VAT Control Framework: Transitioning from Concept to Implementation

Critical Conditions for Success

The significance of indirect tax has escalated recently. While the rates for direct taxes, such as corporate income tax, are decreasing, indirect tax rates continue to rise. For multinational companies, this can mean managing indirect tax amounts exceeding 5 billion euros annually.

Surveys conducted by major consulting firms highlight that existing control mechanisms are frequently inadequate. Errors in accounting can lead to substantial tax assessments and considerable penalties. Given the scale of these amounts, such mistakes can also severely damage the reputation of a publicly traded company. Despite the magnitude of these risks, key performance indicators (KPIs) to monitor them have not been effectively developed, leaving financial executives unaware of the potential threats.

The Indirect Tax Function recognizes that it is often understaffed and operating with a budget that is insufficient for optimal performance. However, there is often a lack of clarity on how to advocate for these issues and elevate them on the CFO's agenda.

It is crucial for change to originate within the organization itself. Advisers can emphasize the need for action, but without the commitment of those who are directly involved in the processes, progress is unlikely. Therefore, it's imperative to break this cycle of inaction. What steps can be taken to facilitate this change?

Establishing Adequate Control Mechanisms

To effectively manage risks, a comprehensive VAT Control Framework must align with the organization’s Business Control Framework and overall Tax Control Framework. From a governance perspective, the indirect tax department needs a clearly defined position within the organization. It should be equipped with the necessary tools—such as adequate budget and resources—to achieve its strategic objectives.

Accountability and the Value of a Tax Policy

Accountability should always lie with the process owner responsible for specific business processes. The published tax policy must foster awareness of tax risks and clarify decision-making authority—specifically, "who can decide what and when" from a tax perspective. Consequently, it is the responsibility of the head of each corporate department to ensure that all team members read, understand, and effectively implement this tax policy.

The indirect tax department faces significant challenges in the absence of a formally documented tax policy, tax objectives, or planning processes. Without clear overall tax guidance, the company lacks essential "dos and don'ts." It is imperative for senior management to endorse and publish agreed-upon objectives and risk tolerance levels for tax planning and risk management—essentially establishing the company’s "tax rules of the house."

In practice, the initial step toward an effective tax function often involves drafting a tax policy that outlines these "tax rules of the house" and facilitates decision-making regarding new tax regulations. Execution of these rules should be seen as a realistic goal, with compliance monitored regularly, and performance assessed.

Without a tax policy in place, the impetus for change relies heavily on the initiative of VAT employees, which often leads to a fragmented approach. If not all stakeholders within the company are convinced of the need for amendments, this can hinder the establishment of standardized VAT controls and the implementation of "best practice" approaches. More critically, an organization becomes overly reliant on individuals, creating increased risks if key staff leave or are reassigned.

Such risks can be mitigated when the tax department’s strategy, objectives, and risk tolerance are well understood across the organization and enforced as mandatory rules. A robust tax policy can guide employee behavior towards achieving overall tax function objectives. This is illustrated in the following operational framework:

Governance: How do we decide to introduce new rules?
Design: How do we determine the necessary rules?
Existence: How do we ensure the rules are embedded within the organization?
Operation: How do we confirm that our rules are effectively executed?

Under these circumstances, employees are responsible for adhering to these internal tax rules. The tax department, internal audit, or risk management can more easily assess whether tax rules are being properly executed by posing a straightforward periodic control question: "Have you operated in accordance with the tax policy?"

This process transcends mere paperwork, as it ensures that tax policies (both overall and specific to VAT) are actively enforced, with designated individuals held accountable. This proactive framework significantly streamlines the remediation of VAT risks through preventive or detective testing of tax controls. Furthermore, the indirect tax department should receive immediate attention when a process owner fails to meet their obligations, with collective support from the tax department to close any identified gaps as quickly as possible.

Facilitating the Development of an In-House Tax Culture

Implementing a cohesive in-house tax culture should be straightforward. It primarily requires referencing the company's established tax rules and the expected tax behaviors endorsed by senior management. When executed successfully, this initiative can foster a robust and enhanced 'in-house tax culture.'

KGT's Design and Implementation of a Tax Policy

A well-structured tax policy should articulate the company's overall tax strategy and objectives while providing a framework to promote best practices and governance procedures. It must clearly delineate the roles and responsibilities of the tax function, other corporate departments, and various corporate entities.

To ensure a unified understanding of the company’s VAT risk appetite and acceptable VAT planning practices, the tax policy should be broadly disseminated across both the tax team and the wider business. This roll-out may involve hosting workshops, conference calls, and training sessions that engage stakeholders from tax, finance, legal, business operations, and other relevant areas.

Unlike the more centralized approach often associated with income taxes, the responsibilities and key drivers for managing indirect taxes can be distributed throughout the organization. This includes not only the tax department but also various other departments, such as finance, information technology, supply chain management, logistics, and human resources. Promoting collaboration among these diverse functions is essential for effective tax risk management and the successful application of the new policy.

The tax policy is the highest in the tax hierarchy - signed off by senior management - and sets the internal tax rules and tax behavior: the dos-and-don'ts of employees regarding tax.

KGT's Building Blocks of a Tax Policy

A comprehensive tax policy should encompass various taxes for which the Head of Tax is responsible, including:

Corporate income tax
Wage taxes, payroll taxes, and social security contributions
Withholding taxes
Capital taxes (including stamp duties and transfer taxes)
Local taxes (e.g., local business tax, packaging tax, surcharges, gift tax)
Indirect taxes and customs duties
And other relevant taxes

KGT's Key Components of a Tax Policy

The following are essential building blocks for an effective tax policy:

Tax Function Objectives: Clearly defined goals for the tax function.
Risk Profile and VAT Risk Tolerance Parameters: An assessment of the company’s willingness to accept certain tax risks.
Approach to Tax Risk: Guidelines on how the company manages and mitigates tax risks.
Relationship with Tax Authorities: Establishing a framework for engagement and communication.
Scope of Taxes Covered: A list of taxes that fall under the policy’s purview.
Entities in Scope: Identification of the entities to which the policy applies.
Roles and Responsibilities: Clear delineation of duties for those involved in tax-related matters.
Tax Resources (Internal/External): Identification of available resources and their allocation.
Tax Strategies by Role and Tax Type: Specific strategies tied to different roles or types of taxation.
Mandatory Pre-Engagement Situations: Instances where prior consultation with tax departments is required.

KGT's Guidelines for VAT Planning

The tax policy must include detailed guidelines regarding VAT planning and clarify whether such planning aligns with the company’s tax strategy. These guidelines should receive approval from senior management and address considerations such as the likelihood of challenges from tax authorities and potential reputational risks. The policy should also outline documented evaluation and acceptance criteria for planning, implementation review processes, and ongoing monitoring mechanisms.

Mandatory Early Involvement of Tax Departments

From a Tax Control Framework perspective, risk-based controls become increasingly vital with the complexity of transactions. The tax policy should specify circumstances that necessitate the early involvement of indirect tax departments, including stakeholders such as Legal, IT, HR, Internal Audit, Procurement, Business, and Finance.

Certain transactions consistently exceed a company's VAT risk appetite and thus require immediate attention:

Significant business transactions
Non-routine transactions:
Share issuances or sales
Reorganizations
Acquisition or disposal of any business or part of a business
Acquisition or disposal of real estate
Financial transformations
Outsourcing of business functions (e.g., Shared Service Centers or third-party accounts payable/receivable)
Other significant financial transactions

To ensure compliance and mitigate risk, it is advisable to provide clear guidance for process owners and stakeholders regarding the necessity of seeking VAT input early in significant transaction processes. Approval from the indirect tax department should be mandatory before executing any non-routine or significant transactions. Additionally, the indirect tax department should be an integral part of workstreams for technology and finance projects.

Considering Tax Implications in Operational Changes

Operational changes can have significant tax implications due to shifts in transactional flows and a company’s assets, functions, and risk profile. It is essential to ensure that any new operating model is not only compliant with direct tax regulations but also aligns overall business processes with tax requirements. This alignment should involve collaboration across various functions such as compliance, finance, accounting, legal, IT systems, VAT, and regulatory affairs.

To transition the tax policy from theory to practice, the implementation phase may also involve organizational changes and enhancements to existing processes and systems.

Optimizing the Use of VAT Resources

Given the typically limited availability of VAT resources within a company, it is crucial to utilize these resources efficiently and effectively. This entails making informed choices and ensuring that the necessary resources and budgets align with the outcomes of the tax risk assessment. Due to the constraints on VAT resources, prioritizing high-risk areas should take precedence to maximize impact and minimize potential exposure.

To effectively allocate resources to areas that optimize risk management and cost savings, it is essential to first establish the company’s risk appetite.

Defining acceptable levels of risk allows for prioritization in resource deployment, ensuring that efforts are focused on areas that truly require attention. This approach prevents unnecessary expenditure of resources on mitigating risks that are already deemed satisfactory. Furthermore, the efficiency and effectiveness of the indirect tax department should be regularly assessed and compared against financial and operational KPIs. Review meetings should be held to discuss these evaluations, and any necessary corrective actions must be identified and implemented.

How KGT can support

KGT helps clients establish effective VAT control frameworks to boost compliance and efficiency. Our standardized framework allows you to assess your current position and identify gaps. Following this evaluation, we recommend standardized controls to address any issues.

Developed by a former EY Indirect Tax partner and a former Director at Deloitte, this framework integrates insights from senior VAT leaders across industries. You'll also benefit from the expertise of former VAT function leaders from multinational companies, and we can help you understand your specific challenges.

KGT delivers comprehensive tax consultancy and advisory services and expert internal audit support designed explicitly for multinational corporations. Our commitment to aligning with best practices ensures that your organization meets compliance requirements and enhances overall performance and efficiency. Trust KGT to optimize your tax strategy and strengthen your financial integrity.