INSIGHT: U.K. Businesses Face the VAT Challenge of Making Tax Digital

The U.K. government’s initiative in relation to Making Tax Digital (“MTD”) represents perhaps the most fundamental change to occur to the U.K. tax system for decades. All businesses who are mandatorily required to be registered for VAT will be impacted initially.

The U.K. is not alone in seeking to digitize the administration and collection of tax and many other jurisdictions are well down the path in relation to implementing arrangements for MTD. It is an objective of the OECD under their Co-operative Compliance Initiative that MTD will make it easier for many jurisdictions to work more closely together in exchanging information making it increasingly difficult for individuals and businesses to engage in tax evasion.

Two Key Drivers

In the U.K. there are two key drivers for MTD, the primary one being to address the tax loss to the Treasury as a result of errors arising. HM Revenue & Customs (“HMRC”) estimate that in the year 2014–15 some £9 billion tax was lost to the Treasury as a result of careless errors. The intention is that MTD will significantly reduce the incidence of errors arising by ensuring that source data flows automatically through to the VAT return with minimal scope for adjustments to be made.

The second key driver for MTD is cost reduction. A number of recent studies confirm that developing a digital solution to deal with tax queries generates significant savings when compared to dealing with the same query via the phone, e-mail/correspondence or at a meeting with the authorities. There will be clearly be significant benefits for HMRC if they can make a success of MTD.

Phased Implementation

In the U.K., MTD will be introduced in a number of phases and VAT will be the first tax to be digitalized but MTD will be extended to cover all mainstream taxes in due course. Initially this will impact all businesses who are mandatorily required to be registered for VAT (those with a turnover in excess of 85,000 pounds) and this will include charities, public bodies, partnerships and sole traders.

For all VAT returns beginning on or after April 1, 2019 VAT-registered entities will be required to implement changes to the way in which they both record VAT accounting information as well as how they submit this to HMRC. A key aspect will be the requirement to have MTD compatible software which will require an application programme interface (“API”) to be put in place which will create a digital link between the businesses accounting systems and HMRC’s accounting systems. This API will be a two-way interface enabling the business to submit the mandatory VAT return information currently set out in the nine boxes on the VAT return but will also enable HMRC to raise queries in relation to the information submitted.

Under MTD, businesses will also be required to record certain supplementary data which will include a record of outputs split between supplies at different rates of VAT including exempt and outside the scope supplies, transactional line data for supplies made and received including the VAT rate, the net amount and time of the supply. It will also be necessary to identify and record VAT that is not recoverable at the point that purchase invoices are input onto the system.

This will represent a significant change for organizations that are VAT adverse and who will ordinarily just expense irrecoverable VAT without recording it separately. This will also prove particularly difficult in identifying the VAT restriction on residual expenditure where this is not typically known until the end of the VAT accounting period. HMRC are aware of this issue and as the business will not know the recovery rate on residual costs until the period end, it is expected that some concession will be made on this point but details of what this may entail are yet to be announced.

Whilst this supplementary data must be recorded digitally it does not have to be submitted to HMRC. Ultimately if all HMRC receives is the mandatory nine box VAT return information then clearly they are no better off than they are under the existing system and HMRC are unlikely to achieve their ambitious objectives for MTD.

It is therefore apparent that HMRC will ultimately want access to the supplementary data as it is this data which will allow them to carry out additional analysis and raise queries via the API link with a view to identifying errors. HMRC does of course recognize that there will be an understandable reluctance on the part of many businesses and organisations to submit more data than is actually required. As an incentive HMRC have indicated that those businesses who do chose to voluntarily submit the supplementary data will be less likely to receive a VAT inspection if no issues are identified from a review of the supplementary data. Whether a business chooses to submit the supplementary data will, to a significant extent, be determined by how confident they are in the quality and robustness of their data.

It is probable that at some point in the future as HMRC require the supplementary information to be recorded that they will make it mandatory for this to be submitted as well although HMRC have yet to indicate whether this will be the case.

A key aspect of MTD is to reduce the incidence of errors being made and to facilitate this it is intended that source data should flow through to the VAT return with minimum opportunity for figures to be adjusted or amended. In practice, however, it is virtually impossible for many businesses and organisations to prepare their VAT return without carrying out adjustments of some sort, many of which are dealt with on spreadsheets. HMRC have recognized this and have agreed that where adjustments are made on spreadsheets then it is only the adjustment on the spreadsheet that needs to be digitally linked to the accounting records. It remains to be seen whether HMRC will allow VAT returns to be completed using spreadsheets only.

Where a business prepares its VAT return using a number of different accounting systems, which is quite common for businesses who have made acquisitions or where a VAT group is in place, those accounting systems must be digitally linked via an API link in order to be MTD compliant.

“Soft Landing”

Whilst the MTD changes will be effective for the first return falling on or after April 1, 2019, HMRC have announced that there will be a “soft landing” up until April 1, 2020. Businesses will be required to have the API link between their accounting records and HMRC’s accounting records in place from April 1, 2019 but they will not be penalized for failing to record information on MTD compatible software until April 1, 2020.

Accordingly, whilst businesses will in practise have another 12 months in order to ensure that their systems and processes are fully MTD compliant many businesses will need to adapt existing systems or invest in new IT and will want to test this before going live. As such the deadline of April 1, 2020 may still prove challenging for those organisations who delay in addressing the changes they will need to make.

Many software providers have developed or are in the process of developing API links which are being made available to their clients who are using supported software. Where businesses are using older legacy systems that are not supported then it should be possible to source API’s from third party software providers. Where this is not possible the only option will be to invest in new MTD compatible software and for many smaller businesses this may well be their first experience of using accounting software. As a result the additional cost burden of MTD will be felt most by smaller businesses who in proportionate terms will have to invest more in order to become MTD compliant.

With effect from April 1, 2018 for those businesses which had access to an API, it is possible to volunteer to be part of an MTD pilot programme which HMRC are running. This has however been limited to relatively small numbers and only available initially to straightforward businesses who were fully taxable and not involved in any international trade. This pilot will be extended in due course and larger more complex international businesses will be able to apply to become part of the pilot enabling them to test their MTD software prior to the go live date of April 1, 2019.

Increased Interaction from HMRC

Perhaps the most significant change in relation to MTD will be the way in which HMRC will interact with businesses in the future. At present most businesses only receive attention from HMRC at a VAT inspection and because of HMRC’s resource constraints many businesses can go for a considerable period of time without having a visit from a VAT officer. Going forward it is likely that HMRC, especially where they have access to the supplementary data, will raise queries on a regular basis which will be communicated to the business via the API link.

In practice, therefore, businesses may have a series of ongoing enquiries open at any point in time. More recently HMRC have been utilizing desktop reviews and as part of these have been using analytical software to identify anomalies and raise queries in relation to VAT returns submitted. The advent of MTD is likely to see HMRC invest more resource in carrying out desk-based reviews and having much more data to review will undoubtedly provide HMRC with an opportunity to close the tax gap and identify additional errors. An additional important aspect of MTD for HMRC is that this will enable them to focus their limited resource on those organisations and businesses who are deemed to be less compliant.

Ultimately for those businesses which have robust systems in place and are confident about the quality of their data then MTD may be good news as they may receive less attention from HMRC and spend less time and cost in dealing with any enquiries raised.

For those businesses with inadequate systems and controls in place then they should expect to receive more attention from HMRC. If MTD can be implemented successfully by HMRC then the benefits of achieving their two main objectives of raising additional revenue and reducing cost are likely to be significant and will encourage them in extending MTD to all other mainstream taxes in due course.

Planning Points

Businesses should:

• confirm with their software provider that they will be able to provide an API by April 1, 2019;

• determine what actions they will need to take in order to ensure that they are able to record and submit VAT return data using MTD compatible software by April 1, 2020 at the latest; and

• decide whether they wish to volunteer to submit the supplementary data.

John Forth is an indirect tax partner at RSM UK. He may be contacted via email at john.forth@rsmuk.com