside the UK, forming what HMRC calls tax loss chains. The fraud depends on businesses that are complicit, prepared to turn a blind eye, or not careful enough about their trading connections.

A common variation is contra trading. HMRC’s VAT Fraud manual at VATF23550 describes a UK trader running two chains in the same VAT period: a tax loss chain where it buys in the UK and exports or sells abroad at the zero rate, claiming input tax, and a contra chain where it buys from abroad and sells in the UK, generating output tax that offsets the repayment claim. The defaulter sits in the first chain, so the contra trader’s own deals can look clean on paper.

The fraud historically centred on high value, easily moved goods such as mobile phones and computer chips, which is why those goods now fall under the domestic reverse charge.

What did the Kittel judgment decide?

The European Court of Justice gave judgment in joined cases C-439/04 and C-440/04, Axel Kittel and Recolta Recycling, on 6 July 2006. HMRC’s manual at VATF52200 quotes the key paragraphs. Traders who take every precaution that could reasonably be required of them to ensure their transactions are not connected with fraud must be able to rely on those transactions without losing the right to deduct (paragraph 51). But a taxable person who knew or should have known that, by its purchase, it was taking part in a transaction connected with fraudulent evasion of VAT must be regarded as a participant in that fraud, whether or not it profited from the resale (paragraph 56), and the national court must refuse the right to deduct (paragraph 61).

VATF52300 breaks the principle into three limbs that HMRC must establish:

  1. Was there fraudulent evasion of VAT?
  2. Was the taxpayer’s transaction connected with that fraudulent evasion?
  3. When it entered the transaction, did the taxpayer know, or should it have known, that the transaction was connected with fraudulent evasion of VAT?

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What does “knew or should have known” mean?

VATF53405 notes that Kittel does not define the phrase but treats it as an objective test. The leading UK authority is the Court of Appeal in Mobilx Ltd (in administration) and others [2010] EWCA Civ 517, quoted at VATF53420. The court rejected both a narrow reading (only where the trader should have known its transaction was connected with fraud) and HMRC’s wider argument (that it was enough that fraud was more likely than not). It held that a trader should be treated as a participant where it should have known that the only reasonable explanation for the circumstances in which its purchase took place was that the transaction was connected with fraud.

VATF53425 stresses that the only reasonable explanation does not mean there is no other explanation, just that no other explanation is reasonable and credible on the evidence. A trader that has the means of knowledge but chooses not to use them, or ignores obvious inferences, is in the same position as one that knew (Mobilx, paragraph 61, quoted at VATF75000).

What does “connected with” fraud mean?

VATF53305 says the transaction must be in a direct or linked supply chain containing a fraudulent tax loss, wherever in the chain the taxpayer’s transaction sits. Mobilx confirmed that a transaction can be connected with fraud even where the loss arises in a different chain, as in contra trading, because offsetting inputs against outputs links the chains. It does not need to be the trader’s own supplier that went missing.

What due diligence does HMRC expect?

Notice 726 accepts there is no definitive checklist, because a fixed list would simply let fraudsters satisfy it (paragraph 4.6). HMRC expects checks proportionate to the risk in the sector, and asks you to consider the type and level of checks, the nature of the supply, payment arrangements and the movement of goods (paragraph 4.5). Section 6 groups the questions into three areas:

  • Legitimacy of the counterparty, such as trading history, whether a supplier also introduces a ready buyer for the same quantity, deals with no commercial risk, predetermined margins, and requests for third party or offshore payments.
  • Commercial viability, such as whether a real market exists, whether prices are negotiated normally, and how the deal is financed.
  • Viability of the goods, such as whether they exist, are in good condition, are in credible quantities, and whether the supplier will provide serial numbers.

Practical steps listed at paragraph 6.2 include obtaining incorporation and VAT registration certificates, verifying VAT numbers with HMRC, getting signed trade references and independent credit checks, meeting a senior officer and visiting premises, and checking bank details for third party payments. Paragraph 6.3 says HMRC focuses most on what you did in response to the results.

Due diligence is not a safe harbour. In Mobilx the Court of Appeal warned that focusing on due diligence can deflect a tribunal from the real question, and a trader that asked the right questions still cannot ignore circumstances whose only reasonable explanation is fraud (paragraph 82, quoted at VATF75000). The High Court added that all reasonable precautions may sometimes mean ceasing to trade in a particular way.

What warning signs suggest a deal is too good to be true?

VATF53425 lists indicators that point towards fraud as the only reasonable explanation, including:

  • unsolicited approaches from businesses with little or no history in the market offering guaranteed profit on high value deals;
  • repeat deals at the same or lower price with a consistent profit;
  • unsecured loans at unrealistic rates of interest;
  • instructions to pay third parties or offshore accounts, often for less than the full price.

VATF53430 adds that HMRC will gather evidence of the trader’s general awareness of fraud in its market, such as press coverage, HMRC warnings, trade body involvement and earlier notifications that its deals traced back to tax losses. Under the reverse charge procedure, Notice 735 paragraph 8.6 warns that a customer failing to tell its supplier the reverse charge should apply will be viewed as suspicious.

What penalties and other liabilities can follow?

Section 69C of the VAT Act 1994 imposes a penalty where a person entered into a transaction connected with fraudulent evasion of VAT by another person, knew or should have known of that connection, and HMRC has issued a denial decision applying Kittel or Mecsek (case C-273/11, denial of the zero rate). The penalty is 30% of the potential lost VAT and cannot be assessed more than two years after the denial decision. VATF45140 confirms it applies to transactions entered into on or after 16 November 2017 and that a company’s penalty may be attributed to responsible officers.

Separately, section 77A makes a business jointly and severally liable for VAT unpaid elsewhere in a chain of specified electronic goods if it knew or had reasonable grounds to suspect the VAT would go unpaid. Notice 726 says buying below the lowest open market value, or below a previous supplier’s price, raises a rebuttable presumption of reasonable grounds. HMRC sends a notification letter, you have 21 days to respond, and a notice of liability can be appealed to the tribunal within 30 days (paragraphs 4.2 and 5.1). See statutory review and the tax tribunal.

How does a denial work in practice?

Illustration only. A wholesaler buys goods for £100,000 plus VAT of £20,000 from a recently formed supplier, then sells them to an overseas customer at the zero rate and claims a £20,000 repayment. HMRC traces the chain to a defaulter that never paid its VAT. If HMRC proves all three Kittel limbs, it refuses the £20,000 input tax and can assess a section 69C penalty of £6,000. The wholesaler bears the loss even though it paid its supplier in full.

Denials typically arise from an HMRC VAT compliance check into repayment claims. Kittel is a civil denial of a VAT right and is distinct from criminal prosecution or a COP9 investigation, although the same facts can lead to both. HMRC must prove its case on the balance of probabilities, as the Court of Appeal confirmed in Mobilx.

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Reviewed by Christine Anderson, Broker, Solar Protect. Last reviewed 8 October 2026. Part of Accountapedia, the Solar Protect guide to UK tax and accounting. This page is general information, not personalised advice.