Author: Aleksandra Bal, Senior Product Manager, Vertex
2 Jan 2020
When managing value-added tax (VAT) and purchase transactions, it’s important to heed the advice of US President Ronald Reagan: “Trust, but verify.” Companies frequently underestimate the importance of considering VAT when validating purchase transactions – the consequences can be disastrous. Incorrect purchase invoices will usually reside in the bookkeeping system until they become visible during tax inspections, when it’s often too late to correct them and penalties are inevitable.
Take nothing for granted
VAT is a tax on revenue rather than profit. This is an important distinction – especially when VAT calculation errors occur. In these instances, companies may be required to remit an additional portion of revenue to the tax authorities, often negatively impacting their financial health. As tax audits generally cover multi-year periods, even small VAT calculation errors can add up to massive sums.
As such, calculating and paying the correct VAT on purchases should be a priority for companies. All VAT on purchases (or input VAT) that is incorrectly deducted is added back onto the company’s tax liability; penalties may be applied in addition to underpaid tax. To prevent this, companies should ensure that input VAT has been correctly determined by checking that purchase invoices comply with all relevant tax rules. Relying on vendors to conduct this determination is risky, in part because vendors can commit invoicing errors, which is where Vertex can help.
There have been many cases where companies have accepted incorrect invoices, deducted the input VAT and then been required to make significant payments following a tax audit. Two decisions by the Court of Justice of the European Union (CJEU) illustrate instances when a failure to check VAT calculations on purchase invoices created a cash flow risk for the business.
The first case concerned a dispute between the construction company PORR Építési and the Hungarian tax authority. PORR had received several invoices in which VAT was charged, and subsequently deducted the input VAT. However, the tax authority determined that these transactions were subject to the reverse charge mechanism and, as a result, no VAT should have been charged in the invoices. Consequently, PORR’s right to deduct the input VAT was denied, as this right is limited to taxes that are duly charged. The CJEU agreed with the verdict of the Hungarian tax administration and ruled that PORR could not deduct the VAT charged to it in error by its suppliers, landing the company with a large tax bill.
Companies frequently underestimate the importance of considering VAT when validating purchase transactions – the consequences can be disastrous
A second case seen in the court concerned a dispute between Romanian company SC Fatorie and the Romanian tax authorities. SC Fatorie received an invoice with added VAT from one of its suppliers. However, the invoice should have been issued without VAT as the transaction was subject to the reverse charge. SC Fatorie did not identify this, paid the VAT and then deducted it in its VAT return. The Romanian tax authorities challenged this, claiming that SC Fatorie should have verified the VAT treatment of the transaction. The CJEU ruled in favour of the Romanian tax authorities.
Both cases highlight the importance of validating purchase transactions for the correct VAT. It’s crucial that purchase invoices are checked by businesses for their compliance, ideally upon receipt. If errors are discovered, corrections must be requested immediately. This may not be an easy task for companies where large volumes of international transactions are processed by a centralised back office. However, having proper control systems in place will ultimately reduce the financial risk of having input VAT deductions denied.
Leave it to the experts
Even with processes in place to perform regular checks of purchase invoices, some errors still go unnoticed. This may stem from a failure to identify certain country-specific requirements or an ignorance of local legislative changes. Companies with centralised tax functions and those without sufficient VAT knowledge are particularly exposed.
Although VAT is harmonised to a large extent, the details vary between countries. The EU is made up of a collection of VAT systems that share some characteristics but also have divergent rules concerning liability. For example, the EU VAT Directive provides a list of transactions on which customers must account for the VAT on the value of goods or services received from a non-resident supplier under the reverse charge mechanism.
The directive also allows member states to extend the scope of this mechanism to other goods and services provided by non-resident suppliers, and to specific transactions, regardless of the supplier’s place of residence or establishment. In the latter case, the application of the reverse charge mechanism may be permanent or temporary. As such, companies trading with many different EU member states must be familiar with the VAT legal framework of each country.
Another development that necessitates timely checks of purchase invoices is the obligation to report transaction data to the tax administration immediately. In Europe, Spain was the first country to implement the near real-time reporting of transaction data. In July 2017, the Suministro Inmediato de Información system took effect, requiring taxpayers to report their sales and purchase invoices within four days of the issue or receipt. Hungary soon followed suit: the country’s real-time reporting obligation came into force in July 2018 and is compulsory for all entrepreneurs registered for VAT purposes in Hungary, regardless of whether the person is established in Hungary or not.
Real-time reporting requires processes and systems to be compliant at all times. Given the short reporting window (which is either immediate or within four days), there is little time for post-transaction verification anymore. It is no longer sufficient to initiate data quality projects from time to time. Instead, such processes must be embedded in the day-to-day operations of all businesses. This will allow VAT errors to be detected at the time the transaction occurs, which is now a legal necessity. Given the complicated nature of procurement, it makes sense for tax functions to embrace new processes, including technology automation, when it comes to validating transactions.