Tax authorities are going digital: why boards and senior executives should understand the risks
Today, new, digitally enabled business models can be activated overnight — a complete sea change from how business has traditionally been conducted.
A startup company can sell into more than 100 markets within 24 hours. Likewise, established businesses in all sectors are finding new ways for digital to create innovative new revenue streams and support their global brand efforts.
Tax administrations around the world are going digital at a rapid pace, too. More and more often, they are creating new capabilities to interact with taxpayers at source, instead of relying on historical information from the tax return.
In some cases, they are actually demanding taxpayer data even before a transaction has occurred, turning the whole model of tax compliance on its head. When combined with the global revolution in tax transparency, companies old and new are finding that revenue authorities everywhere are forging ahead at a pace that has the potential to outstrip their ability to keep up.
The results can be unpleasant and include internal disruption, operational risks, “surprise” tax assessments or audits, financial penalties and reputational risk. Boards and senior executives may not be aware of quite how high the new risks may be.
Governments are reaping significant returns on their investment in digital. Starting in 2015, for example, Russian taxpayers were required to submit value-added tax (VAT) transactional data along with their electronic VAT returns. That year, domestic VAT revenues increased by more than 12%, the equivalent of around US$4 billion (RUB267 billion). Mexico reports a 38% increase in tax revenues without an increase in headline corporate tax rate, while Brazil reported a 42% increase over plan for 2017 audit and penalties collected after implementing a series of new digital reporting requirements.
What is digital tax administration?
Digital tax administration has come far in recent years. Indeed, the electronic filing of tax returns is now more than three decades old in many jurisdictions. In some nations, tax returns are now automatically pre-populated for taxpayers to approve, taking in information from banks, brokers and other third parties, almost fully automating a process that for many previously represented a burdensome review of physical documents.
Although not the initial focus of attention, corporate business taxes are now experiencing their time in the spotlight. “We clearly started this journey with personal taxpayers. I think the next wave will be the business side,”1 says Hans Christian Holte, Commissioner of Norway’s tax authority and Chair of the Organisation for Economic Co-operation and Development’s (OECD) Forum on Tax Administration, a collection of more than 50 tax commissioners who regularly share ideas and insights with one another.
So what does digital tax administration look like, and what exactly are revenue authorities trying to achieve?
Tax authorities have many reasons for their journeys into digitalization. The first was out of
necessity — only by applying digital techniques could tax authorities start to address the shadow economy. Second was efficiency as at a broader level, all government departments have found that they need to do more with less. Shrinking internal budgets, while still under pressure to deliver revenue was a key driver.
Chiefly, collecting more tax revenue (and earlier) heads the list and data matching and advanced data analytics can be used not only to identify tax fraud and evasion, but also to tackle what they consider to be aggressive tax planning.
While there is no one-size-fits-all approach, there are two common characteristics playing out within every tax authority:
First, governments are requiring more and more source accounting and transactional data to be submitted in digital form, creating a “web” of taxpayer data to which data matching and data analytics routines can be applied. The types of data requirements — which tend to be layered upon one another in quick succession, once a tax authority decides to go digital — vary widely, but include:
- Electronic invoices (e-invoicing) are a common requirement, and an early sign that a revenue authority is digitalizing more widely. E-invoices are typically generated on a per transaction basis, and, in many emerging markets, often require tax authority approval before the transaction can commence. Formats and transmission modes vary from country to country, and this can pose a real and ongoing challenge to international taxpayers.
- Electronic accounting information includes a broad range of accounting and financial information, including general ledgers, trial balances and journal entries as examples. These are typically submitted to a tax authority in prescribed formats, on a periodic basis, with many countries requiring monthly or quarterly submission. Again, formats differ around the world, with no common standard anywhere in sight.
- Standard Audit File for Tax (SAF-T): SAF-T can be described as pre-defined audit files that must be submitted to a national tax authority. SAF-T typically addresses all tax types, as well as also incorporating many of the electronic accounting data types. While some countries may only require SAF-T to be submitted on demand (e.g., at the outset of a tax audit), others may require scheduled submission. While SAF-T adoption started (around 2009) in Europe, it has been adopted more widely recently. While there is a suggested standard, many countries deviate from it quite substantially.
Second, tax authorities are becoming far more advanced in their use of data matching and data analytics. All of the data sources noted thus far — along with many others, including a company’s country-by-country reports — are combined to form a complete corporate tax profile. Data analytics and data matching are then utilized, often right across a company’s supply chain, highlighting errors (intentional or not), data inconsistencies, systemic fraud and compliance risks.
The OECD, in fact, published a handbook of 19 tests that it thinks all tax authorities should be running across the data submissions for large multinational companies (MNCs).2 But many tax authorities go far further. As Jeremy Hirschhorn, Deputy Commissioner for Groups in the Australian Taxation Office, said in a recent interview with us, “We have approximately 100 risk factors that we apply to international dealings, and the aim is to make these transparent over time. That way taxpayers can consciously decide whether they want to take a low or a high risk position. We call this 'setting out the flags' at the beach.”3
Key global trends
Graphic 1 illustrates the current state of digital tax administration, with each of the country’s digital maturity levels (1-5). Below are some key points, regionally:
Graphic 1: Global tax authority digitization maturity
Pioneer in digital tax administration and most mature
- Primary objective is to raise tax revenue by detecting fraud and tax evasion
- Focus on e-invoicing and transactional accounting data; emphasis on inter-country sharing
- Key focus countries: Mexico, Brazil, Chile, Peru
- Growing number of countries have adopted OECD’s SAF-T guidance
- Includes detailed invoice and accounting data
- Other countries have adopted their own variations of digital data reporting requirements
- Key focus countries: Spain, Poland, Italy, United Kingdom (“Making Tax Digital”)
- India requires reporting of detailed invoice data
- China introduced data reporting through its 1,000 accounts plan for select large taxpayers
- Other countries are in process of adopting digital reporting — initiatives vary by country
- Key focus countries: Russia, China, India
Moving to real-time analysis
As well as increasing their overall levels of data acquisition and data analytics, tax authorities are also moving to real- or near-real-time tax compliance, demanding data immediately after (and in some cases, even before) a transaction has occurred, instead of capturing and analysing transactions that occurred months or even years ago. This completely disrupts the traditional tax compliance life cycle and, in turn, the tax department, which must now deal with a compliance timeline that has changed from several years to just 90 days, and often shorter.
Moreover, digital tax administration presents a major organizational challenge; while the finance department may submit some of the electronic accounting information, the tax department is then responsible for submitting the balance and also then addressing incoming tax authority inquiries — and, in time, tax audits.
Four key areas of risk
Such significant change also brings significant risk. With more countries moving data acquisition “upstream” (i.e., closer to the point where a transaction originally occurred), unless changes are made companies will be submitting data that has not tax sensitized, checked for errors and generally prepared for final submission (i.e., as it would be for a tax return).
As a result, there is a growing friction between taxpayers and taxing authorities in countries that are going digital. Audit notices tend to increase, and companies find that they have to respond to incoming inquiries in a far more efficient and timely manner, creating a litter of penalties if they fail to keep up. In some unfortunate cases, requests for refunds may be rejected should the taxpayer be deemed to be noncompliant in other areas.
But these are not the only dangers. Broadly speaking, digital tax administration risks tend to span four key areas:
- Operational risks — a common example being where e-invoicing requirements are in place, clearance may be needed from the government before moving forward with a specific transaction. In effect, what should be a relatively simple task to complete has the potential to bring business to a complete halt.
- Internal disruption — meeting digital tax administration requirements requires close coordination between tax, finance and IT departments, particularly when data submission requirements are rapidly changing. But where such coordination is not planned in advance and companies find themselves in a reactive state, IT projects become mission critical and finance processes must be re-engineered without warning. This causes internal disruption and the inability to execute previously planned projects. Likewise, many companies may experience duplication of efforts, with both the tax and finance departments working on identical efforts and solutions.
- Financial risks — many countries impose automatic penalties in the hundreds of dollars for every single transactional mistake, however small. This includes data quality issues such as missing required fields on invoices, incorrect formats and other seemingly minor infractions. With some companies making hundreds of thousands of transactions, the penalties can quickly amount to millions of dollars.
- Audit aggressiveness — alongside shifting data submission requirements, many tax authorities are also demonstrating higher levels of audit aggressiveness in this area. They are implementing higher levels of data analytics and data matching, generating a greater number of incoming inquiries — many of which are electronically generated, without human intervention. And where an incoming inquiry triggers an audit, such audits tend to be quite aggressive in nature.
How the leaders are responding
Preparing for digital tax administration today is relevant and necessary. When forming a response, a key first question companies are asking themselves is, “Who owns this in our organization, and who has visibility into how we are complying with these new and ever-changing requirements?”
Next, companies are asking themselves whether they should adopt a global (or regional) approach or develop point solutions in each and every country. Generally speaking, while formats and delivery schedules may be very different, all countries do in fact have some level of consistency in what they are asking taxpayers to deliver. A global or regional response is therefore a more efficient and cost-effective proposition.
Companies must then assess their readiness, define an enterprise-wide strategy and assess data integrity and quality before finding ways to both pre-test the data they are submitting and then streamline data submissions and the ways in which the company will respond to any incoming inquiries.
One of the hardest challenges to overcome may be developing a globally integrated operating model; getting tax, finance and the IT function all involved and working together to define roles and responsibilities is critical to building the right model.
Digital tax administration is a rapidly evolving topic, and progress is not necessarily linear. Many countries are only beginning their journey, while others are far ahead, already experimenting with the possibility of reaching directly into corporate Enterprise Resource Planning (ERP) systems or connecting directly to point-of-sale cash registers to track sales. Some countries (emerging markets especially) may leapfrog from zero to advanced in a very short period of time. Others may be struggling with legacy systems, and the forward progress may be slower. But for most MNCs, the truth is that they will need to deal with revenue authorities right across the digital maturity spectrum. That means working hard to get onto the front foot, driving efficient operating models and building change management and flexibility into finance processes.
Questions the board should be asking
- Do we have the proper governance and global operating model, demonstrating risk aversion, visibility and cost effectiveness?
- Is our approach to digital and technology keeping pace with that of the tax authorities?
- How are we monitoring global changes to submission requirements and preparing for new mandates?
- Are we confident that our data quality and governance is sufficient?
- Do we have visibility and understanding of what the tax authorities are doing with our data?
- How do we integrate digital audit defense activities into our tax team’s daily processes?
1 An interview with Hans Christian Holte, EY, May 2018. ey.com/Publication/vwLUAssets/ey-a-discussion-with-the-hans-christian-holte/$FILE/ey-a-discussion-with-the-hans-christian-holte-issue-22-june-2018.pdf.
2 OECD publishes two handbooks on Country-by-Country reporting, EY Global Tax Alert, 3 October 2017. ey.com/gl/en/services/tax/international-tax/alert--oecd-publishes-two-handbooks-on-country-by-country-reporting.
3 An interview with Jeremy Hirschhorn, EY, November 2017. ey.com/gl/en/services/tax/ey-an-interview-with-jeremy-hirschhorn.