April 2021 marks the start of the delayed Phase II of HMRC’s Making Tax Digital for VAT (‘MTD’). Over one million VAT registered businesses face tough new obligations on digital recordkeeping and the ‘digital journey’ on their VAT data. HMRC is looking to recover over half a billion pounds in VAT errors with this phase of digitising VAT reporting. What that means for businesses of all sizes is the outlawing of manual data adjustments, manipulation in spreadsheets or most manual calculations of VAT data.
To enforce this, HMRC are imposing full VAT penalties, which had been suspended in late filings for two years. This is very important: HRMC has acknowledged its current missed VAT return penalty regime inflicts disproportionate fines on small businesses. It wants to reform this in 2022. For now, however, it is fundamental for cash flows that you understand and follow the new rules. A core reason for the changes appears to be that HMRC wants free access to all your accounting records.
Phase I – digital filing April 2019
Phase I was introduced on April 1, 2019 and this imposed digital filings of the nine boxes of VAT return data via HMRC’s new API-portal. This was introduced for all VAT registered businesses over the annual registration threshold of £85,000.
This resulted in over 1.4 million businesses moving to accounting software updates or inexpensive Excel-enabled bridging software to be able to digitally file their returns.
It did not go totally smoothly for HMRC as the heavy loads jammed its filing portal across the summer of 2019. This reflected the three big filing ‘staggers’ under the new regime between August and October. To help with this HMRC ensured a one-year soft-landing, with no fines for late returns.
Phase II – digital bookkeeping and journey April 2021
The major change; the ending of most manual processes in completing the VAT data and return, was saved for phase II. This was originally scheduled for April 1, 2020 but was postponed by HMRC just 36 hours before its implementation as the Coronavirus lockdown started.
The main changes for phase II include:
Digital bookkeeping – all VAT records (sales, purchases, stock, and fixed asset transactions etc) must be maintained in digital form. For most businesses, this means in accounting or ERP software and similar systems for invoicing processes. This can include spreadsheets with some restrictions. However, there must be no manual element to this. Practically, for small businesses, this means invoice date may initially be manually keyed-in to accounting packages or spreadsheets, but there can be no further manual adjustments.
Digital journey – where VAT data is then moved between accounting or invoicing systems prior to the digital filing, this may only be done via ‘digital links’. These include spreadsheet formula links, emailing data, memory sticks, and up/downloads of data in CSV or XML formats. HMRC have forbidden manual cut and paste in spreadsheets or adjustments. This will affect businesses of all sizes. In particular companies that consolidate data in spreadsheets from various systems or divisions prior to filing. Anyone producing group VAT returns will likely struggle too, as that is typically done through manual spreadsheet processing.
To ensure that the phase II changes are implemented, the normal VAT penalty regime will be imposed from April 1, 2021. This had been suspended on late returns for the introduction of the digital filing obligations in April 2019.
The current missed return penalty system means you enter a 12-month surcharge period. If you then miss a further return, the 12-month period is extended and you will have to pay a surcharge. The surcharges ratchet up from two percent for a second missed return to 15 percent for a fifth missed return in the surcharge period. Note: HMRC plan to overhaul this regime in 2022 as it does produce the risk of huge, disproportionate fines on missed returns.
The regular penalties for missed VAT payments have been in place throughout the launch of MTD.
What’s next for MTD?
The question that has always loomed around MTD is why the extraordinary effort and expense for HMRC and over a million taxpayers when the result is the same as pre-April 2019 – nine boxes of VAT numbers are still filed? The answer lies behind the choice of the API technology, which enables huge and fast exchanges of data. At some point in the not-too-distant future, HMRC may require taxpayers to submit all VAT transactions to them for verifying the VAT calculations.
HMRC may ‘own’ the source of tax data, which is your accounting records. That will signal a colossal shift of power from accountants, Finance Directors and accounting departments to HMRC.
Originally focused on satisfying the immediate minimum requirements, the initial aim was to digitalise records and submit the tax return electronically. There was no real focus on how the business could use MTD to its advantage.
From April, businesses will need to comply with Phase 2, requiring them to digitally link from the source data all the way through to the tax return, and they will no longer be able to carry out manual procedures such as cut and paste. Should a business seek to ensure compliance with their existing software and is this the best long-term solution? The answer does not just depend upon the capabilities of the software but also the VAT process of the business and its ambitions.
Who should use Phase 1 software?
If your MTD solution is an API-enabled spreadsheet there is no reason why you cannot use this to be compliant with Phase 2. Exporting data from an ERP or accountancy system into this spreadsheet and then digitally linking from those cells into the tax return will qualify.
It is an approach best suited to businesses with simpler VAT environments i.e. those with a straightforward process that sees digital records taken directly from your ERP system into an API-enabled spreadsheet. Any adjustments are made prior to the results being input into the tax return but there’s typically no need to perform any manual intervention. Because of this the risk of introducing error is low. However, what happens if the business grows and with its VAT process? Or how will it cope if regulatory demands increase?
If your business has a more complex process, you will need to evaluate how easy it will be for you to comply using your existing software. A complex VAT process has multiple aspects. You may need to export and collate data from multiple sources, make manual adjustments and manipulate data. You will typically have multiple trading entities and/or VAT groups and may use VAT schemes.
The need to perform adjustments across numerous spreadsheets will see potential errors creep in and so there is a real danger that a digital link may be broken. This means you will need to ascertain if your vendor has extended the capabilities of the solution to safeguard against the risk of non-compliance.
You will also need to assess if your processes are sustainable in the long term. If you do decide to look at a new solution, this may benefit your business. You may well be able to achieve operational efficiencies, for example, using automation to streamline processes and reduces workloads, freeing up time and resource.
Who should upgrade?
The final group are those who have very complex processes. These organisations might also have multiple trading entities/VAT groups but where they differ is that they will also tend to handle large volumes of data and need to perform numerous, sometimes bespoke, adjustments such as Partial Exemption. They will be dependent on multiple spreadsheets but the cessation on transposition means this will not be viable under the digital links mandate.
While these businesses can continue to carry out complex calculations such as Partial Exemption standard or special method (PESM), as its possible to perform such calculations outside the digital links process, it should be noted that this does increase the risk of error. Some fully compliant MTD solutions can instead automate the PESM and include it in the digitally linked VAT process.
These very complex businesses will undoubtedly need to invest in a robust compliance platform that can accommodate all the nuances of their VAT environment because the risk of breaking a digital link is just too high. Doing so is likely to confer real operational advantages due to how convoluted their manual process is. They can expect significant time reductions in automating their VAT process and may even benefit from more opportunities to recover VAT that were previously missed.
Making Tax Digital Phase 1