Ever since the early beginnings of value-added tax (“VAT”) in France and Germany, as a general consumption tax after the First World War, countries have battled to obtain the full value of VAT that is owed to them. This problem persists today, with the majority of nations battling a “VAT Gap.”
It’s an eternal issue, which despite the best efforts of numerous national treasuries, has continued to grow—leaving many economies’ national accounts much weaker than they should be.
In the EU, it’s a common problem across the bloc of 28 member states, according to the European Commission, which defines the gap as “the difference between expected VAT revenues and VAT actually collected.”
The issue varies greatly across Europe, from 0.85 per cent in Luxembourg to 35.9 per cent in Romania, but collectively the gap is huge—currently sitting at a combined total of just under 150 billion euros ($170 billion) in 2016—a phenomenal figure.
It is useful to define the sheer scale of the issue against two different metrics which put its impact into perspective: monetary value and the aforementioned percentages of governmental revenue. Money on a global scale is very difficult to conceptualize, but an estimation of 500 billion euros being the figure of the global VAT Gap is enormous, and in reality is probably a conservative, rather than a realistic estimate. Think what impact such an amount of money could have on global healthcare, education or transport infrastructure.
So, what is causing this huge hole in the middle of national budgets?
While fraud does make up a large chunk—the EU Commission estimates a third of all VAT is lost due to factors such as elaborate money laundering and espionage—the rest is made up of incorrect VAT reporting, lost records and transactions made through cash.
On hearing the aforementioned ingredients of this missing VAT recipe, many might question how, in 2019, just so much money can be lost unintentionally. But when I remind them of how much simple human error still exists in business and that this contributes to millions of mistakes on tax returns each and every day, it becomes more understandable.
After all, there is a reason government organizations like HM Revenue and Customs (“HMRC”) in the U.K. have invested in such a large education program on filing tax returns.
Latin America in the Forefront
But it’s not all doom and gloom. Increasingly, nations are becoming smarter in how they reduce the void. Thousands of miles away from Brussels, many Latin American ("LATAM") countries have been leading the fight against the VAT Gap for some time. Here, a number of smart initiatives exist, spearheaded by mandatory electronic invoicing and real-time reporting systems.
Brazil in particular is an innovator in this space. Increasingly concerned by its huge VAT Gap, fueled by a large-scale cash economy, the tax authorities realized that—without change—Brazilian businesses would continue avoiding the tax man.
To combat this, the government established continuous reporting on tax on an invoice-by-invoice basis; a far more efficient way for its tax department to ensure transactions were accurately recorded at the source, as opposed to businesses having to periodically report on what they had undertaken. In short, invoices had to be uploaded to a government platform and approved before being finalized. Business-to-business transactions became business-to-government-to-business transactions.
Once implemented, the system produced massive improvements. Brazil’s tax system is notoriously complex and simplification efforts are underway, but even without those, the introduction of continuous invoice and other electronic document controls increased legal certainty for businesses by turning written laws, which are open to interpretation and abuse, into computer code, with more predictable control results for all companies, regardless of size or type.
This also meant standardization now existed that made it simpler for business systems to exchange data with each other. This system of continuous controls also minimized the intrusion of auditing, which was not just an opportunity for the authorities to focus expert audit resources on pockets of fraud and malpractice, but was also beneficial for business in general.
Brazil and subsequently other LATAM nations also focused on clearance creating laws that ensured goods could not be shifted from a supplier to a purchaser without the invoice being signed off via the government portal.
Initially some industries were hit—fresh produce for instance—but measures were put in place to end this so the economy could continue moving if unexpected technical difficulties arose. Further innovations, where data collected in real time for tax purposes were made available to facilitate business transaction financing, became a major reason why LATAM countries do not have directives to cover late payments, like other economic powers.
As other Latin exports have thrived in Europe—so too has this tax model. European governments are now implementing their own versions of real-time invoice controls as they look to combat their own VAT gaps effectively.
Hungary introduced real-time transactional reporting in 2018, while Spain adopted real-time reporting the year before. Italy made electronic invoicing for domestic business-to-business transactions mandatory in January 2019. Others are following suit; the U.K. is in the middle of its Making Tax Digital (“MTD”) initiative, live from April 2019, while Greece and France have similar plans.
MTD is an interesting case; although a small step in comparison to the sweeping steps other countries are making, its purpose is to lay the foundations for further change and to future-proof HMRC. This is just one step on a journey, evidenced by the plans for 2020, where transactional data will be linked to digital VAT returns, providing HMRC with a clear image of a business’s deals and corresponding tax information.
While smarter technology has given birth to a new era in the fight against the VAT Gap, it’s only the beginning of a longer shift change.
Businesses cannot rest on their laurels and it’s imperative that they become proactive in regard to changing their processes to make sure they adapt with the tax authorities when it comes to collecting VAT. Failure to do this risks a future headache, especially for businesses who trade internationally.
A reactive attitude and leaving local subsidiaries to implement a solution per tax jurisdiction will certainly lead to system and process fragmentation.
A company that wants to thrive in this new world of continuous interaction between business and government systems needs to use state-of-the-art technology to stay at the cutting edge of tax compliance. New software is being produced, and improved every day, that can assist companies to do this and it simply has to become part of their core business model, built in alongside their enterprise resource planning software and payroll.
The world is waking up to the VAT Gap and organizations, large, medium and small, need to ensure they don’t end up on the wrong side of the Great VAT Recovery.
Christiaan van der Valk is VP of Strategy, Sovos
The author may be contacted at: firstname.lastname@example.org