Regardless of whether your business uses a relatively straightforward accounting systems such as Xero/QuickBooks, or a more sophisticated ERP system such as Oracle/SAP, there are some basic principles that apply to the management of VAT compliance and creating an effective VAT determination process to ensure that you are managing VAT risk appropriately. The benefit of this is that the tax or finance team has confidence the correct amount of VAT is being paid at the correct time, and the compliance burden is reduced if the VAT compliance tools and systems are being used effectively.
There is an increasing array of VAT analytical tools and automation software to manage VAT compliance but these are only effective if the underlying master data is accurate and comprehensive. For example the underlying sales and purchase transactions need to be coded correctly for VAT purposes with an appropriate tax code, and the customer master data should flag their VAT registration/business status to ensure the appropriate VAT rules can be applied. If not, any analysis of the data using a VAT analytical tool is likely to miss key areas of risk or throw up so many exceptions that the VAT compliance burden may feel as though it is increasing rather than decreasing.
In this article we will take a look at best practice in relation to VAT compliance to enable the business to reduce the amount of time spent in preparing VAT returns but also increase the level of comfort achieved for the tax or finance team in relation to the accuracy of the data being reported to the tax authorities using ERP Systems and Tax Engines.
Reconciled Numbers versus Accurate VAT Coding of Transactions
Preparing an accurate VAT return is not solely about whether the numbers add up and reconcile with the data in the wider financial systems – this can be a relatively easy achievement and in our experience, particularly in larger businesses, this part of the VAT compliance pipeline should ideally be completed by the finance team before the data is passed to the VAT team or whoever is responsible for reviewing and filing the return. The route to having real certainty of the accuracy of VAT returns lies in ensuring the transactions are taxed correctly – there is little value for example in ensuring that the total value of zero rated sales being reported is accurate in terms of reconciled values, if the actual individual sales transactions do not qualify for zero rating. This cannot be determined by a review of the values in isolation, and any robust VAT risk management framework should include a review of a sample of individual sales and purchase transactions to test accuracy.
In our experience gained from being embedded within the tax and finance teams of large businesses, tax codes are the holy grail to making the life of the VAT/finance team easier in terms of VAT compliance. This is because they are a hugely effective mechanism to flag and categorise transactions into groups which describe the VAT treatment applied. This sorting process facilitates the completion of the VAT return itself but more importantly enables a focused set of checks to be carried out on the transactions with each tax code on a VAT return.
The VAT Consultancy is often asked to advise on the optimum number of tax codes for a business. This ultimately depends on the complexity of the purchase and sales transactions. However as a minimum it is typically useful to have separate codes for purchases and sales. In addition it is wise to have a range of codes that bear 0% VAT so that a distinction can be made between the following:
- zero rated (separate code for goods and services if relevant to allow for specific checks to be made to each)
- outside the scope (intra VAT group, on the high seas, salaries, tax)
Most accounting systems including the most straightforward ones have tax codes, and the key is to ensure that the description attached to each code is clear and readily understood by those using the codes outside of the VAT team. Training should be provided in the use of the codes to reduce the risk that they are used incorrectly. This applies regardless of whether a tax code is assigned automatically during the tax determination process, or manually when the default has to be overridden eg for a non-standard transaction with a customer/supplier.
The system needs to have up to date tax rates for each jurisdiction and these should be locked down so that they cannot be manually amended for individual transactions and so that they cannot be amended without sign off by the tax team or a senior member of the finance team.
High Quality VAT Reports
It can be surprisingly difficult to obtain a high quality reports from the systems to assist the VAT team in producing an accurate VAT return. This typically applies more often when the business has an ERP system in place as opposed to a more straightforward accounting system. Where possible however the tax team would be well advised to work with the finance team to ensure it has a bespoke report that enables it to sort and filter data appropriately to prepare the VAT return as efficiently as possible whilst carrying out appropriate credibility checks. A report showing the following data headings in addition to other fields should enable credibility checks to be carried out:
- invoice date and tax point date (to ensure the transaction is reported in the correct period)
- invoice number (to ID the transaction for a deeper review of the invoice)
- customer and supplier full legal entity name including suffix eg GmbH, SA (this helps with high level sense checks on the VAT treatment)
- customer and supplier country location (essential to test the correct VAT treatment)
- customer and supplier VAT ID (the best indication of business status which impacts VAT treatment – for all customers, not just EU)
- transaction value (net, VAT, total)
- description of goods/services provided (to enable the correct Place of Supply VAT rule to be identified and checked)
- tax code (to facilitate sorting for credibility checks)
Data Mining Tools
There are lots of data mining tools in the marketplace which aim to quickly identify transactions falling outside of programmed parameters with a view to identifying VAT errors. These tools can be a very effective way of reviewing the accuracy of VAT returns provided they are used effectively and enable the team preparing the return to focus on the high risk transactions and high risk errors. It is good practice when using such tools to monitor the amount of time taken to work through all of the exceptions generated and the resulting VAT adjustments that have been identified as a result. Otherwise there is a risk that too much time is spent reviewing exceptions that do not materially alter the VAT or net sales values on the VAT return. For example spending half a day reviewing variances in the net purchase value to re reported in box 7 of the UK VAT return does not add a significant amount of value compared to spending the same amount of time checking underlying source documents ie sales invoices or supplier invoices to test accuracy.
Follow up is also key here. Exceptions leading to adjustments should be prioritised for remediation, otherwise the same issue will reappear next VAT return period. It is all too easy for busy finance and tax team members to de-prioritise this action but the short term pain in resolving pays dividends.
Role of the VAT Team
The team responsible for reviewing and signing off the VAT return should focus on carrying out credibility checks on the data that has ideally been prepared by a separate finance team. This is so that they can focus on determining whether the transactions have been taxed accurately as opposed to focusing on making sure that the data reconciles although clearly both are ultimately important.
VAT Credibility Checks
These should consist of a mix of generic VAT credibility checks that apply to all businesses and also a range that are specific to the VAT risk profile of the business in question. In all cases the credibility checks should involve the reviewing of a sample of underlying source documents ie invoices, as even a small sample from the total typically generates queries and identifies errors if errors have been made. It also provides an opportunity to reach into other areas of the business to check eg that proof of export evidence is available within the logistics team. Such checks mimic the approach HMRC might take during a VAT audit.
One of the key points often overlooked in relation to VAT return review and the credibility checks is that there is no segregation in relation to the specific checks carried out by the various people in the VAT return review chain. Assuming there is more than one person involved, this means that checks can be duplicated or not carried out at all.
Equally important is documenting the findings of the checks carried out to evidence that they have been carried out. Documented evidence within the VAT return workbook helps evidence to the tax authority that checks have been carried out. This can be helpful where an error has been made and HMRC are deliberating over whether to apply a ‘careless behaviour’ penalty. Evidencing a robust control environment with appropriate credibility checks can assist in demonstrating ‘reasonable care’ with VAT risk management
Tax Engines and ERP Systems
Tax engines are bolt on software which runs alongside the ERP system. It is fair to say they are typically of most value in the US where the sales tax system is extremely complex and has multiple layers of different taxes and rates within the same state. In a VAT jurisdiction this is less critical and ERP systems such as SAP and Oracle already automate the VAT calculation in the same way. It is fair to say that the primary benefit of the actual tax engine itself lies in the fact that the provider of the tax engine will be responsible for updating the VAT rates rates if these change. Therefore the risk of a rate change being missed diminishes. Nowadays of course tax engines include lots of other VAT diagnostic tools which can be useful in helping manage VAT risk as outlined above.
Summing up Tax Engines and ERP Systems
The monthly or quarterly completion of VAT returns can consume a significant amount of resource in the finance and tax team but the variety of automation tools available can ease this burden, provided the customer and supplier and other master data is in good shape before they are implemented. The VAT Consultancy has a great deal of experience of working with businesses to streamline VAT processes and ensure that VAT risk is being effectively managed by the ERP or other VAT accounting system.
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At The VAT Consultancy we support in the design, implementation and testing of ERP and accounting systems used to report VAT. Stripping away the complexity of the ERP system down to the core processes impacting VAT determination.
Contact us today to schedule a consultation and discover how we can tailor our expertise to suit the unique needs of your business. Let The VAT Consultancy be your ERP system partner, guiding you towards efficiency, compliance, and sustainable growth.