When I started working for HM Customs and Excise many moons ago, I always thought VAT to be an odd tax, especially in the way it was operated.
VAT had been introduced in 1973 when the UK joined the European Economic Community (the forerunner of the EU), when it broadly replaced a form of Sales Tax called Purchase Tax, levied on luxury goods.
I found it strange that so much Output Tax charged by one business became Input Tax claimed by another. It struck me then, that it wasn’t a very safe tax, because If the seller suppressed the sale, disappeared or went into liquidation, it meant the government was out of pocket.
Sales Tax: Potential exploitation
Consider this scenario; a married couple, Mr & Mrs Smith check into a top hotel to celebrate their wedding anniversary. The couple run their own VAT registered business. They provide proof of their VAT number to the hotel manager and state that they are on a business trip and therefore should not be charged VAT.
The hotel manager duly acquiesces, puts the couple’s VAT number on the hotel’s system, which results in the amount payable being £1,000 and not £1,200.
The above scenario could very well happen if VAT was replaced by a Sales Tax. The idea of a Sales Tax instead of a Value Added Tax is very attractive in many ways because all the tax paid to HMRC will then be what we used to call ‘sticking tax’ ie it would be paid by consumers and not claimed back by the buyer of goods or services.
But how would it work to avoid massive fraud and manipulation, as this example shows? There are also potential practical challenges, for example if a business were partially exempt?
(Partial exemption is when a business has both taxable and exempt sales, such as a Funeral director. Output VAT cannot be charged on an exempt sale and any input VAT incurred directly in making the exempt sale, cannot be recovered).
Sales Tax: Potential fraud
The reality is that the Smiths can still manipulate the hotel stay with the current VAT system by posting the weekend break as a business trip in their purchase ledger and claiming back the Input Tax. In this scenario the Smiths have committed an offence that makes them liable to a penalty of up to 70% of the VAT as ‘deliberate not concealed’ behaviour.
The £200 input tax claim could cost them £340 if HMRC finds the transaction during a routine VAT inspection of their books. There is a big incentive to do things properly; but with a Sales Tax system it would be difficult to penalise the Smiths when the decision to not charge VAT has been taken by say, a junior member of staff in a hotel?
Sales Tax: Domestic Reverse Charge
Perhaps the solution is already in existence, with the new domestic reverse charge (DRC) which came into effect on 1st March 2021. Whilst the DRC was brought in for the construction industry, perhaps it could be adapted and used for all sales.
What would be needed would be to require all business owners to do a reverse charge declaration on their business purchases if they are not charged VAT, which is what builders have done since 1st March. So, using a reverse charge, the Smiths would include £200 as both Output Tax and Input Tax on their next VAT return as far as the hotel stay is concerned.
The onus is now back on them to make an honest declaration. If the trip was private, they should only account for Output Tax in box 1 and make a nil entry in the Input Tax box 4. If however they claim £200 in box 4, they once again become liable to a 70% penalty for this behaviour.
Domestic Reverse Charge: Disappearing trader fraud
The DRC for the construction industry is expected to reduce VAT fraud by £100m, as builders are being restricted from charging 20% VAT on their invoices and disappearing with the VAT money, as the customer declares the VAT instead.
So, if the Exchequer is benefitting from an extra £100m of tax from one industry because of the reverse charge, perhaps a gradual extension of these principles to more and more industries is the way forward? VAT would then be transformed into a true sales tax and with a much greater yield.
Domestic Reverse Charge: Other challenges
As many businesses in the construction industry have found, the concept of the DRC has been difficult to grasp, this is evidenced by the fact that the introduction was delayed by 17 months from its original planned introduction date of 1st October 2019, because so many builders were confused about the rules.
The new VAT rules for DRC inevitably added some complexity and additional layers of red tape from which the potential for misunderstanding arose. But, if you think of the DRC in the same light as when you were confronted with the arcane world of algebra when at school, once the concept clicked, you quickly realised that it was relatively easy to understand.
Tax Accountant Comment
The truth is that when DRC was first announced, very few accountants could tick a box to say they fully understand the DRC rules, which were initially a very long way from being in simple, easy to understand, English. But transforming VAT into a Sales Tax would in my opinion, significantly raise the amount of tax raised and perhaps allow Rishi Sunak to start chipping away at the debt mountain and at the same time give nurses et al, a decent pay rise.
The main impediment to this possible change is HMRC’s seemingly irrepressible need to add unnecessary complexity to any major change in the tax system. They managed to resist this urge with the temporary VAT rate cut for the hospitality industry in summer 2020, perhaps they should learn from this and extend simpler and clearer rules to the whole of the tax system.
Finally, my plea to HMRC boss Jim Harra is please remember that tax is a simple concept, so try much harder to resist the temptation to overcomplicate matters.
As ever, if you would like more detailed information on some aspect of UK Tax, send me an e-mail and I’ll be pleased to advise further.