Written by Richard Cornelisse
Published in 2005
A key business objective in today’s complex regulatory environment is the promotion of shareholder confidence in a company’s financial statements. Finance functions of major multinationals operate within a corporate culture that places increasing emphasis on the core values of trust and integrity. Within this culture the overriding strategic imperative of many CFOs is to manage their company’s financial reporting obligations and avoid reputational risk.
The indirect tax function has a vital role to play in the execution of this strategy. A sample survey of the published accounts of several Global 1000 companies suggests that their throughput of indirect taxes in 2004 was significantly greater than their reported net income.
Recognize VAT risks This is not surprising when you consider that VAT is a transactional tax with the potential to impact all profitable exchanges of value with suppliers and customers. However, not every organization recognizes the potential impact of indirect tax reporting errors on the validity of its financial statements.
Many organizations continue to manage their global indirect tax throughput without reference to risks that are inherent to all transactional operations and processes.
Other organisations have successfully identified indirect tax risks within their global ERP systems design and accounting processes, but have yet to develop a coherent and proactive indirect tax strategy that addresses and effectively manages these risks.
Managing indirect tax risk – the principal challenges
A combination of external regulatory factors and changed operational priorities has resulted in a significant increase in the profile of Indirect Tax risk for multinational organisations.
As the courts continue to develop a concept of ‘abuse of law’, local tax authorities promote assurance and anti- avoidance strategies that place a significant compliance burden on the internal indirect tax function. At the same time, the drive towards value-optimized procurement and distribution functions - often on a regional or global basis - has added greater complexity to the transactional reporting
Absence of a VAT strategy Ratio of indirect tax throughput to other key accounting items - a typical example (Global 1000) obligations for most major multinationals. Failure to refine VAT-critical accounting systems and processes to reflect this greater complexity gives rise to an increased risk of VAT reporting errors.
In our experience a common factor among organizations with an increased risk profile is the absence of a clear strategy to manage both the technical and operational risk issues associated with indirect taxes.
Most major multinationals now include one or more indirect tax specialists within their internal tax function. However, the way in which organizations seek to utilize this specialism tends to mirror the traditional consulting model: the specialist adviser holds a central position within the tax function, responding to individual queries raised by logistics managers, accounting staff and local business units.
The role is typically a reactive one, relying on the ability of colleagues with an operational or local market focus to identify potential areas of indirect tax risk and refer them to the tax department for specialist review. As a consequence, central visibility of the VAT compliance issues affecting local country operations tends to be patchy at best, with little or no continuity in the management of local indirect tax risk across the enterprise.
A further limitation on the effectiveness of the in-house VAT adviser is that he or she tends to focus on technical questions of strict VAT liability, rather than on the operational issues affecting the integrity of transactional reporting.
Who is responsible? This restriction on the scope of the Indirect Tax function is partly determined by traditional assumptions as to the appropriate division of responsibilities between the information technology, finance and tax functions.
Within most organizations there is no single person or department responsible for the end-to-end VAT accounting process. The finance department owns overall responsibility for the sales and purchase processes, but the application architecture underpinning those processes is configured and maintained by the IT department.
IT setup and manual intervention VAT-critical aspects of ERP systems design such as master data set-up, VAT determination logic and tax code functionality can fall into a ‘black hole’ as a consequence, the IT department lacking the specialist knowledge to optimize and maintain the VAT reporting functionality of the ERP system.
In a similar fashion, the control environment surrounding manual intervention in the accounts payable and receivable processes remains the responsibility of the finance department. VAT-critical processes such as PO creation, invoice verification and AP tax code selection are subject to limited or inappropriate controls, while the attention of the internal indirect tax function remains focused on the provision of ad hoc advisory support to local business units.
Despite the potential impact of indirect tax errors on the audited accounts, the financial reporting responsibility of the in-house VAT specialist tends to be limited to VAT returns and associated filings (eg. EC Sales List, Annual Sales Listings, Intrastat).
Developing a proactive strategy for indirect tax
Robustness of risk framework An increasing number of in-house VAT managers are facing the challenge of creating an indirect tax strategy that is more closely aligned with the business objectives of operational integrity and the promotion of shareholder trust. Key to this development is a growing awareness that the effective management of indirect tax risk requires an operational as well as a technical focus.
Failures in VAT-critical systems and processes can result in overpayments of VAT that represent a real cost to the business, or in underdeclarations that entail the threat of penalties and reputational risk. The task of the in-house VAT function is to consult with the CFO, Board and other parts of the organization to design and implement an Indirect Tax strategy that can be communicated to non- tax specialists within the organization who fulfill key operational roles in the end-to-end VAT accounting process.
By working with the IT and finance functions, the in-house VAT function can help identify latent risks within existing VAT-critical systems and processes. He or she can then begin to build a risk framework around those core functions to help minimize operational errors.
The scope and robustness of the risk framework will depend on the individual organization, its operating structure and its preferred risk profile. However, a number of operational risk issues will be common to many multinational organizations. How does the IT department guarantee the integrity of transactional data processed through its ERP systems?
- What safeguards are there against failures in connectivity between individual ERP systems and other VAT-critical applications (e.g. standalone T&E systems)?
- How often is the ERP tax code set-up and tax determination logic reviewed and updated?
- What subject matter guidance is available to non-tax specialists in VAT-critical operational roles such as procurement, logistics and accounting?
- Who discusses materiality issues with external auditors and advises on the accuracy of provisions?
- Who owns the relationship with local tax authorities?
- If significant operational changes are required to the end-to-end VAT accounting process, who takes overall responsibility for project and workflow management?
- To what extent is the appetite for planning risk within the indirect tax function aligned with the strategic approach to operational risk taken by the business?
Increased visibility and internal awareness By taking steps to address questions of this type, by identifying key stakeholders in the IT and finance functions, and by defining VAT-critical roles and responsibilities within the end-to-end VAT accounting process, the in-house VAT manager can begin to raise an awareness of the operational impact of indirect taxes throughout the organization.
Through the development of an appropriate risk framework around VAT-critical functions, he or she can then provide the organization with improved visibility of the impact of indirect taxes and certainty as to the true impact of the VAT numbers on the financial statements. With improved visibility of the current state will come opportunities to optimize the way in which the organization manages its throughput of indirect taxes.
Increased automation of VAT accounting and reporting, greater use of tax technology enablers (e.g. e-invoicing, e-filing) and the use of place of supply simplifications or payment deferral options to reduce VAT working capital requirements are all examples of ways in which the in-house Indirect Tax function can add value through tax operational improvement rather than traditional VAT consultancy.
Defining “Best Practice” Indirect Tax Management
Responsibility for the operational integrity There is no ‘one size fits all’ approach to the design and implementation of an operational indirect tax strategy. However, the goal should be to create an Indirect Tax function that is fit for purpose and fully aligned with the operational priorities and risk appetite of the business.
Through the design and implementation of effective controls, the objective of the internal indirect tax function should be to assume overall strategic responsibility for the operational integrity of VAT-critical systems and processes.
However, the allocation of VAT-critical roles and responsibilities will depend on the specialist resource available to the in-house VAT function as well as the internal operating structure of the organization.
For example, if the organization has chosen to centralize its transactional processing, accounting and reporting functions at a Shared Service Center, it may be possible to make specialist indirect tax resources available on-site to oversee VAT-critical processes and guarantee the prompt resolution of queries.
Where responsibility for transactional processing, accounting and reporting remains in the local markets, a different control environment will be appropriate, with local financial controllers required to act as key stakeholders in the tax management process.
The important point is that whatever the operational structure, the indirect tax function should take responsibility for designing appropriate controls, documenting those controls and ensuring their operational effectiveness throughout the organization.
Tax risk management model The controls must recognize the systemic nature of indirect tax risk – the traditional focus on the month-end reporting process alone will fail to address potential exposures arising from poor ERP functionality or weaknesses in accounts payable and receivable processes.
Unless there are measures in place to capture and control the end-to-end VAT accounting process, the result will be an incomplete risk management strategy that is essentially unreliable.
By contrast, an improved tax risk management model should involve periodic testing of controls to guarantee the effectiveness of VAT-critical processes.
A fully optimized risk management model will integrate the automatic testing of controls within its operational design. For example, the tax function could take advantage of diagnostic tools to verify the integrity of transactional data on a periodic basis. Automated exception reports, variability reports and duplicate posting reports can all be used to identify undetected weaknesses in VAT-critical systems and processes.
VAT Function Effectiveness – next steps
Contribute added value For organizations with significant geographical reach, diffused responsibility for VAT-critical accounting processes, or a complex ERP application architecture, improving the operational management of indirect taxes represents a sizeable challenge.
In meeting this challenge, the internal VAT manager will necessarily redefine his or her own role and raise the profile of indirect tax within the organization.
In the short term, the initial task of capturing the end-to-end VAT accounting process and identifying the operational impact of ERP systems design and AP/AR practices on the management of indirect tax risk may require additional resource and expertise. However, by redefining the indirect tax strategy, giving it an operational as well as a technical focus, and aligning the strategy to the key business objectives of transactional integrity and financial reporting accuracy, the in-house VAT function can make a valuable contribution to the organization as a whole.
Written by Richard Cornelisse
Richard advises multinational businesses in improving the efficiency and effectiveness of their Indirect Tax Function and Tax Control Framework.
He started his career as a manager at Arthur Andersen and then became a partner in EY where I led the indirect tax performance team for Netherlands and Belgium. Currently he is a senior managing director of Phenix Consulting.
Richard has over 20 years’ experience advising clients on international VAT issues. He is specialized in the tax aspects of financial transformations, shared service centre migration, and post merger integration work. Richard is also somewhat of a mentor, giving back to the profession. If you are interested in conversation and discussion, please feel free to contact him.