Split payment VAT systems: how it works ?

The VAT gap and VAT fraud

Value-added tax (VAT) is a consumer tax imposed at various rates on the purchase of almost all goods and services in the UK. It is an indirect tax, in that it is included on the invoice by the seller, who then pays the VAT to the HMRC by filing a VAT return on a regular, usually quarterly basis. 

Failure to file a VAT return on time or failure to make the appropriate VAT payment is subject to various penalties and surcharges that vary depending on the severity of the offence.

The “VAT gap” is what is referred to as the difference between what the government expects to receive in VAT payments and what it actually collects. In 2020, the government estimated the VAT gap in the UK alone to be around £9 billion.

The VAT gap can be explained by a number of shortcomings, including inadequate tax collection and recovery systems, tax fraud, tax evasion, tax avoidance, financial insolvencies and administrative errors.

VAT fraud occurs when businesses accept cash-in-hand payments and fail to record these transactions through the books, when only part of the sale is recorded and reported, when a business fails to register for and charge VAT when it should and when businesses use VAT numbers belonging to other firms or use fake VAT numbers.

Because the VAT gap means billions of pounds of public money are going unclaimed or unreported, governments are constantly striving to close the VAT gap and find new ways of enforcing VAT legislation and improving compliance.

The split payment VAT system

The split payment VAT mechanism is one way that has been proposed of closing the VAT gap and making it easier for governments to track and collect VAT.

Currently, sellers bank entire payment amounts for the goods or services they sell and only weeks (or months) later do they report this and account for the VAT part of the sale. Under the split payment system, at the time of sale the VAT part of the transaction would be paid into a dedicated VAT account allocated to the seller by the government.

The idea behind the split payment system is that it would avoid overdue tax payments and reporting errors, thereby contributing to reducing the VAT gap.

Experience in other countries

Variations on the split payment VAT scheme have been implemented in countries around the world. Within the European Union, Italy, Poland and Romania have introduced split payment schemes in an attempt to reduce the VAT gap.

In Italy, the split payment scheme applies to all goods and services supplied to public bodies and certain major companies. The consumer pays the net amount of the purchase into the supplier’s bank account and the VAT portion into the supplier’s VAT account that has been allocated by the tax authorities.

In Poland, consumers pay the full amount to a bank which then splits the payment into the net amount which is paid to the supplier and the VAT paid to the nominated VAT account. The system is currently voluntary in Poland.

In Romania, the split payment scheme is compulsory for businesses that have gone beyond the limits set on outstanding VAT payments. The consumer then splits the payment and transfers the VAT part into the supplier’s nominated VAT account.

In recent years, the UK has conducted consultations to gauge opinion on the introduction of a split payment VAT scheme. The proposal has had mixed reviews, highlighting the strengths and weaknesses of the approach.

Strengths and weaknesses

One of the strengths of the split payment system is that because it takes place at the time of sale and the VAT is transferred directly to the seller’s dedicated VAT account, the VAT transaction is more secure. Because it takes place in real-time, the time lag between the transaction and the government receiving the tax is also reduced.

Because the VAT proportion of sales is transferred to a dedicated VAT account, the business cannot use that money for other purposes, thus reducing the potential for fraud.

The biggest strength of the split payment system is the inflow of tax into the public coffers. The real-time collection of VAT will mean an injection of cash into tax authorities’ accounts. In contrast, this will also mean that businesses will notice a negative impact, with the tax which previously sat in their accounts for several weeks or months being definitively unavailable at the point of sale.

The split payment system is often criticised for affording companies very little leeway in terms of cash flow. Under the current system, businesses can invest the VAT proportion of their sales into other business costs until the VAT payment is due. Particularly for small companies with tight cash flow systems, this can ease pressure in the short term.

As with the introduction of any new tax system, the split payment system will also lead to an increase in administrative costs as the system is established and the new reporting requirements come into effect.

The approach has also been criticised for its sluggishness in dealing with VAT refunds and repayments. While the VAT is paid promptly at the time the transaction is concluded, if the company is due a VAT refund, this will inevitably take time to process, leaving many companies, particularly SMEs, struggling to bridge the gap.

Conclusion

The proposal to introduce a split payment VAT system in the UK has received a mixed reception. The potential benefits of real-time collection are seen by some to be outweighed by the difficulties the scheme may lead to for some businesses and the costs of establishing and monitoring the scheme. No timetable has yet been announced for the introduction of such a scheme.

Mooncard can help your business to simplify VAT accounting. Get in touch with our team today to book a demonstration.