The road to VAT (indirect tax) Automation: Harmonize – or at least clean up - your tax codes

20+ years of experience in VAT automation motivated me in writing the ‘road to VAT automation’.

I tried to formulate it in different topics. This is the third one whereby I discuss the set-up of the tax codes. Tax codes are crucial from a VAT perspective, not only for VAT automation purposes. 

My texts are meant to trigger discussion: How did you cope with VAT Automation in your company? What experiences you want to share? What questions you have? 

I will be using the word 'VAT' throughout the entire blog, but it does cover indirect tax systems called GST as well as sales tax.

Off we go again ... let's continue on the road to VAT Automation.

Tax codes are often the key drivers for VAT automation, so it is very important to pay a lot of attention to the set-up.

Tax codes set-up

The greenfield approach

If you are in the luxuriously position to be able to start from scratch, the greenfield approach, then you simply must grab the opportunity to harmonise the set-up of your tax codes and GL-accounts.

A greenfield approach is most likely to happen when upgrading your ERP system, e.g. when using SAP and migrating so S4 or radically implementing a new ERP system.

Start early

Harmonising the tax codes is very important exercise which can and actually should be started before the project really starts.

Harmonizing tax codes should be looked at as a rationalization exercise. Only the necessary tax codes are created or withheld but as many additional tax codes as needed in order to automate or simply avoid any manipulations of data are to be added.

Simply clean up your VAT codes

In order to start off a VAT automation project, it is recommendable to have a start which is ‘as clean as possible’. A greenfield approach is ideal, but you may not always be in the capacity to do so, then still, cleaning up your tax codes is a necessary exercise when you wish to automate your VAT calculation or reporting, or even simply to sanitize your VAT set-up.

Why clean up your tax codes?

Going through the below steps allows you to achieve four goals:

1. Delete obsolete tax codes
2. Create missing tax codes to allow automation
3. Correct errors and instruct AP
4. ... and you will have learnt a lot about your business operations from your colleagues which are located all around the world and about the flows you need to automate!

Steps to be taken to have a ‘clean set of tax codes’

The reason to start with a clean set of new harmonized tax codes or to clean up your tax codes is fairly straightforward at first sight: it is not necessary to do any development (and testing) for tax codes which are obsolete.

1. Check what VAT rates are not applicable anymore and since when and delete them: this is easy

So, skip those tax codes! But do check whether those codes have been used after the date they have become obsolete. If a material amount was posted with the obsolete tax code or it was recurrently used, investigate why this tax code was continued to be used.

2. Starting from the remaining tax codes from point 1, check what tax codes have not been used anymore for the last three years:

• What were those tax codes set up for? See what the meaning of these tax codes is and set up a meeting with the person locally responsible in order to know what this tax code was meant for when set-up.
• Delete them or instruct AP to use them in a correct way: based on the information obtained, which ought to be verified, it can be decided to skip those tax codes as well, but it is also possible that those tax codes should have been used and that AP needs to be informed – in whatever appropriate way – that they need to post certain transactions differently.

3. Analyse the tax codes still used over the last three years

• A tax code had been used very occasionally: an occasional transaction or erroneous use? It can be an occasional transaction, but it can also be a posting which was cancelled afterwards. The tax code will have been used twice but is not relevant at all anymore. Deleting this tax code will avoid incorrect use.
• Do random checks on frequently used tax code: the checks should be partly based on materiality and partly just random. It will again become clear whether or not the tax codes have been used by AP for what they are meant for or not, and consequently, whether new or updated instructions should be given to AP and monitored

4. Create extra tax codes compared to the ‘old’ set-up based on the transactions you have and want to automate. This may be discovered at this stage when discussing with local responsible persons but also in a later stage. Whether you are harmonizing your tax codes with the greenfield approach, or cleaning up your tax codes, this is not just about deleting or eliminating tax codes but also about adding additional ones.

• To eliminate all manipulations in order to sort or split different transactions for which there is not separate tax code. If you want to automate, you must have enough individual tax codes which allow to fully automate all your flows.
• It is therefore utmost important to set-up a meeting with the person effectively preparing all reports and have that person demo how the declaration is prepared. This way you can easily assess what manipulations are currently done and how they can be overcome and thus automated by adding more tax codes.The outcome of this consultation exercise should be a full overview of about all transactional flows you need to set up tax codes for.

The process of setting-up tax codes

Per jurisdiction where VAT needs to be reported the above steps should be followed in order to come to the set of tax codes needed for each jurisdiction.

For clarity, you could opt to have the tax codes linked to a certain jurisdiction start with a certain letter or the ISO country code if enough characters are allowed for the code set-up.

After the set of tax codes has been created, the tax codes have to be lined up next to each other to align them. Not only the description (the meaning of the flow) is important to align, but also all parameters and conditions linked to the underlying set-up of the tax codes.

In this phase it will become clear that this process is best handled by one very highly experienced VAT expert.

At this very moment, it will need to be decided what descriptions of transactions which look at first sight different actually mean the same or vice versa. A straightforward example is the low rate versus reduced rate. It very likely means the same. A less obvious example are e.g. purchases in the EU for which the intra-union acquisition VAT must be applied (intra-community acquisitions), often wrongly described as reverse charge. However, the VAT to be paid over the acquisition and the VAT to be paid over the reverse charge may need to be reported in a very different way. Not to speak of the different kinds of reverse charge operations that exist: for supplies from abroad or from another EU-member state. Or is it a reverse charge regime, like in many African countries for which there is no deduction at all possible? Or does the reverse charge mean that the VAT must be paid up as such to tax authorities and not via the VAT return? Let alone the numerous description for importations for which the VAT is paid through the VAT return: deferred VAT, reverse charge, … .

As said within the scope of reverse charge, VAT due does not always mean that the VAT is paid through ‘a VAT declaration’ or more generally speaking by setting off VAT payable and deductible. Sometimes the VAT must be literally paid to the authorities.

The parameters and conditions which constitute the set-up of the tax code in the ERP system should be set-up in a harmonized way throughout the entire ERP system all over the globe. This is crucial when implementing add-ons or other modules. If no harmonized approach has been taken in this respect, you may loose a lot of time and money over extra customization to overcome those hurdles.

However basic the exercise of setting up the tax codes seems to be, it really should be done by highly experienced people and if the set-up is global, then this person needs to have global knowledge.

By gathering all information about all processes, reporting and determination procedures in place all around the globe where your business is acting together, it is possible to harmonize, rationalize but also optimize the use of the tax code. Similarities will pop up and advantage should be taken of them.

“Keep the number of tax codes as limited as possible”

Keep the number of tax codes as limited as possible is a popular statement made. Although, if you want to be compliant and on top of that automate your VAT, then it is really a bad idea. You shouldn’t have too many tax codes but you should have enough to be compliant and to allow automation.

GL-accounts set-up

The process of setting up GL-accounts

The same exercise should be done for the GL-accounts used as for the tax codes used when cleaning up your tax codes or when starting from scratch.

Are they still valid? Changes in the tax system may have rendered some GL-accounts obsolete. Go through the same steps as for assessing the tax codes and skip what is not needed anymore. In general, the exercise will be less intense for the GL-accounts than for the tax codes.

However, also for the GL-accounts, the golden rule is: check with local people what the reason was for creating, using, …  a particular GL-account and document it.

Do we need to create more? Having detailed GL-accounts for taxes is a must if you want reconcile the tax declared in the declaration and tax position resulting from your postings in your ERP system. If not detailed enough, meaning having at least one GL-account per jurisdiction for VAT to be paid and one GL-account for VAT to be deducted in jurisdictions where VAT is to be declared, then reconciling is very difficult and time-consuming. At the end of the period the VAT can be netted off.

A simple structure could be to have the GL-account end by a specific number, linked to the jurisdiction for which the VAT is to be declared. This is especially relevant for entities having more than one VAT registration number for which VAT must be declared.

However, some jurisdictions may legally require a further split down of the GL-accounts used. Go after the local requirement and list them, you may find similarities again and be able to harmonise further than expected.

Go-live: what's next?

Creation of new tax codes and GL-accounts 

Live doesn’t stop after the go-live of the project. On the contrary. It takes a lot of effort to achieve a clean and harmonized set-up of the tax codes and GL-accounts, but in no-time, the harmonized set-up can be ruined.

Therefore, make sure that all changes or additions are administered centrally so that the harmonized approach stays in place. Hence also the recommendation (see below) to do a three-year health check. You may discover discrepancies and correct them.

Every three years: spring tax codes & GL cleaning

I am writing this post on ‘cleaning up’ your tax codes and GL-accounts within the framework of a VAT automation project, but actually, this is an exercise which should be made every three years. Having the correct tax codes and GL-accounts in place avoids a lot of unnecessary errors as well as a lot of unnecessary manipulations which always lead to extra risks, no matter whether you are automating or not.

Even with the greenfield approach, three years after defining your tax codes, you should do a first check-up of your tax codes – okay, this may be in some cases straight after going live – and then schedule this task every three years.

Conclusion

The process of harmonizing the tax codes and GL-accounts is a time consuming and often underestimated task. It should definitely dealt with by a VAT expert, even high level, who does understand the business’ transactional flows, international VAT legislation, as well as domestic habits, both legal and cultural!

Isabelle Desmeytere

VAT Technology Implementation Consultant - VAT Interim Manager - VAT Software Developer

isabelle@desmeytere.be