Tax fraud crisis: Innovators needed

Organized crime is assaulting national treasuries around the globe. CFEs could advocate for new laws that would make excise and value-added tax fraud harder to commit and easier to detect and prosecute. Learn how groups of tax cheats are stealing billions and how researchers and fraud fighters are finding new ways to beat them.

A “giant sucking sound,” warned U.S. presidential candidate Ross Perot in 1992, would accompany the flight of American jobs to Mexico under the North American Free Trade Agreement (NAFTA). Though that never quite happened, today that fearsome metaphor heralds the massive theft of excise and value-added tax (VAT) revenues, mostly by organized crime groups. Their frauds make it even harder for the still-struggling American and European economies to fully recover from the global financial crisis. For CFEs, this crisis is a summons to speak out as thought leaders.

CFEs’ advocacy could help spur action by the governments of the European Union (EU) and its member states and by U.S. federal and state governments. As this article’s interviews with tax fraud-fighters reveal, new laws are urgently needed to make tax fraud harder to commit and easier to detect and prosecute. These fraud fighters’ insights make a strong case for more funding of research, technology, staffing and other resources to beat back organized crime’s assault on national treasuries and the citizens whose contributions finance them.

DIAGNOSIS AND CURE

In the EU, VAT fraudsters steal €100 billion annually in fictitious transactions involving most goods and services, says Europol, the EU’s law enforcement agency. (See p. 52 of the “Europol Review” PDF released by the European Police Office.) In the U.S., the picture is no brighter. There, federal, state and local governments collect excise taxes on products such as tobacco, alcohol and motor fuel and on some services, including communications and transportation. It’s difficult to pinpoint how much fraudsters evade in all such U.S. taxes annually. But for merely one class of taxable items — tobacco-related products — $5 billion to $10 billion in excise levies goes unpaid each year as a result of cigarette smuggling and other fraud schemes, says the Justice Department’s Bureau of Alcohol, Tobacco, Firearms and Explosives (ATF).

Taxing authorities, law enforcement and fraud examiners therefore need more flexible and responsive laws, tools and techniques for conducting audits and investigations and tracking taxable goods and services from origin to consumption. Fortunately, innovative approaches and technology are making it easier to mitigate such frauds. But despite the urgent need, countries on both sides of the Atlantic are frustratingly slow to adopt and implement these innovations. CFEs can help by familiarizing themselves with these resources and spreading word of their benefits.

Just how do the latest methods work in actual practice? Fraud Magazine found out by speaking with law enforcement professionals and tax specialists fighting these frauds in the U.S., Europe and Africa. Before discussing their recommendations, though, it’s important to define two key terms.

WHICH IS WHICH?

Excise tax and VAT both are sales taxes collected more than once as an item flows along the supply chain. But an item is never excise-taxed more than once under the same tax jurisdiction.

The U.S. is one of few nations that don’t have a national consumption tax, such as a VAT. When a U.S. cigarette manufacturer, for example, sells to a wholesaler, the manufacturer pays federal excise tax on the sale. And when a retailer buys cigarettes from the wholesaler, the retailer pays state and local excise taxes, which it recovers by adding an equal amount to the price it charges a retail customer. (See Figure 1, “U.S. Legal Tobacco Supply Chain” below.) Note that the state/local excise tax system is separate from its federal counterpart. Each excise system taxes an item only once.

Figure 1: U.S. legal tobacco supply chain

Conversely, under the EU’s VAT system, which applies to all its member states, a single item moving from raw material supplier to manufacturer to wholesaler to retailer to consumer is VAT-taxed with each transaction. Everyone may apply for — and some will get — a refund of VAT they paid. (VAT fraud most often consists of asking the government to reimburse you for VAT you never paid; it works astonishingly well and can be hard to distinguish from legitimate claims for a refund.)

All VAT levies are applied within a single tax system. Thus, it’s easier to create and share data about each transaction. This makes it possible to track the source and movement of traded goods and services, whether tangible (e.g., computer chips) or intangible (e.g., carbon emission credits). However, the EU’s member states haven’t yet agreed on a methodology for creating and sharing data on transactions and taxes. Once they do, detection of VAT fraud will be easier, if not simple.

The U.S.’s federal and state governments, to mitigate cigarette smuggling and counterfeiting, will have to unify their excise tax systems or, at least, make them more alike — as in a single, national VAT system — before they can streamline tax data creation and sharing to facilitate enforcement and fraud detection. Because of the enormity of that undertaking, an incremental approach to implementation — for example, beginning in only one industry — might sooner prove its value by earning a positive return on investment.

DOUBLE WHAMMY

EU and U.S. governments and tax strategists are striving to reduce tax evasion. However, substantive progress is particularly slow in advanced economies, says Goran Todorov, a consultant in Belgrade, Serbia. He advises governments, retail equipment manufacturers and point-of-sale (POS) software developers on the design and implementation of invoicing and sales data systems. Todorov also manages a certified invoicing system for the Revenue Authority of the East African nation of Rwanda.

Todorov and his research colleague, Richard T. Ainsworth, LLM, director of the Graduate Tax Program at Boston (Mass.) University School of Law, have conducted practical research on how revised, unified tax systems and relatively inexpensive technology can help governments fight tax fraud. Ainsworth independently advises the federal and state governments in the U.S. on such matters, and later in this article he offers recommendations specific to stemming the tide of sales tax evasion in America and Europe.

“Effective technology is available,” Todorov says. “But in developed countries, government sometimes lacks the determination to make changes and implement the technology.” Third-world countries, in contrast, usually are desperate to increase their domestic revenue and reduce dependence on foreign aid, he adds. That increases their willingness to adopt new anti-tax fraud technologies.

For example, in 2012, the Rwanda Revenue Authority (RRA) began requiring that each small- and medium-sized enterprise use an Electronic Billing Machine (EBM) — a networked cash register certified as an invoicing (that is, receipt-producing) system. (See “Electronic Billing Machine” by the Rwanda Revenue Authority.) Such businesses had been responsible for much of the country’s tax evasion. Owners would sometimes intentionally fail to “ring up” sales and would neither issue receipts nor report the sales to the government. But they would still collect VAT from their customers. RRA is phasing in the EBM for other taxable entities. The government expects this will greatly increase tax revenue much needed to improve infrastructure and social services.

“A government-certified, tamper-proof POS system that issues detailed, digitally signed invoices or receipts discourages under-reporting of sales income, smuggling and other tax evasion schemes,” Todorov says.
 

Figure 2: A digitally signed VAT receipt from an Electronic Billing Machine certified by the Rwanda Revenue Authority (highlighting added).

And that’s just what Rwanda’s new technology does. Each EBM contains a Certified Invoicing System (CIS) and a Sales Data Controller (SDC). Any electronic cash register can serve as a CIS, provided RRA certifies it. An EBM can issue a receipt only when connected to an SDC, a hardware device installed in the EBM. The SDC records every transaction the CIS communicates to it. When the SDC receives transactional information, it allows the EBM to print a digitally signed receipt. (See Figure 2 at left.) Thus, a unique traceable record exists for every sale, whose details are electronically recorded and transmitted to RRA for auditing. A tax inspector, armed with a handheld electronic device, can inspect an EBM’s digital signature and detect any tampering that might indicate owner-perpetrated skimming to evade sales and income taxes.

If other rapid advances Rwanda has made over the last 10 years are any indicator, its new system will pay for itself many times over. After a horrific civil war in the 1990s, Rwanda has in recent years ratified a new constitution, held elections and racked up impressive ratings from the World Bank and others. When compared to the U.S. and the EU’s 28 member states on ease of paying taxes, Rwanda ranked sixth, far ahead of the U.S. and three-quarters of EU members. (See “Doing Business Economy Rankings 2012” by The World Bank. Note: The World Bank ranked 185 nations on this measure, with Rwanda placing 52nd. But relative to only the U.S. and EU, Rwanda ranked sixth.) And Transparency International gave Rwanda a higher anti-corruption rating than four EU member states. 

EU UNMERRY-GO-ROUND

The VAT evasion scheme ravaging the EU is known by two names. Its formal nomenclature is Missing Trader, Intra-Community (MTIC) fraud, reflecting both the predominantly intra-EU nature of the scheme and the functional identity of one party to the fraud — a company, or trader, which, after collecting VAT from another company on behalf of the government, vanishes without remitting the VAT funds to the taxing authority.

Of course, while the missing trader has stolen the VAT it collected from its customer — its co-conspirator in the fraud — the tax authority doesn’t suffer its loss until further down the transaction chain. That happens when another participant in the scheme — a company that has good reason to not disappear — fraudulently claims a real refund from the government for the non-existent VAT collected by its conspirator — the missing trader. When the government honors the refund claim, the fraud is consummated. In sum, the fraudsters have made little or no VAT payments, and the government has issued a large VAT refund.

While such claims are fraudulent, legitimate refunds are a normal and frequent occurrence in the VAT system. Because the scheme works so well, fraudsters repeat it over and over, producing extended circular transaction chains that gave rise to the term carousel fraud.

Europol, in its 2012 summary of crime in the EU, confirmed that such fraudulent requests for refunds of VAT never paid to the government had cost the Union €106.7 billion in 2006. Europol also reported that despite great efforts since then, annual EU VAT fraud losses had declined only slightly to a still-appalling €100 billion (est.) in 2011. Unfortunately, with current laws and the technology in use, investigators can distinguish fraudulent transactions from legitimate ones only through large investments of very scarce resources.

EU governments — short-staffed and legally required to keep refunds flowing to legitimate taxpayers — sometimes take so long to inquire about suspicious claims that it’s too late to recoup any losses or apprehend the fraudsters, who often are members of organized crime groups (OCGs).

FraudTrack, a 2013 research report by the London office of international accountancy and business advisory firm BDO LLP, concludes the U.K.’s high level of VAT fraud is “a function of a significantly under-resourced HMRC [Her Majesty’s Revenue & Customs, Britain’s national taxing authority].” However, as EU fraud statistics show, other member states are little or no better at reducing VAT fraud.

WANTED: RESOURCES AND TRUST

Carl Watson, CFE, who spent several years investigating VAT fraud as a higher officer with HMRC, explains how fraudsters take advantage of VAT’s poor controls. (Watson is now a fraud specialist with ChantreyVellacott DFK, an accounting, taxation and advisory firm headquartered in London.)

“Most carousel fraud is the work of gangs spread across several countries under sophisticated international leadership,” Watson says. “By controlling shell companies that pose as legitimate shippers, buyers and sellers, they create convincing-looking transaction chains in support of their co-conspirators’ phony VAT refund claims.”

According to Europol’s 2013 Serious and Organised Crime Threat Assessment (SOCTA), approximately 3,600 OCGs are active in the EU. Seventy percent draw members from multiple nations, and 30 percent specialize in several types of crime, especially carousel fraud and its consequence — money laundering. Ominously, SOCTA warns of OCGs’ fast-growing use of legitimate business structures and advanced telecommunications.

“The red flags are there to be recognized,” Watson says. “People rent a small office for a new business and register for VAT. Two months later, they claim to have traded £100 million worth of goods. If they were legitimate, these guys would be on the covers of business magazines. But proving such frauds takes resources. Even before the financial crisis there just weren’t enough law enforcement officers.”

HMRC officers, however, in spite of being outnumbered, use their analytical skills to find telltale inconsistencies in the otherwise realistic transaction chains that gangs fabricate to support their fraudulent VAT refund claims. In one such case, solved during Watson’s tenure at HMRC, an officer reviewing a series of 5,700 transactions among trader companies in Belgium, Spain and the U.K. noticed that many involved newly released smartphones manufactured in Japan and South Korea.

According to statements that gang members made to HMRC, they imported the phones for sale in the U.K. But when the officer researched the phones in question, he found that neither manufacturer had released its model for sale anywhere in Europe. The fraudsters, however, had reported paying VAT on them and received a £176 million refund for VAT they supposedly had paid to legitimate traders, who in fact were their co-conspirators. The astute officer’s discovery led to the gang’s arrest, conviction and imprisonment in 2012; the leader received a 17-year sentence, and the government seized the fraudsters’ assets. Despite such investigative triumphs, however, law enforcement and tax authorities face a variety of factors that hinder their effectiveness.

Watson, in the course of pursuing a doctorate in criminal justice, has extensively researched collaboration and information-sharing among tax authorities and law enforcement agencies charged with fighting fraud. One of the more significant impediments to anti-fraud synergy among organizations he’s found is an unwillingness to collaborate or share information.

“There’s often a lack of trust between competing government agencies,” he says. “Likewise, government and industry generally have an adversarial relationship. Accounting and law firms representing businesses accused of VAT fraud defend their clients against the government regardless of apparent or actual guilt. Many just don’t perform adequate due diligence.”

Yet, Watson says, the U.K. government’s implementation of tactics to disrupt carousel fraud has occasionally been faulty, sometimes inadvertently delaying VAT refunds to innocent businesses caught up in broad enforcement actions. Trust, he concludes, is greatly needed among those opposed to fraud. But it’s been and remains in short supply among them, which slows progress and makes it even harder for investigators to keep up with fraudsters’ latest schemes.

A close look at how carousel frauds have evolved provides an example of how fraudsters refine their techniques in an effort to stay one step ahead of the authorities. Watson, based on his years of experience investigating carousel frauds, explains what they looked like when they first appeared (see Figure 3 below), how they became more complex to throw investigators off the scent (see Figure 4 below), and how they metastasized to encompass dual transaction chains, one of which is completely “clean,” in a more advanced and devious form (see Figure 5 below). Note: In Figures 3, 4 and 5, the defaulter is the business that fraudulently fails to pay HMRC the VAT it says it’s collected from the party to whom it supposedly sold goods or services. 

Figure 3:  Basic carousel VAT fraud - The First-Line Buffer, which buys directly from the defaulting trader, makes a gross profit of £500 for simply issuing an invoice and some supporting paperwork. On its VAT return it reports £60,300 due in VAT and claims a refund of the £60,200 it paid to the defaulter. So it ends up paying only £100 to the HMRC. The defaulter defrauds HMRC of the £60,200 it owes on the transaction, while the broker requests a refund of £60,400.

Figure 5: Contra carousel VAT fraud The contra is the party who, in a dual transaction chain scheme, executes two trades that offset each other. To prevent the authorities from refusing to issue a VAT refund, the contra trader buys VAT-free goods or services from a trader in another EU member state in the shorter transaction chain. The contra then sells to a U.K.-based broker, charging £101,200.00 VAT.  Next, the broker sells the goods outside the U.K., and will subsequently claim a refund of the VAT that it paid to the contra trader on the purchase, while the contra trader owes this amount to HMRC from this short transaction chain. The longer transaction chain operates like a standard carousel fraud transaction, with a defaulter going missing without paying HMRC the £100,400.00 in VAT that it collected from the First Line Buffer in this transaction.  In this long transaction chain, the contra acts as a broker, paying £101,200.00 in VAT on the purchase of goods to Buffer No. 3 in the chain and selling the goods without VAT to a customer based outside the U.K. On this transaction, therefore, the contra trader would be in a position to request a refund of £101,200.00 from HMRC.  However, on its VAT return, the contra doesn’t need to request any refund at all, because it will offset the £101,200.00 it owes to HMRC from the shorter transaction chain against the £101,200.00 it’d be refunded from the longer transaction chain. HMRC suffers the fraud loss — arising from the defaulter at the start of the longer transaction chain — when the broker in the shorter transaction chain requests a refund of £101,200.00 on its VAT return to HMRC.  Unless HMRC can detect and prove wrongdoing, it has to make the refund. The challenge for investigators is to find and prove a link between the broker in the shorter (“clean”) transaction chain and the defaulter in the longer transaction chain and show that the broker knew or should have known that the transaction chains had fraudulent elements, even though the broker wasn’t directly involved in the longer transaction chain.

EUROPE’S SOLUTION?

Ainsworth, as discussed above, has extensively researched sales tax evasion and devised mitigation strategies and tactics that keep pace with fraudsters’ latest schemes.

“The EU is applying checks and balances to the VAT process, but they’re doing it too late,” he says. “A gang of fraudsters could receive an ill-deserved €1 million VAT refund today and wire the money overseas within hours. It’s pointless for the EU authorities to look for that money five months later. My solution is to implement real-time verification of the transactions and VAT payments a refund requester says it made. That would enable the government to withhold the refund until verification is complete. And because it would happen quickly, the verification process wouldn’t unduly delay legitimate refunds.”

Ainsworth and his colleague, Todorov, quoted above, in August 2013 introduced such a system, which they devised and call Digital Invoice Customs Exchange (DICE). Among systems already in operation, they say, Rwanda’s EBM is the one that comes closest to doing everything that DICE does.

“Given access to the necessary data, DICE can verify commercial contracts in real time and prevent carousel fraud and other forms of tax evasion,” Ainsworth says. “It emulates the U.S. Internal Revenue Service’s (IRS) 1986 introduction of a requirement that taxpayers list the Social Security numbers of any dependents claimed on their tax returns. Seven million dependents promptly vanished from the tax rolls, and the IRS recovered $3 billion in revenue. When fraudsters know they are or could be watched in real time, fraud plummets.”

For example, Ainsworth says, Canada’s province of Quebec introduced a mandated digital invoice system on a limited basis in 2011 only for restaurants, which tax authorities believed were underpaying C$420 million annually. Within one year after the system debuted, voluntary payments had risen by C$160 million and are expected to reach C$2.3 billion by FY 2018-19.

In contrast, Todorov notes, Rwanda’s EBMs have been mandated for both retail and business-to-business commerce and send automated reports to the national tax authority’s central computers. That puts the EBM model closer to DICE fulfillment than any other nation’s system and is good news for the national economy and citizens of Rwanda. It’s also a model other nations would do well to adopt. What it would require is a VAT or other national sales tax sufficiently unified to produce standardized transactional data that can be collected by mandatory universal invoicing systems and monitored in real time by taxing authority audit and disbursement systems.

UP IN SMOKE

America’s federal, state and local excise taxes on tobacco in theory make smoking very expensive for everyone. In practice, however, collecting all those taxes from everyone isn’t easy. There simply aren’t enough inspectors to check trailers, vans and retail stores for contraband frequently and thoroughly enough to stop tobacco tax evasion.

Smuggling cigarettes — the leading form of fraud in this context — is most profitable between low- and high-tax states. For example, Virginia’s 30-cent per-pack levy is the lowest on the East Coast, while New York State’s is the nation’s highest at $4.35. New York City applies an additional $1.50 tax, creating a $5.55 per-pack differential between Virginia and New York City. (See “State Cigarette Excise Tax Rates & Rankings,” Campaign for Tobacco-Free Kids.)  With 10 packs in a carton and 60 cartons in a case, anyone smuggling a typical tractor-trailer load of 800 cases from Virginia up I-95 to the Big Apple would evade more than $2.6 million in taxes. Retailers who get their supplies at a deep discount from smugglers can in turn tempt their customers with cut-rate prices that are hard to resist, especially in a recession. It’s a strong tide to turn.

ATF Special Agent Ryan Kaye, in dozens of investigations, has encountered every variation in the tobacco tax evader’s playbook.

“A cigarette is a black market-ready product, and everyone wants a piece of the action, even terrorists,” he says. “Organized crime grunts from New York and New England head down to Virginia and the Carolinas on smurfing runs once or twice a week. They load up their minivans with as many cigarettes as they can buy and head home; that’s their workday. We see a lot of that.”

Experienced investigators like Kaye understand the dynamics of the markets they cover and know what factors motivate the players in it. For example, he explains, convenience stores and smoke shops generally are independently owned or franchised, with less oversight and control than larger organizations with internal auditors.

“This opens the door to a lot of fraud by smaller stores that sell cigarettes but don’t advertise it,” Kaye says. “All wholesalers give retailers discounts. But savvy retailers know that big wholesalers often sign contracts with manufacturers and are therefore obligated to tell the manufacturer how much they sell to whom. But smaller wholesalers who don’t sign contracts don’t have that obligation. So retailers buying from them don’t have to ring up their sales because there’s no record of their own purchases from small wholesalers, unless the retailers happen to maintain one. This enables those retailers to sell ‘out the back door’ in bulk to smugglers and not pay retail tax. Down the road, that becomes yet another form of tax fraud because they don’t report their income either.”

To detect such frauds, state inspectors have to visit each retailer, manually inspect its records to see how much it purchased from wholesalers and sold to retail customers, and then compare that with whatever the retailer reported to the state. Unfortunately, the volume of such work can easily exceed a state’s resources.

“Fraudsters keep a phony paper trail to show the state,” Kaye says. “In most cases, investigators will accept the retailer’s records at face value. Very few verify that this company sold that product to such-and-such company and that it was fully taxed.”

AMERICAN VAT?

Across the U.S., states are in dire financial straits. Losing $5 billion to $10 billion in excise tax to fraudsters each year doesn’t help. So what’s the solution when states don’t have enough money to hire more enforcement agents?

Ainsworth has given that question considerable thought. He thinks a U.S. VAT, applied to certain market segments, such as the tobacco trade, would improve the situation dramatically.

“To accommodate the existing tax structures, you could have a federal VAT and a state VAT. Both would apply to every transaction along the supply chain,” he says. “Every pack would have a bar code, as would its state tax stamp and every shipping document. And every invoice would be transmitted to a central federal database. It all would tie together, making it possible to audit inventories by hand-held scanner. And strong encryption would protect the confidentiality of this information.”

Under Ainsworth’s plan, third-party vendors would provide all the systems businesses would have to implement, and their cost would be deductible. Based on Quebec’s experience, he believes the average cost for certified registers would be about $1,000.

“If governments play their cards right, they even could get enforcement help from the public,” Ainsworth says. “For example, in some Latin American countries a government-certified cash register receipt also serves as a lottery ticket. That gives consumers an incentive to demand an official receipt, and it discourages businesses from collecting tax but not remitting it to the government.”

THERE OUGHT TO BE A LAW

In its 2012 report, “Illicit Tobacco Trade,” the Financial Action Task Force (FATF), which the Group of Seven (G-7) nations established in 1989 to fight international money laundering, called attention to counterproductive limitations that currently prevent U.S. law enforcement agencies from sharing with each other their information on tax and criminal activity. (See the FATF June 2012 PDF report, “Illicit Tobacco Trade.”)

The report stated that “without the ability to freely share information in a timely manner among agencies, it is difficult to collect intelligence that portrays the complete picture.” FATF also noted that “… the STOP Act (S.1706), a bill recently reintroduced in Congress to reduce tobacco smuggling, removes some of the restrictions by allowing information sharing with designated state, federal, and international law enforcement and tax agencies.”

The House also is considering such legislation. Rep. Lloyd Doggett (D-TX), who sponsored an ill-fated bill in 2011, reintroduced it in August. If passed, the Smuggled Tobacco Prevention Act (STOP) would increase federal agencies’ ability to pool their tax and crime data and thus improve the scope, depth and effectiveness of their investigations.

BRINGING ABOUT POSITIVE CHANGE

Modernizing our tax systems has to be a top priority.

“The fraudsters are way ahead,” Ainsworth says. “But we can catch them with the same technology they use to cheat us. That means converting our tax systems from paper to digital.”

It’s just as important to make the most of our current resources — by sharing them.

“As CFEs, the best thing we can do is champion the need for trust and collaboration, emphasizing the benefits to government, industry and all of society,” Watson says. “Where sharing is legally permissible and desirable, it must take place. Only in that way can we tackle these types of fraud effectively.”

Robert Tie, CFE, CFP, is a contributing editor at Fraud Magazine and a New York business writer. 

Sidebar 1: Tax laws 

European Union VAT: An Overview

U.S. Excise Tax Legislation
• Jenkins Act of 1949. Requires any person who sells and ships cigarettes across a state line to a buyer, other than a licensed distributor, to report the sale to the buyer’s state tobacco tax administrator. 
• Contraband Cigarette Trafficking Act of 1978 (CCTA). Enacted to stop organized criminal networks from smuggling and selling untaxed cigarettes.  
• Prevent All Cigarette Trafficking Act of 2009 (PACT). Passed to close loopholes in the Jenkins Act and to expand the ATF’s authority to enforce the CCTA. 

Sidebar 2: ACFE resources 

Self-study courses
• Government Fraud, online course
Books
• “Benford's Law: Applications for Forensic Accounting, Auditing and Fraud Detection”  
• “Financial Investigation and Forensic Accounting, Third Edition” 
CFE Exam Review Materials
• Financial Transactions and Fraud Schemes: Public Sector Fraud 


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