Introduction
In this module:
Fraud Risks and Implications: Discover how labour supply chain fraud leads to financial, legal, and reputational damage, with businesses facing potential prosecution under the Criminal Finances Act 2017 (CFA 2017) for failing to prevent tax evasion.
Public Sector Risks: Explore vulnerabilities in public sector contracts, including tax evasion and worker exploitation.
The Kittel Principle: Understand how businesses are held accountable if they "knew or should have known" about fraudulent transactions.
High-Risk Sectors: Focus on fraud challenges in the Construction, Security industries as well as the NHS.
HMRC’s Response: Learn how HMRC tackles fraud through targeted investigations, IR35 enforcement, CFA2017 compliance checks, and supply chain due diligence guidance.
This lesson empowers you to spot and mitigate fraud risks across your labour supply chain. Let’s dive in!
Risks Affecting Labour Supply Chains and the Procurement Life Cycle
Labour supply chains and the procurement life cycle are inherently vulnerable to fraud and corruption at every stage. These risks impact both the public and private sectors, particularly where significant sums of money are involved. Such environments often attract organised crime, exploiting weaknesses in due diligence, compliance, and oversight.
Public Procurement of Goods and Services
Let’s take a closer look at an example:
His Majesty’s Revenue and Customs (HMRC) has been paying close attention to public procurement of goods and services. Public procurement represents the largest component of government expenditure, as it channels public funds directly into the private sector.
In 2022-23, the UK government spent an astounding £393 billion on procuring goods, services, or works from external suppliers.
The NHS alone spends around £30 billion annually on goods and services.
£1 in every £3 of public sector spending goes toward procurement, spanning schools, health and social care, roads, defence, IT, and labour services required to deliver these essential functions.
Given the sheer scale of these sums, organised crime groups are increasingly targeting public sector supply chains to perpetrate serious tax fraud, labour exploitation, and waste crime. Such activities undermine public services and erode trust in the system.
Tackling Fraud
HMRC, OPRaaS and other private and public sector partners, are dedicated to enhancing customer confidence by promoting the importance of due diligence and implementing meaningful checks. These measures are designed to mitigate the risk and occurrence of fraud within the labour supply chain and procurement processes.
By fostering a culture of compliance and accountability, these efforts aim to:
Protect UK PLC from unscrupulous and nefarious operators
Strengthen UK PLCs Labour Supply Chains to create a fairer, more ethical and more level playing field for all businesses.
Reduce harm by protecting vulnerable individuals from exploitation and abuse.
Course Overview: Principles of Effective Risk Management
Throughout this course, we will explore key principles for applying effective risk management, conducting robust due diligence, and ensuring the integrity of supply chains.
These principles are not a definitive checklist but serve as best practice guidelines to help you minimize risks and safeguard your supply chain. They provide a solid foundation for assessing the credibility, legitimacy, and compliance (both legal and tax-related) of the following:
End-hirers
Intermediaries (Agencies & Umbrellas)
Temporary Workers
The End to End Labour Supply Chain
By applying these principles, you will enhance the resilience and transparency of your supply chains, reducing vulnerabilities to fraud, exploitation, and non-compliance.
Key Area of Interest 1: Construction
Organised labour fraud is a term used by HMRC to describe fraudulent activities that typically occur in the supply of labour, particularly in high-risk sectors like construction. It typically involves criminally orchestrated schemes to evade taxes, exploit workers, and gain unfair commercial advantage. This umbrella term includes:
Labour fraud in construction – Misclassification of workers (e.g., false self-employment), failure to deduct or remit taxes, or the use of falsified records within complex supply chains.
Payroll company fraud – Abuse of payroll operations, such as withholding PAYE or NIC deducted from workers instead of paying HMRC.
Mini umbrella company (MUC) fraud – Fragmenting the workforce across multiple small companies to illegitimately claim tax reliefs like Employment Allowances or avoid employer NICs.
Key Characteristics:
Organised crime involvement: These frauds are structured and systematic, often led by organised criminal groups.
Genuine labour supply: The fraud involves real work and workers, making it harder to detect.
Supply chain exploitation: These practices thrive where due diligence and oversight are weak.
Impact:
Organised labour fraud undermines the construction industry, erodes trust in supply chains, exploits vulnerable workers, and deprives the public of vital tax revenue—placing ethical businesses at a commercial disadvantage.
Labour Fraud in Construction
Labour fraud in construction is a form of Missing Trader Fraud where genuine work is carried out by an off-record workforce, and the supply chain is manipulated with bogus companies that falsely appear to provide labour or services. This fraud is common in both public and private sector building projects.
Key Characteristics:
Bogus Companies: Entities obtain VAT registration and CIS gross payment status to appear compliant, but are created solely to facilitate fraud.
Missing Traders: Companies disappear from the supply chain, leaving behind unpaid VAT and tax liabilities.
Broader Risks:
Modern slavery: Exploiting vulnerable workers in unsafe or illegal conditions.
Illegal working: Engaging individuals without legal right to work.
Benefit fraud: Workers receiving undeclared income while fraudulently claiming benefits.
Labour fraud in the construction industry undermines tax compliance, fosters worker exploitation, and erodes trust in the industry and public procurement.
Payroll Company Fraud
Payroll company fraud occurs when Organised Crime Groups (OCGs) pose as legitimate payroll service providers to infiltrate the labour supply chain. They target genuine businesses, offering to handle Pay As You Earn responsibilities and workforce management.
Key Characteristics:
Supply of Workers:
The payroll company supplies workers back to the business, charges VAT, and appears to operate as a legitimate intermediary.PAYE & NIC Deductions:
PAYE and National Insurance are deducted from workers’ wages, and RTI submissions are made to HMRC—creating a false appearance of compliance.Fraudulent Intent:
Instead of remitting the deductions to HMRC, the payroll company withholds the funds, building up large PAYE and VAT debts.
Once liabilities reach a critical level, the company disappears, leaving HMRC unpaid and workers potentially underpaid or exposed.
Mini Umbrella Company (MUC) Fraud
MUC fraud involves splitting a larger umbrella company into multiple micro-companies, each employing only a few workers. This is done to illegitimately exploit tax reliefs and allowances, with workers typically unaware they are part of the scheme.
Key Characteristics:
Business Fragmentation:
A single labour provider creates multiple MUCs, each with a small workforce, overseen by an overarching business.Exploitation of Tax Reliefs:
VAT Flat Rate Scheme: Each MUC registers for the scheme, retaining part of the VAT as profit—passed to the parent business.
Employment Allowance: Each MUC claims the £5,000 allowance to avoid Employer NICs—saving substantial costs illegally.
Fraudulent Dissolution:
Once tax benefits are maximised, MUCs are dissolved or abandoned, leaving behind unpaid tax liabilities, while the parent business creates new MUCs to repeat the cycle.
Impact:
This model distorts fair competition, deprives HMRC of revenue, and can undermine workers’ rights and entitlements.
Key Area of interest 2: National Health Service (NHS)
The Importance of Robust Due Diligence in NHS Supply Chains
All NHS departments must take reasonable and proactive measures to ensure robust due diligence is applied across their supply chains. This is essential to minimize the risk of exposure to supply chain fraud, safeguarding against financial, reputational, and legal consequences. By implementing effective due diligence practices, departments can reduce the likelihood of negative media attention and the reputational damage that often accompanies supply chain scandals.
A Healthcare Labour Supply Chain in Crisis?
The healthcare labour supply chain is often described as a ticking timebomb. Despite its sensitive nature, department heads must take control and address the risks head-on. Ignoring these challenges leaves the NHS exposed to significant ramifications.
Consider this example:
A permanent nurse may take home only 60% of their gross pay after deductions, such as PAYE and National Insurance Contributions (NICs).
A temporary nurse, working through a non-compliant umbrella company and being paid the same gross amount, might take home as much as 90% of their gross pay
This disparity raises serious questions about:
Financial implications: Potential non-compliance with tax regulations and PAYE obligations.
Political consequences: Public and government scrutiny of how the NHS manages its supply chains.
Workforce morale: A sense of inequity among permanent staff versus temporary workers.
Individual impact: Nurses may unknowingly engage with non-compliant umbrella companies, leaving them vulnerable to tax investigations and personal financial loss.
A Case Study: HMRC vs. Ducas Limited and Related Entities
The recent Ducas Limited case illustrates the gravity of supply chain fraud and its potential impact on organizations like the NHS. In this case, HMRC obtained a Freezing Injunction against Ducas Limited, Enix Services Ltd, and FL Capital Holdings Ltd amid allegations of widespread fraud involving Employer NIC evasion.
The evidence presented highlights key risks:
False Accounting: HMRC alleged the use of fake payslips and manipulated RTI submissions to hide the non-payment of NICs.
Dishonest Practices: Funds were transferred to parent companies without justification, and agreements with recruitment agencies were deliberately breached.
Asset Dissipation: With assets held abroad, HMRC identified a high risk of dissipation, necessitating a freezing order to prevent funds from being moved beyond recovery.
The scale of the alleged fraud was staggering, with an estimated £171 million in unpaid NICs. This case underscores how organized fraud within supply chains can erode public trust, compromise compliance, and result in significant financial losses.
Note: This case study is based on public legal proceedings and includes allegations made by HMRC. The outcomes of the case may be subject to ongoing legal review or appeal.
Key Takeaways
Legal Liability: Under the Gross Payment Model, both the end client (e.g., the NHS) and recruitment agencies may face liability if they fail to conduct adequate due diligence on their supply chain partners.
Proactive Measures: Implementing rigorous compliance checks and regular audits can help protect against fraud, reduce risks, and ensure adherence to legal standards.
The Cost of Inaction
Failure to act exposes the NHS to:
Financial risk: loss of public funds through VAT, PAYE, or NIC fraud.
Workforce risk: worker exploitation, morale issues, and loss of skilled temp staff.
Reputational damage: media or political fallout from scandal or audit findings…
The cost of inaction is simply too high!
Click through the slideshow below to explore an example
Key Area of Interest 3: Security
The security sector faces a high risk of labour supply chain fraud, largely due to the widespread practice of outsourcing labour to third-party security providers. It is uncommon for end users of security services to employ their own security staff directly, making robust due diligence essential to prevent exploitation and fraud.
Emerging Risks in the Security Sector
The Security Industry Authority (SIA), in collaboration with HMRC, is intensifying its focus on payment and employment arrangements within the industry. Key areas of concern include:
Cash-in-hand payments: These create opportunities for tax evasion and obscure compliance.
Misclassification as self-employment: Fraudulent claims of self-employment to avoid employer obligations such as PAYE and NICs.
Payroll Company Fraud (PCF): Schemes where payroll companies fraudulently mismanage PAYE and NIC deductions, leading to large tax liabilities.
Complex tax avoidance schemes:
Non-compliant umbrella arrangements: Often exploit workers and evade taxes
Offshore wage routing: Moving wages through offshore jurisdictions to avoid UK tax obligations
SIA – Approved Contractor Scheme (ACS): A Proactive Measure
Incorporating SIA-Approved Contractor Scheme (ACS) accreditation as a minimum requirement in procurement processes can mitigate risks by ensuring that security providers meet strict compliance standards.
Key benefits of ACS accreditation include:
Tax Compliance Transparency: As part of the accreditation process, businesses consent to allow HMRC to disclose tax compliance information to the SIA.
Worker-Supplier Relationship Review: The ACS evaluates the nature of employment relationships between security workers and suppliers to ensure compliance with legal and ethical standards.
Promoting Best Practices: ACS-approved contractors are required to demonstrate their commitment to ethical and compliant labour supply practices.
A Call to Action for End Hirers of Security Services
To safeguard against fraud and exploitation in the labour supply chain, end users of security services should:
Incorporate ACS Accreditation: Require SIA-ACS accreditation as part of your procurement criteria to ensure suppliers meet high compliance standards.
Conduct Regular Audits: Monitor and verify the tax and employment practices of third-party security providers.
Collaborate with Authorities: Work with SIA and HMRC to detect and prevent fraudulent schemes.
The Kittel Principle
Before we go any further, it's essential to understand the Kittel principle and its significant financial implications.
The Kittel principle originated from a European Court of Justice (ECJ) judgment in the case of Axel Kittel vs. Belgian State, and it centers around the concept of “knew or should have known”. This principle places responsibility on businesses involved in transactions linked to VAT fraud, even indirectly.
What Does the Kittel Principle State?
The judgment established that:
“A taxable person who knew or should have known that by their purchase they were taking part in a transaction connected with fraudulent evasion of VAT…”
In such cases, the business or individual is deemed to have:
Aided the perpetrators of VAT fraud.
Acted as an accomplice, whether knowingly or through negligence.
As a consequence, they lose the right to deduct input VAT related to those transactions. This means a business could face significant financial losses, even if they were not directly involved in the fraud but failed to perform adequate due diligence.
When Does the Kittel Principle Not Apply?
The Kittel principle does not apply to VAT recovered under the Contracted Out Services Treasury Direction (COS), as this VAT is related to non-business activity. For example:
Recovering VAT on capital projects undertaken by public sector bodies under COS headings.
COS VAT Recovery Explained
HMRC Easements for Capital Projects: VAT recovery is allowed for specific procurement frameworks in England, Scotland, and Wales. This easement facilitates the recovery of VAT for construction services not typically covered under COS.
Relaxation of COS Rules: The easement extends VAT recovery to services classified under COS headings, such as:
COS Heading 35: Repair and maintenance.
COS Heading 52: Professional fees.
Implications for Businesses
No Protection for Turning a Blind Eye:
Ignorance is not a defense. If a business fails to ask the right questions or ignores obvious red flags, it will still be held liable under the Kittel principle.Risk of VAT Denial:
HMRC or other tax authorities may deny input VAT claims, which can lead to substantial financial penalties and reputational damage.Responsibility for Supply Chain Due Diligence:
Businesses must ensure that their supply chains are free from fraud. This requires proactive measures such as verifying suppliers, monitoring transactions, and maintaining thorough documentation.
Key Takeaways
Due Diligence is Essential: Businesses must assess the entire supply chain, ensuring all transactions are credible and free of fraudulent connections.
COS VAT Recovery is Exempt: Recovering VAT under COS Treasury Directions is not subject to Kittel.
Proactive Risk Management: Incorporating robust due diligence processes protects businesses from VAT denial under the Kittel principle.
A Costly Lesson
The Kittel principle serves as a powerful reminder that compliance is non-negotiable.
Failure to conduct proper due diligence can result in devastating consequences, including:
Loss of VAT deductions.
Penalties and fines.
Reputational harm.
Choosing to overlook or ignore signs of potential fraud could leave a business vulnerable to significant financial liabilities.
HMRC expects businesses to undertake a level of due diligence that is proportionate to the risk—especially in high-risk sectors like labour supply, construction, and electronics.
“Should Have Known” = Due Diligence Required
One key aim of due diligence and risk assessment is to empower businesses to make informed judgments about the integrity of their supply chains, including suppliers, customers, and the goods or services within them.
What Does Due Diligence Entail?
To comply with the Kittel principle, due diligence should not be limited to immediate suppliers and customers. Instead, businesses must evaluate:
The credibility of supply payment arrangements.
The surrounding circumstances that might indicate irregularities or fraud.
The broader integrity of the entire supply chain, including upstream and downstream transactions.
The Kittel Ruling and VAT Recovery
Under the Kittel ruling, the right to reclaim input VAT can be denied to anyone in the supply chain if it is proven that the business knew or should have known their transactions were connected to VAT fraud.
This principle remains in effect in the UK post-Brexit, making thorough due diligence an essential practice for protecting businesses from financial and reputational harm.
The Bottom Line:
Thorough due diligence of your entire supply chain is not a choice—it is a critical safeguard against VAT fraud and potential loss of VAT recovery rights.
What is HMRC Doing About Organised Labour Fraud?
HMRC is actively addressing the threat of organised labour fraud through a combination of strategic measures, specialised enforcement, and legislative updates. Recognizing the financial, legal, and reputational risks associated with these schemes, HMRC has dedicated resources and trained personnel to tackle fraudulent activities within labour supply chains.
Key Measures by HMRC
Legislative Updates:
The introduction of the VAT domestic reverse charge for construction is a proactive measure designed to combat VAT fraud within the construction industry.
Supply Chain Monitoring:
A Supply Chain Investigation Monitoring Unit has been established to identify and scrutinize supply chains linked to suspected fraud. This unit focuses on ensuring tax compliance and addressing vulnerabilities that could be exploited by organised crime groups.
Direct Actions:
Tax Loss Letters: Issued to businesses believed to be involved in or linked to fraudulent activities, outlining their potential exposure.
Inspection Visits: Physical inspections of business premises to assess compliance and uncover potential fraud.
Enforcement Actions
Enforcement activities by government agencies can have serious implications for non-compliant businesses and supply chains. Key agencies involved include:
HMRC: Tackling tax evasion, payroll fraud, and VAT non-compliance.
Home Office & Immigration Enforcement: Addressing illegal employment practices.
Gangmasters and Labour Abuse Authority (GLAA): Monitoring exploitation and illegal labour practices.
Health and Safety Executive (HSE): Ensuring worker safety and compliance with health regulations.
Potential Enforcement Actions
Workforce Disruption: Illegal workers, victims of exploitation, or criminals may be removed from worksites, potentially halting operations temporarily or permanently.
Worksite Closures: Entire sites may face temporary shutdowns or permanent closures depending on the severity of the infractions.
Legal Proceedings:
Provisional Liquidation: Businesses involved in fraud may face immediate insolvency proceedings.
Bankruptcy and Director Disqualification: Key personnel could be declared bankrupt or barred from serving as company directors.
Broader Impacts
Fraud and non-compliance in labour supply chains can result in significant secondary consequences for businesses, including:
Reputational Damage:
Inclusion in government naming schemes for minimum wage violations or illegal employment can lead to negative public and media attention.
Public protests or activism targeting non-compliant businesses can escalate reputational risks.
Financial Losses:
Penalties, fines, and unpaid wages owed to workers can cause severe financial strain.
Social Responsibility Failures:
Businesses that fail to meet their social and ethical responsibilities may face boycotts, loss of clients, and long-term damage to their brand.
A Call for Vigilance
The combination of HMRC’s proactive measures, enforcement actions, and the potential for severe financial and reputational consequences highlights the critical need for robust due diligence and compliance within labour supply chains. By staying informed and adhering to regulations, businesses can protect themselves from the fallout of organised labour fraud.
Summary
To ensure your labour supply chain remains compliant and to identify whether a potential supplier has been linked to tax fraud, visit the Current list of named tax avoidance schemes, promoters, enablers, and suppliers on the UK Government's website at Gov.uk – Named Tax Avoidance Schemes
Key Takeaways from This Section
You’ve explored the following critical topics:
Risks and Implications of Fraud
How fraudulent labour practices can impact businesses, supply chains, and reputational integrity.Public Sector Vulnerabilities
The unique exposure of sectors like the NHS to financial, legal, and operational risks from non-compliance.The Kittel Principle
The “knew or should have known” test and the importance of due diligence to avoid denial of VAT recovery.High-Risk Sectors
Why Construction, Healthcare, and Security are under increased HMRC scrutiny due to labour fraud risks.HMRC’s Response
Key measures such as the VAT reverse charge, dedicated supply chain monitoring units, site inspections, and cross-agency enforcement.
Next Steps
In the next module, we’ll explore Labour Supply Chain Assurance —the actionable process of protecting your organisation and staying compliant.
Let’s continue to build a resilient, fraud-busting supply chain.
OPRaaS LSCA Self-Certification Audit Document
A full OPRaaS Labour Supply Chain Assurance Self-Certification Audit will become available to download in the next lesson (Module 3) upon purchase of this course.
This Audit Spreadsheet (a Microsoft Excel document) can be used alongside this course as part of your own due diligence and assurance procedures and also provides space to answer the questions you are encouraged to “Ask Yourself” within each of the modules.
Links to supplementary info you may find useful