At its simplest, carousel fraud involves a company that is registered for VAT in one EU member state (the exporter) selling goods to a company that is registered for VAT in a different member state (the importer) (see box "The money-go-round").

Exporters of goods from other member states can claim VAT refunds for VAT that they paid on buying goods for export but do not charge VAT when exporting them.

Importers do not in practice pay VAT on the import of the goods from another member state. This is because, although an importer is obliged to record VAT chargeable on the import on its VAT return, it can also claim a credit for that VAT on the same return (to the extent it is generally allowed to recover VAT), leaving a net payment to HMRC of nil.

So, for example, on a standard-rated import of goods with a value of 100 from Germany to the UK, the importer will show in its VAT return a payment of VAT to HMRC of 17.5 and a matching VAT credit of 17.5.

When the importer resells the goods, it charges VAT to its customer (who is registered for VAT in the same member state and may or may not be in on the scam). If the goods are resold for 95, the importer will charge its customer 111.62 (95 plus 16.62 VAT).

And that is where the fraud comes in. In our example, the importer should pay a total of 16.62 to HMRC (that is, 17.5 on the original import less the matching 17.5 credit, plus 16.62 on the resale). However, in a carousel fraud, the importer fails to do so, becoming a "missing trader" and leaving HMRC down 16.62 and itself 11.62 in profit, despite having sold the goods at a discount.

Even if the importer fails to pay its VAT, the customer can claim 16.62 from HMRC, either by way of an actual refund or by reducing its own liability to pay VAT. This is true even if the customer re-exports the goods VAT-free (charging, for example, 98 plus VAT at 0%).

In practice, what this means is that HMRC has not just lost out on tax it should have received from the importer: it has actually paid money away to the importer's customer. In this example, all parties have made a profit (11.62 to the importer, 3 to the customer and 2 to the exporter), so there is an incentive for the middleman (the importer's customer) not to ask too many questions as to the source of this new line of business.

The goods used in carousel fraud are usually mobile phones or computer chips, due to their small size and relatively high value. They are usually resold several times before being exported again.

By adjusting the timing of the various VAT returns made by the parties, the customer can obtain his VAT refund and re-export the goods before the importer goes missing. This means that the same goods can be taken round and round before the fraud comes to light, often making a detour via Dubai, Switzerland or some other non-EU country to avoid EU authorities tracking the goods, hence the name "carousel" fraud. Each revolution generates a VAT payment from HMRC which the importer effectively steals by failing to pay its VAT.

If the goods are exported to another member state, the carousel can start up all over again in that country.

HMRC has undertaken detection operations like Operation Sunrise to try and stem the tide, using methods such as identifying the serial numbers on mobile phones as they enter the country and tracking the phones across Europe with the assistance of their counterparts in other member states.

The fraud works only where all the companies on the carousel are registered for VAT in their respective member states, so HMRC has also increased its checks on companies registering for VAT. HMRC claims that these practical measures have had some success, reducing the estimated value of carousel fraud this year by nearly one-third. However, the reason the fraud is so widespread is that it exploits failings in the system, so the ultimate answer lies in changing the system itself. HMRC is aware of this but any fundamental change to the EU-wide VAT system has to have the consent of all member states. This is a slow political process.

In the meantime, HMRC has taken two main legislative steps to combat carousel fraud, each with limited success.

First, in 2003, HMRC introduced new provisions into the Value Added Tax Act 1994 (VATA) which were aimed at customers who bought imported goods from missing traders.

These provisions provided that purchasers of mobile phones and other computer equipment could be held jointly and severally liable for the VAT on the purchase if they knew or had reasonable grounds to suspect that the VAT would remain unpaid by the seller (section 77A, VATA). The provisions also allowed HMRC to require the purchaser to provide security to HMRC for the seller's obligation to pay VAT to HMRC (paragraph 4(1A), schedule 11, VATA).

The provisions were challenged in the European Court of Justice (ECJ) in Federation of Technological Industries and others v Customs and Excise Commissioners and another (Case C-384/04) on the ground that they were not permitted by the Sixth Directive on VAT (77/388/ EC) (the Directive).

The ECJ decided that such measures are permitted by the Directive, but that they must be proportionate and legally certain so that traders can be clear they do not fall within them (www.practicallaw.com/9-203-1830). It is now up to the domestic courts to decide whether the existing measures meet these requirements.

Second, HMRC has made an application to the European Commission (the Commission) for derogation from the Directive in order to establish a reverse charge on supplies of mobile phones and computer processing units and other accessories. Under the reverse charge procedure, the usual system for charging VAT is reversed and the purchaser (rather than the seller) of imported goods is required to account for VAT on the sale.

HMRC appears hopeful that the application will be approved later this year. However, earlier attempts by Germany and Austria to obtain a similar but wider-reaching derogation have been rejected by the Commission. The provisions have been inserted into VATA by section 19 of the Finance Act 2006, but will not come into force until at least 2009.

The reverse charge procedure alleviates the problem of the importer disappearing without paying his VAT, because the importer no longer charges and collects cash payments of amounts in respect of VAT from its customers; instead, the liability to account to HMRC for VAT on the supply is passed on to its customer, and through any other VAT-registered middlemen, until the goods are finally sold to the ultimate consumer.

No one in the chain has any great incentive to disappear because their liability for VAT is only incremental. The exception is the business that sells the goods to the ultimate non-VAT-registered consumer, but the theory is that businesses dealing with ultimate consumers can be trusted to pay their VAT, as they are more likely to have a permanent or fixed place of business.

The problem, of course, is that while this may make life more difficult for fraudsters, these provisions will not apply to types of goods that are not specifically targeted, leaving a weakness in the system. And weaknesses in the system are likely to continue unless and until there is a fundamental change to the way the EU's cross-border VAT system operates.