Countries within the European Union (EU) are losing billions of euros in value-added tax (VAT) every year because of VAT fraud, VAT evasion, VAT avoidance and inadequate tax collection systems. As of 2016, the VAT gap in the EU was 159.5 billion euros, or 14% of the total expected VAT revenue for the EU. As a result, EU countries have been introducing several measures to increase VAT compliance and make their VAT systems more fraud-proof. One such measure is the split payment mechanism.
What are Split Payments?
The split payment mechanism changes how VAT is generally collected by making the payment for the tax base (i.e., product price net of VAT) separate from that for the VAT amount. There are variations of the split payment mechanism, but generally, an invoice is paid by the customer to two separate accounts: The net amount is paid to the supplier’s business bank account, and the VAT amount is paid directly to a dedicated bank account of the supplier, called a VAT account. In practice, a single payment will be made and it will be divided by the bank.
Split payments are regarded as a measure to combat VAT fraud and non-compliance by removing the opportunity for suppliers to charge VAT and disappear without declaring or paying it to the tax authority (‘missing trader fraud’). It digresses from the mainstream of VAT collection in the EU, which relies on vendor-based collection of VAT and on periodic remittance of VAT by registered traders.
The European Commission completed a comprehensive study of split payments in December 2017 to design and assess legally and technically feasible scenarios for a split payment mechanism as a VAT collection tool. The study found:
“….no strong evidence that the benefits of split payment would outweigh its costs. The main identified effects were that a wider scope of split payment would potentially provide a larger decrease of the VAT gap, but would also significantly increase the related administrative costs.” [source]
EU Countries with Split Payment Mechanism
Despite the European Commission’s inconclusive assessment, split payment mechanisms are currently in place around the world, primarily outside of the EU. In the EU, Italy and Romania have implemented split payment mechanisms while Poland plans to implement it, and the UK has started to consider it.
Italy has employed a split payment mechanism since January 1, 2015 for payments to public authorities under Law 23/12/2014, n. 190 (Stability Law). It has been expanded several times, most recently on January 1, 2018. Currently, it applies to supplies of goods and services rendered to several categories of public bodies, such as public economic entities, special companies, foundations and their subsidiaries, as well as companies included in the FTSE MIB index. As per the design of the system in Italy, suppliers charge Italian VAT on goods and services made to the entities listed above. These customers then “split” the payment of the invoice: they pay the taxable amount to the suppliers and pay the VAT to an allocated VAT bank account of the treasury.
In Poland, split payments are scheduled to be implemented as of July 1, 2018. Unlike Italy, Poland’s scheme will not require customers to make two separate payments. Instead, Poland will require a single payment executed to the bank who will then split the payment into two separate bank accounts: one account for the amount net of VAT to be paid to the supplier’s business bank account, and the other account for the VAT amount to be paid directly to a dedicated VAT bank account of the supplier.
The scope of Poland’s split payment mandate is much broader than Italy’s as it will apply to all VAT registered businesses. On the other hand, the Polish split payment mechanism will be optional as the buyer may but does not have to apply it.
In Romania, a split payment mechanism has been implemented since January 1, 2018 for companies which exceed certain thresholds for outstanding VAT liabilities. Under the Romanian split payment mechanism, obligated VAT registrants are required to open separate bank accounts for the collection and payment of VAT. The VAT split payment applies to all their taxable supplies of goods and services, for which the place of supply is in Romania. Similar to Italy but unlike Poland, the split payment mechanism is mandatory. The suppliers charge Romanian VAT on goods and services, then the split payment is made by the business customer, who transfers the VAT directly to the VAT bank account of the supplier. The VAT bank account of the supplier can only be used for output and input VAT payments.
The UK has held a public consultation on adopting anti-VAT fraud split payment mechanism for eCommerce. The split payment mechanism would require the VAT due on online supplies to be paid directly to the UK tax authorities at the time of purchase. The UK is debating several issues:
- Which party in the transaction is best placed to identify and pay the VAT directly to the tax authorities;
- The role of online marketplaces in determining the VAT and split payment calculations;
- How to calculate the VAT due;
- A timetable to build the necessary IT infrastructure for all parties.
The HMRC has made an initial proposal with respect to how the split payment mechanism would function, titled “Alternative method of VAT collection – split payment,” and is seeking public comment until June 29, 2018. HMRC’s proposal would have the merchant identify and make the split payment for transactions relating to UK residents, and have payment service providers identify and fulfill the split payment for transactions relating to non-UK residents. There would be an approved register of payment companies (both merchants and payment service providers) who could split payments. With respect to overseas sellers, for each payment, the card issuer would check if an approved payment company will be responsible for splitting that payment. If so, the card issuer would pass the payment in full to the payment company. The payment company would then split out the VAT, pay it directly to the HMRC, and pass on the balance to the overseas seller’s bank account. If not, then the card issuer would have to split out the VAT, pay it directly to the HMRC, and pass on the balance to the unapproved payment company which would then pass on that amount to the overseas seller’s bank. Finally, the HMRC would credit the seller’s UK VAT bank account with the output VAT thus collected.
Impact of Split Payment on Companies
Under a split payment mechanism, suppliers may suffer negative cash flow. Although funds within the VAT account belong to the supplier, the supplier will not be able to use them freely. Such funds may be spent only in specific ways prescribed by the regulatory regime. In Poland, businesses can use the funds only to pay invoiced VAT to the VAT account of the invoice issuer, and to pay VAT to the tax authorities.
In Italy, a large delay has been observed on processing refunds to businesses (up to 90 days after quarterly VAT refund request). This hiatus allows authorities to hold input VAT for a longer period of time, earning interest for the government, while affecting the cash flow of Italian businesses. To fully estimate the cash flow implications of a split payment system, one must consider the costs of borrowing for the businesses and for the government.
The European Commission considered a variety of factors and models of split payment mechanism to determine impacts on businesses. The impact of split payments on different types of businesses varies depending on a number of factors, including the type of transaction, where the liability lies for the payment, whether the transaction is cross-border, and compliance costs that businesses will bear to implement split payment best practices.
Split payments are emerging as a new VAT collection mechanism in the European Union. Businesses need to continue to stay alert and adaptive in the ever-changing landscape of VAT compliance. Contact us to know how we can help your business to stay on top of VAT Compliance landscape.
About the Author
Brendan Magauran is a Junior Regulatory Counsel at Sovos Compliance specializing in international taxation, with a focus on Value Added Tax Systems in the European Union. Brendan received his B.A. and J.D. from Washington University in St. Louis and is licensed to practice in New Hampshire and Massachusetts.More Content by Brendan Magauran