Dutch Financial Management Magazine 2007
Indirect tax control frameworks offer businesses many advantages, such as improved VAT risk control, cost savings and, for large companies, the opportunity to draw up a tax agreement with the Dutch Tax Office. However, sound frameworks do not come out of the blue, but require targeted action by management.
Indirect taxes such as VAT are still quite often neglected within a company's tax control framework. Almost all attention focuses on managing direct tax risks. It is telling that accounting standards FIN 48/FAS 109 do mention direct taxes, but not indirect taxes. However, VAT reporting errors regarding transactions regularly lead to substantial financial losses and damage to corporate reputations.
For instance, a software error caused a major telecom company to pay too much VAT for 11 years. The total excess VAT paid ultimately amounted to approximately EUR 55 million, only EUR 20 million of which the tax authorities were willing to refund. At another company, a software error resulted in the opposite: the company had declared a surplus of EUR 40 million in input VAT. It sometimes happens that a company's annual profit, or even a multiple thereof, is wiped out by the discovery of VAT computation errors.
Painful
Major financial blows resulting from VAT reporting blunders are quite painful in themselves. In times when stakeholders greatly value the integrity and accuracy of financial figures, these types of errors are extra difficult to digest. Often, the proper strategy, systems and mechanisms to control VAT reporting risks are lacking or, in other words, a solid indirect tax control framework is lacking.
Accounting scandals have resulted in a new way of thinking and in mandatory centralized final VAT reporting responsibilities. In practice, we also see that, internal systems and controls tend to be quite imperfect. The role played by internal tax departments and, in particular, VAT experts is often not ideal.
The fact that those departments now bear final VAT reporting responsibility does not mean that they have been able to design and implement adequate indirect tax control frameworks in all companies. The contrary is the case. Even today, internal VAT advisers in financial departments often do not have systems in place to identify weaknesses in their VAT reporting, but deal with problems as and when they arise.
They provide advice on an ad-hoc basis, when questions happen to be posed by logistics managers, accountants or foreign business units. Moreover, most questions asked by these parties are confined to technical VAT matters. Occasionally, internal VAT advisers are asked to assess what VAT rate applies to a specific type of transaction. However, these advisers are much less involved in the operational risks that may stand in the way of proper VAT reporting.
However, it is specifically those operational issues that often cause trouble. The problem is usually not that a business made the wrong VAT reporting decision for a specific class of transaction, but the problem is of an operational nature: due to faulty internal systems, transactions are not correctly processed and accounted for on the VAT return.
No one bears (end)responsibility
Operational errors occur because no one in the company takes responsibility for the integrity of the entire VAT reporting process. The most visible consequence of this is that insufficient attention is devoted to the proper VAT treatment of each class of transaction when designing and adjusting the ERP system. IT experts are not VAT experts. Consequently, critical VAT aspects of ERP systems are sometimes lost in space.
No one cares anymore, and no one checks. In the example of the telecom company given above, the software did register when customers giving notice of termination of their subscriptions during the month were refunded the balance of their subscription fees.
However, the system did not register the fact that they were also refunded the VAT for the fees paid in excess. So, for 11 years, the telecom company missed out on this reduction of output VAT. Another company's ERP system computed the VAT on incoming invoices incorrectly, by computing VAT over the gross (i.e. including VAT) amount of incoming invoices instead of the net amount. Because of which, the input VAT declared turned out much higher than what the company had, in fact, paid in VAT.
To the extent that people are involved in processing and classifying incoming and outgoing invoices, the situation is often also far from ideal from the VAT perspective. The task of processing and classifying incoming and outgoing invoices is commonly delegated to the financial department, where VAT expertise is generally not available. Incorrect decisions and defective controls may lead to costly errors.
Genuine VAT specialists confine their role to a relatively minor part of VAT reporting and only speak up when requested to do so. The risk of VAT errors causing financial losses and damage to corporate reputations is increasing.
In the light of the internationalization of the business community, the complexity of transactions is growing from the VAT perspective, which increases the chance of incorrect processing and reporting. Often, the source of an operational VAT problem is the inadequate adjustment of an ERP system after an acquisition or merger, after international expansion in new markets or after a change in the tax status of a class of transactions, for instance: as a result of a country's accession to the EU.
Just as important as the original design of an ERP system is the proper adjustment of that system to changing circumstances.
Test results
- Has the tax department been sufficiently involved in the design, implementation and amendment of the ERP system?
- Have the test results of new or amended ERP systems been assessed and signed off by the tax department?
- Is the VAT expertise regarding the ERP system available?
- Is this knowledge shared and available to users via documentation and/or instructions?
These are vital questions for a company's financial top management. If internal tax departments and, in particular, VAT experts want to bear their new final responsibility in the best possible way, they must set up an indirect tax control framework in consultation with the company's financial director and management board.
This means that they should first design a comprehensive corporate indirect tax strategy which is to be implemented in a system that is both solid and flexible, and includes effective control mechanisms.
The strategy and the system must be comprehensible for non-experts carrying out essential VAT actions, thus keeping not only the risk of system errors but also the chance of human error to a minimum.
Internal tax specialists can not only reduce risks to a minimum because of an indirect tax control framework, but also save costs by introducing operational improvements, such as the computerization of VAT calculations and reporting, and the reduction of the required VAT working capital. A properly functioning indirect tax control framework also enhances the relationship with the tax authorities. An ERP system with sound VAT functionalities allows the company to follow and account for all of its critical VAT variables much more accurately. This is important in times when responsibilities continue being shifted from tax authorities to taxpayers. The tax authorities require (large) companies to have thorough indirect tax control frameworks in place should the latter wish to conclude a tax agreement [handhavingsconvenant] with the tax authorities.
The advantage of such an agreement for companies is that they will have certainty as to their tax position much sooner. In other words, indirect tax control frameworks offer major advantages, but require ambitious and targeted action.
