Indirect tax challenges loom large
The international landscape of indirect taxes is being transformed at a swift pace and many of the changes represent profound challenges for multinational enterprises, argues Philip Robinson of EY.
Rapid-growth markets (RGMs) are transitioning towards new frameworks of taxes on consumption. China, for example, has started the long process of amalgamating all forms of turnover taxes into a system of VAT, while in India, a new nationwide GST is ready to be implemented, subject to agreement between central and state governments. These transitions are big undertakings for both tax authorities and tax payers. In the EU, the European Commission has launched a comprehensive reform of the existing VAT system to make it more efficient and fraud-resistant.
At the same time, VAT and GST rates are rising, while the scope of these taxes is expanding. Governments try to increase revenues to reduce deficits, but without endangering fragile economic growth or the competitiveness of their local economy. In this context, raising indirect taxes is deemed more suitable than raising direct taxes such as corporate income tax. In the US, various states are extending the scope of their general consumption taxes, often bringing more internet purchases into the net. Over the next couple of years, Japan will ratchet up its current VAT rate of 5% to 10%. In the EU, the average standard VAT rate increased from around 19.5% in 2008 to more than 21% in 2012. The increases affect consumer prices but they also add to costs in important VAT-exempt economic sectors such as banking and insurance.
But changes to indirect taxes are not limited to VAT and GST. Longstanding excise duties on products such as tobacco, alcohol and mineral oil are rising, too. New duties on products such as fatty food and sugary drinks are being introduced in many countries to modify consumers' behaviour. In various jurisdictions, environmental taxes on carbon dioxide emissions, motor vehicles and airline tickets have seen the light.
The relative importance of customs duties may have declined over the last half century, as countries have concluded hundreds of bilateral or multilateral trade agreements. In some regions and sectors, however, the level of customs duties is still very high. Moreover, sudden shifts in the level or character of customs duties will increase the risk of mistakes and non-compliance by the taxpayer. An example is the radical changes in customs duties applied by Nigeria to the sugar industry, effective January 1 2013. To boost the development of local sugar cane production and refining, Nigeria now applies a 0% import duty on machinery for local sugar industries, but it has increased the total tariff on imported refined sugar to 80% from 35%, while raw sugar tariffs increased to 60% from 5%.
Ensuring that all these important changes in the structure, scope and rates of indirect taxes are reflected appropriately in companies' accounting and reporting systems is a difficult task. This task is even more urgent for two reasons. First, the financial risks of non-compliance have risen with the sheer increase in the amount of indirect taxes due. Second, tax authorities are increasing their scrutiny of companies' compliance with indirect tax obligations and becoming more assertive in their relationship with taxpayers. Worldwide, the number and depth of indirect tax audits are on the rise. Furthermore, tax authorities exchange more information, both with tax agencies in other jurisdictions and with other public departments in their own country, for example social security authorities or customs. Globally, penalty regimes imposed on taxpayers for non-compliance tend to become more severe.
Business leaders could be forgiven for underestimating the importance of indirect taxes. Over the last couple of years, corporate income tax paid by multinational enterprises has received a lot of media and political attention. The question whether companies pay a fair amount of corporate income tax has been addressed by national parliaments in numerous developed countries, by the G20 and by the OECD.
If we look at the figures, however, it becomes clear that the relative importance of indirect taxes for government revenues is far higher than the importance of corporate income tax. In 2009, corporate income tax made up just less than 10% of total tax and social security revenues in the OECD area. Indirect taxes, on the contrary, constituted more than 30%. General consumption taxes such as VAT alone made up roughly 25% of total revenues from taxes and social security contributions. The balance of indirect taxes was mainly made up of excise taxes, customs duties and certain special taxes.
The rise and rise of VAT and GST over the last half century is particularly impressive. Limited to less than 10 countries in the late 1960s, VAT and GST are now an essential source of government revenue in more than 150 countries. Over the last few years, the tax mix has continued to shift toward indirect taxes on consumption and we believe that the relative importance of these taxes will continue to grow.
This is not to say that companies can neglect other forms of indirect taxation. Customs duties remain an important area of attention. As opposed to VAT, customs duties charged at one stage of the supply chain cannot be offset against taxes due at a later stage. In addition, customs clearance procedures can add to the time and cost of moving goods cross-border.
Multinational enterprises should not only look at the possible costs of new tax developments, but also at opportunities. In their endeavour to attract foreign investors, governments provide incentives to business in the forms of tax breaks or subsidies. If the conditions are right, these incentives can provide companies with clear opportunities to reduce costs.
Increased sophistication of tax authorities may be seen as a threat by some companies, as it may increase their capacity to detect errors in tax returns and to perform rigorous tax audits. However, very often an increase in the sophistication of tax authorities – the adoption of modern IT systems; the creation of common interfaces and the reduction of gaps in the system; a switch to e-filing of tax returns – in fact presents companies with an opportunity to reduce their own costs and risks. To seize these opportunities and reduce risks, companies should focus on the accuracy and efficiency of their indirect tax compliance processes.
Multinational enterprises would also benefit from international harmonisation of indirect tax systems, rules and practices. As mentioned, more than 150 countries operate a VAT or GST system and international trade is steadily rising. Against this background, it is becoming more important than ever to provide a global framework for a consistent interaction of all these different systems. The OECD has been working on the development of just such a framework for a number of years now and hopefully this work will result in positive results soon.
Even without such a framework, local tax authorities can help to make life easier for bona fide businesses by being more open and constructive. All honest businesses should support stricter compliance enforcement if it actually helps to avoid or detect fraud. After all, fraud is not only bad from a moral and macro-economic perspective. Fraud also puts legitimate businesses at a competitive disadvantage.
However, what we see now is that tax administrations have generally become more wary towards all taxpayers and less open to entering into discussions. In many countries, it has become more difficult to reach mutual agreements on specific, complicated issues before a company files a tax return. Tax administrations nowadays tend to take a strictly formal approach without considering the specific economic and business aspects of a tax issue. This trend increases burdens on bona fide business, while it can be questioned whether it is an effective way of reducing fraud.
An increase in rates and scope of general consumption taxes such as VAT and GST; the introduction of new excise duties and the rate-increases for existing ones; an efficiency drive at many tax authorities; a stronger focus on compliance, enforcement, audits and penalties by tax authorities – these trends are not brand new, but it is precisely their persistence that renders them so important for business in a globalising world where trade steadily increases.
Indirect tax issues have become some of the key factors determining the operational and financial performance of companies. Now more than ever, indirect tax opportunities and threats can make or break a business strategy such as the expansion into a new market. Multinational enterprises should reflect this growing importance of indirect taxes in their overall business strategy and tactics by including the indirect tax perspective at the early stages of decision making, engaging the right tax professionals in this process.
Indirect taxes and rapid-growth markets
As the first wave of RGMs such as Brazil, China and India mature, a new group of RGMs is entering into the limelight, including Africa, Colombia, Peru, Thailand, Turkey and Vietnam. The economic growth in both old and new RGMs ensures that the total size of commercial transactions between developed economies and RGMs as well as between RGMs themselves keeps increasing. This trend is likely to continue, despite the recent slowdown in growth rates in some more mature RGMs.
Governments in RGMs rely on indirect taxes to boost revenues. In various RGMs, including China and Russia, customs duties and local excise taxes represent a much higher percentage of overall tax revenues than in most developed markets. However, with the proliferation of trade agreements and the increasing importance of the service economy, consumption taxes such as VAT and GST are becoming more and more important in RGMs as a source of government revenue. VAT and GST systems are spreading in RGMs. Various RGMs – including China, India and Malaysia – have all announced or started major reforms to their VAT or GST systems. Chances are that, a few years from now, VAT and GST are the consumption taxes of choice in China and India.
Although VAT and GST sound familiar to businesses based in developed economies, the rules, regulations and practical realities on the ground in many RGMs are still very different from the situation in developed markets, and they will continue to be so in the near future. Obviously, differences between RGMs themselves are and will continue to be profound, too. These important differences complicate efforts by multinational enterprises, wherever they are based, to streamline and standardise internal indirect tax practices. Each market may require a different approach to data management and reporting. This lack of international or even national harmonisation regarding indirect tax reporting adds to the compliance burden of multinational enterprises and increases the risk of errors in tax filings.
Companies may encounter unfamiliar indirect tax laws, obligations and practices when starting business activities in an RGM. They are not always prepared to meet these challenges satisfactorily. Often, lack of experienced indirect tax staff and opaque regulations further complicate companies' efforts.
As a multinational enterprise moves into a new market, it often wishes to adopt the business models, processes and practices that it has used successfully in its home market or in markets that are geographically close to the new market being entered. However, local indirect tax rules and practices may differ significantly and require a company to adapt its plan of operation in the new market. A few examples can illustrate this. Whereas an RGM may be a member of the World Trade Organisation (WTO), its customs authority may apply particular interpretations regarding the valuation and of the origin of goods, interpretations that are unfamiliar to companies without experience in this jurisdiction. As a result, unexpected additional duties may be levied, and the company in question may be hit by fines and delays.
VAT and GST offer another area of possible confusion. For example, the VAT rates in a country may be relatively low and attractive. However, the local VAT system may be highly complex or undergoing reform, with high levels of uncertainty leading to risks of errors.
Decisions about starting operations in a new RGM are, of course, intended to obtain operational and financial benefits. In its analysis whether such a step makes business sense, companies should take indirect tax factors into account at an early stage of the planning process. Indirect tax treatment of transactions, compliance obligations, and customs regimes and incentives in an RGM may greatly affect the costs, speed of execution and even feasibility of a project. For example, processes such as VAT registration may be very different, complex and therefore time-consuming in some RGMs, with the risk of business delays, increased costs and poor cash flow if they are not managed properly. On the other hand, effective forward planning can help to enhance a company's return on investment.
As RGMs develop, so will their indirect tax systems. These changes in VAT and GST, in customs, and in grants and incentives must be taken into account, both to ensure compliance with day-to-day tax obligations and in the design of future plans. Multinational enterprises need to anticipate these changes. This is process that will allow companies to avoid costly pitfalls and to take advantage of growth opportunities.
Indirect tax management for multinational enterprises
In this day and age, the C-suite of multinational enterprises cannot ignore indirect taxes when defining and implementing new business initiatives. The impact of indirect taxes on business has become too important to choose to leave all tax matters to the tax function as the default option.
Of course, it is basically up to the tax function to ensure that companies are in compliance with all applicable tax rules and regulations in the countries where they do business. In a rapidly changing and globalising world, this task is difficult enough. But beyond this question of compliance, companies should keep the bigger picture in mind. How do rules and regulations, local realities on the ground, and trends in indirect taxation impact our business and affect our plans? Which indirect tax issues impact us most and what threats and opportunities do they present? What actions should we take? Should we adopt our internal organisation to seize opportunities and minimise risks? These are the questions that management should ask itself at an early stage when thinking about indirect taxation in relation to business strategy. For example, it is important to analyse the impact on VAT/GST, excises and customs costs – direct financial costs, but also indirect costs in reporting requirements and management time – before deciding on entering a new market.
As for compliance, effective controls, robust processes, standardised procedures and the use of appropriate, advanced technology can all help to improve accuracy and reduce risks. With tax authorities becoming more assertive and increasing the number of indirect tax audits, it is important to ensure proper documentation and archiving of all relevant transactions. Companies do well to proactively identify potentially controversial issues and, where feasible, seek clarification from tax authorities or external experts. It is also useful to adopt key performance indicators for indirect tax management to monitor compliance and results.
Collaboration between functions and across geographies is crucial. Isolated functional or geographic silos are definitely unsuited for a multinational enterprise in a globalising world where indirect tax developments in a specific jurisdiction tend to have more and more consequences for business operations far beyond its borders. Of course, cooperation also means allocating clear responsibilities to each function involved: tax, finance, IT, logistics and the business units. This allocation should eliminate gaps and minimise unnecessary overlaps.
To achieve the best operational structure for indirect tax management, some companies choose to centralise their compliance processes to improve standardisation and management oversight. Others prefer a decentralised approach to be able to deal more effectively and efficiently with detailed requirements of scores of local tax authorities around the world. Both options can be right, depending on the context. There is no one-size-fits-all solution; the best approach for each company depends on its activities, its structure, and the taxes it must manage and – last but not least – the countries where it operates. Whatever approach is suitable, a multinational enterprise will benefit from assigning responsibility for indirect taxes at a high level within the organisation, for example by appointing a global VAT director.
More than ever, it pays for a company to proactively manage indirect taxes. Establishing a clear indirect tax strategy aligned with its overall business strategy will help a multinational enterprise to keep its business up to date with the rapidly changing tax environment, to reduce risks and to seize opportunities.
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Philip Robinson is EY's global director of indirect tax and member of the global tax leadership team, he also leads the firm's tax and legal practice in Switzerland.
Philip Robinson's experience as a tax adviser covers most areas of taxation important for large corporations operating in an international environment, that is cross-border planning, transaction support, transfer pricing and indirect tax. In the area of indirect tax, he is considered to be one of the top advisers in Switzerland.
Philip Robinson has a doctorate in history from the University of Zurich and a master's degree in business administration and economics from the University of St Gallen. He is a certified Swiss tax expert and regularly publishes articles, acts as a seminar speaker and lectures at the University of Zurich. He is a member of the tax committee of the Swiss Fiduciary Chamber and of the executive board of the Swiss branch of the International Fiscal Association (IFA).