Indirect Tax: A Source Of Risk

Indirect Tax Process Review

The issue

As business complexity increases, so too can the burden of VAT. As the regulatory environment tightens and the authorities develop ever more efficient means of auditing tax data, Financial services businesses are increasingly experiencing failures in VAT computations and treatments.

These can lead to real costs to businesses in the form of tax penalties, reputational risk and a decrease in stakeholder confidence.

VAT/GST rates are increasing. Coupled with the ongoing economic crisis, VAT/GST rates have increased impressively in recent years as a result; at the same time, the scope of VAT has broadened in many countries. Higher VAT rates increase risk as companies must manage greater amounts effectively in their accounts.

The consequence of making errors also increases, as penalties for errors are a percentage of the underpaid tax.

Global indirect tax developments: the shift in 2013

Managing The Multinational Indirect Tax Burden

For MNEs wishing to improve the levels of efficiency, control and value in this area, the issues for consideration are many and diverse.

The multinational indirect tax burden

While MNEs are increasingly being challenged to meet their multiple obligations for VAT, GST and other transactional taxes around the world, they typically have limited resources who fully understand the obligations and how to meet them.

Globally, indirect taxes to be managed are diverse and may include VAT, GST, other federal and local sales and business taxes, customs duties and excise taxes. No matter whether they are structured globally, regionally or otherwise, MNEs’ finance, tax and legal functions may struggle to understand and control this wide range of indirect taxes due to their local nature and tendency to quickly change as governments increasingly use them as a policy tool.

Managing VAT/GST globally

Despite very real obstacles, MNE taxpayers can significantly improve their indirect tax performance in all phases of the tax life cycle (tax planning, tax accounting, tax compliance and controversy) through better management of their indirect tax function.

Advances in technology and process capabilities are providing opportunities that were not available even just two or three years ago. These new capabilities allow MNEs to strike a better balance between efficiency, control and value in managing indirect taxes. As MNEs increasingly undergo financial transformation (which may include enterprise and resource planning (ERP) system implementations, rationalization projects, changes in tax or financial management and the adoption of a global compliance and reporting framework it provides a rare opportunity to bring indirect taxes “into the fold.”

“The tax authorities get more and more sophisticated with electronic auditing and that will give them a big advantage. Now they just run some reports and they have software and they very quickly see everything.”

The Global VAT Director of a multinational manufacturing company

The Global VAT Director of a US financial institution explains how a corporate move of the VAT function prompted a wider review of the group’s underlying processes:

“ With regard to the UK VAT return, the big issue for us has been completing a transition of the VAT work to an in-house shared service center under a completely new team, and that has been very challenging.
“ To achieve that, we looked at much wider issues relating to the AP and AR functions. In AR we had a major review of our billing systems, and at the moment we are implementing that report. There was nothing seriously wrong but there were some gaps in the knowledge that our billing teams had when they on-boarded a new client, and all that has lot of detail that has to be put right.”

“In Germany we will get new legislation regarding a penal law for taxes. As I do not want to go to prison if something goes wrong, I have to address indirect tax risks.” The Global VAT Director of an EU multinational

“I have a lot of support in the company for the basic idea of adopting a VAT control framework, but as soon as it comes to who bears the cost, you don’t have support at all. As long as you are not billing to a particular cost center, everybody supports this idea. But as soon as some cost center has to pay the amount, then the support is gone.” The Global VAT Director of a multinational manufacturing company

The Global VAT Director of an EU multinational discusses drivers that could help make a case for undertaking a project to manage VAT/GST better:

“ In the board you will see direct taxation is an issue because it is a line in the P&L, and there have been some really nasty cases with transfer pricing and they are even asked for the tax rate and things like that. So, they have a feeling that this is something important. But for indirect taxation, they have no awareness because in the best case, you come out at zero. We cannot really gain. This
is where they don’t see the importance of VAT and that’s why I would think it is important for advisors to address the board and say, ‘Listen guys, if something goes wrong with VAT, it will have this and this result on the earnings per share,’ and give them some numbers so they can see, ‘Oh, gosh, this can really hurt me!’.”

The Global Indirect Tax Manager of a US multinational operating in more than 100 countries talks about the measure of VAT risk:

“ I do not understand why most of the businesses in (the corporate group) do not see VAT as material. In other words, there is no SOX testing. On the one hand, we say VAT is important, we have major risks, we need processes, and we need resources. But on the other hand, when it comes to SOX testing, it’s not material. I think that’s contradictory. It’s partly how it’s quantified. In general, when they look at VAT risks, and obviously this is people outside the VAT community, they say, ‘Basically, you have your pluses and minuses and the balance between the two is a risk.’ Rather than looking at the amount that’s going out and the amount coming in and adding them up, they net them off. They never look at the throughput because that would blow the roof off the risk. It would be material — there is no doubt about it.”

The Global VAT Director of a US financial institution talks about corporate responsibilites for VAT:

“ I don’t think previously it was understood that the underlying feeder systems to the VAT account and the VAT return have to be 100% accurate to put you in a position that when you sign off the return you can say, ‘This is correct and I stand by it.’ Of course, that’s an issue which has become much more important for senior management with the developments around Sarbanes-Oxley. And more recently things like the senior accounting officer (SAO) sign-off in the UK is concentrating attention, the realization that the buck stops pretty high up on VAT compliance." One way of sleeping more securely on that is to make sure that you have good systems and you have enhanced automation of the VAT processes, that you are actively managing the tax rather than just letting it drift. For example, you can analyze what went wrong each time you complete the VAT return and put it right for the future rather than dealing with it every time the issue comes up. That’s really where I have been concerned to try to push through some quite radical changes in the way we do things.”

“I would like to see there be a function within our own tax department that has responsibility and oversight for indirect taxes and to see that we are optimal, neutral and compliant.” The Global Tax Director of a South American multinational corporation

The Global Tax Director of a South American multinational company talks about plans to increase indirect tax management resources and how he perceives other companies are doing in this area:

“ There is no one individual that has management of VAT/ GST clearly in his or her job description. We are thinking of appointing someone to be responsible for global VAT with perhaps oversight over the shared service center in Brazil and the outsourcing to third parties in the other countries. But we are not there yet. “ I don’t know how other companies are organized but I would expect that we are a bit behind. If I look at other multinationals in Europe, I know that some of them have people with VAT responsibility with a bigger or smaller team to support them. The bigger multinationals, I would say, those with over €5 billion in turnover, yes, they have a VAT director — some for many years now.”

The Global VAT Director of an EU multinational outlines his plans for implementing gradual change to manage VAT/GST within the organization:

“ In the mid-term, I would prefer it to be our Tax and Legal department giving the directions and conducting the quality assurance, like VAT risk management, just to check whether the instructions we have given are properly implemented.
“ In the long term, I would like advisory and compliance combined in one central department which is then the owner of the VAT process and, in the best case, is the owner on a worldwide global basis.”

Read more: Managing The Multinational Indirect Tax Burden

Indirect tax in 2013: With change comes complexity

The sheer number and variety of changes in indirect taxes in recent years and the challenge of implementing them into accounting and reporting systems can be overwhelming -- making it hard to keep sight of the bigger, strategic picture. But what do all these changes add up to? Do common themes emerge? What changes can we expect in the future?

I. The “tax mix” is shifting toward taxes on consumption

The economic crisis has caused many governments to find sustainable ways to rebalance their budgets and stimulate growth. This would imply governments will continue the shift from direct to indirect taxes, which are less harmful for growth, look to improve the efficiency of indirect taxes and take action to combat tax fraud and avoidance. We believe that the importance of indirect taxes will continue to grow. We have identified five key trends in indirect taxation that we believe will be significant for international businesses in 2013 and beyond.

A. Increasing VAT and GST rates

Limited to less than 10 countries in the late 1960s, value-added tax (VAT) -- or, in several countries, goods and services tax (GST) -- is today an essential source of revenue in more than 150. The spreading of these taxes has also driven constantly rising rates in many countries. In the European Union (EU), between 2008 and 2012, the average standard VAT rate increased from around 19.5 percent to more than 21 percent. The upward rate trend in Europe continues as Cyprus, the Czech Republic, France, Finland, Italy, Poland and Slovenia have already increased rates recently or have announced increases later in 2013 and 2014.

In Asia Pacific, the upward VAT and GST rate trend is less explicit, but still noticeable. Japan, for example, which is struggling with massive budget deficits, decided in August 2012 to increase the current VAT rate from 5 percent to 8 percent effective April 1, 2014 and to 10 percent effective October 1, 2015. Thailand was also considering the possibility of raising its VAT rate from the current temporary 7 percent to the normal 10 percent rate but it is still not known if this will happen.

By contrast, VAT and GST rates in the Americas remain relatively stable. In South America, where VAT systems are widespread and have been in use for some time, rates have not changed much in recent years. One exception is in the Dominican Republic, where the rate is set to increase from 16 percent to 18 percent this year and next year.

B. The impact on business

The significance of this trend for final consumers is clear: retail prices rise. But its impact on businesses is equally important: higher VAT and GST rates increase compliance risks and may result in a higher tax burden where cascading VAT may not be fully recoverable. Companies must ensure that all the increases are properly dealt with in their accounting and reporting systems, which often results in a range of IT and administrative costs. Errors frequently arise when rates change, resulting, for example, from incorrect product or tax codings or confusion about the correct rate for supplies that span the change. More generally, rate increases mean the amount of VAT or GST “under management” also increases, as do penalties for errors that are based on the amount of tax payable.

II. Rising excise taxes

Europe also seems to be the leading region for increasing excise taxes as the three important groups of “classic” excise taxes (alcohol, tobacco and mineral oils) have seen significant increases. This year, excise taxes on tobacco and alcohol have increased, or will soon increase, in most EU countries, including Guernsey, Moldova, Norway and Switzerland. But the trend can also be seen in other parts of the world; in Africa, higher excise taxes are being imposed on these items, e.g. in Benin, Gambia and Zimbabwe. In the Americas, Aruba, Canada, Costa Rica and Mexico have also raised taxes on alcohol or tobacco, as have Fiji, New Zealand and the Philippines in Asia Pacific.

A. Influencing consumers

While the main purpose for excise tax rate increases is to raise revenue, these taxes are also increasingly being used to discourage consumption of certain products considered to be harmful, thus influencing consumer behavior in a number of areas. A relatively new trend is the introduction of excise taxes on health-related products (other than alcoholic beverages and tobacco products), such as snack taxes on “unhealthy” food. For example, Benin, Costa Rica, Norway and the Philippines have all increased excise duties on soft drinks, Finland has introduced an excise tax on sweets and ice cream, and in France a specific contribution has been introduced on suppliers of beverages (sodas) with added sugar or sweeteners.

Over the last decade, environmental issues have also played an increasing role in determining the nature and application of taxes, e.g. on road fuel, motor vehicles and CO2 emissions. This type of measure includes tackling issues such as waste disposal, water pollution and air emissions. With support from the Organisation for Economic Co-operation and Development (OECD), whose analysis seems to confirm the advantages of environmental taxes,1 many countries are introducing or increasing such taxes. Current examples are Germany, Ireland and South Africa.

B. Taxing financial transactions

Finally, there is a noticeable trend toward increasing the tax burden on financial transactions. Although there seems to be a common and widespread belief among countries that the financial sector should contribute its fair share in remedying the damage arising from the financial crisis, there is no common approach as to how this should be achieved. Some countries have increased supervision of the industry and tightened regulations. However in Europe, in particular, the preferred approach has been to levy taxes on financial transactions. France introduced a financial transactions tax in August 2012, and on January 1, 2013, Hungary introduced a tax of 0.1 percent on the amount involved in any payment service. Italy followed in March 2013, with a tax on the transfer of shares and derivatives and high-frequency trading. In addition, 11 EU Member States have agreed to introduce a common transaction tax on the exchange of shares and bonds and on derivative contracts, which could be introduced as early as 2014.

III. Free trade increases, but is meeting protectionist challenges

Customs duties were once a primary source of revenue for most countries. Global, multilateral and bilateral efforts to globalise trade, through organisations such as the World Trade Organization (WTO) and others, have led to decreasing duty rates and a downward trend in customs duties around the world.

The WTO currently has 158 members (the most recent, Laos, joined at the start of February 2013) and it reports 546 active and pending reciprocal regional trade agreements among its members. A number of new free trade agreements (FTAs) are expected to enter into force in 2013, thus further reducing the amount of customs duties imposed on global trade. Examples include the agreement involving the EU and Peru and Colombia, Montenegro and the European Free Trade Association, Hong Kong and the European Free Trade Association, and Indonesia and Pakistan. Nearing completion are, among others, the trade agreements between Costa Rica and Peru and between Canada and India, and negotiations are in various stages of completion for a range of others.

However, the situation is not always that straightforward. Although customs duty rates are generally reducing for international trade, these taxes still play a very significant role in meeting countries' budgetary needs. In many cases, duty rates on many goods and materials remain high. Additionally, the compliance obligation to access the lower customs duty rates, such as meeting strict country of origin requirements, means companies must maintain controls to enjoy the preferential rates or risk large assessments for violations.

Unlike VAT and GST, duties charged at one stage in the supply chain are not offset against taxes due at later stages, so duties form part of the cost base of affected goods. In addition, customs clearance procedures can add to the time and related costs of moving goods cross-border. And even where FTAs exist, many businesses are not actually obtaining the potential benefits offered because they cannot, or do not, meet the qualifying conditions.

A. Protectionism

More generally, global trade may be hampered by the current economic climate, which is encouraging protectionist tendencies, as evidenced by the current difficulties encountered in the Doha Round. Non-tariff barriers have grown substantially in recent years, many in the form of health, safety or environmental requirements. The WTO reported 184 new trade-restrictive measures enacted between October 2010 and April 2011 and 182 between October 2011 and May 2012.

In addition, where countries are not bound by FTAs, import duties are still a common and often-used means to steer trade and production. For example, to boost the development of sugar cane production toward meeting the raw sugar needs of domestic sugar refining companies, effective January 1, 2013, Nigeria now applies a 0 percent import duty on machinery for local sugar manufacturing industries, but it has increased the total tariff on imported refined sugar to 80 percent from 35 percent, and raw sugar tariffs increased from 5 percent to 60 percent.

IV. Making indirect tax systems more efficient

A. Changing law and practice

Many countries are currently in the process of refining their indirect tax systems. In developed markets, long-standing VAT systems need to adapt to the demands of a 21st century digital economy. In emerging markets, which are experiencing economic developments at a fast pace, indirect tax systems need to adapt to keep pace. In India, for example, a new nationwide GST is ready to be implemented and only awaits agreement between the central and state governments. Similarly, China is in the process of combining its current business tax (BT) on services with a broader-based VAT through a series of VAT pilots. In the end, the VAT pilots and reforms are intended to join China's BT and VAT into a single GST, with the authorities targeting an aggressive timeline of 2015.

In the EU, the European Commission has launched a comprehensive reform of the existing VAT system. The Commission has identified no fewer than 26 priority areas for further action. Significant changes can be expected in the near future, such as the adoption of a one-stop-shop registration for all taxpayers' duties or a standardised EU VAT return.

The US is still far from implementing a federal VAT. But, even in the US, a trend can be seen toward states extending the scope of their current sales taxes. While sales taxes, by definition, only apply to purchases of physical goods, it is the market in electronically supplied services (such as digital music distribution, internet downloads or telecom services), which is growing fastest. An increasing number of states are, therefore, trying to expand their current sales tax to cover electronic goods and services or are trying to create a “nexus” for out-of-state vendors to constrain sellers to collect sales taxes on remote sales.

B. Improving tax administration

Finally, governments have discovered that, on the administrative side, the efficiency of indirect tax systems can be drastically improved -- which increases tax revenues. There are many approaches taken by governments, but an important one is to create common interfaces and reduce gaps in the system. This is one reason why many governments are enforcing the use of electronic data transmission and filing. The reason for this trend is clear: e-filing considerably eases processing the information for tax administrations and makes administration faster and more efficient. In addition, having electronic data enables tax administrations to use IT-based audit tools more easily, which can help to combat fraud and evasion.

Most taxpayers can also benefit from increased efficiencies arising from e-filing, but dealing with multiple tax administrations' different requirements and tax administrations' increased audit capacities means that greater focus must be given to the accuracy and efficiency of indirect tax compliance processes to avoid an increased risk of incurring penalties.

V. Increased focus on enforcement

The growing importance of indirect taxes to governments places more pressure on tax administrations to enforce compliance. This focus is leading to greater scrutiny of taxpayers' affairs through more frequent and more effective tax audits and greater consequences for errors.

A. Audits and exchange of information

In December 2012, we conducted a survey of Ernst & Young Indirect Tax professionals in 39 countries.2 The responses given in the survey indicate that the number of tax audits has increased in recent years and is likely to increase further in the future. Only six countries reported that audits had decreased; even then, in some cases, while the number of audits carried out was said to be lower, the amount of additional tax levied due to tax audits is still increasing. This can be explained by tax administrations carrying out more targeted audits; 24 out of the 39 countries already use specialised IT tools, such as audit software, to detect irregularities or suspicious patterns in taxpayers' tax returns.

The level of exchange of information between countries varies widely. It is widespread in Europe, where the common EU VAT system requires an extensive information exchange. On a global scale, the multilateral Convention on Mutual Administrative Assistance in Tax Matters, which is open to all interested countries, facilitates exchange of information on all compulsory payments to the general government except for customs duties.3 In the last two years, more than 50 countries have either become signatories to the convention or have stated their intention to do so. But, even if countries do not (yet) share information, they increasingly exchange information internally, between different authorities and departments (e.g. with customs or social security authorities). Only 4 out of the 39 countries we surveyed do not share any information at all.

B. Targeting fraud but hitting “honest” taxpayers too?

There is nothing to be said against stricter compliance enforcement if it actually helps to fight fraud and abuse. The other side of the coin, however, is that tax administrations have generally become more wary toward all taxpayers; they are less open to entering into discussion, and it is more difficult to reach mutual agreement on specific issues.

Tax administrations increasingly apply a strictly formal approach without considering specific economic and business issues. This has massive consequences, in particular for VAT and GST, where being compliant increasingly requires deep expertise, even more so as our survey shows that formal mistakes (e.g. missing information on invoices) are still by far the most frequent reason for VAT and GST adjustments, be it an additional tax charge or the denial of input tax recovery. In addition, we observe a tendency for tax administrations to pay out input tax surpluses with increasing delay -- if at all -- or to reject an input tax claim based on bad faith, stating that claimants should know that their suppliers did not handle the tax correctly.

At the same time, many countries are applying stricter penalty regimes in the case of non-compliance and mistakes. In our survey, 27 of the 39 countries reported that penalties are increasing, and only 3 saw a decrease. Fines are generally imposed faster and sooner and the fines are higher than in the past. Increasingly, fines are enforced for timing issues, such as late payment, where in the past tax administrations were more lenient on these issues (for example, Austria, Germany, Pakistan and New Zealand).

VI. What can taxpayers do?

The trends identified in this article are not entirely new but they have become more pronounced in recent times. And it is precisely their continuing existence that indicates that they are important and long-term developments. All of these trends have a direct impact on businesses, which need to keep abreast of these changes.

Indirect taxes are not easy to manage. For example, excise duties, such as carbon taxes, change quickly and represent a high compliance risk because they typically operate differently in each country. Taxpayers who collect VAT or GST from final consumers on behalf of the state run increased risks of carrying the tax burden, and eventual penalties, themselves if they do not manage the tax correctly.

With tax administrations assessing taxes more thoroughly and using powerful and efficient tools, the chance that mistakes will be found has risen considerably and will remain high. Also, as indirect tax rates increase, the consequences of mistakes become more severe. This is particularly true for businesses that do not recover VAT or GST in full (e.g. because of VAT-exempt activity), such as banks and insurance companies. But higher rates also have an increased cost or cash flow impact on companies that incur VAT or GST in foreign jurisdictions, which is not refunded quickly, or which they do not or cannot recover (e.g. because of an absence of refund schemes for non-residents or because of complicated refund procedures).

As indirect tax administrations are turning increased attention to enforcement -- including joint audits with other taxes and even other countries -- these activities may disrupt business activity. Large assessments for underpaid tax or penalties for late filings do not only have an impact on profitability, they may draw unwanted adverse publicity, even for compliant businesses.

More than ever, it pays to manage indirect taxes proactively. Establishing a clear indirect tax strategy aligned to the overall business strategy will help in staying up to date with the rapidly changing tax environment and avoid the additional costs and risks of poor compliance or missed opportunities.

Notes

1 Environmental Taxation: A guide for Policy Makers, available at
www.oecd.org/greengrowth/environmentalpo...luation/48164926.pdf

2 The survey included the following countries: Australia, Austria, Belarus, Brazil, Canada, Chile, China, Cyprus, Czech Republic, Denmark, Egypt, Finland, Germany, Greece, India, Indonesia, Italy, Kazakhstan, Latvia, Malta, Moldova, Morocco, New Zealand, Norway, Pakistan, Peru, Portugal, Romania, Russia, Singapore, Slovakia, Slovenia, South Korea, Spain, Sweden, Switzerland, Tunisia, Turkey, Ukraine.

3 www.oecd.org/ctp/eoi/mutual

Tax policy and administration – Global perspectives

June 2013: The trend for governments to raise more revenues through indirect taxes seems set to continue. The resulting shift from direct to indirect taxes will give multinationals fresh challenges. Your company may need to take a different approach to tax management in the future.

Shifting the balance from direct to indirect taxes: bringing new challenges

SAF-T

More efficient use of technology can also lower costs of collection and compliance. Electronic invoicing
has now become the global norm. Interest is growing in the concept of electronic auditing by tax authorities of a business’s financial records
and systems, with countries such as France now systematically applying these techniques. More territories are adopting tools that can interrogate such records on the basis that they must support the standard audit file for tax (SAF-T) methodology. Singapore is encouraging businesses to adopt the SAF-T standards and is helping to fund projects in cases where the business has an appropriate internal indirect tax control framework to manage

GST risks, as noted in our country profile. Brazil, notably, requires a business to hand over all its electronic financial records.
The network of agreements for the exchange of information between territories has grown substantially since the OECD’s publication of a list of countries not co-operating in applying its information standards. It’s now exploring further opportunities for automatic exchanges of information.

The possible extension of joint audits including elements of indirect taxes, with tax authorities in different countries directly collaborating in planning and carrying out an audit, is another interesting potential development, which is already taking place within the EU.

Greater cooperation between tax authorities on indirect taxes

There are probably three main areas for further cooperation in indirect taxes between tax authorities in the near future:
• transfer pricing and customs valuation;
• compliance and enforcement, including information exchange and risk management; and
• capacity building, i.e. developing
a team of civil servants with the right knowledge, skills and tools to administer a viable tax system.

The first meeting of the OECD’s Global Forum on VAT in November 2012 (attended by tax authorities from both OECD member and non-member countries plus a delegation from BIAC, the business and industry advisory committee) identified that strategies to address VAT fraud need to be aligned and operated in conjunction if they’re to have the desired success.

OECD International VAT/GST Guidelines

That was also part of a wider recognition that countries could (and probably should) collaborate more, both on specific issues and in establishing best practice in VAT administration and compliance. There are particular challenges to address, it was agreed, on applying VAT in international trade. There was also discussion of the OECD International VAT/GST Guidelines to develop and broaden consensus and a chance for non-OECD economies to input before the work is finalised by the end of 2013.

Those guidelines, being finalised after the recent consultation, will deal with the following:

• VAT-neutrality: what does it mean and how to ensure it in practice?
• applying the destination principle on cross-border supplies of services and intangibles between businesses (B2B) – a main rule and specific rules;
• applying the destination principle on cross-border supplies of services and intangibles to final consumers (B2C);
• anti-abuse provisions; and
• mutual cooperation and dispute resolution.