VAT fraud worsens social problems.

09.04.2012

At first glance, the issue of VAT fraud may seem one with major macroeconomic significance, for discussion by economists and policy wonks, but with little application to Russian society as a whole. It may generate extra income for criminals, but not affect the lives of ordinary Russians all that much.

Looking more closely, however, the more sinister effects become clearer. Apart from tragedies like the death of the lawyer Sergei Magnitsky, who was investigating cases of fraudulent refunds, criminal gangs frequently target the underprivileged and poor to help them, often unwittingly, in their schemes.

‘Dead Souls’ in real life

Yelena Panfilova, director of the Russian office of Transparency International, said that criminals often use stolen or purchased passports to forge supporting documents for refund claims, with homeless people or students in difficult financial straits the chief victims. These victims then become fall guys if the scheme is uncovered, being sent to prison instead of the actual criminals.

Panfilova cited the case of one man who was accused of stealing 5.4 billion rubles ($182 million) through a VAT fraud scheme. To arrest him, police had to go to a village saw mill, where they found the suspect company’s “general director” working odd jobs. He has since been sentenced to five years.

The Novaya Gazeta newspaper reported a similar story last week, after a woman named Yulia Gorskaya was arrested for fraud. According to case documents leaked to the media, Gorskaya is a multibillionaire. Photographs of her house, published by Novaya Gazeta, show that in reality she is barely scraping together enough to live.

Thieves buy property rights

Document and identity theft are not the only features of fraudulent activity, however, as so-called “black notaries” have access to property databases to help them find desperate owners of houses or apartments, who can provide them with an address for a shell company. As with the victims of document theft, the property owners are often the targets of investigations and arrests once the authorities catch wind of the schemes.

“We have people here who find themselves in a hopeless situation and are forced to get involved in this or that criminal enterprise,” Panfilova said.

Meanwhile, the schemes’ developers remain in the shadows.

“Their inventions work well and the schemers somehow think that conceptually it’s almost a legitimate business,” Panfilova said. “They walk along the streets, smiling.”

How the refunds work

Adopted in most developed countries, the United States being a major exception, value-added taxes are designed to achieve tax equalization between different sectors of the economy, so-called “fiscal neutrality.” Governments often grant exemptions, particularly to support export sales, and therefore allow refunds for sales that satisfy official criteria.

Because the bureaucratic process of applying for refunds is so formalized and clearly outlined, cases of fraud pose a huge problem for authorities, said Sergei Budylin, of the Roche & Duffay law firm – and not just in Russia.

“All you need is to submit a set of papers proving that your company is entitled to VAT refunds,” he said. Therefore, when a company claims that it has exported an item and claims a VAT refund, even if the export never happened, it can get the money as long as it has the required paperwork—which is forged, but still satisfies the procedure.

Government response

It would be unfair to deny that the state is pursuing cases of VAT fraud. Last year, police raided several firms following tax inspections, and former Moscow tax bureau chief Olga Stepanova was arrested for approving a bogus refund amounting to $230 million. Investigation of her actions is ongoing.

Andrei Shpak, partner with the law firm Goltsblat BLP, said the Federal Financial Monitoring Service has set up a special group to supervise the VAT refund scheme, and has been tightening the screws on laundering, driven by international initiatives of the Financial Action Task Force.

Controversially, however, Federal Tax Service director Mikhail Mishustin is modernizing the FTS, making it easier for businesses to operate. While modernization proposals are welcomed for fostering a more transparent business climate in Russia, they could also help fraudsters who manipulate the VAT refund scheme.

Solutions under discussion

The future of VAT refunds was raised most recently at a macroeconomic conference in late March. Prime Minister Vladimir Putin had ordered agencies to assess the impact of the refund scheme’s potential abolition, and Deputy Finance Minister Sergei Shatalov announced his ministry’s findings.

The Finance Ministry “sees more minuses than pluses” in the abolition, especially in the hit exporters would find themselves taking by paying more in VAT, Shatalov said, RIA Novosti reported.

“Exporters will find themselves at a disadvantage,” he said. “It will require rearranging the entire tax system of Russia.”

FTS data released in December 2011 explain the ministry’s position, since they show that VAT is the largest source of tax revenue after mineral taxes, with rates of 38 percent and 45 percent, respectively. Goltsblat’s Shpak expanded on these statistics, saying that VAT has historically played a crucial role in Russia’s fiscal management, as the government is not reluctant to borrow on capital markets and needs the revenue from taxes to support its borrowing.

Even with the refund scheme in place, tax authorities try to throw up as many obstacles as they can in order to retain revenue, Shpak said.

Legitimate businesses suffer

Obstacles can include engrained suspicion on the part of tax authorities of applicants for refunds. Despite the benefits the refund scheme is supposed to provide for businesses, Transparency International’s Panfilova said that honest companies can suffer from unwarranted investigations and delays.

“One of my friends tried to get a refund,” she said. “He spent half a year in some local fiscal office, until they were asked for a half of the refund’s amount to complete the deal.” In addition, lawyers say that Moscow arbitration courts are overloaded with VAT disputes between businessmen and the FTS, and some cases have involved big multinational companies. Most famously, the French retailer Leroy Merlin lost its case in the Supreme Arbitration Court of Russia in February 2012, and Dirol Cadberry won its own in the same court in December 2009.

A more radical solution, which could be the simplest, was proposed by presidential aide Arkady Dvorkovich a few months ago: to get rid of VAT altogether and substitute it with a sales tax, passing the responsibility on to the consumer rather than the company.

The article by Oleg Nikishenkov

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