Four Generations of VAT Administration Systems

History and Basic Concepts of VAT

Value-added tax (VAT) is a consumption tax on goods and services that government levies at each stage of the supply chain with added value, from the manufacturing line to the point of sale. The amount of VAT the buyers pay along the supply chain is based on the price of the product minus cost of materials in the product for which seller already paid the tax at the previous stage. [1]. Many tax experts consider VAT as the optimal tax because it does not multiply the tax burden and the end user prices of goods after passing through the many layers of distribution.

It is also a widespread practice that the export of goods, works and services is a subject of VAT exempt, which increases the competitiveness of the national economies in international markets.

Carl Siemens first revealed VAT concept in 1919. Maurice Loret implemented it in France (with a pilot project in Côte d’Ivoire) in 1954. Now, over 130 countries have implemented it across the world.

With all its effectiveness, VAT also presents the enormous potential for evasion via the organized fraud. It also alters collection of the corporate income tax since the reduction in VAT base achieved via bogus expenses. VAT fraud alone creates in the EU a tax gap of 60 billion euros annually according to Europol. MTIC (Missing Trader Intra-Community) is the most ordinary form of VAT fraud in the EU.

The basic MTIC fraud model involves organized sophisticated activities that look to exploit differences in how different EU Member States treat VAT. The criminals create a structure of linked companies and individuals across these states to abuse both national and international trading and revenue-accounting procedures. Therefore, the fight against VAT fraud is one of the most important tasks for the states and the tax administrations.

VAT Evasion Methods

First, let us introduce basic terminology that we will use later. VAT fraud uses VAT taxpayer companies that either do not file a VAT return or file a return, but do not pay VAT, or file a zero VAT return. In different countries they have different names: missing trader, garbage dumps, one-day, fictitious or terminal companies.

Companies that use various kinds of VAT optimization schemes are beneficiaries of the evasion scheme. If the beneficiary directly interacts with the terminal company and it does not pay VAT, then the tax administration will remove the deductions from the beneficiary and charge VAT. Therefore, the VAT fraud should use a structure of linked companies and individuals to create a chain between the terminal company and the beneficiary. Intermediaries drain up part of the optimization benefits, but if the VAT rate is high, then the game is worth the candle, and fraudsters built sometimes a chain of up to 10 interlayers between the terminal company and the beneficiary.

It is a usual practice to introduce preferential VAT rates for some goods, works and services or a zero VAT rate, for example, for exporting. As a result, a fraud involves not only VAT optimization and a reduction in VAT payable to the budget, but also negative or recoverable VAT. If the country’s legislation allows taxpayers to receive VAT refunds from the country’s budget, then the appetite of scammers increases many times over.

As mentioned above, potential benefit to the fraudsters can reach the tens and hundreds of billions of dollars a year. As a result, the level of skill and the sums of money they use to develop fraudulent schemes are incredibly significant. That also includes the allocation of substantial funds for corrupting employees of the tax authorities.

How to Fight and Prevent a VAT Fraud?

To combat the VAT fraud, it is necessary to build the VAT administration system with a systematic approach to analysis of the business environment of VAT taxpayers and aim to separate companies that conduct actual business activities from the technical and terminal companies. VAT returns and VAT invoices can provide tax authorities with these insights, and they can use more data about taxpayers, for example, other tax returns, data on shareholders and executive bodies, information about employees.

It is important to pay attention to businesses that are inactive and file zero returns. Although they may not currently take part in the evasion schemes, they can pop up at any moment. The number of such silent companies can reach hundreds of thousands. It is not clear what to do with them, since only business owners and courts can liquidate such companies. To solve this problem, tax authorities can introduce a special status of “VAT taxpayer” and either give or remove it by their own sole decision. This flexibility will allow the tax authorities to clean up the VAT environment effectively and quickly from unscrupulous taxpayers.

In the next step, it is necessary to get primary data from taxpayers to calculate the VAT amount payable or refundable. Primary data are primary VAT invoices or the accounting records that hold key information about invoices: number, date, counterparty, invoice amount, VAT amount. Below we will discuss the generational history of VAT administration systems.

First Generation of VAT Administration Systems

The tax authorities receive VAT returns with the calculation of VAT and totals of payables or refunds. To verify the correctness of the tax calculation, the tax authorities must come to the taxpayer and take the primary documents that form the tax base.

Since these documents mostly exist in the paper form, such verification is cumbersome, takes time, costly and is not very efficient. Considering the potential corruption and direct contacts of the tax officers and taxpayers, this system can make a black hole in the state budget.

Second Generation of VAT Administration Systems

The tax authorities collect not only VAT returns, but also VAT invoice records to calculate the tax base, VAT payable and VAT deductions as the foundation of the tax return.

The VAT administration’s task is to compare VAT payable and VAT deductible between counterparties to calculate a tax gap (the so-called simple tax gap). It may happen if the seller did not add VAT, which the buyer wants to deduct, or the buyer deducted VAT, which the seller did not add.

The second generation of VAT administration systems supports centralized processing of tax data, as well as electronic communications with taxpayers to limit tax officials’ personal decisions on taxpayer audits, which dramatically reduces the ability of fraudsters to corrupt tax employees.

Third Generation of VAT Administration Systems

Taxpayers use electronic VAT invoices. The seller of goods or services registers the VAT invoice with the tax authorities. The buyer can only deduct VAT against the registered invoice. This system automatically eliminates simple tax gaps and does not require additional communication with taxpayers.

Depending on the regulation, implementation of any VAT administration system may require a transitional period when there will be issues with administration of old invoices. For example, if the regulation allows buyers to deduct VAT during several years after the seller issued the original invoice.

Fourth Generation of VAT Administration Systems

The fourth generation is a radical way to combat the optimization of VAT, which, for example, Azerbaijan implemented in 2007.

VAT tax administration in Azerbaijan replaced the accrual method to the payment method when the VAT charged not on the base of invoices, but directly on the financial transactions. They immediately split the payment amount into the main body and VAT body. The main body goes to the seller, and the VAT amount goes to the seller’s special VAT deposit account. At the end of the tax period, the tax administration withdraws the balance of the deposit accounts.

This is a method of VAT administration that no one can deceive under the condition of a restriction on the cash payments. The major drawback is that the VAT money becomes withdrawn from the economy and lay frozen in deposit accounts. Unlike with the previous generations of VAT administration systems, where the taxpayers have more flexibility by using all their money.

Administration of the Simple Tax Gaps

Administration of the simple tax gaps after centralization and automation is a highly effective way to improve VAT collection. In some countries, it resulted in a 100-150% increase in VAT collection over 2-3 years.

Eliminating simple tax gaps works like squeezing toothpaste out of a tube. By eliminating the gaps between the supply chain links, they remain on the last link. This entity will not respond to electronic request from the tax authorities and is the subject of the on-site inspection by the local tax administration. Understanding that the local corruption may influence its results, it is necessary to apply preventive methods if required.

As an interesting approach to address this issue, we can consider using the method of gamification. A straightforward indicator of the effectiveness of the local VAT administration is the ratio of a simple tax gap to the total amount of deductions calculated for each tax inspectorate and local tax administration.

By using this indicator, the national tax administration can decide to reward the top performing local administrations and dismiss the lagging ones according to the countrywide rating. As a result, the misbehavior of dishonest employees leads to inevitable consequences for the top management of the local tax administration. With the subsequent addition of financial incentives to decrease that ratio, it creates an atmosphere of intolerance towards fraudulent activities in a particular territory.

Administration of the Complex Tax Gaps

The next step in improving the efficiency of VAT administration is the fight against complex tax gaps to determine the beneficiary of the last simple tax gap associated with the terminal company. Here, the major task is not only to determine the beneficiary, but also to form an evidence base to withdraw his VAT deductions rights for that remaining tax gap. For doing this, tax administrations should implement several specific tools.

Relationship Tree

Relationship Tree is a tool that aggregates all the movement of VAT flows between counterparties with visualization of the status of the company: terminal, technical, or beneficiary. It allows the tax authorities understand VAT optimization schemes and to determine participants and beneficiaries of these schemes.

VAT Chains

VAT Chains Builder is a tool that automatically generates all VAT evasion chain links between beneficiaries and terminal companies, opens a control work cases, and monitors the execution results.

VAT Taxpayers Associations

VAT Taxpayers Associations is a tool that helps to generalize information about terminal and technical companies, find out their similarities and identify individuals who are behind the organization of the VAT evasion schemes.

Conclusion

Tax administrations use powerful tools and motivation systems to combat VAT optimization to generate significant revenue increase for the state budgets. But it must be clear that their smart opponents still counter these efforts in a permanent analysis and search for the new evasion techniques, since there is a lot of money at stake. It is necessary to look for an opportunity to stop not the consequences of transactions already completed with mandatory reporting and use of electronic VAT invoices, but to stop fraudulent transactions in motion, namely the transfer of funds.

If tax administrations can monitor financial transactions in real-time, not quarters after returns submission, and can block the suspicious transfers until clarification, that will increase the exposure risks for the tax fraudsters manifold. This can reinforce their reluctance to use evasion schemes.

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[1] Value-Added Tax (VAT). Investopedia. URL: https://www.investopedia.com/terms/v/valueaddedtax.asp