Transactions in today’s business world
A different approach to business indirect tax advice 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.
'As Is' situation to benchmark at
Does it fit or not? A common factor among organizations with an increased risk profile is often the absence of a clear strategy to manage both the technical and operational risk issues associated with indirect taxes. Most major multinationals include one or more VAT specialists within the 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 often 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 VAT 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. An increasing number of in-house VAT managers however are facing the challenge of creating an indirect tax strategy that is more closely aligned with the business objectives of operational integrity.
Surveys are alarming
Managing risk is about making decisions at all levels of an organization, to limit the effect and likelihood of threats happening and to increase the effect and likelihood of opportunities.
Control mechanisms are still inadequate Benchmarking exercises against trends in the indirect tax market can be done via global surveys that capture info on tax function, attitudes and priorities. These surveys are useful as they give insight into what others are facing or have faced and how you could improve yourself. According to big4 surveys, the related control mechanisms are still inadequate. Not only can an error in the accounts lead to major additional tax assessments and substantial penalties, with amounts like these, it can be devastating for the reputation of a listed company.’
The global bench mark study on VAT / GST of KPMG among multinationals (clients and relations), inter alia, shows that most companies haven’t yet developed an effective VAT/GST approach.
‘The chance that the Tax Authorities will issue additional assessments and penalties in the near future because errors in indirect tax are detected, increases by the day.’
Risk management and governance Tax Authorities, due to technological innovations, have become increasingly better in executing their tax audit. The probability that the Tax Authorities will issue additional assessments and penalties in the near future because errors in indirect tax are detected, increases by the day.’ Tax authorities collect and analyze already indirect tax data (e.g. SAF-T for VAT). The focus is not only about timely and accurate VAT reporting but as well whether on high risk areas an effective tax control framework is in place. Tax risk management methods are assessed.
OECD Trends Consumption Tax Trends 2016 highlights that VAT revenues are the largest source of consumption tax revenues in the OECD, and have now reached an all-time high of 6.8% of GDP and 20.1% of total tax revenue on average in 2014.
Benchmarking provides objective evidence. It can show whether or not you have achieved your objective set such as a 'mature' tax function' or make visible what needs to be done to make that happen. It might provide the extra arguments to realize change and get buy-in.
Benchmarking yourself against your peers
CFOs / Head of Tax focus on indirect tax The surveys of the Big4 are clear: we are talking about extremely large amounts of money that lack appropriate control, but because KPIs have never been developed for this particular purpose, the risks remain outside the CFO’s field of view.
Ownership is often lacking around indirect taxes as no one is actually responsible for the entire end-to-end process causing operational gaps most visible when (cross border) changes occur.
However, CFOs / Head of Tax apparently still focus more on direct tax than indirect tax.
At multinational companies we’re easily talking about amounts of over 5 billion euros of indirect tax flowing through the books. Yet according to big4 surveys, the related control mechanisms are still inadequate. Not only can an error in the accounts lead to major additional tax assessments and substantial penalties, with amounts like these, it can be devastating for the reputation of a listed company.
Because of the structure of determination and control within organizations, indirect tax is dealt with completely differently than direct tax.
‘Just consider: a mistake of one percent can make the difference between profit and loss for a multinational company'The Head of Tax is responsible for all taxes in the company, but it appears that the main focus is on direct tax. The Indirect Tax Function often reports to the Head of Tax, who, in turn, reports to the CFO. This is one of the reasons that hardly any KPIs are determined for VAT/GST and the CFO almost exclusively attends to direct tax regarding tax risks.
The most important reason is that the CFO has a lot on his plate. Indirect tax has still no priority. Due to economical circumstances, choices have to be made regarding budgets for internal control. And because indirect tax has traditionally received little attention, it will surely not get more in times of crisis.
That is strange since I assume that the results of the benchmark studies are not only shared with clients, but especially within the organization itself, including colleagues in the audit department.
In terms of quality and providing integrated service, it can be expected that a position be taken each year concerning materiality and thus the necessity for further examination during the annual audit. It is therefore essential that financial auditors also read the surveys, acknowledge the risks and discuss them with the CFO.
The best outcome would be if the indirect tax would be controlled by default in audit or if a stand point would be taken not to do that.
The deployment of expensive fiscal knowledge therefore usually remains limited to control of direct tax. The Indirect Tax Function is aware of the fact that it is understaffed and that budget is too limited to optimally execute its tasks, but they often don’t know how to change this and get it on the agenda of the CFO.
Shift from direct tax to indirect tax
VAT accounts for more than 20% of total tax revenue CFOs / Head of Tax apparently still focus more on direct tax than indirect tax. This is interesting as from a tax revenue perspective the current trend is a shift from direct tax to indirect tax by decreasing direct tax rates and increasing VAT/GST rates.
Corporate income tax rates are continuing to fall in many countries. Global indirect taxes can amount to as much as 75% of the overall corporate tax burden, with VAT and sales/use tax outlays nearly 40% of total business tax expenditures — almost twice as much as corporate income tax.
More than 160 countries have a VAT regime. In the EU, between 2008 and 2013, the average EU standard rate increased from around 19.5% to more than 21%. The EU average VAT rate is now approximately 21.5%. VAT accounts for more than 20% of total tax revenue (OECD).
Not only are the amounts in the indirect tax cycle continuingly rising internationally, these surveys also reveal that the Tax Authorities, due to technological innovations, have become better at executing their tax audit.
Netherlands: Tax revenue in 2015
Indirect tax revenue in NL was in 2015 EUR 74,9bn compared to Corporate Income Tax EUR 21,3bn. Wage tax and income tax was EUR 133,7bn.
A cash in and a cash out?
VAT is a tax on consumption. It is collected in stages by the businesses (or intermediaries) and is fully borne by the final purchaser. As a consequence, VAT is a transactional tax with the potential to impact all transactions with suppliers and customers.
Unexpected costs are high and ‘above the line’
Neutrality has to be earned Measuring risks is often based on the balance between output VAT and input VAT and not on the total amount of VAT/GST throughput (also called VAT numbers ‘under management’).
The findings listed above are not surprising as often the question is asked what risk management even has to do with VAT/GST. The reasoning behind this question is that VAT/GST is typically cost neutral for most businesses: “a cash in and cash out” scenario. However, every indirect tax function knows that deductible input VAT and liable output VAT have to be managed separately to avoid substantial VAT assessments, penalties and interest payments.
It is a risky business to monitor only the balance between output VAT and input VAT. Neutrality can only be achieved – better is the word ‘earned’ – if certain formal and material requirements are met.
It starts with the people in the organization becoming aware of the amounts that are at stake and the risks of something going wrong. Big4 surveys show unanimously that we’re easily talking about amounts of 5 billion euros concerning indirect tax. Benchmark studies repeatedly create the same picture: too little control, too few KPIs and when a mistake is made in the control, it usually concerns large amounts of money.
A mistake of one percent can make the difference between profit and loss for a multinational company. Explain that to your shareholders.’
Managing this indicator is the responsibility of senior management
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59 percent of respondents (53 percent in 2014) expect the personal liability of compliance officers to increase in 2015, with 15 percent expecting a significant increase.
Compliance officers or its Executives at firms as diverse as Swinton Insurance, Bank Leumi, Bank of Tokyo-Mitsubishi, Brown Brothers Harriman and Deutsche Bank (DB: VAT fraud) having been fined, banned or jailed (or a combination).
Criminal charges and jail time
More often tax and public prosecutors‘ offices file criminal charges for tax-related scenarios with consequences for nor only the businesses reputation wise but also the executives and employees that could be jailed.
Prosecutors said they were investigating 25 bank staff on suspicion of severe tax evasion, money laundering and obstruction of justice, and searched the headquarters and private residences in Berlin, Duesseldorf and Frankfurt.
"Two of Deutsche Bank's Management Board members Juergen Fitschen and Stefan Krause are involved in the investigations as they signed the value-added tax statement for 2009," Deutsche Bank (DBKGn.DE) said in a statement.
Financial impact: an AR & AP example
Above the line costs The supplier is responsible for ensuring that all the conditions for applying the zero VAT rate are met. If not, the tax authorities will seek to recover tax due from this supplier via a levy of a tax assessment. If the applicable VAT rate is 25%, the tax assessment will be 25/125 of the consideration charged. This assessment has to be increased with interest and penalties to determine the total tax burden.
Something as basic as a billing error leading to invoices issued in the wrong name could not only delay revenue receipt but also result in nonrecoverable VAT. The penalties for incorrect invoicing can be a percentage of the turnover, so amounts can quickly become material—up to 25 percent VAT in Europe (Hungary 27%) on the turnover plus penalties.
In many countries indirect tax returns are not audited by the tax authorities. Tax certainty about tax positions taken will exist once the statutory time limits are exceeded.
That might change when e-audits approaches are standard implemented as audit method or other VAT fraud measures come into force.
- An oil and gas company had to pay $2 million in VAT instead of getting the refund they expected in the same amount.
- A mining company was assessed $500 million in taxes and penalties because they lacked the proper documentation.
- A consumer products company missed out on a $20 million VAT refund.
- A Fortune 100 company saw its officials put in jail because of personal liability.
A single operational failure in the systems and processes that manage the flow of Indirect Taxes through the supply chain can have significant consequences in terms of additional assessments, penalties, blocked VAT refunds and delayed payments from customers.
A real world example
Local knowledge lost and not managed 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 that 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 more and more 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?
Financial changes and indirect tax 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
Strategic objectives per role
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.
Exposures associated with the wider impact on the company's that arises from a company's actions or errors and have become public knowledge
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 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.
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.
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.
Financial risks are any risks which are impacting 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 financial 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.
See chapters: ERP systems and tax engines, Spreadsheets and VAT Compliance, Templates for VAT strategy plan, Incorrect VAT numbers, VAT determination of incoming invoices, VAT control framework, and Writing a business case, problem statement and calculate Return on Investment
Root cause examples
|Root causes examples|
A process failure (either within or outside of 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)
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);
A failure to evidence the non-application of VAT to a transaction, e.g. lack of export documentation, etc;
A failure to account for VAT on inter-company transactions;
A failure to reconcile VAT turnover to AR;
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;
A failure to claim credit for VAT charged at importation;
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.
Senior management's involvement needed
Senior management involvement needed Senior management frequently perceives VAT/GST according to the survey findings as a low risk because the flow of taxes is similar to a “cash in and cash out” scenario. That is a misperception. In order for any structural change to increase the effectiveness of the (indirect) tax function to be fruitful, both the formal support and active involvement of senior management are required.
Many organizations try to establish change without this active senior management involvement. Projects are not assigned, tools not implemented and results not tracked.
"However, optimum process improvement or business transformations will not likely be realized by the sum of individual independent efforts. The risk is that individually everybody knows what needs to be done within his or her own area of expertise, but what is lacking is overall direction and thus progress.
Important is to get every stakeholder aligned to the same direction and way of thinking: speaking the same language of performance improvement. Thus, ensure that a common process and language for risk management exists with ambassadors for integrating the management of risk into and across the organization."
Eagle eye view Benchmark studies are useful in getting both the tax function and senior management to focus on indirect tax priorities and to implement a proactive management approach within the company.
When an improvement is made in one area, improvements in other areas should also be made. What sense does it make if cost reduction is the business strategy, but from an indirect tax perspective the implemented changes result in substantial commercial risk, tax risks and a hidden costs (significant amount of rework due to corrections) if not properly managed in time?
Be operationally efficient
Hidden factory or hidden operation definition
Unnecessary rework The rework and cover ups, the hours and days of wasted time in a company of people who constantly correct mistakes . The objective is to make the hidden factory visible (measure/calculate ROI) and as result returns precious time and money to the business. It is about extra man-hours, additional costs due to rework (credit/debit notes) and retrospective corrections and/or disclosures. Example: how much rework is required before numbers received from finance systems can be used?
- Does the process of preparing and compiling the client’s VAT return take more than 5 man days? (starting from the moment of VAT-data collection until the VAT return is approved and filed).
- Are manual adjustments made to ERP figures before inclusion in VAT Returns?
Reduced the man hours spent on gathering data
During assessment of any solution determine the amount of increase of workforce efficiency, how much rework is avoided, risk exposures are decreased but as well how visibility and awareness are improved by which the tax function is able to set better priorities.
The objective is to make the hidden factory visible (measure/calculate ROI) and as a result, return precious time and money to the business.
Non-routine and significant business transactions
Disruption of daily business Getting ahead of possible problems at the planning stage before they arise in practice is one critical way to make sure that the company reaps the benefits. When the business model changed as a result of the implementation of a centralized procurement model, this could create not only VAT risks, but commercial risks as well.
For example logistics problems with importing goods into a country and subsequent delays and hold offs of shipments resulting in disruption of daily business.
A root cause could be that the company forgot to register for VAT and/or procurement staff forgot to communicate with suppliers 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.
Operational changes and tax Operational changes have a tax consequence due to the change in transactional flows and the change in a company’s assets, functions and risks profile: 'reevaluate operations and processes'.
Important is to ensure that the new operating model is not only implemented correctly from a tax perspective, but also ensures that business processes are tax aligned realizing support of the business in the areas of compliance, finance & accounting, legal IT systems, indirect tax and regulatory matters.
Technology-related tax risk
understand and address
the potential harms and benefits of (new) technology
Work streams and need to team up That means teaming is a necessity with various work streams.
The selling arrangement may change from a buy/sell to broker/agent or vice versa. Goods purchasing may become centralized. The flows and storage locations of goods may change.
In any of these cases, new VAT registration obligations may be created in different countries. Likewise VAT could be chargeable by different entities and the recoverability of the VAT could change and different billing flows are created.</p
See chapter: 'non-routine and significant business transactions
Examples where indirect tax expertise is always needed upfront
- Share issues or sales
- Acquisition or disposal of any business or part of a business
- Acquisition or disposal of real estate
- Financial transformation
- Part of the business is outsourced (e.g. a Shared Service Centre or accounts payable/receivable to a third party service provider)
- Other financial transactions
VAT should be considered in every aspect of the migration process, from concept through completion and beyond. Managing by design — looking at any process or transaction from end to end and factoring in all the requirements and controls essential to designing and optimizing a compliant VAT process.
How to manage change
Increase tax function's visibility Likewise, the VAT work stream should be integrated with contingent technology and finance projects.
This may prove challenging as a number of initiatives, particularly those that deal with systems development and technology enablers, are often not visible to the tax function — another point that underscores the need for transparency and upfront communications.
Failure to align with initiatives that can intersect with VAT can result in a VAT design that is inefficient from a process perspective and not a “best fit” for the business.
In order to get buy-in from senior management it is often about setting the right priorities, understanding the root cause of underperforming and select a method for measurement that best fits.
The deck explains what a tax function could do to get indirect tax higher on the priority list of senior management.
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 an EY partner where he led the indirect tax performance team for Netherlands and Belgium. Currently, he is a managing director of SAP Tax Consultancy Firm.
Richard has over 20 years of experience advising clients on international VAT issues. He is specialized in the tax aspects of financial transformations, shared service center migration, and post-merger integration work.