Financial service providers and financial institutions often have a mix of exempt and taxable supplies and this can cause real confusion.
Industry group, UK Finance, which represents more than 250 firms across the banking and finance sector, says its members face “significant uncertainty regarding their VAT recovery position and spend considerable time and resource in getting their PESM agreed with HMRC”.
It goes on to say that the process can take “a number of years, meaning having to file VAT returns on a ‘provisional’ basis, with risk of challenge continuing for an indefinite period”. This implies that many businesses within the sector are having to rely upon guesswork when estimating their recoverable VAT, running the risk of them over or under compensating when it comes to determining the sum they are entitled to.
Volkswagen Financial Services (UK) Ltd (VFS) is a case in point. The company makes two supplies (the taxable supply of the car and the exempt hire purchase) and obtained a PESM from HMRC but this did not allow for the recovery of overhead input tax in respect to its hire purchase supply. As the company assumed it could recover funds associated with hire purchase, it ended up underpaying.
VFS appealed against the interpretation of its PESM. The case took several years to progress through the legal system, with the Court of Justice of the EU returning a verdict that HMRC’s approach was unlawful in 2020. This set a new precedent for the recovery of VAT from hire purchase and HMRC is now seeking to develop a common framework for all such PESMs which would apply a method of recovery consistent with the judgment but the case illustrates how open to interpretation the rules can be.
Not only is it confusing determining where VAT can be recovered if you work in the finance sector but it’s also very time-consuming. Most financial service providers/institutions run extremely complex calculations across linked spreadsheets. Teams will, for example, often have to sift through source data files to count transactions, class these and then calculate a recovery percentage, necessitating the addition of extra fields to spreadsheets. This can see spreadsheet formulas fail, jeopardising the accuracy of the calculations.
It is not uncommon for financial institutions to have to pull data from over 20 data sources and a similar number of spreadsheets relating to percentage recovery calculations. This results in high levels of manually intensive data processing in order to ensure the resulting figures are correct. For example, one large financial institution we deal with spent 15 days annually just checking the integrity of spreadsheets before starting any transaction review.
In order to solve these two issues its necessary to rethink how we approach compliance. We need to ensure the business is complying with the PESM agreed with HMRC and to evidence that compliance. That’s very hard to do using spreadsheets because tracking back to source data or showing where transactions have been excluded is beyond the capabilities of the software.
This brings me to my second point which is that spreadsheets are a far from ideal tool for implementing a PESM. Performing the process manually increases the risk of error and prevents changes from being made safely. It also creates a laborious cost allocation and review process because it has the ability to interrogate the data is limited.
Automating a PESM process by accommodating it within compliance software can solve both these issues.
Using software-generated templates, financial transactions can be mapped to the correct business activities, with a greater degree of accuracy than by manual methods. Targeted visual checks can be carried out, both pre- and post-calculation, using customisable searches and exception reporting. And data analytics within the software provides the capability to compare and contrast historic returns, identify anomalies and potential errors, and forecast future liabilities.
A real-world example
To see how businesses can transition from a manual to an automated approach, consider the example of a large financial institution that is deploying our AlphaVAT compliance platform.
The business manages funds of £50bn+ and uses a sectorised special method spanning 20 sectors. It employs six allocation steps, multiple spreadsheets (including one large central calculation spreadsheet), and reports on tens of thousands of transactions (accounts payable and receivable) per quarter.
Problems experienced by the company included:
- Apportionment – Standard costs were time-consuming to re-apportion e.g. canteens are technically a general building expense, but activities and costs associated here need to be apportioned out to ensure that they maximise the recovery of related taxable activities.
- Change management – Their existing third party PESM software meant change management was onerous and expensive charges for adjustments to financial software resulted in five figures costs for even simple changes (eg ERP systems etc).
- Adhering to the agreement – Over 15 days a quarter was spent managing transaction allocations and ensuring that all line items were classified in accordance with the HMRC agreement.
- Blocking and excluding transactions – this was a highly time-intensive process. In their latest reporting period, 35,000 transactions had to be manually filtered to identify 35 non-claimable items.
- Future compliance – The management team had concerns over how compliance with MTD Digital Links would be achieved in the future.
Automating its PESM will enable the company to dramatically reduce the time dedicated to checking calculations and allocation adjustments, as well as providing it with an audit trail that will prove its compliance to HMRC.