Hype? Or is an immutable distributed ledger technology the solution to missing EU VAT revenues?
The VAT gap of €136 billion per annum and costly complexity of the compliance rules begs for a technological leap. Is blockchain, made (in)famous by cryptocurrencies, the answer? The appeal of open recording of VAT transactions may address the €50billion in missing trader fraud – including carousel frauds. Adding in the power of self-executing ‘smart contracts’ which could add double tax security through automated tax payments based on blockchain security, then the appeal seems overwhelming to resolve the fraud conundrum which has escaped resolution through measures such as the disruptive reverse charge.
But huge questions over security, speed, interoperability and investment costs hang heavily over the technology. In recent EC consultations on Digital Reporting Requirements, blockchain gained little favour as a base to support Continuous Transaction Controls and e-invoicing. Partially, perhaps, due to a lack of understanding where blockchain could help – security of data.
But it will have have uses in the tax compliance arena. Perhaps the most attractive is in Customs declarations and tariff payments, offering a highly efficient, compliance-ready data pool and tariff payments and calculations for tax authorities, counter-parties and other third-parties in supply chains.
How blockchain real-time recording and payments could work for VAT
- complete VAT transaction tracking process for all parties
- automated and independent transaction data extraction and processing
- seamless VAT reporting
- governmental and counter party auditing and cross-validation tool
Blockchain is an immutable distributed ledger technology, meaning data (or transactions in the case of VAT) are not kept centrally. Instead, they are held in chains of data blocks by processors ‘nodes’ (individual computers for example). When a transaction is added, by sellers’ invoices, each independent participant verifies the authenticity of the transaction by solving complex cryptographic puzzles and store new data (blocks) on the chain. This means the full chain of transactions are visible to all across the chain, including the tax authorities.
Aside from securely recording the transaction, including the essential proof of cross-border transport which is essential for the right for zero-rating, this could be used to trigger automatic payments and VAT liability settlements. This would be based on ‘smart contracts’ which would facilitate split payments of the VAT element of contracts – so by-passing the vendor.
This structure makes it attractive to solving the EU VAT gap, particularly on cross-border transactions, where fraudulent traders have missdeclared zero-rating on invoices, when in fact they have charged and withheld VAT, to the next participant in the chain.
Real-world xxamples include:
- The EU is funding private sector research into using blockchain for VAT transactions to report invoices
- The new German coalition government has backed innovative technologies to combat tax fraud, including blockchain
- Finland has piloted using blockchain in VAT following successful implementation for real estate tax transactions
- China is looking at blockchain contracts to deal with the problem of fake invoices
- In Sweden, blockchain is being tested to digitalize invoices, non-resident income tax, and customs duties.
- Argentina has implemented the Single Tax Registry — Federal Register, a tax simplification mechanism that allows payers of gross income tax to use the same channel to comply with the formal requirements of tax registration and declarations of all modifications of data, cessation of jurisdictions, partial and total cessation of activities, transfer of goodwill, merger, and spinoff.
How blockchain can help fight VAT fraud
The distributed ledger nature of block chain that makes it highly attractive to tackling the cross-border VAT compliance and fraud problem:
- Live data collection of transactions – which can be analysis in real-time by tax authorities for discrepancies and follow-up. One of the most important failings in the existing VAT return system is that data is slow to gather and process, enabling fraudsters to disappear.
- Trustworthy data – based on the repeated copying of transactions be separate points. This means changes and discrepancies can be quickly identified and followed-up as to when and who may have tampered with the correct version.
- Cryptography security a particular speciality feature of blockchain, could enable exchange of limited amounts of key data, without sharing whole transactional information, that would easily help identify errors or fraud to be investigated further. This would allay some fears around sharing all data in the public blockchain.
- Transparency across the supply chain history – with clear records of each transaction and allocation of transport and therefore when and if a VAT exemption was appropriate. Also, identifying when goods where VAT may have been exempted AND charged fraudulently.
- Lifting the customer VAT liability inequity – most countries impose potential VAT liabilities on customers where their suppliers clearly were committing VAT fraud. See Kittle Principle. The customer may end-up paying the missing VAT if it is clear from, for example, suspiciously low prices from unknown suppliers should have promoted closer questioning. Aside from the unfairness of this, it also imposes further heavy compliance burden and costs on law abiding businesses across the EU. This would likely also dissuade many businesses from trading cross-border, where VAT fraud is prevalent, as so undermining the EU Single Market.
Challenges to implementing blockchain to combat fraud
- Speed – blockchains dispersed nature means VAT transactions would be calculated by each node separately to give it the duplication that makes verifying transactions possible. This makes the system much slower and puts doubts over scalability.
- Interoperability – the need to link seamlessly with existing ERP’s, invocing, e-commerce platforms and other transaction databases. This is essential for transaction invoice uploads, but also to ensure any blockchain does not become a single point of failure risk.
- Implementation costs – which will be required for businesses of all sizes to adopt any new solution. There can be no exemption thresholds for small companies since that would leave open loopholes that criminals will adapt to exploit.
- Standards – a single transaction data set and schema must be agreed not only at the EU level, but also globally to ensure no duplication of systems, heavy expense for lawful taxpayers or loopholes for fraudsters to exploit. Based on the lack of harmonisation on basic VAT compliance, this would be a major challenge.
- Security fears – blockchains may be either open to all to join and validate (permissionless) or private in some part, requiring tax authorities for example to have control over mechanisms for authorisations for reading, writing, and validating transactions. If it is decentralised and high levels of security, it will again slow processing speeds and scalablility. Technical hurdles aside, the national legal and cultural sensitivities to sharing hugely sensitive data outside of the originating business will create a large volume of opposition which will be challenging to herd toward the trust and vision required for some meaningful level of unanimity.
Blockchain for customs declarations
The above objections amongst such a majority of the stakeholders will likely make the adoption for a blockchain-based solution to solve the VAT fraud issue unlikely.
However, there are certainly more manageable compliance environments where it would be more practicably adopted. This would include customs declarations for the cross-border movement of goods. Data on the goods (description; manufacturing and processing details; volumes; origin details; ship from and too; carrier; Incoterms etc) would automatically produce declarations, including tariff calculations. This would provide customs authorities highly reliable and auditable informational, and produce huge savings in time and expense on administration.