The basic principle of value added tax (VAT) is that the government gets a percentage of the value that is added at each step of an economic chain, which ends with the consumption of the goods or services by an individual. While VAT is paid by all parties in the chain, including the end customer, only businesses can deduct their input tax. For this reason, VAT requirements concerning invoices generally only apply between businesses.
Many governments use invoices as primary evidence in determining “indirect” taxes owed to them by companies. VAT is by far the most significant indirect tax for nearly all the world’s trading nations. Broadly speaking, it contributes over 30% of all public revenue. VAT as a tax method essentially turns private companies into tax collectors. The role of assessing the tax is critical which is why these taxes are sometimes referred to as “self-assessment taxes”.
The VAT Gap
VAT depends on companies meeting public law obligations as an integral part of their sales, purchasing and general business operations. The dependency on companies to process and report VAT makes it necessary for tax authorities to audit or otherwise control business transactions. But despite such audits, fraud and malpractice often cause governments to collect significantly less VAT than they should. The difference between the expected VAT revenue and the amount actually collected is the VAT gap.
In Europe, that VAT gap amounts to approximately €140 billion every year, according to the latest report from the European Commission. This amount equates to a loss of 11% of the expected VAT revenue across the EU. Globally, we estimate VAT due but not collected by governments because of errors and fraud could be as high as half a trillion EUR. This is comparable to the GDP of countries like Norway, Austria or Nigeria.
The VAT gap represents some 15-30% of VAT that should be collected worldwide. And these figures would certainly be much higher if lost tax revenue from unregistered business activity is added as the numbers only include bona fide, registered business activity.
Governments across the globe are enacting complex new policies to enforce VAT mandates. Through these mandates, they obtain unprecedented insight into economic data and close revenue gaps. Tax authorities are steadfast in their commitment to closing the VAT gap and will use all the tools at their disposal to collect revenue owed. This holds especially true in the aftermath of COVID-19 when governments epxect to face significant budget shortfalls.
VAT challenges and the cost of non-compliance
To close the VAT gap, countries are pushing tax authorities to comply with VAT requirements. As a result, they’re enforcing different legal consequences for irregularities. The consequences on noncompliance with VAT requirements can be huge. Most companies therefore want to be as certain as possible that they can quickly and easily prove their VAT compliance to avoid risks including:
- Administrative fines
- Sanctions under criminal law
- Protracted audits
- Spillover effects into other areas of taxation or accounting
- Trading partner audits
- Mutual assistance procedures
- Loss of right to deduct VAT
- Obligation to pay VAT over fraudulent invoices
At a time when the requirements from tax authorities globally are only set to increase, it’s clear that businesses need to be aware of the compliance challenges they face and prepare for what lies ahead.
Download VAT Trends: Toward Continuous Transaction Controls for a comprehensive look at the VAT regulatory landscape