VAT the Great and Terrible or the 5th Generation of VAT Administration System

Key VAT Fraud Methods

VAT was introduced in Germany in 1918 and was first applied in French colonies in the 1950s. Today, over 160 countries utilize VAT or Goods and Services Tax (GST). These countries continually face fraud, including criminal groups assisting taxpayers in avoiding or reducing VAT payments. Tax authorities are seeking ways to combat such “optimization.”

Fraudsters employ the following methods to reduce VAT obligations:

Issuing fictitious invoices that overstate the buyer’s input VAT and reduce the payable VAT amount.
Concealing revenue to lower the output VAT and the VAT amount to be paid.
Smuggling goods into the country and evading VAT during import.
Understating the value of imported goods to reduce payable VAT.
Falsely exporting goods using a zero-rated VAT for exports.
Failing to pay VAT in the buyer’s country in cross-border trading of goods and services.
Sellers receive payment with VAT and disappear without remitting the tax to the government.[1]
Splitting a business to stay below revenue thresholds subject to VAT.

Let us examine the VAT “optimization” scheme using fictitious invoices for domestic transactions. The scheme with the greatest damage to the state is structured as follows:

The seller issues a fictitious invoice to the buyer without conducting an actual business transaction.
The seller does not remit the output VAT from the issued invoice.
The buyer claims an input VAT deduction, reducing VAT payment obligations.

As a result, the VAT payment chain is disrupted, and VAT disappears. Astute buyers build a chain of intermediary companies between themselves and such sellers to avoid scrutiny by tax authorities. Audacious buyers use this scheme to claim refunds from the budget when their input VAT exceeds their output VAT.

Two Groups of VAT Administration Systems

Previously, we discussed the four generations of VAT administration systems.[2] They can be categorized into two groups.

“Reactive” Systems

VAT administration that reacts to tax manipulations that have already occurred. The objective of tax authorities is to detect such fraud schemes and recover additional taxes. This is a standard process in tax administration. However, the issue is that the reaction occurs after the funds have been converted into cash or sent abroad, encountering “traps and cover” created by taxpayers. Investigation and evidence collection require manual and labor-intensive administration, making it impossible to control 100% of violations and ensure inevitability of penalties.

Furthermore, the ingenuity of tax authorities in detecting optimization schemes often affects honest taxpayers and negatively impacts business and investment decisions. This group includes first, second, and third-generation VAT administration systems, which focus on collecting and processing electronic invoices in electronic form:

The first generation supports the collection and processing of aggregated VAT declarations without invoice details.
The second generation collects and processes electronic VAT declarations with additional details on purchases and sales in the form of invoice registers.
The third generation implements a separate process for issuing, collecting, and storing electronic invoices and related VAT declarations.

Adequate tax control is only possible using second and third-generation VAT administration methods.

Initiative-taking Systems

These tax administration systems aim to prevent VAT fraud rather than deal with its consequences.

The goal is to segregate the VAT amount from the transaction total and prevent the use of VAT for other purposes, such as wage payments or cash withdrawals, reserving it exclusively for VAT remittance to the budget. Of course, this considers not the entire output VAT but only the difference between output and input VAT.

Such systems are known as “sealed” or “closed,” as they are believed to make VAT fraud impossible, and the calculated liabilities will be paid in full. If a crime cannot be committed, there is no need for investigation, evidence collection, recalculations, or returning money to the budget.

The idea is appealing but comes with side effects, including freezing and outflow of funds from circulation, a complete or partial shift to a cash-based VAT accounting method, and necessitates changes in the taxpayer’s business processes.

Advantages and Disadvantages of 4th Generation Systems

Let us briefly summarize key features of the 4th generation of VAT administration systems, which utilize special clearing accounts to receive VAT payments from buyers. For instance, when selling goods, the product’s price goes to the seller, while the VAT amount is allocated to special accounts for both the seller and the buyer, debiting the buyer and crediting the seller.

Buyers and sellers create transactions that generate a balance in a dedicated VAT account, which, after the end of a tax period, is remitted to the budget. Taxpayers are not allowed to use this account for other purposes. The dedicated VAT account can be opened with the state treasury or the taxpayer’s bank. The taxpayer can independently allocate payments, or this can be done automatically by the bank or the treasury.

The primary drawback of this model is the diversion of funds from business activities and their freezing in special accounts during the tax period. The precise amount of frozen funds and the cost of the freeze for the taxpayer depend on the economic situation, the proportion of prepayments, the average payment deferral period, as well as the tax period and the VAT payment schedule. However, it can be confidently stated that this brings no positive benefit to taxpayers.

Furthermore, the state may lose part of the GDP since VAT is removed from circulation. If accrual-based accounting and profit tax calculation methods are used, this shift necessitates a transition to the cash-based VAT calculation method, requiring additional work for accountants and changes in accounting systems.

Since the transition to the 4th generation follows the 1st to 3rd generations, there is no abandonment of invoices, which retains the administrative burden from the previous system. In cases where different VAT rates apply to distinct types of goods, works, and services, it is impossible to eliminate invoices. The transition to the 4th generation of VAT administration requires renegotiating agreements with all counterparts, as the relationships between them change concerning payment amounts and special account control obligations.

Key Features and Advantages of the 5th Generation of VAT Administration System

The examination of the 4th generation and its drawbacks has led to the development of the 5th generation of VAT administration systems. The primary goal of this generation is to ensure the reliability and security of VAT administration for tax authorities while minimizing issues for taxpayers.

To implement the 5th generation, banks are involved, tasked with monitoring an irrevocable balance in taxpayers’ VAT accounts. The core concept revolves around real-time calculation of VAT balances based on invoices and payments via so-called virtual VAT accounts.^[3] This balance determines the irrevocable amount, which will be remitted to the budget for VAT payment at the appropriate time.

This approach creates a flexible balance that can be managed, rather than simply freezing funds in a clearing account. This system does not impact accounting systems, operations, and the country’s GDP because money is transferred and received inclusive of VAT. The only change is that only paid invoices can be used for VAT offset or deduction, eliminating the possibility of creating fake documents.

Consequently, banks with a similar function to existing ones emerge in the VAT administration system. Honest banks will support this system as they gain insights into invoice data, enabling them to offer financial services like guarantees or factoring, thereby generating revenue.

Dishonest banks engaged in VAT optimization and cashing out will oppose this administration system. However, their clients are likely to transition to banks that support the system.

The 5th generation system can be partially implemented, unlike the 4th generation system, which requires immediate and comprehensive deployment. For instance, tax authorities assess taxpayers and assign an irrevocable balance to those they do not trust, while for those they trust, it is only assigned for informational purposes.

This approach reduces the administrative burden and motivates taxpayers to comply with tax obligations and maintain good relationships with tax authorities. It enables behavior management by encouraging taxpayers to be conscientious and collaborate with tax authorities.

Conclusion and Recommendations

Tax authorities often show interest in 4th or 5th generation VAT administration systems but are unwilling to abandon the full spectrum of tax control measures used in 1st-3rd generations. Tax control creates a sense of greater involvement for tax officials in the process and decisions made.

It is crucial to note that creating a sealed VAT system eliminates the need for control measures related to VAT and conducting complex investigations for VAT refunds or compensation. However, this does not eliminate control measures for other taxes.

In conclusion, here are some recommendations:

VAT is a high-risk tax. Even if you do not currently observe tax optimization schemes or evasion, they may emerge in the future.
Lowering VAT also leads to a decrease in profit tax.
If you do not pay attention to the “illness,” you might find the state paying taxpayers instead of the other way around.
The “cure” might be even more harmful to the state than the “illness.” This relates to combating fake invoices and the growth of local corruption.
Preventing VAT optimization schemes is much more effective than dealing with their consequences, but their impact on the economy must be assessed.
It is crucial to understand the business processes of taxpayers and how they will change with the introduction of a new VAT administration system. The complexity and cost of changes can be a barrier to any promising idea.
Always seek a balance of interests among all participants in administration and manage the motivations and behavior of the parties in the process, rather than imposing something on the part of the state.

[1] See, for example: MTIC (Missing Trader Intra Community) fraud. Europol. URL: https://www.europol.europa.eu/crime-areas-and-statistics/crime-areas/economic-crime/mtic-missing-trader-intra-community-fraud

[2] Anatoly Gaverdovskiy, “Four Generations of VAT Administration Systems.” URL: https://taxtech.digital/2020/09/02/four-generations-of-vat-administration-systems/

[3] For more details, see: Anatoly Gaverdovskiy, “A New Approach to the Digital VAT Administration for B2B.” URL: https://taxtech.digital/2022/12/05/virtual-vat-accounts/