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Will PESM always be too complex for MTD? 

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Will PESM always be too complex for MTD?  1

Partial Exemption Special Method (PESM) is classed as an exception under MTD. So does this mean financial organisation will miss out on the advantages associated with the technology used to automate the tax process?

 By Russell Gammon, Chief Innovation Officer, Tax Systems

Many financial providers and institutions use Partial Exemption calculations in the production of their VAT; two separate methods (standard or special method) can be used, depending on approach. The special method “PESM” is a process that allows a bespoke calculation to be applied to ensure the fair recovery of VAT, albeit a complicated one that is resource and time intensive. And yet digitalising the PESM process is not mandated under Making Tax Digital.

In VAT notice 700/22, HMRC says that, while it is permissible to perform calculations outside of the MTD compatible software, the inference this is not recommended: “however, using software for all your calculations will reduce the risk of errors in your (VAT) return”. By carrying out PESM manually, businesses will miss out on the accuracy and efficiency gains associated with technologies used to comply with MTD.

Why does it matter?

The idea with digital linking is that, by minimising human intervention, it reduces the likelihood of error. Digitalising the process also ensures the process becomes more efficient and productive, requiring less resource. If PESM continues to be performed manually it won’t benefit from automation that could no reduce the time taken to perform the calculation, enable checks to be made to verify calculations or ascertain any missed opportunities to recover VAT, or a digital audit trail be used to prove compliance, for example.

So what does this mean? In effect, while the MTD regulation fully applies to those using a PESM, it could result in a part manual part digital process, which is far from ideal. It makes much more sense to choose to automate your PESM in order to reap the benefits associated with MTD. This begs the question, why didn’t HMRC extend the digital links requirement to include PESM?

The problem is that each and every PESM is unique which means the process used to deliver it has to be as flexible as possible in order to mirror the company’s specific circumstances. I believe it’s for this reason that HMRC has steered clear of mandating the digitalisation of PESM, instead allowing businesses to stick with their existing processes.

Barriers to automation

HMRC is right to consider PESM as complex. Most financial service institutions run extremely complex calculations across linked spreadsheets. Teams will often have to sift through source data files to count transactions, class these and then calculate a recovery percentage, necessitating the addition of extra fields to spreadsheets. This can see spreadsheet formulas fail, jeopardising the accuracy of the calculations.

It’s not uncommon for financial institutions to have to pull data from dozens of data sources and a similar number of spreadsheets relating to percentage recovery calculations. This often results in high levels of manually intensive data processing in order to ensure the resulting figures are correct. For example, one large financial institution we deal with spent 15 days annually just checking the integrity of spreadsheets before starting any transaction review.

All of these reasons make a compelling case for the automation of the PESM process. The problem is that attempts to automate the process have struggled because each PESM is so unique, which means that generic software often fails to cater for the nuances of the calculations required. It needs to be flexible enough and dive deep enough to ensure accurate results but that’s not the approach many have taken.

As PESM is regarded as an aspect of VAT, solutions have typically followed the same development pathways. This means they’ve tended to begin not with the source data held in ERP and accountancy systems, but with the data held within spreadsheets. Consequently, if those spreadsheets contain errors, these are then replicated within the new system.

Such solutions also tend to obfuscate rather than simplify and create transparency.  This makes it very difficult for the finance professional to see what’s going on under the hood, causing problems when they need to evidence where transactions have been excluded, or to query, track back and correct calculations, for instance.

Russell Gammon

Russell Gammon

So can I automate my PESM?

MTD may not compel you to digitalise your PESM but that shouldn’t deter you, particularly given that there’s the prospect of further change on the horizon. Last year HMRC opened a consultation on the simplification of the PESM process in which it stated that MTD “has the potential to streamline” PESM if automation occurs organically. This suggests that, unless PESM is automated by association, we can expect further regulation in the future that will bring it within scope of MTD.

The same consultation also mooted the possibility of making it easier to amend a PESM, which could see businesses find it easier to tweak their PESM without the need to reapply to HMRC. If this were the case, organisations could then manage their PESMs more dynamically. But today they’re hamstrung by expensive costs incurred when they need to make changes to their financial systems, as well as the fact that having a new PESM approved by HMRC is a lengthy and costly process Automation would allow such changes to be made inhouse by the finance team, putting them back in control.

So if you do decide to act now and include PESM as part of your MTD strategy, what options do you have? Thankfully, automation has come a long way in the intervening years and there are now solutions out there dedicated to the process that can accommodate the intricacies involved i.e. applying numerous recovery metrics and attributing costs across numerous cost bases, even for those using the sectorised method.

Automation in action

There are plenty of examples of businesses that have already streamlined their PESM, showing that there is value in doing so even without the MTD mandate coming into play. This also helps evidence their compliance with their PESM letter of approval from HMRC.

For example, we have worked with a large financial institution managing funds in excess of £50bn. With over 20 sectors and six allocation steps, involving multiple spreadsheets, the business was routinely reporting on tens of thousands of transactions per quarter.  It had to use a third party to make any adjustments to its PESM, resulting in a five figure fee annually, and spending over 15 days a quarter managing transaction allocations and ensuring that all line items were classified in accordance with the HMRC agreement. Blocking and excluding transactions was also laborious and in its latest reporting period, 35,000 transactions had to be manually filtered just to identify 35 non-claimable items.

The business has since automated its PESM. It will now be able to automatically map financial transactions to the correct business activities but can still carry out visual checks pre- and post-calculation using customisable searches and exception reporting. Data analytics provides the capability to compare and contrast historic returns, identify anomalies and potential errors, and forecast future liabilities, while software generated templates allow the process to be performed more quickly next time around. As a result, the business is going to be able to significantly streamline its PESM and reduce the time dedicated to preparing the return.

Grasping the initiative

HMRC has clearly felt the need to tread the middle ground when it comes to the automation of PESM. The complexities of PESM mean many businesses have in place bespoke manual processes which, while laborious and time consuming, were the only option available to them at the time. Given that many vendors have struggled to automate the process, it made little sense for HMRC to step in and mandate it.

Yet the tax authority clearly recognises PESM is ripe for reform and needs simplification. It’s hoping that there will be some degree of self-regulation, with businesses choosing to automate the process as part and parcel of their wider tax strategy. Indeed, many will find it makes sense given the need to digitally link in their calculations to the returns process, which is why we’re now seeing such interest in automation.

The danger is that, post-April, many financial organisations will find themselves part-digitalised with the worst of both worlds: manual processes that are difficult to review and a digital submission process that prevents them from back tracking. That’s why it makes sense to grasp the initiative today in order to benefit from the transparency, accuracy and efficiency gains of MTD. Only then can these businesses make their own changes, manage their own process dynamically, and unequivocally demonstrate their compliance with their PESM.

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