The saying “There’s a way to do it better . . . find it!” is attributed to inventor Thomas Edison, but it encapsulates perfectly the current global indirect tax management landscape. In the last decade, innovations in tax technology have significantly changed not only how value-added tax (VAT), also known in certain jurisdictions as goods and services taxes (GST), applies to new and more complex business models but also how tax authorities administer and businesses comply with these transaction taxes.
This trend will likely continue as more tax authorities and businesses embrace new tools facilitating the management of more and more complex taxes. In this article, we provide an overview of why VAT is a tax particularly amenable to technological innovation and how tax authorities and businesses can leverage such innovation to improve and ease compliance.
Challenges of Modern VAT
Over 170 countries, including thirty-six of the thirty-seven member countries of the Organisation for Economic Co-operation and Development (OECD), have implemented some form of VAT. Three main criteria distinguish a VAT from the retail sales taxes levied by state and local authorities in the United States and explain why countries have adopted VAT systems rather than sales and use tax systems.
First, VATs generally apply to all sales of goods, services, and intangibles, with generally few exemptions (although there are great variations among the 170-plus countries). Second, a VAT is charged at each step of the supply chain, with a credit for tax paid when the item has been purchased for business purposes, until the item is purchased by the final consumer, who bears the ultimate tax burden. Finally, a VAT is considered a self-enforcing tax, because, absent a valid invoice, a purchaser cannot claim a tax credit, thus creating an incentive for the purchaser to request an invoice.
In practical terms, these characteristics create burdens for tax authorities and businesses. VATs are generally more difficult to manage than direct taxes, because every VAT transaction (whether a sale or a purchase) and many activities related to that transaction (e.g., inventory transfers between locations) must be assessed in real time to determine the specific tax treatment. Direct taxes, on the other hand, are assessed only periodically, often just once yearly. While on the corporate income tax side some details of certain transactions must be taken into consideration, with indirect taxes like VATs it is crucial to assess all elements of transaction data in real time.
This transactional approach becomes even more complex with non-harmonized VAT/GST rules, increasingly intricate business structures (think about the sharing economy or on-demand supply chains), and pushes by countries to tax consumption effectively where it occurs, especially in cross-border situations. Unlike in the corporate income tax arena, nonresident vendors, mainly in digital services, already must comply with foreign VAT obligations in more than eighty jurisdictions even without any physical presence. Economic nexus, often from the first dollar of sale, is enough to create a foreign VAT compliance obligation. The number of countries requiring such compliance will only grow in the near future, and the scope of transactions imposing compliance obligations can only broaden.
Finally, VAT systems often come with burdensome compliance obligations. VAT filing periods are often shorter than those for corporate filings (generally monthly or quarterly), with many jurisdictions requiring taxpayers to provide transaction-level details through either the return itself or supplemental filings. In addition, given the importance of the invoice in VAT systems, countries impose strict content and formatting requirements defining what constitutes a valid invoice for VAT purposes.
As the complexity and risks of indirect tax increase around the world, tax authorities and businesses heavily rely on innovations in tax technology.
Innovation on the Side of Tax Authorities
According to the OECD, governments, on average, raise more than twenty percent of their revenues from VAT, compared with only nine percent from corporate income taxes. In addition, the tax gap—the difference between the VAT collected and the VAT that should have been collected—may be considerable, depending on the jurisdiction. In the European Union, the VAT “lost” has been estimated at €137.5 billion for 2017 alone, representing a loss of 11.2 percent of the total expected VAT revenue for that year. As a result, in recent years tax authorities worldwide have invested heavily in technology to close the VAT gap caused by simple errors, fraud, and abuse. These tools mainly cover four areas: e-filing, e-invoicing, real-time reporting, and e-accounting/audit.
For tax authorities, the first step in leveraging technology is often to require taxpayers to file their VAT returns and additional reports electronically. This allows tax authorities to use submitted information not only to verify timely submission of reports but also to cross-reference information provided by taxpayers. For instance, the United Kingdom recently introduced Making Tax Digital, a system that requires VAT-registered businesses to keep digital records and to file their VAT returns using specified software. The software must be able to keep and maintain the records specified in the regulations, prepare VAT returns using the information maintained in those digital records, and communicate digitally with the UK tax authority through the application programming interface (API) platform.
As mentioned earlier, invoices are the cornerstone of the VAT system, since the invoice is simultaneously the proof that the vendor has charged and collected the tax and the proof required for the purchaser to get credit for the tax paid through its VAT return. Shifting the invoicing mechanism from paper to digital format will help to make the VAT system fraud-proof by enabling tax paid to be matched with credits claimed. Countries in Latin America were the first to introduce mandatory e-invoicing requirements in the mid-2000s. Countries in Europe and Asia have in recent years started to implement such requirements (e.g., Italy in 2019), with more countries likely to launch such systems in the next decade (e.g., France in 2023).
E-invoicing comes in two main forms: a mandatory government-regulated mechanism and an optional mechanism with guiding principles set out by the tax authorities. Under a mandatory e-invoicing system, e-invoices generally must include preset details that enable tax authorities to verify transactions carried out and tax invoiced. Under this system, the tax authority verifies and certifies e-invoices before the transaction can be completed, a setup that enables real-time verification of all transactions. Current systems approve only the validity of the document itself and cannot approve the validity of the underlying transaction, though this is the long-term goal.
To circumvent some shortcomings of e-invoicing systems, some tax authorities have implemented real-time or quasi-real-time systems under which the taxpayer must provide transaction-level information to the tax authority, thus allowing the tax authority to perform a first audit of the transaction and to use the data collected for further analysis. For instance, in 2017 Spain introduced the Immediate Supply of Information (SII) system, which requires certain taxpayers to electronically submit data relevant to sales invoices, purchase invoices, intra-EU transactions, and investment goods in a specified format within a limited number of days after the transaction.
Finally, some countries have implemented e-accounting/audit requirements. Several countries—especially in the EU—require taxpayers to provide their financial data in a specific format, such as the standard audit file for tax (SAF-T). The SAF-T format has emerged from work the OECD has done to facilitate tax audits. In practice, tax authorities request the files and use special audit software that enables them to detect errors in VAT reporting. In Poland, for instance, all VAT-registered businesses, whether established or not, must file periodic SAF-T reports that include key electronic accounting information. Poland plans to replace the separate VAT returns and SAF-T reports with a new SAF-T report in October 2020.
Innovation on the Side of Businesses
Due to the continued complexity of indirect taxes, tax technology is increasingly part of VAT management. When considering the role technology should play in indirect tax management, businesses quickly realize there is no one-size-fits-all solution, nor is there one solution that works for all businesses. For some businesses, less advanced solutions still have merit, whereas for many, if not most, more advanced options tend to deliver greater value. The potential benefits of automating VAT management include eliminating manual processes; simplifying VAT compliance management; accessing tools to manage complex transactions; improving flexibility and controls to adapt to business changes; improving and centralizing the management of the tax decision-making process, SOX compliance, and security controls; improving control of and insight into data; and enhancing reporting capabilities.
In choosing a technology solution, businesses have the option to rely on the native functionalities of their enterprise resource planning (ERP) system, sometimes customizing it to manage their global VAT obligations. However, changes in tax determination rules, tax code updates, and producing new reports can be cumbersome and raise the risk of human error. Instead, implementing a tax engine that includes provider-supplied updates on rules and rates may reduce errors and risks as well as improve compliance.
A third-party tax engine has several advantages over native ERP capabilities, because the tax engine provider monitors tax law and rate changes and regularly pushes these updates to users without requiring constant updates to ERP settings. This setup facilitates maintenance of the tax engine and provides the ability to carry out complex tax determinations and calculations and automate the return preparation process, while allowing flexibility for business model changes.
These VAT determination tools can be supplemented by VAT compliance tools ranging from simple bridging software to more complex automation tools. Bridging software can take information from other applications (e.g., spreadsheets or in-house record-keeping systems) and lets the user send the required information digitally to the tax authority in the correct format. An example of a more complex tool is KPMG’s Bahrain ENARA tool, which assists companies with their VAT compliance and reporting obligations under Bahrain’s new VAT system.
ENARA, derived from an Arabic word for enlightenment, is an end-to-end robotic process designed to meet Bahraini tax requirements. Its features can be customized to a company’s needs, including multiple entity login, trial balance reconciliation, VAT return completion, automatic exchange rates, tax authority format output, VAT recovery apportionment computation, scanning emails, and reporting. Using such a tool simplifies VAT compliance by reducing time and costs, eliminating human errors, and validating submitted data, thus increasing speed and accuracy without affecting workflow.
Another way to ensure that VAT is correctly managed is to use data and analytics tools that transform tax data into insights such as gaining certainty on invoices and returns, finding overpaid or under-claimed tax, and revealing buried business opportunities. KPMG, for instance, has developed a tool called ITAP, or Indirect Tax Analytics Platform. ITAP is a complete end-to-end technology platform that can be used to deliver reverse audits or to continually monitor a client’s indirect taxes. ITAP standardizes the process for data extraction from a company’s ERP system, stages and transforms the data using a common data model, runs predictive analysis through KPMG’s proprietary machine-learning algorithms, and stores the data in KPMG’s cloud for analysis, review, and reporting. To enhance the customer experience, ITAP’s Project Insights dashboard allows companies to review metrics around total transaction amount in scope, invoices reviewed, total tax reviewed, and refund identified to date. Companies can pull up for review specific transactions that have been identified as potential errors, so that relevant issues can be identified and corrected.
Given the complexities of indirect taxes worldwide, businesses should choose the tool that meets certain country or task requirements. For instance, given the complexities of Brazil’s indirect tax system and its heavy reliance on data, businesses may want to leverage a Brazilian tool that ensures the quality of the indirect tax data. One example of a Brazil-centric tool is KTAX, a data analytics and validation tool developed by KPMG Brazil that performs more than 22,000 smart analysis and validation rules. The tool analyzes data, files, and the integrity of processes; reviews tax credits; assesses the impacts of legislative changes (e.g., new tax base computation); and cleanses the tax reporting files. KTAX further includes a test tool to ensure the integrity of the data during implementations of tax solutions or while applying new reporting processes.
Another tool that businesses can implement is e-invoicing software that can meet various mandatory e-invoicing requirements. Such software creates a bridge between a company’s ERP and relevant local requirements and often provides integrated management of all transaction documents such as purchase orders, invoices, payment terms, shipping notices, delivery confirmations, payment confirmations, credit notes, and more.
Finally, businesses increasingly use machine learning (ML) and robotic process automation (RPA) to assist in VAT management. ML is a field of computer science that uses artificial intelligence and statistical analysis to give computers the ability to “learn” and assist in decision-making. With indirect tax, ML can be used to evaluate a data set previously reviewed by a professional and then, based on what it has learned from that first data set, it can determine the taxability of each transaction in a different data set based on elements common to the two data sets. Leveraging ML can significantly mitigate the risk of missing opportunities.
RPA, in contrast, uses software to replicate processes and eliminate manual labor. For example, RPA can automate the process of retrieving electronic images of invoices. RPA will automatically retrieve electronic invoice images from a company’s imaging system by simulating user actions such as data entry and point-and-click. RPA processes can be run during off-hours when there is less demand on systems, saving significant time and resources. For instance, RPA can be used to pull all the tables required to prepare the VAT return and create a standard format template. This in turn allows the return preparer to focus exclusively on preparing the return and reviewing the quality of the data.
Given the current push for tax authorities to find new revenue streams, the trend toward leveraging technology to administer VAT will only grow. Businesses need to improve their ability to comply with requirements. At the same time, businesses can use this opportunity to further embrace technology to simplify and streamline their own VAT compliance management processes. Solutions will differ by company and by country. To identify the best solution, companies need to embrace an ongoing iterative process through which they evaluate their footprint, their plans, and their current processes; match up what they need to do now and what they will need to do; and be able to adapt as situations and tax authorities’ requirements change.
James Freed is principal, practice leader, international indirect tax (SALT) at KPMG LLP. Philippe Stephanny is senior manager, state and local tax, indirect tax, Washington National Tax at KPMG LLP.