Innovation for VAT: Tax technology is changing how VAT applies to new and more complex business models, how tax authorities administer these taxes, and how businesses comply.

• Author: Freed, James
• Position: Value added tax

The saying "There's a way to do it better ... find it!" is attributed to inventor Thomas Edison, but it encapsulates perfectly the current global indirect tax management landscape. In the last decade, innovations in tax technology have significantly changed not only how value-added tax (VAT), also known in certain jurisdictions as goods and services taxes (GST), applies to new and more complex business models but also how tax authorities administer and businesses comply with these transaction taxes.

This trend will likely continue as more tax authorities and businesses embrace new tools facilitating the management of more and more complex taxes. In this article, we provide an overview of why VAT is a tax particularly amenable to technological innovation and how tax authorities and businesses can leverage such innovation to improve and ease compliance.

CHALLENGES OF MODERN VAT

Over 170 countries, including thirty-six of the thirty-seven member countries of the Organisation for Economic Co-operation and Development (OECD), have implemented some form of VAT. Three main criteria distinguish a VAT from the retail sales taxes levied by state and local authorities in the United States and explain why countries have adopted VAT systems rather than sales and use tax systems.

First, VATs generally apply to all sales of goods, services, and intangibles, with generally few exemptions (although there are great variations among the 170-plus countries). Second, a VAT is charged at each step of the supply chain, with a credit for tax paid when the item has been purchased for business purposes, until the item is purchased by the final consumer, who bears the ultimate tax burden. Finally, a VAT is considered a self-enforcing tax, because, absent a valid invoice, a purchaser cannot claim a tax credit, thus creating an incentive for the purchaser to request an invoice.

In practical terms, these characteristics create burdens for tax authorities and businesses. VATs are generally more difficult to manage than direct taxes, because every VAT transaction (whether a sale or a purchase) and many activities related to that transaction (e.g., inventory transfers between locations) must be assessed in real time to determine the specific tax treatment. Direct taxes, on the other hand, are assessed only periodically, often just once yearly. While on the corporate income tax side some details of certain transactions must be taken into consideration, with indirect taxes like VATs it is crucial to assess all elements of transaction data in real time.

This transactional approach becomes even more complex with non-harmonized VAT/GST rules, increasingly intricate business structures (think about the sharing economy or on-demand supply chains), and pushes by countries to tax consumption effectively where it occurs, especially in cross-border situations. Unlike in the corporate income tax arena, nonresident vendors, mainly in digital services, already must comply with foreign VAT obligations in more than eighty jurisdictions even without any physical presence. Economic nexus, often from the first dollar of sale, is enough to create a foreign VAT compliance obligation. The number of countries requiring such compliance will only grow in the near future, and the scope of transactions imposing compliance obligations can only broaden.

Finally, VAT systems often come...