Partial Exemption Special Method (PESM) is a process that begs to be automated. Based upon a set of unique metrics agreed in advance with HMRC, it seeks to allocate recoverable input VAT in a fair and reasonable way but is highly complex to manage. Ensuring costs are correctly classified and allocated in accordance with the agreed PESM methodology makes for a resource intensive manual process and one that is highly susceptible to error.
Technology vendors have previously attempted to automate the PESM process but with limited success. Such efforts typically mirror the company’s manual processes, replicating the data (and potential errors) within spreadsheets, rather than streamlining and adding value to the process. This has provided very little incentive to invest in automation but that’s all now changing due to a number of regulatory drivers and technological breakthroughs.
What makes automation difficult?
Automating PESM calculations raises significant challenges as the solution needs to be able to interpret the conditions agreed in the letter of approval received from HMRC and meet the requirements specific to all special methods which should:
- Reflect all your business activities
- Provide for direct attribution of input tax to taxable supplies
- Provide for direct attribution of input tax to exempt supplies
- Identify residual input tax
- Calculate the element of residual input tax that relates to taxable supplies
- Calculate the element of residual input tax that relates to exempt supplies
- Allow you to determine the total input tax that you can recover
Within each of these steps are further processes and checks and balances. All transactions relating to input tax need to be accurately classified and allocated to their appropriate sectors prior to calculation, for example. Certain transactions will need to be blocked from recovering input VAT and excluded from the VAT calculation, such as cars or entertainment expenses. And any changes or additions to cost centres or ERP systems must be proactively updated and reflected in the PESM calculation algorithms.
Why is automation now feasible?
Regulation in the form of Making Tax Digital for VAT has centred attention on how we calculate PESM. The digitalisation of the process does not have to include PESM but many businesses are naturally looking at extending automation to include this adjustment. There’s also a general consensus that it will eventually be made part of MTD further down the line.
But regulation isn’t the primary driver here. It’s the need to achieve greater accuracy and efficiency that is really concentrating hearts and minds. Businesses recognise that manual processes are too unwieldy, too time consuming and too prone to error. For instance, one large financial institution spent 15 days annually just checking the integrity of its PESM spreadsheets before starting the transaction review.
Alongside this desire for change, technological advances have been made. It’s now possible to build a virtual PESM process from the ground up so that you can precisely map the process to the requirements of the PESM and even reuse those settings for subsequent submissions. Filters can be applied to make sure cost allocations are applied to the right business centres while unique identifiers can flag data that may need to be blocked or excluded. All of these procedures can be recorded in a digital audit trail to prove your compliance with the PESM detailed in your letter of approval from HMRC.
Why should I automate my PESM?
Previous generations of product struggled to automate PESM because of the way they approached the issue. They sought to process the data taken directly from spreadsheets, so failed to address the problem of source data quality, and in doing so often replicated the errors these contained. They also didn’t offer any value such as filtering, flagging, diagnostics and reporting. Plus there was often little technical support, resulting in teams drifting back into old spreadsheet habits.
The advances made over recent months mean automation is now not only viable but confers numerous operational benefits. Using a compliance solution enables you to:
- Prove compliance – An automated, digital audit trail can demonstrate compliance with the HMRC approved PESM scheme. It also shows the connectivity between calculations, adjustments and the underlying transactions themselves, thereby ensuring compliance with the next stage of MTD.
- Be more accurate – Reducing dependency on legacy calculation spreadsheets improves the accuracy of submissions as there is less scope to introduce human error. As the process uses data at source, recovery percentages can be directly calculated from this source data
- Automate cost allocation and filtering – Software generated templates allow you to map financial transactions to the correct business activities while customisable searches can highlight anomalous transactions and those that should be excluded from calculations
- Carry out efficient reviews – Visual checks, both pre- and post-calculation, can be more targeted, thanks to customisable searches and exception reporting.
- Perform trend analysis – Data analytics within the software can be used to compare and contrast historic returns, identify anomalies and potential errors as well as for forecasting future liabilities
- Repeat Returns – Data tagging and templates can be used to create successive Returns, simplifying the process
- Take control of change management – Changes to cost centres or ERP reporting can be updated in-house so that the business no longer needs to pay for external expertise. This is likely to become increasingly important if HMRC decides to make it easier to change the conditions of a PESM, an issue it is currently considering as part of the simplification of the process.
These accuracy and efficiency gains, coupled with the direction of regulatory travel, make for a compelling case for automating this manual process. Doing so will free up considerable time and resource and make it easier to manage, allowing changes to be made more readily.
To find out how you can automate your PESM, click here to request a demo of our AlphaVAT compliance platform.
