Transactions in today’s business world
Even as the world is shrinking, businesses and their growth strategies are becoming more complicated. A schematic drawing of the functions of a typical multinational today might look like a Rube Goldberg contraption—a complex of moving parts that must connect one to another for tax, regulatory, and reporting purposes.
And unlike the more contained structure for handling income-based taxes, responsibilities and key drivers for indirect taxes may be spread throughout the enterprise, residing not just in the tax department but in any of such diverse departments as finance, information technology, supply chain management and logistics, human resources, and beyond.
Added is the growing trend toward shared service centers (SSCs) that are responsible for operational processes including accounts payable and accounts receivable as well as other outsourced functions for tax, finance, and treasury. Tax determination and reporting for the entire operation may be governed by one or more enterprise resource planning systems, which in turn may be integrated to varying degrees, with or without the benefit of sophisticated technology tools.
All these factors make for a changing and increasingly sophisticated business environment that requires a different approach to business indirect tax advice.
The tax function should be able to understanding business activities/objectives including R&D and get aligned with other functions like legal, HR and IT. The tax objective is to mitigate risk and identifying opportunities to support company's supply chain.
Current 'As Is' Situation for Benchmarking
A common issue among organizations with a heightened risk profile is the lack of a clear strategy for managing the technical and operational risks associated with indirect taxes. While most major multinationals employ one or more VAT specialists within their tax functions, the utilization of this expertise often resembles a traditional consulting model. The tax specialist typically occupies a central role, addressing individual inquiries from logistics managers, accounting staff, and local business units.
This reactive approach relies on colleagues with operational or local market insights to identify potential indirect tax risks and refer them to the tax department for specialist review. As a result, central visibility into VAT compliance issues affecting local operations is often fragmented, with little continuity in managing local VAT risks across the organization.
Moreover, in-house VAT advisors frequently focus on technical questions related to strict VAT liability rather than on operational issues that impact the integrity of transactional reporting. However, an increasing number of in-house VAT managers are working to establish an indirect tax strategy that aligns more closely with the organization’s objectives for operational integrity.
Alarming Trends Revealed by Surveys
Effective risk management requires informed decision-making at all organizational levels to mitigate threats and maximize opportunities. Benchmarking exercises that analyze trends in the indirect tax market can be conducted through global surveys exploring operations, attitudes, and priorities within tax functions. These surveys yield valuable insights into the challenges others face and identify areas for improvement.
However, reports from the Big 4 indicate that existing control mechanisms are inadequate. Errors in accounting can lead to substantial tax assessments and penalties, posing significant reputational risks for publicly listed companies. The global benchmark study on VAT/GST conducted by KPMG has shown that many multinationals have yet to develop an effective VAT/GST strategy. The likelihood of tax authorities issuing additional assessments and penalties due to detected errors is alarmingly high.
As tax authorities leverage technological advancements, their auditing capabilities have improved. They can now collect and analyze indirect tax data—such as Standard Audit File for Tax (SAF-T) for VAT—effectively. The focus is shifting not only to timely and accurate VAT reporting, but also to ensuring that an effective tax control framework is in place, particularly in high-risk areas.
OECD's "Consumption Tax Trends 2016" report notes that VAT revenues have become the largest source of consumption tax revenues within the OECD, reaching an all-time high of 6.8% of GDP and accounting for an average of 20.1% of total tax revenue as of 2014.
Benchmarking for Improvement
Benchmarking provides objective evidence regarding your tax function's maturity and effectiveness. It can help assess whether objectives have been achieved or highlight areas requiring attention. This data can serve as a powerful argument for initiating change and securing stakeholder buy-in.
Benchmarking Against Your Peers
Surveys from the Big 4 reveal concerning trends: significant amounts of indirect tax are lacking necessary controls, and the absence of established KPIs allows these risks to remain outside the CFO’s view. Often, there is a lack of ownership concerning indirect taxes; no single individual is responsible for the entire end-to-end process. This oversight leads to operational gaps, especially during cross-border changes.
Despite the importance of indirect tax, CFOs and Heads of Tax typically focus more on direct tax. In multinational companies, indirect tax amounts can exceed €5 billion, yet surveys indicate that control mechanisms are still insufficient. Errors in accounting can result in substantial tax assessments and penalties, which can severely impact a company's reputation.
Due to organizational structures, indirect tax is often managed quite differently from direct tax. While the Head of Tax oversees all tax matters, their attention is predominantly directed toward direct tax. The Indirect Tax Function usually reports to the Head of Tax, who then reports to the CFO. This hierarchy contributes to the lack of KPIs for VAT/GST, leading the CFO to concentrate chiefly on direct tax risks.
A significant barrier to addressing these issues is the CFO’s overwhelming workload. Indirect tax often receives low priority, especially in times of economic uncertainty when internal control budgets are scrutinized. Given the traditional neglect of indirect tax, it is unlikely to receive increased attention during a crisis.
This oversight is especially surprising since the results from benchmark studies should be shared with clients and disseminated within the organization, including the audit department. In terms of quality and integrated service provision, there should be annual expectations regarding materiality, necessitating further examination during the annual audit. Therefore, financial auditors must review these surveys, acknowledge the identified risks, and engage in discussions with the CFO.
The ideal scenario would be for indirect tax controls to be integrated into the audit process by default, or for a clear rationale to exist for their exclusion.
Unfortunately, the deployment of specialized tax expertise tends to focus solely on direct tax management. The Indirect Tax Function acknowledges that it is understaffed and lacks a sufficient budget to fulfill its responsibilities effectively, yet staff often struggle to elevate these concerns to the CFO’s attention.
Shifting Focus from Direct Tax to Indirect Tax
There is a notable trend where CFOs and Heads of Tax prioritize direct tax despite the growing significance of indirect tax, driven by decreasing direct tax rates and increasing VAT/GST rates. Corporate income tax rates are declining globally, with indirect taxes now constituting up to 75% of the overall corporate tax burden. VAT and sales/use taxes account for nearly 40% of total business tax liabilities, nearly double that of corporate income tax.
More than 160 countries have established VAT regimes. In the EU, for example, the average VAT rate rose from approximately 19.5% to over 21% between 2008 and 2013, with the current average now around 21.5%. VAT constitutes over 20% of total tax revenue according to OECD data.
The amounts flowing through the indirect tax cycle continue to rise internationally, while surveys also indicate that tax authorities are now more adept at conducting audits, thanks to technological advancements.
Cash In and Cash Out
VAT is a consumption tax, collected in stages by businesses (or intermediaries) and ultimately borne by the final purchaser. Thus, VAT is a transactional tax that affects all transactions with suppliers and customers.
Unexpected costs can be significant and often "above the line." Measuring risks frequently focuses on the balance between output VAT and input VAT, rather than the total VAT/GST throughput (commonly referred to as VAT numbers "under management").
The concern that arises is often, “What does risk management have to do with VAT/GST?” Many assume that VAT/GST is typically cost-neutral for businesses, embodying a “cash in and cash out” scenario. However, every indirect tax function understands that deductible input VAT and liable output VAT must be managed separately to avoid substantial assessments, penalties, and interest payments.
Relying solely on monitoring the balance between output VAT and input VAT is risky. True neutrality can only be achieved—better described as "earned" neutrality—if specific formal and material requirements are met.
Awareness within the organization regarding the amounts at stake and the risks involved is crucial. Surveys from the Big 4 consistently show that we are often discussing sums exceeding €5 billion concerning indirect tax. Benchmark studies repeatedly reveal insufficient control, inadequate KPIs, and significant financial implications when mistakes occur.
A mere 1% error can mean the difference between profit and loss for a multinational company—something shareholders must understand.
Managing this indicator is the responsibility of senior management
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Personal Liability
In 2015, 59 percent of respondents (up from 53 percent in 2014) anticipated an increase in the personal liability of compliance officers, with 15 percent expecting a significant rise.
Compliance officers and executives from various firms, including Swinton Insurance, Bank Leumi, Bank of Tokyo-Mitsubishi, Brown Brothers Harriman, and Deutsche Bank, have faced fines, bans, or imprisonment due to compliance failures.
Criminal Charges and Jail Time
Tax prosecutors are increasingly filing criminal charges for tax-related offenses, impacting not only the businesses' reputations but also the executives and employees who may face jail time. For example, prosecutors have been investigating 25 bank employees for severe tax evasion, money laundering, and obstruction of justice, conducting searches at headquarters and private residences in Berlin, Düsseldorf, and Frankfurt.
Deutsche Bank's statement revealed that two members of its Management Board, Jürgen Fitschen and Stefan Krause, are implicated in ongoing investigations for having signed the value-added tax statement for 2009.
Financial Impact: Accounts Receivable & Accounts Payable Example
Suppliers bear the responsibility for ensuring that all criteria for applying the zero VAT rate are met. Failure to do so can lead tax authorities to recover the tax owed from the supplier through a tax assessment. If the applicable VAT rate is 25%, the tax assessment would be calculated as 25/125 of the total consideration charged. This assessment is further compounded by interest and penalties, which significantly increase the total tax burden.
Even a basic billing error, such as issuing an invoice under the wrong name, can delay revenue collection and lead to non-recoverable VAT. Additionally, the penalties for incorrect invoicing can amount to a percentage of turnover, escalating quickly to material sums—up to 25% VAT in Europe (and as much as 27% in Hungary) on turnover plus penalties.
In many jurisdictions, indirect tax returns are not subject to audits by the tax authorities. Tax certainty regarding positions taken will only be established once the statutory time limits have passed. However, this may change as e-audit practices become standard and stricter VAT fraud measures are implemented.
Significantly, there have been instances where companies faced severe financial repercussions due to compliance failures:
- An oil and gas company had to pay $2 million in VAT instead of receiving a refund of the same amount.
- A mining company was assessed $500 million in taxes and penalties due to inadequate documentation.
- A consumer products company missed out on a $20 million VAT refund.
- Officials from a Fortune 100 company were incarcerated due to personal liability.
A single operational failure in the systems and processes managing the flow of indirect taxes through the supply chain can lead to substantial consequences, including additional assessments, penalties, blocked VAT refunds, and delayed payments from customers.
A real-world example
A multinational company based in France decided to centralize and transfer functions to Switzerland. Not only did they neglect to document the processes and thoroughly analyze the VAT impact, they also lost staff that was familiar with the functions.
As a result, the company also lost access to the historical data relating to the preparation of VAT returns and had employees who were unfamiliar with the methods for preparing the returns or making manual adjustments. At the time the VAT audit was announced, major panic ensued and the SSC staff had to work around the clock to obtain more insight into the original processes and collect information for reconstructing the VAT returns.
The company was at risk for the full amount of the VAT and for penalties of up to 100% of the VAT owed. In short, the potential benefits of the SSC migration were largely overshadowed by the additional time and money that had to be spent for this emergency response and the disruption to orderly operations.
As MNCs move increasingly to the shared service model to meet their varied objectives, the responsibility for indirect taxes migrates with them, especially in the case of VAT and goods and service tax (GST). Also, complexity in managing these taxes increases exponentially when cross-border activities are involved, especially in today’s VAT environment, where all too often controls are external, processes are manual and procedures are not documented.
But do these taxes and tax planning opportunities get the attention they need, especially in light of increasingly complicated and globalized business models?
There is one common denominator that is too often missing from strategic or planning elements of any financial transformation — indirect tax. And although these tax considerations may not be among the issues that drive a decision, tax can certainly give rise to some significant and costly challenges.
That is particularly true of value added tax (VAT), which hits a number of disparate points within the enterprise as diverse as finance, procurement, IT or HR.
An important element built into making these business choices is identifying their impact and any changes they could have on current processes. Centralizing functions into an environment like a SSC entails a shift of responsibilities, which then requires establishing and documenting new protocols and new lines of communication.
This early stage is the time for surfacing potential problems and identifying the time frame and approach for addressing them (e.g., further integration of ERP systems, tax engines, procedural guidance and controls).
Risk management - strategic objectives
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Activities |
Strategic objectives per role |
Why | |
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Risk management |
Ensure identification, select and manage tax risks as a basis for indirect tax management and reporting, ascertain that unacceptable but existing tax risks are identified and that clear, timely communication on tax status, tax activities and tax risks takes place. |
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Risk definitions
| Risk | Definition |
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Reputational risks |
Exposures associated with the wider impact on the company's that arises from a company's actions or errors and have become public knowledge |
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Strategic risks |
Strategic risks can impact the achievement of strategic objectives of the tax department like e.g. governance, tax planning, mergers & acquisitions, financial transformation outsourcing. Is the level of tax risk at an acceptable level taken, the tax function been part during the design and implementation, is what is agreed upon properly documented correctly implemented and in time. |
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Compliance risks |
Compliance risks impact compliance of the company with regulatory and legal requirements and the resolution of government inquiries. Compliance risks occur due to incorrect numbers in the system, for example, because of lack of data, misinterpretation of the law or the miscommunication or misinterpretation leading to wrong conclusions or actions. |
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Operational risks |
Operational risks are both internal and external risks impacting the operations of the tax department e.g. tax activities embedded in business operations, the underlying systems and tools, access to data, and knowledge. Examples of operational risks from not having embedded proper tax procedures in the business processes include hold-up of goods at the border due to failure to properly handle customs duties, VAT registrations are missing or failing to update ERP system setup of processes and controls when VAT law or the supply chain has changed. |
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Financial risks |
Financial risks are any risks which impact the financial reporting processes of the tax department, e.g. accounting and reporting, SOX 404 and other regulatory regimes. Financial risks are for example not disclosing adequate or timely tax information resulting in regulatory scrutiny, not correctly estimating contingency reserves for uncertain tax positions, and not being able to support the calculation of deferred taxes and related valuation allowances reported in the financial statements. For a transactional tax like VAT, the financial risks are almost identical to the compliance risk, as VAT return are based on accounting data. An example of additional financial risk is the scenario where the applied VAT rate is 0% and there is no sufficient evidence for the correctness of applying 0% VAT, which could result in VAT assessments for the VAT liability. These VAT assessment amounts are not recorded in the financial statements automatically. |
Root cause examples
| Root causes examples | |
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A process failure (either within or outside the accounting system) to apply the correct VAT liability to a transaction (either not charging VAT when it should be, or charging VAT when it should not be) |
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A failure to identify a requirement to register for VAT within a jurisdiction (establishment is often unnecessary in creating an obligation – a mere sale of goods can be sufficient to create an obligation to register for VAT); |
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A failure to evidence the non-application of VAT to a transaction, e.g. lack of export documentation, etc.; |
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A failure to account for VAT on intercompany transactions; |
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A failure to reconcile VAT turnover to AR; |
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A rejection of a VAT credit through AP because of invalid documentation, e.g. the purchase invoice to support the credit was missing or defective; |
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A failure to claim credit for VAT charged at importation; |
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A failure to self-assess VAT on the receipt of services from a non-resident or on transfers of goods from one EU Member State to another. |
Keep a logbook – risk register – of all identified inconsistencies. The internal tax function should always have insight into the areas for attention through this logbook.
The risk register should contain the following labels: number, name of the risk, risk definition, cause for the risk to occur, risk category and the risk owner. This allows tax managers to set the right priorities and take measures timely.
The Need for Senior Management Involvement
Survey findings indicate that senior management often views VAT/GST as a low-risk area, perceiving it as merely a “cash in and cash out” scenario. This perception is misleading. To achieve meaningful structural changes that enhance the effectiveness of the indirect tax function, both formal support and active participation from senior management are essential.
Many organizations attempt to implement change without the involvement of senior management, leading to unassigned projects, non-utilized tools, and untracked results.
Optimal process improvements or business transformations are unlikely to result from isolated, independent efforts. While individuals may understand the necessary actions within their areas of expertise, the lack of a cohesive direction often hinders overall progress.
It is crucial to align all stakeholders towards a unified goal and shared perspective, effectively fostering a common language of performance improvement. Establishing a standard process and language for risk management is vital, as is appointing ambassadors to facilitate the integration of risk management across the organization.
Benchmarking studies can be instrumental in guiding both the tax function and senior management to prioritize indirect tax issues and adopt a proactive management approach within the company.
Improvements in one area should naturally lead to enhancements in others. What is the value of a cost-reduction strategy if changes in indirect tax practices introduce significant commercial, tax, and hidden costs—such as excessive rework due to corrections—when not managed effectively?
Achieving Operational Efficiency
Defining the Hidden Factory
The concept of the "hidden factory" refers to the rework and corrections that consume countless hours within an organization, as employees continually rectify mistakes. The goal is to make this hidden factory visible—measuring and calculating the return on investment (ROI)—thereby reclaiming valuable time and resources for the business. This involves addressing extra man-hours, additional costs resulting from rework (including credit and debit notes), and the need for retrospective corrections and disclosures.
Key Questions to Consider:
- How much rework is required before the data from finance systems can be reliably used?
- Does the process of preparing and compiling the client’s VAT return take more than five man-days from the moment of VAT data collection until the return is approved and filed?
- Are manual adjustments necessary for ERP figures before they are included in VAT returns?
Strategies for Improvement
To enhance efficiency, it's crucial to reduce man-hours spent on data gathering and streamline processes. As you assess any proposed solution, consider:
- The potential increase in workforce efficiency.
- The reduction in rework and risk exposure.
- The improvement in visibility and awareness, enabling the tax function to establish better priorities.
By making the hidden factory visible and measuring its impact, organizations can ultimately return invaluable time and money to the business.
Non-Routine and Significant Business Transactions
Proactively addressing potential issues during the planning phase is essential for ensuring the company maximizes its benefits. A shift in the business model, such as the implementation of a centralized procurement model, can introduce both VAT and commercial risks.
For instance, logistical challenges associated with importing goods into a country may lead to delays and hold-ups in shipments, disrupting daily operations.
A root cause of these issues could be the failure to register for VAT or a lack of communication among procurement staff regarding which party is responsible for importing the goods.
The tax function should ascertain proper implementation and determine the impact of changes in businesses, laws and regulations on implemented tax planning.
The Tax Implications of Operational Changes
Operational changes can have a significant impact on tax obligations due to shifts in transactional flows, as well as changes in a company’s asset profile, functions, and risk exposure. It is essential to reevaluate operations and processes in response to these changes.
Implementing the new operating model correctly from a tax perspective is crucial. Additionally, it is vital to ensure that business processes align with tax regulations, providing effective support in areas such as compliance, finance and accounting, legal matters, IT systems, indirect tax, and regulatory compliance.
Technology-Related Tax Risks
Understanding and addressing the potential risks and benefits associated with new technology is critical. Collaboration across various work streams is necessary to succeed in this effort.
For instance, the selling arrangement may shift from a buy/sell model to a broker/agent model, or vice versa. Furthermore, purchasing goods might become centralized, leading to changes in the flows and storage locations of products.
In such scenarios, new VAT registration obligations may arise in different countries. Additionally, VAT could become chargeable by various entities, affecting the recoverability of VAT and creating new billing flows.
Instances Where Indirect Tax Expertise Is Essential
Certain situations warrant upfront involvement of indirect tax expertise, including:
- Share issuances or sales
- Reorganizations
- Acquisitions or disposals of businesses or business segments
- Acquisition or disposal of real estate
- Financial transformations
- Outsourcing parts of the business (e.g., Shared Service Centers or accounts payable/receivable to third-party service providers)
- Other financial transactions
VAT considerations should be integrated into every aspect of the migration process, from initial concept through completion and beyond. This requires a "managed by design" approach, where each process or transaction is evaluated end-to-end, incorporating all requirements and controls for designing and optimizing a compliant VAT process.
Managing Change Effectively
The VAT workstream should be seamlessly integrated with ongoing technology and finance projects. However, this integration can be challenging, as many initiatives—especially those related to systems development and technological advancements—are often not visible to the tax function. This highlights the critical importance of transparency and proactive communication.
Failure to align with initiatives that intersect with VAT can lead to inefficient VAT designs that are not optimized for the business’s needs.
To gain buy-in from senior management, it is essential to establish clear priorities, understand the root causes of underperformance, and select appropriate measurement methods that align with the organization’s objectives.
The accompanying presentation outlines strategies the tax function can employ to elevate the importance of indirect tax on senior management's priority list.
