Tax : HOW DIGITALISATION COULD SIMPLIFY PARTIAL EXEMPTION SPECIAL METHOD

Partial Exemption (PE), as specified under VAT Notice 706, is a notoriously complex area as HMRC readily acknowledges. It admits PE can 'involve a significant amount of administration for businesses, with complex calculations often being required for some businesses to determine the amount of input tax that they are entitled to recover'. This lead the tax authority to issue a call for evidence to the industry in July to determine if there was a way PE could be simplified, and the measures it proposed included a change to the PE Special Method (PESM) approval process and the increase or scrapping of the de minimis limit. But can these truly reduce the burden of PESM on the business?

A recent Ipsos MORI poll found 68% of those businesses using PE had incurred associated compliance costs, most of which related to staff time and the cost of hiring an often expensive adviser. It's a finding substantiated by the Chartered Institute of Taxation (CIOT) and Association of Taxation Technicians (ATT)who, in their response to the HMRC consultation, said PE requires 'quarterly and annual calculations…as well as the work undertaken to allocate costs of the business to the taxable/exempt/residual categories, which many businesses find difficult'. Surely the solution, then, is to find a way to reduce this compliance burden?

First of all, let's recap how PE works in principle. Supplies of goods and services are subject to VAT - at one of the three applicable rates: standard 20%; reduced 5%; zero 0% - unless the supply is exempt or 'outside the scope'. If the business makes exempt supplies, as summarised by HMRC here, then any input VAT that relates to those supplies is not recoverable (with the exception of those covered by the de minimis rules). So-called residual costs, those that don't directly relate to either taxable or exempt supplies, are partially recoverable. The business therefore needs a method by which to reclaim that residual tax.

Partial exemption: Standard vs Special Method

Businesses claiming residual tax are described as 'partially exempt' and can deploy one of two methods to calculate their percentage of recoverable tax: Standard Method (the default) or Special Method. Special Method (PESM) allows the businesses to determine how it calculates its input VAT recovery (although PESM can also be applied at the insistence of HMRC). The overheads or pots used for PESM can vary significantly, from the number of transactions handled, the headcount of different business units, or the square footage of a building.

Approval must be sought from HMRC for a business to use a PESM, a process which itself can be long. The approval process is one of the areas identified for review by HMRC. Responding to the tax authority's call for evidence, the CIOT and ATT conducted a members poll which found that the process typically took up to year (according to 49% of those surveyed) although in one case it took more than three years. What this means in reality is that the business is unlikely to make changes to its PESM criteria once these have been fixed even though the consensus is that these should be reviewed every four years. Businesses are therefore currently locked in to their PESM.

Sectors, attribution and recovery

The business can further compartmentalise input VAT by allocating costs to different aspects of the business to maximise recoverable VAT. These 'sectors' will see a different methodology applied, so that multiple special methods may be used. Commonly the business will have a maximum of between 5-12 sectors; beyond this, increased complexity can often begin to outweigh any benefit.

Attribution within PESM is also challenging. The business needs to attribute costs either directly (ie with a cost specifically identified as relating to a sector) or indirectly (ie with costs apportioned across several sectors). If this is performed indirectly then the business needs to have a methodology for determining the percentage of costs allocated to each sector, which will often be more involved than determining the recovery percentage itself.

Executing Partial Exemption Special Method

There are real problems associated with executing PESM. As we've already touched upon, there are administrative costs, but the complexity of the calculations can also make it a difficult process. There's the need to collate data from multiple sources and bring this into a standard format, multiple special method pots for different entities and sectors within the organisation, and attribution can see input VAT split out directly and indirectly in order to determine a favourable residual amount that can potentially be recovered. On top of this, the requirements of the annual adjustment calculation mean that this whole process has to be repeated a further time at the end of each year.The sheer number of calculations involved means it is a laborious process and one that creates significant opportunities for error.

The digitalisation of tax processes will help alleviate both these issues. Data mapping can be used to allow automatic upload of specific data and it is possible to automate the calculations need to be performed sector by sector. Special method pots can be applied using a template that can record recovery tables, custom fractions, direct percentage, taxable supplies, counts and values while direct and indirect values can be automatically attributed to sectors. Once these criteria have been set its then simply a matter of applying the same set of rules each quarter allowing greater consistency.

Real-world results

For evidence of how digitalisation software can streamline PESM in reality, consider Company X. A mid-sized UK corporation with a network of UK stores, the company processes over 2.4 million transactions per quarter and has 18 VAT reporting entities consolidated into two groups. It uses both PE Standard Method and Special Method.

On automating its VAT processes, it will be able to reduce the time spent on calculations and adjustments across its entities and group teams from 37 days per quarter to just 11. The finance teams in 18 reporting entities will no longer have to make spreadsheet calculations. Local source data will be mapped to the group compliance engine which will automatically then conducts standard VAT calculations, adjustments and produces a position per entity. At group level the compliance engine automatically will conduct group consolidation and special method calculations still allowing the finance controller to review and spot check reporting per entity as normal. Submission will then be made via a software API to comply with MTD for VAT regulations

The VAT process will now take just 11 days per quarter, saving 26 days per quarter or 104 days per annum, equivalent to a reduction of 70%.

Technology benefits

Automating PESM can equate to a massive reduction in workloads and costs related to consultants. It's possible to slash manual data input time, reduce the need for local spreadsheet consolidation and semi-automate the PESM process through allowing easy attribution and calculation of the input VAT recoverable. It also improves accuracy by reducing the potential for errors and drives consistency because the same calculations can be run automatically quarter on quarter due to the fixed nature of PESM. Complexity is also reduced because the process makes it easier to collate and review the results at the end of the period. In this way, digitalisation is able to realise the ambitions identified by HMRC by simplifying the PESM process.