Why innocence isn’t enough: The hidden VAT risks in labour supply chains
Robin Prince · Posted on: September 11th 2025 · read
HMRC is stepping up its use of the Kittel principle to challenge VAT recovery where fraud is identified in supply chains.
Originally developed to tackle large-scale missing trader fraud, we are now seeing the principle being applied more broadly, with temporary labour supply chains a particular focus.
For businesses reliant on agency staff, this trend brings heightened compliance risk and a pressing need for robust due diligence.
The Kittel principle – a refresher
The European Court of Justice’s 2006 decision in Axel Kittel established that a business may be denied input tax recovery if it knew, or should have known, that its transactions were connected with VAT fraud.
The principle allows HMRC to look beyond the immediate supplier and consider the integrity of the entire supply chain. Importantly, a business does not need to have participated in the fraud; failure to recognise and act on warning signs can be enough to trigger denial of VAT recovery.
Recent First-tier Tribunal cases have underlined HMRC’s determination to apply Kittel more widely, with labour supply arrangements a consistent theme.
Why labour supply chains are under scrutiny
Temporary labour supply chains are often complex, involving multiple layers of subcontractors and umbrella companies. This structure creates opportunities for fraudulent operators to insert themselves into the chain. HMRC frequently highlights:
- Short-lived or “phoenix” companies that vanish before liabilities fall due.
- Umbrella companies with opaque structures or offshore links.
- Uncommercial pricing or terms inconsistent with market norms.
- Reluctance to provide information when due diligence is requested.
Case spotlight: Cheema Construction Ltd
The recent case of Cheema Construction Ltd v HMRC illustrates HMRC’s willingness to deploy the Kittel principle aggressively, even against businesses that see themselves as operating honestly.
HMRC had denied Cheema input tax recovery on the basis that fraud existed within its labour supply chain, arguing that the company “should have known” of the connection. However, upon appeal, the Tribunal found in Cheema’s favour, concluding that the business had not turned a blind eye to risks and that HMRC’s case did not meet the Kittel threshold.
While the taxpayer was ultimately successful, the case highlights that HMRC will pursue Kittel-based challenges even where the evidence of culpability is weak.
For honest businesses, this means the burden of proof lies in demonstrating a structured approach to due diligence and documenting supplier checks. Without this, even a legitimate business risks being dragged into costly and disruptive disputes.
The risks for businesses
Where HMRC applies the Kittel principle, the impact can be severe:
VAT denied
Input tax recovery can be blocked, often for substantial amounts.
Penalties
Financial penalties under FA 2007, Sch 24.
Personal liability
Directors may face Personal Liability Notices.
Operational disruption
Delayed VAT recovery, cashflow strain and reputational damage.
Even if businesses ultimately succeed in defending a challenge, the cost and reputational damage of prolonged disputes can be significant.
Mitigating the risk
The best defence lies in demonstrating a robust and ongoing due diligence process. Businesses should:
- Verify VAT registration, trading history of all suppliers.
- Assess whether commercial terms and margins are realistic.
- Know how long the supply chain is.
- Keep thorough, date-stamped records of checks undertaken.
- Repeat checks at regular intervals, not just at onboarding.
- Repeat checks at regular intervals, not just at onboarding.
In practice, HMRC often focuses as much on the evidence of a process as on the checks themselves. A well-documented audit trail can make the decisive difference.
Engaging with HMRC
If HMRC raises concerns, early and constructive engagement is essential. Producing contemporaneous evidence of due diligence and demonstrating active monitoring of supply chains are the most effective ways to defend against a Kittel-based challenge.
Looking ahead
"Temporary labour supply is currently in HMRC’s spotlight, but the use of Kittel is expanding. Other high-risk sectors with complex supply chains are likely to come under scrutiny. Businesses should not wait until HMRC comes calling to review their controls."
Conclusion
The Kittel principle has become a central part of HMRC’s enforcement approach. For businesses that rely on temporary labour suppliers, VAT recovery is only secure where robust due diligence can be demonstrated. Strengthening compliance frameworks now is the most effective way to minimise exposure, protect cashflow and remain prepared for HMRC’s increasingly assertive stance.
If you would like to discuss how these developments may affect your business, or to review your current supplier due diligence processes, please get in touch with Robin Prince or your usual VAT adviser.
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