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Principles of value added tax risk management.

Since the enactment of the Sarbanes-Oxley Act and the passage of similar legislation outside the United States, there has been much discussion in professional circles around operational, systems, tax ,and reputational risk management. Little detail and even less practical guidance has emerged, however, from this activity on VAT risk management, even though most multinational businesses are heavily affected by the tax. This article addresses those gaps by looking at how VAT risks have developed and continue to emerge; provides a basic understanding of the principles of risk management; and considers how those principles can be applied to businesses.

VAT is an indirect tax that has its origins in 1950s France and has spread to more than 140 countries around the globe. Today, it is the world's preferred supply chain and consumption tax, with the United States being the only Organisation for Economic Cooperation and Development (OECD) country that does not employ this tax type. There has, however, been much discussion of the VAT in the United States in terms of being a possible solution to the country's debt mountain.

Most risk management principles and processes have their origins in the financial sector, having been developed by banks and other institutions to provide a framework for their lending practices. History teaches that these processes were not well enforced in recent years, but that does not necessarily mean that they were or are ill-conceived or invalid.

The VAT Risk Management Environment

Prefatorily, consider the environment in which VAT has operated for the last 10-plus years. Pressures have been building on organizations to ensure that their various tax positions (including VAT) are well controlled and assured. One of the most obvious pressures is the basic fact that VAT has assumed a higher profile both from the taxpayer and tax authority points of view. Examples of this include:

* There has, for many years, been a global shift away from direct taxes (such as income tax) toward indirect taxes (such as VAT). This has seen many countries reduce their income tax rates and increase their indirect tax rates or introduce new indirect taxes to compensate. This has generally had the effect of bolstering national competitiveness and encouraging inward investment. It also means that the tax authorities have been placing more of their control focus on indirect taxes, so raising their risk profile as far as the taxpayer is concerned.

* VAT rates have been increasing around the world. The average standard rate of VAT in the European Union is now in excess of 20 percent and this increases the VAT throughput (or VAT under management) for most multinational companies. Although VAT is commonly seen as a wash-through tax, effective management of VAT throughput is critical to ensure that position. Weak management of VAT leads to tax assessments, interest charges, and penalties. For these reasons, companies are under greater pressure to build VAT risk management frameworks and make sure they have strong processes around their indirect tax accounting.

* The global spread of VAT (or its cousin, the Goods & Services Tax or GST) has been building for many years. Thus, India has announced that it will launch a GST system in 2012; China will be greatly expanding its VAT system in 2013 (pilot scheme) and 2015 (full launch); Malaysia will start its GST system in 2013; and the Gulf Cooperation Council countries are expected to adopt GST systems over the next two or three years. Thus, the applicability of VAT/GST continues to expand its worldwide coverage and their effect on multinational corporations is clean

* The adoption of VAT/GST systems has long been promoted by a number of global organizations such as OECD, the International Monetary Fund, and the World Bank, which view these tax systems as preferable to income taxes and sometimes link their financial support to a country's adoption of a VAT.

Another major contributor to the importance of VAT risk management has been the Sarbanes-Oxley Act and similar legislation outside the United States. Significantly, Sarbanes-Oxley applies to VAT in the same way as it applies to any other tax: demanding transparency and section 404 attestations. Similarly, in the United Kingdom, the authorities require what is known as a Senior Accounting Officer (SAO) attestation, which is basically the same as the U.S. requirement except that an incorrect attestation opens the SAO up to penalties that are levied against him or her personally.

Another emerging pressure is increased cooperation between tax authorities, especially within the European Union, where the practice is known as "mutual cooperation." This development is due in part to the need to combat an uptick in VAT fraud but is also a response to the wider economic environment, which has required greater tax revenues to support government programs. In addition, many tax authorities are becoming far more sophisticated in their tax management and control methodologies. Not only have they made extensive efforts to close down legislative "loopholes" and off-shore tax havens, but they have also invested heavily in updated technological tools to help mine data and identify potential areas where additional revenue might be found.

Finally, the pace and extent of tax changes happening around the world (legislative, case law, and administrative policy) have become so intense for many multinational companies that they have entered a "hyper-regulatory" environment in which their usual tax processes and controls no longer suffice. For many businesses, this has resulted in assessments and penalties arising in multiple countries, and for others, it has heightened the demand for technology-based solutions. In either case, the VAT risk management plan must take into account hyper-regulation as a primary culprit in creating and expanding tax risk.

Identifying VAT Risks

So, having recognized that VAT risks need managing, where do you find such risks in your organization? The answer is twofold. Firstly, there are internal risks, which are those that arise out of things that you do, such as how you structure your business, where you do business in the world and how you design your supply chains.

Secondly, there are external risks, which are those that arise out of events that are outside of your own control, such as legislative, economic and tax authority policy developments. Let's look at these in more detail.

1. Internal Risks

The first and most critical factor ill building a VAT risk management framework is to understand your business at a detailed level. This means having a full understanding of all of the company's key supply flows, which is likely to involve discussion with (at a minimum) your finance and logistics people to get a good picture of how things actually work in the business. Supply flow documents should be created to preserve this information for the future because, without this knowledge, it is impossible to make any reliable identification of where VAT risks lie.

Secondly, a company must understand its VAT liability risks. These can arise out of miscategorizing the goods and services the enterprise supplies into incorrect tax classifications. It is surprising to see how many long-established companies discover that the supplies they make have had the incorrect VAT rate applied to them over many years. An analysis of all goods and services supplied in all countries where the supplies take place is a basic VAT risk management exercise.

Thirdly, a company must understand its geographical risks, which means understanding whether or not the enterprise is required to register and account for VAT in every country where it trades or is deemed to trade. It is notable that the greatest number of VAT assessments that become material to a company's accounts typically arise out of this area so bear in mind that a failure to register for VAT at the required time is most likely to land you in the deepest water. Therefore, one of the first activities in a VAT risk management project is to examine closely where the company is and--just as important--is not registered and accounting for VAT.

The next area to examine is supply chain risks in which changes to an earlier supply chain can give rise to VAT issues. Perhaps the most obvious of this type of risk can be seen in the outflow of manufacturing from western countries to China over the last decade. Taking the United States as an example, 10 years ago much of the manufacturing process was carried out in the country, so the supplies being made to wholesale and retail customers would have been domestic, U.S. supplies. For tax purposes, these would have been handled under the Sales and Use Tax regulations and the exemption certificate process. Once manufacturing is moved offshore, the company has to deal with the foreign country's VAT system, to the extent that any supply takes place there, and also the U.S. importation process, which may involve the payment of customs duties, which were not payable under the earlier structure. In this way, some supply chain projects that have sought to reduce the cost of manufactured goods have, in fact, generated new tax liabilities that have eroded the expected savings and added a new tax process that has to be managed.

Another key area of internal VAT risk lies in business process risk. This can be broken down into two main components:

* People. Whenever people are involved in a process, there is always the possibility of human error. This can be minimized through specialist training, but the effectiveness of this approach in the VAT world has proven to be inconsistent since accounts payable and accounts receivable staffs have a tendency to move from job to job on a regular basis, requiring more training for their replacements. A broader question, of course, is whether a company really wants non-VAT experts making tax decisions in the financial system. As part of a VAT risk management project, it is important to recognize people as a risk factor in this way and consider automated alternatives.

* Systems. Especially with reference to tile hyper-regulatory environment, many multinational companies simply find it difficult to research and then enter all the global VAT changes into their financial systems. Furthermore, the systems themselves are not under the control or management of the tax department, so there is an additional risk in terms of miscommunication between the tax professionals, who understand the effects of a tax change, and the 1T department, which has to implement that change into the system.

Finally in this section, companies struggle with control risks. One example of this type of risk relates to the reconciliation of invoices with supporting documents (e.g., matching sales invoices with exemption certificates or attaching export invoices to shipping documents). The inability of businesses to provide required documentation at audit has been one of the longest-running issues in the audit of any transaction tax process.

Another example are the challenges associated with establishing a global overview of the organization's VAT footprint. Very few multinationals have anyone on staff that has a truly global view of the company's operations. This constitutes a VAT risk because, in the absence of a global view, it is nearly impossible for the tax department to identify and implement VAT accounting and process enhancements across the board or establish best practices throughout the organization.

2. External Risks

For the purposes of building a VAT risk management framework, it is important to identify the external factors that will constitute risk areas. Some examples are:

* Legislative developments. Statutory changes could include the adoption of a VAT or GST system in a country, the mandating of e-filing for VAT returns (which is beginning in some jurisdictions), the European Union's current VAT simplification project.

* Case law developments. Judicial developments often slip under the radar, because they are not necessarily connected to or mirrored by legislative developments. Accordingly, they can pose a significant risk.

* Administrative Changes. Increasingly, tax authorities are conducting more sophisticated tax audits, using technology tools and more technologically advanced auditors.

* The Economic Outlook. The current economic climate has prompted tax authorities to be more aggressive (across tax type) in many countries.

Setting VAT Risk Priorities

The process for setting VAT risk priorities is much the same as establishing priorities in respect of any other type of risk. There are several questions to consider, including "What is your appetite for risk?" and "What is the right amount of risk?" The answers to these questions will vary greatly from company to company, so they are not addressed here but generally the risk appetite of most companies when it comes to taxes is fairly low, especially in the current risk-averse climate.

The starting point in setting VAT risks priorities is to identify those internal and external risks that could affect the company and then fit them into a framework to differentiate the low-impact risks from the high-impact ones. Figure 1 is a very simple example of such a framework.


What this achieves (at a very high level) is a basic separation of risk elements. Arraying some of the risk issues identified into this framework would yield a risk ranking along the lines of that portrayed in Figure 2.

This type of analysis can be done at many levels such as by tax type, by country, by business division, etc., but it is critical that the information is rolled up to higher levels to provide a broader, global overview of the company's risk profile. Additionally, these frameworks should be living documents, since new risks will emerge regularly, existing risks will change priority, and resource capabilities can fluctuate. A best practice would be to revisit the risk frameworks at least quarterly to ensure their relevance and to provide guidance on the parts of the business that should be areas of focus for the tax department.

Once risks have been identified and priorities have been established, a company must consider the various approaches to managing those risks. There are essentially four routes that can be taken with VAT risk, the most appropriate differing from company to company:

* Avoid risk. for example, restructure or even decline a high risk transaction.

* Transfer or share risk. Use agents, consultants, or outsourcers who could share risk.

* Reduce its likelihood. Consider best practice processes and adopting automated solutions.

* Reduce its effect Make provisions against recognized risks.



The last 10 years have seen a significant shift in the authorities' views on taxpayer management and control. The very clear direction being taken globally is to focus on transparency in tax accounting, which includes VAT. Thus, the pressure on taxpayers has been increased not only from the tax authorities' perspective, but also from a wider regulatory group (including the Securities and Exchange Commission), which could well expand in countries outside the United States.

The issues of transparency and VAT risk management are not, therefore, national or even regional problems for taxpayers; they are global concerns that need to be addressed as such. For these reasons, businesses must recognize the imperative that is tax risk management and, for those that trade internationally, VAT risk management as a specialist area needs to become a priority in the near term.

Chris Walsh is the Chief Tax Officer, International for Vertex Inc. and has more than 25 years" experience. Before joining Vertex, he held senior tax roles with PricewaterhouseCoopers (Kenya, Ireland, and United States), Rothmans Tobacco, Foster's Brewing Group, and HSBC. His work has taken him to more than 30 countries. Chris is a regular writer, speaker, and commentator on operational and strategic issues surrounding indirect taxes. He may be contacted at chris.
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Author:Walsh, Chris
Publication:Tax Executive
Date:May 1, 2011
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