Many financial institutions find VAT reporting challenging due to their complex reporting structures. Organisations have numerous VAT entities that employ differing recovery rates, leading many to utilise options such as Partial Exemption Special Method (PESM) to help manage the recovery of input per sector.

Usually carried out manually, a PESM requires aggregations and calculations to be carried out across multiple data sources and dozens of complex spreadsheets, making for a time intensive, costly and error prone process. For example; a large financial institution we deal with used to spend 15 days annually just checking the integrity of spreadsheets macros and formulas before even starting their transaction reviews.


On top of this, the finance sector now finds itself faced with a number of new challenges:

  1. Making Tax Digital (MTD) phase 2. The second phase of MTD mandates the use of digital links in the VAT process from data source through to the submission.
  2. HMRC is intensifying its efforts to tackle the tax gap and is focused on increasing the compliance yield in the absence of any tax rises. In the budget, the Chancellor stated it will be given a taskforce of 1,000 additional investigators to clamp down on tax avoidance and evasion.
  3. Working practices are being reshaped by COVID-19 with remote working now the norm  This in turn is driving the need for tax process improvements
  4. Brexit. Financial services providers can now recover VAT incurred on costs of supplies of financial and insurance services to EU customers, so many of those who previously chose to put non-UK-based subsidiaries into a VAT Group to enable the supply to the UK to be classed as exempt will now be looking at reversing that decision to ensure supplies can be taken into account when calculating partial exemption.
  5. Future change.  The EU is currently considering the removal of exemption for financial services which could influence HMRC’s working group reviewing UK VAT rules governing financial services”.

So how will the sector adjust to meet these challenges? Why is using a PESM so time consuming? And can the process be made easier? Let’s look at each of theses questions in turn.

Implications of MTD for PESM

HMRC has stated that calculations do not have to be digitally linked. However, in VAT Notice 700/22, the tax authority also directs that “using software for all your calculations will reduce the risk of errors in your returns”.

Digital linking is now going to be a standard VAT requrement, so it makes sense to extend this to the PESM and there are a number of advantages in doing so.

1. Completing calculations in spreadsheets is prone to error. Research suggests up to 88% of spreadsheets contain errors cause by human input, incorrect formulas or broken macros, and as the number of spreadsheets in a process increases, so too does that risk of error.

2. No safety net. There are no alert mechanisms to flag potential anomalies or mistakes. Even if you do detect an error during the review process, it’s very difficult to track back through the calculations  to identify the source. A digitally linked process solves this problem by generating a digital audit trail. It’s even possible to time-stamp and attribute calculations.

3. Digital linking provides evidence of compliance. The tax team can show that the conditions of the PESM, as stated in the letter of agreement with HMRC, have been adhered to, right down to the transaction definitions themselves, helping to answer queries and head-off a possible audit

Time consuming  

PESM utilises a bespoke set of criteria to attribute costs in order to determine the amount of recoverable VAT. It’s time consuming because every stage requires manual processing.  A significant part of PESM process is spent preparing data from ERP and accounting systems, with many financial sector organisations in our experience spending more than 60 days per year collating, identifying, and inputting data for their VAT returns.

Classifying transactions

Classifying transactions is also demanding. Teams can often spend weeks checking the integrity of spreadsheet formulas and then sifting through source data files to correctly allocate or exclude transactions. One of our customers recently had to manually filter in 35,000 transactions to identify just 32 exempt items. And there’s also the risk of missing opportunities to recover input VAT. Moreover, any changes to ERP reporting or cost centres will impact the PESM calculation and so this must be continually monitored and reflected in the compliance process. These factors can mean there is little time left in the compliance cycle to carry out detailed reviews or to analyse tax data to inform decisions.

Can the PESM process be improved?

Digitalisation and the MTD mandate has re-focused attention on the potential automation of PESM. Previous attempts to automate the process met with limited success. This was largely because errors were replicated in the software process as there was no ability to automatically  highlight or query potential anomalies, system change management was complex and expensive, and calculation decisions were often hidden, making it difficult to sanity check the results.

Fast forward to 2021 and technology has come a long way. Software automation platforms can now replicate manual PESM process reducing reliance on spreadsheets, whilst increasing accuracy by mapping transactional data from multiple datapoints to their corresponding sectors. Anomalous transactions and exclusions can be highlighted and flagged, allowing teams to visually check the calculations, and PESM processes can be simply updated by adding or changing data sources or filtering criteria at the click of a button, without the need for external support.

Using a software compliance platform can also allow digital linking of the PESM, so that it becomes part of the fully linked end-to-end MTD process. This allows you to demonstrate the calculation of VAT reclaimed on purchases using your methodology, from the PESM calculations, to adjustments, right back to the underlying transactions, reducing the likelihood of investigation.

Use case: Large financial provider

The business manages funds of in excess of £50bn and uses a sectorised Partial Exemption Special Method (PESM) spanning 20 sectors. It employs six allocation steps, uses multiple spreadsheets (including one large central calculation spreadsheet), and reports on tens of thousands of transactions (accounts payable and receivable) per quarter.

Using the MTD process as a catalyst to justify automation, the company expects to dramatically reduce the time dedicated to checking calculations and allocation adjustments. The digital audit trail that will also enable it to prove its compliance to HMRC as well as to demonstrate its compliance with the ‘systems and delivery’ elements of the Business Risk Review +, helping to reduce the company’s risk rating.

How Tax Systems can help

AlphaVAT, our VAT compliance platform, now caters for finance organisations operating a PESM scheme with an integrated PESM Builder module that allows exact replication of a bespoke PESM calculation and the ability to create a digital audit trail from source to submission.

The PESM Builder application automates the cost allocation process, ensuring that any VAT that cannot be reclaimed is automatically blocked or excluded, attribution rules and recovery percentages are automatically created and are used to enable multi-level allocations and transaction movements between sectors. But the ability to manually review the process remains so you can check the calculations as you go. Anomalies in source data, such as unexpected VAT rates, intergroup, out of period or duplicate transactions, are highlighted, for example, allowing manual adjustments to be made prior to calculation and submission.

Automating the bulk of the process not only increases accuracy and efficiency but also frees up time to dedicate to analysis. The tax data analytics function in AlphaVAT allows you to compare current and historic submissions, providing insight into data quality and error rates or unusual deviations: information that can then be used to support future forecasting, such as forward liability projections.

Automating your VAT can provide you with a more accurate and robust process that can withstand the scrutiny of HMRC and keep pace with regulatory change. So that, in the event you do restructure, your VAT process can change with you.

For a one-to-one review of your VAT process and to find out if you could use AlphaVAT to automate your PESM, contact us today.