Making tax digital and PESM

Strictly speaking, Partial Exemption Special Method doesn’t have to be accommodated within the Making Tax Digital (MTD) process at all. The majority of PESMs are performed in spreadsheets today, and as HMRC has conceded that spreadsheets can be used for MTD compliance, PESM calculations can be performed outside the process. Once the necessary computations have been carried out, the results can then be factored back into the VAT Return and digitally submitted.

But PESM is a complex beast. Performing all those cost allocations outside of the MTD process results in a high potential for error. Spreadsheets are a common source of mistakes with 88% containing errors due to incorrect formulas, corrupt macros or human input errors. This is why they are often the first port of call for HMRC when it scans software during an investigation.

Proving compliance

Using a spreadsheet-based approach also means you can’t time stamp adjustments or track back calculations to the original transaction to determine how the error occurred. In effect, there is no digital audit trail. This makes it extremely difficult not only to correct errors but to prove compliance; an issue that is becoming increasingly important as regulators begin to advance their ambitions.

We’re moving towards an era of ever greater culpability where finance and tax teams will be expected to prove their workings. If you can’t evidence your compliance, you create latency within the VAT repayment process effectively suspending the recovery of any input VAT the business may be owed.

With respect to PESM, one of the most common areas businesses fall down upon is their compliance with the conditions of their PESM. Being able to prove you’ve judiciously followed the agreed criteria even when changes have been made is paramount. The business therefore needs to show how any changes, or additions, to cost centres or ERP systems have been updated and reflected in calculation algorithms, transactions accurately classified and allocated to their appropriate sectors, transactions blocked/excluded and that any definitions agreed with HMRC upheld.

Digital links as a game changer

HMRC will also look for evidence of compliance with the second MTD mandate – digital links – due to come into effect from April 2021. While a PESM is classed as an adjustment and can therefore be performed outside the MTD process, the source to submission process must be digitally linked.

Cut/copy and paste of data is disallowed and this has led to a great deal of confusion over how data can then be digitally linked back in. During a market survey conducted in March 2020, we found that 78% of businesses were concerned about the management and calculations of adjustments, including partial exemption, under digital links. An example of how this confusion is manifesting itself can be seen in the query below which was posted in an HMRC forum in February 2020.

“The organisation I work for completes a partial exemption calculation in an excel spreadsheet before submitting our return using bridging software. We download excel reports from our accounting software to use for the calculation. I understand that “cut and paste” and “copy and paste” are not acceptable digital links but is using the function in excel to right click on a tab on a sheet and choose “move or copy” and then picking ‘create a copy’ in another work book acceptable as a digital link as this is more of an automated function than a manual one?”

The answer given was that this would not constitute a digital link and that only a formula mirroring the data would be considered compliant. In short, any form of manual input would break the digital link.

Best practice

HMRC has attempted to clarify how factoring back in to the VAT process would work in VAT Notice 700/22: Making Tax Digital for VAT.  It states that:

“If the adjustment requires a calculation, this calculation does not have to be made in functional compatible software. If the calculation is completed outside of functional compatible software then digital links are not required for any information used in the calculation. However using software for all your calculations will reduce the risk of errors in your returns.”

The guidance therefore clearly implies that using a fully integrated single software solution is preferable because it provides an unbroken digital chain, links the data and reduces the scope for error.

Future ready

Many businesses now acknowledge that making PESM part of the digital end-to-end process under MTD makes sense. They recognise that, in the event of an audit, they will need to be able to demonstrate digital links compliance and so are voluntarily automating their PESM process.

It is also commonly assumed that MTD will eventually encompass PESM. Indeed, in its ongoing consultation on the simplification of PESM, HMRC noted that MTD “has the potential to streamline” PESM and that if automation occurs organically this may reduce the need for further regulation of the process.

So while PESM doesn’t need to be accommodated within MTD, it does need to be digitally linked or uploaded into the Return. Performing it in spreadsheets fails to realise the benefits associated with MTD, namely increased accuracy and efficiency, and means the business can’t benefit from a digital audit trail. For these reasons, performing your PESM within your MTD compliance software is by far the preferred solution.

But is your MTD software up to the task?

AlphaVAT, our compliance platform, now caters for customers operating a PESM scheme, with a PESM Builder application that allows customers to replicate their bespoke PESM calculation within the software itself. To arrange a one-to-one demo to see how AlphaVAT can ensure your compliance, click here.


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