The final element of the UK’s Making Tax Digital for VAT rules takes effect for VAT periods commencing on or after 1 April 2021. From this date, it will be necessary to maintain a digital audit trail to support the UK VAT return. However, this is the end of the beginning, rather than the beginning of the end, of HMRC’s Making Tax Digital journey. Senan Kavanagh of our Tax Transformation & Technology team and Jennifer Upton of our Belfast Tax team discuss.

What is Making Tax Digital?

The UK MTD regime came into effect from 1 April 2019 for UK VAT registered entities that had a taxable turnover in excess of the UK VAT registration threshold (£85,000). However, with effect from April 2022, MTD will apply to all UK VAT registered entities and not just those whose taxable turnover is in excess of the VAT registration threshold. The introduction of MTD for VAT as part of HMRC’s ambition to become one of the most digitally advanced tax authorities in the world. A key objective of MTD is to modernise the collection of tax, with a view to reducing the number of errors in tax compliance and thereby helping to close the “tax gap”, i.e. the difference between the tax revenue that should be collected and the amount actually collected by HMRC. This will result in fundamental changes to how HMRC conducts UK VAT (and other tax) audits in the future for UK VAT registered entities that had a taxable turnover in excess of the UK VAT registration threshold (£85,000). However, with effect from April 2022, MTD will apply to all UK VAT registered entities and not just those whose taxable turnover is in excess of the VAT registration threshold. 

The introduction of MTD is part of a global trend that has seen the introduction of various measures to allow tax authorities to utilise technology to facilitate the filing of tax returns and the gathering of transaction data. Other examples are the introduction of real-time reporting (SII) in Spain; the SAF-T (standard audit file for tax) in France, Portugal, Poland and others; and e-invoicing regimes in Italy and Greece, as well as the introduction of PAYE Modernisation in Ireland. 

The UK regime differs from the indirect tax regimes in other countries in that source data is not collected by HMRC. Instead, there is an onus on the taxpayer to maintain a digital audit trail to support all data relevant to the tax return filing. Although MTD was initially introduced for VAT, it has been envisaged from the outset that MTD would ultimately apply for direct tax compliance purposes, with MTD for income tax set to be introduced next. 

There are three principal requirements in relation to MTD for UK VAT: digital records, digital links and digital submission. 

Digital records

VAT return figures due for periodic submission to HMRC must be maintained in digital form within “functional compatible software”. HMRC has clarified that functional compatible software includes Microsoft Excel and that it is permitted to maintain records in multiple systems. 

For all accounts payable/purchases transactions, the following must be recorded digitally: 

  • the time of the supply, 
  • the value of the supply and 
  • the amount of input tax to be claimed. 

For accounts receivable/sales transactions, it is necessary to record: 

  • the time of the sale, 
  • the value of the sale and 
  • the applicable VAT rate.
Fig. 1: Making Tax Digital – Digital Links.

Fig. 1: Making Tax Digital – Digital Links

Digital links

A taxpayer must be able to demonstrate that “digital links” are used throughout the end-to-end process for preparing the UK VAT return to transpose data between the various systems that may be used, before the data ultimately reaches the VAT return. Although there was a deferral for the mandatory introduction of digital links, this no longer applies for VAT return periods starting on or after 1 April 2021. Therefore, digital links must be in place from this date. 

Rekeying data and the use of “cut and paste” are specifically prohibited, thereby allowing information flows between systems to be automated. As set out in Fig. 1, this requires there to be an electronic audit trail between the source invoice data and the nine boxes in the UK VAT return. 

It should be noted that links between various Excel documents are permitted. However, the digital links requirement has presented a significant challenge for businesses when it comes to the manual adjustments and various journal entries that often form part of the VAT reporting process. 

Digital submission of VAT returns

With effect from 1 April 2019, VAT return information can now be submitted to HMRC only via an application programme interface (API). It is no longer permitted to complete the nine-box UK VAT return manually via HMRC’s portal. 

Key challenges under MTD for VAT

The MTD for VAT regime presented a number of challenges for businesses, and indeed also facilitated some valuable learnings that can be used by businesses to manage the further expansion of MTD or the roll-out of similar measures in other jurisdictions. MTD may also be a trigger for businesses to transform how they manage tax compliance and maintain tax data. 

Data quality

Although the UK regime differs significantly from the various measures introduced across Europe, the need for high-quality data to help businesses to meet the MTD “digital records” requirement is the same. The impact of MTD has been minimal for those that already had good data in their systems in relation to purchases, sales, vendors, products etc. Although the “digital links” requirement may have presented the greatest challenge from a systems/IT perspective, the changes required to enhance the quality of the data being captured have proved much more arduous. Those businesses that have high-quality “digital records” and data have found it much easier to build the necessary digital links to be MTD compliant. 

Stakeholder interaction

The submission of VAT and other tax returns is typically the responsibility of tax advisers or accountants within the business; however, MTD has illustrated for many the reliance that is placed on other teams or business divisions. Accounts payable and accounting teams are often responsible for the preparation of the data that is typically relied on by those preparing tax returns, and the changes required under MTD also called for significant interaction with IT and project personnel. The ability to communicate and effectively interact with a growing range of stakeholders is becoming an increasingly important element of the job for in-house tax advisers, as well being a critical element of the support provided by tax advisers in practice. 

Opportunity to improve processes

MTD has prompted many businesses to take the opportunity to automate and streamline their VAT (and wider tax) processes such that not only are they compliant with the new regime but also time and operational cost savings are achieved. In many instances the burden on those responsible for tax compliance, particularly among large multinational businesses, has grown significantly in recent years. New compliance regimes, combined with the challenges that the COVID-19 pandemic has presented, have forced many businesses to reconsider how they manage VAT and other taxes. 

Existing IT may be the answer

Although most businesses would have needed to acquire bridging software to facilitate the “digital filing” of VAT returns under the MTD regime, minor amendments to existing technology/IT systems have helped many to meet the “digital records” and “digital links” requirements of MTD. Subtle changes to the master data set-up (e.g. supplier, customer, product data) and tax logic in ERP systems can make a significant impact on the downstream reporting processes and mitigate the need for journal entries and manual adjustments, which are typically time consuming for those preparing tax returns. 

Looking ahead: VAT Audits in the UK

The manner in which tax audits are conducted in the UK is likely to change significantly on the back of the MTD regime. The MTD requirements will potentially pass a significant element of the audit work from HMRC back to the taxpayer. However, businesses that have put a robust process in place to meet the MTD requirements are likely to be “audit ready” on an ongoing basis. 

Some key changes that we may see in relation to how VAT audits are conducted are: 

  • In the first instance, there will be an onus on the taxpayer to demonstrate that there is a digital audit trail in place to support the numbers included in the VAT return. 
  • In addition to demonstrating that the correct amount of VAT has been filed, it will be necessary to show that there are digital records in place to support each purchase and sale transaction. 
  • HMRC auditors will be able to assess easily whether data has been manually transposed by rekeying or copying and pasting. 

A key challenge presented under MTD has been in relation to journal entries and manual adjustments. Many businesses have thought about this in the context of the “digital links” requirement but have failed to recognise that it is necessary for a digital record to be in place for all purchases and sales. As a general rule, manual adjustments that amend an existing digital record are permitted under MTD. However, where a manual adjustment results in the creation of a new transaction, it must meet the “digital records” requirement. 

Fig. 1: Making Tax Digital – Digital Links

Fig. 2: Key building blocks for HMRC audits/interventions under MTD regime.

Fig. 2: Key building blocks for HMRC audits/interventions under MTD regime

Expansion of MTD

Income Tax, Corporation Tax and All VAT-Registered Entities

HMRC announced a roadmap in July 2020 that set out plans in respect of the future of MTD and, in particular, for MTD for income tax. As outlined above, with effect from April 2022, MTD will apply to all UK VAT-registered entities and not just those whose taxable turnover is in excess of the UK VAT registration threshold (currently £85,000), which has been the position since its introduction. April 2023 is then set to bring the introduction of Making Tax Digital for income tax, which will apply to sole traders and landlords. Although legislation has yet to be published in this regard, details of the key measures to be introduced under MTD for income tax have been provided. 

Key measures pertaining to MTD for Income Tax

  • It will apply to sole traders and landlords with income above £10,000.  
  • Subject to any further deferrals, it is set to apply to the first accounting period starting on or after 6 April 2023. 
  • For each of their businesses, individuals will be required to submit details of income and expenditure on a quarterly basis. 
  • At the end of the year, an EOPS (End of Period Statement) must be submitted for each business. 
  • The quarterly submissions will be collated by HMRC’s system to compute an individual’s income tax liability for the year. Taxpayers will be required to complete a final declaration each year to confirm that they are in agreement with HMRC’s assessment. Therefore, it will no longer be necessary to complete a year-end tax return. 
  • All of the relevant data and information must be submitted using “functional compatible software”. 

Some planning will be required to ensure that the correct data can be captured and maintained in functional compatible software, particularly for smaller businesses that are currently reliant on a year-end process. Tax advisers working in practice will need to adapt to a new way of supporting their clients, with the emphasis set to shift from a busy year-end process to the provision of quarterly filings, potentially with information to be shared with HMRC in a tight timeframe. 

A detailed roadmap for the roll-out of MTD for UK corporation tax is yet to be published. A public consultation process is currently under way, following which it is expected that a voluntary pilot will be launched from April 2024. The mandatory introduction of MTD for corporation tax may not come into force until 2026, at the earliest. The corporation tax measures can be expected to be in line with those introduced for income tax, perhaps with more detailed financial data to be provided as part of the quarterly updates. 

Preparing for change

The UK Making Tax Digital journey is just beginning, and significant changes can be expected in Ireland in coming years, with the introduction of real-time reporting said to be “inevitable”. The digitisation of tax is a daunting prospect for many tax professionals. Although it is not necessary for tax professionals to become IT experts, consideration should be given to whether operating practices are robust and digitally enabled. It may be beneficial for tax advisers, particular those working in in-house teams, to carry out periodic reviews of existing processes and the quality of tax data. It is critical for tax teams to understand upstream business processes that produce the data to support tax compliance, planning or reporting. Carrying out such an exercise means that tax teams not only will be ready for future regulatory changes (such as the MTD changes discussed in this article) but also may find efficiencies in existing practices and be in a better position to deal with tax authority audits and interventions. 

This article first appeared in The Irish Tax Review and is reproduced here with their kind permission.

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If you have any queries on the Making Tax Digital regime and its impact on your business, please contact our Tax Transformation & Technology team. We'd be delighted to hear from you.