Doctrine of Due Care and Caution ~ U-Tax Blog

Wednesday, March 14, 2012

Doctrine of Due Care and Caution

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This seems logical to treat the doctrine of business purpose and the doctrine of due care and caution as two of the most important anti-avoidance tools in Ukraine developed by the court practice in recent years.

This article will talk about the doctrine of due care and caution. Unlike the doctrine of business purpose, this doctrine has not become part of the Tax Code of Ukraine yet. Nevertheless, this fact does not significantly diminish its high importance for tax litigation.

The Essence of the Doctrine

The doctrine applies to cases related to the recognition of VAT input/deductible expenses by a taxpayer who purchases goods (services) from problem (in terms of taxation) suppliers, including their counterparties in the chain of supply.

The doctrine provides the answer to the question whether such a taxpayer-purchaser should be held liable by depriving of his VAT input and deductible expenses in connection with the tax abuses committed by his suppliers or their counterparties.

The answer is as follows: the taxpayer-purchaser should not be held liable only if he showed due care and caution and he was not aware of the abuses of his counterparties.

To prove the familiarity of the taxpayer-purchaser with the abuses of his suppliers the reference can be made, for instance, to the following circumstances:

- the orientation of the taxpayer-buyer or his affiliates to the transactions predominantly involving counterparties breaching their tax liabilities, particularly in the case the transactions are entered into through intermediaries in the presence of direct contacts with manufacturers;

- the dealing of the taxpayer-purchaser with the supplier in one market segment where there are the stable relationships and all the participants are aware of the nature and the real intentions of each other in carrying out business transactions.

Starting Point

The first widely known mention of the doctrine of due care and caution occurred on 12 February 2008. This was the date of the resolution of the Administrative Chamber of the Supreme Court of Ukraine in case No 08/28brought by  "Metpromservis", LLC against the State Tax Inspection in Shevchenkivskiy District of the city of Zaporizhia.

In this case the Supreme Court of Ukraine found for the local State Tax Inspection, cancelled the ruling of the Highest  Administrative Court of Ukraine (issued  in favor of the taxpayer) and remand the case to the court of first instance for new consideration.

Overriding the ruling of the Highest Administrative Court of Ukraine, the Supreme Court of Ukraine made the following interesting conclusions:

- "... the violation of the tax liabilities by the suppliers of a purchaser may constitute the grounds for denying such a purchaser’s entitlement to tax benefit - VAT refund from the state budget if the tax authorities establish that the taxpayer (purchaser) acted without due care and caution and he had to be aware of the breaches committed by his suppliers ... ";

 - "Satisfying the claim the courts only referred to the availability of the VAT invoices issued by the suppliers. They did not take into account the fact that the claimant had been acquiring raw materials, particularly scrap metal, for a long time from intermediaries who regularly did not pay taxes, whose activities were of fake nature, who did not reside at their registered offices, did not file tax returns or filed “zero” ones, whose  registered owners (shareholders) and officers  did not acknowledge their involvement in their activities, and that the claimant, his suppliers and contractors had been trading in the same market segment in which there was the stable relationships and all the participants were knowledgeable about each other".

Borrowing from Northern Neighbor

The doctrine of due care and caution exists in the Russian Federation as well. One would like to believe that the Russians have borrowed it from us, but, unfortunately, things are quite the contrary.

In Russia, this doctrine has been actively used since October 2006 (the Resolution of the Supreme Arbitration Court of the Russian Federation dated 12 October  2006 No 53). In Ukraine the doctrine has found its operation only since February 2008 (the above-cited decision of the Supreme Court of Ukraine of 12 February 2008).

Doctrine and Practice of the European Court of Human Rights

It is worth noting that the issue of the liability of the taxpayer-purchaser for the tax abuses of his suppliers also finds its solution in the practice of the European Court of Human Rights, which is mandatory for the use in Ukraine.

In the case of "Bulves" AD v Bulgaria (para  71 of the judgment dated 22 January 2009) the European Court of Human Rights took view that does not fall foul of the doctrine of due care and caution: the VAT payer should not be held liable for the abuses committed by his suppliers, if he does not have knowledge of those abuses or the means to obtain such knowledge.

What should taxpayers do?

In view of the operation of the doctrine, it is advisable for good faith taxpayers to create evidence confirming the expression of due care and caution when choosing the suppliers.

The smallest, but very necessary and important thing that every taxpayer should do before entering into any supply contract is to check his suppliers with regard to their tax “integrity” through the electronic databases available on the official website of the State Tax Service of Ukraine. Those databases encompass: the Database of VAT Payers, the Database of Cancelled VAT Payers Certificates, the Database of “ Non Bona Fide” VAT Payers, and the Database of the Places of Mass Registration of Taxpayers.

Everything else depends on the resources and imagination of the taxpayer. One can, for example, ask the certified copies of the supplier’s registration documents, the copy of the passport of the signatory of the supply contract, the letter specifying the number of the supplier’s personnel, the availability of the fixed assets, the size of his warehouse and office space, his actual location, etc. In other words, the idea is to gather as much as possible information attesting real, not fake nature of the supplier’s business.

The documents collected in the course of the inquiry, including the screenshots made while running the suppliers through the State Tax Service of Ukraine’s electronic databases should be kept in electronic and /or hard form taking account that a dispute with the tax authorities may arise.

The ideal decision seems to be the adoption of internal regulation (policy) governing the examination of the suppliers with reference to their tax “reliability” embracing the list of responsible employees, examination procedures, documents storage procedures and so on.

In Lieu of Conclusion

Apparently, the implementation of the doctrine of due care and caution has loaded taxpayers at least those of them concerned with minimizing their tax risks with a great deal of new work related to the need to check the tax "integrity" of the suppliers. However, it is difficult to view this doctrine as something out of the ordinary. The doctrine appears to be in  line with the practice of the European Court of Human Rights and offers more or less a fair balance between public and private interests in the fight against tax evasion.

The main problem today is the vague criteria of due care and caution resulting  in the material risks for taxpayers.  Hopefully, this gap will be filled in the future by the clarification of the Highest Administrative Court of Ukraine.

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