10 challenges associated with PESM

Partial Exemption Special Method (PESM) is a bespoke way for businesses to recover their input VAT but it’s not without its drawbacks. While each PESM is unique, there are some common issues that can make a PESM difficult to enforce.

  1. Common VAT challenges – The manual processes used to calculate VAT increase risk enormously. These are time consuming and resource intensive, with up to a fifth of businesses spending over 50 days a year on VAT. Errors can often creep in and if the submission is incorrect HMRC will want to see evidence of how the Return has been calculated and will suspend the VAT process while it investigates, delaying any repayment.
  2. Change – HMRC is stepping up efforts to enforce compliance to close the 5.6% tax gap and tackle the growing national deficit caused by COVID-19. We’re also on the cusp of PESM reform. In July 2019 HMRC issued a call for evidence in a bid to reduce the complexity of the PESM, proposals for which included abolishing the approvals process. If this does happen, businesses are going to need to prove their PESM process is ‘fair and reasonable’ on an ongoing basis but they will also be free to make business changes without the need to reapply to HMRC. Today, making any changes that directly impact a PESM can be costly, usually requiring the business to engage the services of an advisor to facilitate those changes
  3. Making Tax Digital From April 2021 businesses cannot cut and paste data. This has led to confusion over how data can be manipulated to perform PESM calculations. Whilst HMRC has confirmed it is possible to dip out of the MTD for VAT process for now, perform the PESM calculation in a spreadsheet, and then factor it back into the Returns software, this is not regarded best practice. Instead, the tax authority advocates using the compliance software to do the necessary computations, saying that “using software for all your calculations will reduce the risk of errors in your returns” and is therefore preferable.
  4. Recovery metrics – While some recovery methods are static, such as floor area, others may fluctuate – such as the number of transactions or staff headcount – or apply to more than one sector/business unit. This makes a PESM resource intensive to maintain, because changes could impact multiple sectors within the business.
  5. Sectorisation – The ‘sectorised’ method is commonly used by large businesses. Where things get difficult is when there are dozens or even hundreds of cost centres that span a number of sectors, entities, sub entities or specific business activities. HMRC cautions that it may also be necessary to create additional sectors for “distortive transactions” or to “amend attributions where they may not properly reflect use”.
  6. Cost allocation mapping – Allocation may follow existing cost-accounting mechanisms, but it can become incredibly complex if a transaction is mapped to more than one sector. Granular reporting is required to demonstrate that the correct allocations have been made for each cost. Any changes during the period could affect numerous transactions, meaning cost allocation must be continually monitored to keep on top of the calculations.
  7. Spreadsheet management – It is not uncommon for organisations to have over 20 data sources and a similar number of spreadsheets relating to percentage recovery calculations. This results in high levels of manually intensive data processing in order to ensure the resulting figures are correct. Running extremely complex calculations across numerous linked spreadsheets can increase the risk of error exponentially.
  8. Proving compliance the letter of approval regarding the PESM method applied for that the business receives back from HMRC does not detail how to implement the PESM in practice. This means it can be open to interpretation and error. A business will need to be able to prove compliance by showing any changes, or additions, to cost centres or ERP systems, all transactions are allocated to their appropriate sectors prior to calculation, that the necessary transactions have been blocked and excluded from the VAT calculation, and that any definitions agreed with HMRC are evidenced.
  9. Annual adjustments – HMRC has stated that the need for adjustments associated with changes of intention is an area that is “often overlooked” and an area where businesses could potentially incur or lose out on recoverable VAT.
  10. Risk – Identifying and allocating costs is where most of the errors tend to occur. Cost allocation is a laborious process and costs can often be incorrectly mapped. Even small errors within the Return can attract the attention of HMRC and trigger an audit and serious or repeated miscalculations could threaten the viability of the PESM –  which HMRC has the power to withdraw. Another risk is that of lost revenue, as the business may fail to recover all of the input VAT it is entitled to.

These challenges all point to one thing – the need for automation. The increase in regulatory scrutiny and potential simplification of PESM will make it vital that the business can both prove its compliance and make changes more readily, on the fly, in order to get the most out of the methodology.

Similarly, in order to curb the risk of error, we must see a reduction in spreadsheet dependency which needs to be either augmented by or replaced by automation. This will then make it easier to manage the complex aspects of a PESM ie the application of a variety of metrics, across a number cost bases and sectors.

A compliance platform can enable you to address the regulatory and technological challenges the PESM process now faces. To find out how AlphaVAT can help automate your PESM, click here for a one-to-one demo.

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