How Recruitment Agencies Can Lose The Right To Recover VAT

Dains Partner Sam Davies and Employment Services Team Assistant Manager Jack Bonehill explain how the Kittel Principle can prevent a recruitment agency from recovering VAT and recommend how to mitigate this.

Dated: 12 February 2020 Authors: Employment Taxes Partner Sam Davies & Employment Services Assistant Manager Jack Bonehill.

VAT is a European Union tax.  The EU institutions do not collect the tax, but EU member states are each required to adopt a value added tax that complies with the EU VAT Code.  The EU VAT system is regulated by a series of European Union directives, the most important of which is the Sixth VAT Directive.

The Kittel Principle was established in relation to a Belgian VAT case (involving a company in receivership represented by the receiver Axel Kittel) which was ultimately heard and determined in the European Court of Justice (ECJ) in 2006.  In that case, it was found that a taxable person who knew or should have known that, by his purchase, he was taking part in a transaction connected with the fraudulent evasion of VAT must, for the purposes of the Sixth VAT Directive, be regarded as a participant in the fraud.

Conversely, it was recognised by the ECJ in the case of Kittel, that traders who take every precaution, “which could reasonably be required of them”, to ensure their transactions are not connected with fraud, must be able to rely on the legality of those transactions without the risk of losing their right to deduct the input VAT.

Subsequent cases have further clarified the impact of the Kittle Principle and we are now clear that HMRC can deny input VAT recovery for a business where the following circumstances are met:

  • The business is part of a supply chain where there has been fraudulent VAT evasion by a party in the supply chain
  • The business knew, or should have known, that there was fraudulent VAT evasion in the supply chain

Where the only reasonable explanation for the existence of a supply chain is that it is connected with fraud, then where there is fraudulent VAT evasion, it is deemed that businesses engaging in transactions should have known of that fact, and Kittel can be applied.  However, it is not enough that it is more likely than not that there is fraudulent VAT evasion in the supply chain – where there are other reasonable explanations for the existence of the supply chain, this can be used to refute any allegation by HMRC that the business knew or should have known of VAT evasion.

In considering whether a business knew, or should have known, of a fraudulent VAT evasion, the knowledge of directors, other office holders, employees, and agents can be attributed to the business.

Risk to Recruitment Agencies

Due to low margins and in order to remain competitive, it has become a necessity for many recruitment agencies to utilise third-party arrangements offered by labour providers (sometimes referred to as payroll companies) to engage with and pay temporary workers.  It is engaging with these labour providers which bears risk for agencies under the Kittel Principle.

It is no secret that there are ‘rogue’ labour providers, whose tax compliance is poor, and in some cases, where large amounts of tax go unpaid.  The risk of rogue behaviour increases with the complexity of arrangements, which often achieve the tax advantages being sought in their design, but due to being difficult to operate correctly, fall short of meeting the conditions to obtain the tax advantages in practice – which results in HMRC being due tax.

HMRC is aware of rogue behaviour and complicated arrangements in the recruitment sector and sees the sector as high risk.  This awareness prompted the creation of a specialist HMRC team within the Fraud Investigation Service (FIS), which is increasingly proactive in addressing matters of compliance in the sector.

From our discussions with HMRC, we know that HMRC is aware of two arrangements which are under scrutiny and potentially high risk:

  • Mini-umbrella arrangements (also referred to as outsourcing, or small intermediary company arrangements)
  • Co-employment arrangements where the recruitment agency usually retains all employer responsibility whilst paying over the payroll costs (wages, Employer National Insurance, etc.)

HMRC will use the fact that supply chains are complicated and contrived to substantiate a position that an agency knew or should have known of VAT evasion.

How to Mitigate the Risks

It is important in the event of a Kittel challenge by HMRC, that agencies are able to refute arguments that they have been a party to the evasion of VAT because they knew or should have known of transactions associated with fraud.

All agencies utilising labour providers to supply temporary workers can mitigate the risk by undertaking due diligence to check prior to engagement and on a regular basis:

  • The feasibility of the arrangements in achieving compliance and the sought tax advantages;
  • That the arrangements are financially viable (particularly where there are rebates, discounts or administration services agreements which financially benefit the recruitment agency); and
  • That tax liabilities are being paid

HMRC provides due diligence guidance, and it is apparent from recent HMRC interactions on behalf of our clients, that serious attention and consideration of the risks by company directors, with thorough and regular checks on an ongoing basis, is considered essential.  Equally, where the findings of due diligence are frustrated or concerning, HMRC has been clear that businesses should react appropriately and in line with reasonable timescales.  We have seen first hand how effective due diligence can head-off potential challenges by HMRC where VAT fraud has been established in labour supply chains.

As indicated in the Kittel case, an agency must show that they have taken “every precaution, which could reasonably be required of them”, to ensure their transactions are not connected with fraud in order to rely on the legality of those transactions without the risk of losing their right to deduct the input VAT.


We recommend that all recruitment agencies utilising third-party arrangements to engage temporary workers undertake the following to mitigate their risks:

  1. Understand the risks associated with utilising labour providers
  2. Identify the labour suppliers and matters of risk to the agency; i.e. arrangements deriving unexplained financial benefits or incorporating tax efficiencies
  3. Ensure contractual terms and agreements are in place between the agency and labour providers, which:
    - Cover all services provided between the parties (including any rebates, discounts and administration agreements);
    - Are a true reflection of the agreement between the parties; and
    - Borne out by the arrangements in practice
  4. Establish a due diligence process in relation to labour suppliers, which imposes the requirement to undertake  initial and regular ongoing due diligence on all third party arrangements
  5. Ensure that the due diligence checks establish that:
    - The required contractual documentation is in place and is a true reflection of the arrangements as they are meant to operate in design and in practice
    - The arrangements are financially viable (legitimately)
    - The tax-compliance of the arrangements is feasible (in design and operation)
    - Taxes are paid to HMRC
    - Sufficient information is provided to the worker for them to understand who their employer is
  6. Consider adopting a preferred suppliers list
  7. Address any questions from HMRC carefully and thoroughly
  8. Be prepared to provide a robust and detailed response to any arguments HMRC might raise in relation to Kittel

If you would like to discuss any matters relating to the Kittel Principle, please contact:

Sam Davies, Employment Taxes Partner:, 07713 421899

Jack Bonehill, Employment Taxes Assistant Manager:, 07967 815595