Policy Memorandum Feb 11 Final.doc

Policy Memorandum following adoption of Automatic VAT Refunds Processes

Introduction.

As part of the Government’s stated aim of moving to the operation of a full VAT input/output system over time (Letter of Intent to IMF June 2010) another step has been taken towards that aim with the repeal of the absolute need for audit or survey prior to refund coming into force on the 1st January 2011.

Due to various attempts over the years to stop fraudulent actions by uncoordinated Law Amendments the Armenian VAT Law and procedures are out of step with the basic principles and concept of the Tax. As usual the problem centres on the issues of allowable inputs, repayments and carry forward of excess input tax.

Most of the Law and related decrees, orders, instructions etc. appear to be designed to restrict the normal internationally established best practice of accepting commercial invoices and actual repayment or offset against other government liabilities at the earliest opportunity. Until recently there has been no incentive for the SRC to process any application for repayment or offset as there has been no sanction if they exceeded the legal time limits for action. But the Government has now changed that by introducing interest payments to the taxpayer if the repayment or offsetting is beyond the legal time limit. (Another move towards a full system).

The problems of dealing with excess VAT inputs in developing countries are well understood, the financial pressures refunds cause and the opportunity for fraud are well known. But Armenia has for too long ignored the fact that many of the Laws and procedures have turned the Tax into a tax on business as well as a tax on consumers. Delaying repayments for some limited time or by staged time periods have not been uncommon in developing economies and Armenia is gradually reviewing the situation but has not stated a clear strategy to improve the situation for compliant taxpayers.

The VAT Law, Regulations, Decrees etc are numerous and the Law on Taxes does create ambiguity for the rules on offset and repayment especially after the change noted in the first paragraph of this Introduction. A consolidation with clarification could be of major benefit at this time.

Review of Current Situation

With the work being undertaken to computerize the Automated VAT Refund procedures it became clear that the various Laws, Decrees, Regulations etc., covering the status of excess inputs were causing confusion and in some cases contradiction in the administration of refunds and offsets. The change in the Law that made refunds and offsets allowable without audit or survey was only made to the Law on Taxes and although Annex 1 to the RA Law “On Taxes” (Clauses 8.4. and 9.3.) may be the over-riding Article there are many references to the need for audit/survey prior to refund/offset in other Articles in the Laws and Decrees relating to VAT. The comprehensive list of these conflicting Articles that was written by the Project in February 2010 and sent to the SRC has been attached as for information at the Annex.

The lack of any VAT registration requirements for taxpayers who exceed the monetary limits set out in the Law is a serious handicap when trying to manage and control the tax. It leads to all kind of disputes and makes monitoring the chain of inputs and outputs far more difficult.

Together with the above other issues of procedure and policy have become more pressing for clarification with introduction of automatic refunds and they are discussed below.

· The Return and Application issue.

Generally international best practice is to treat each VAT Return as a separate declaration and if the declared liability is a negative amount this will automatically be repaid or offset following various electronic risk assessments and other credibility checks. There is no requirement for application or presentation of supporting documentation. If the Return does not pass the tests, the risk assessment will indicate if the automatic repayment should be withheld for audit prior to payment, a post repayment check should be made during the next routine audit or some other action is needed.

The present culture in Armenia sees little relationship between the VAT Return and the Refund/Offset Application. The taxpayer has the option to make an application immediately after filing the VAT Return or they can let the debit (Taxpayer’s credit) accumulate over a number of periods before they make application. Information obtained tends to indicate that applications are not made on a regular basis even with compliant taxpayers because taxpayers feel an application will result in an Inspector visit/audit which is to be avoided at all costs. Conversely, therefore, it would seem that if the fear of an audit/visit was removed most refund taxpayers would prefer to get the repayment into their cash flow forecasts as soon as possible and would start making applications with the Return.

The setting up of an automatic refund system should move the SRC towards treating the Return as either a declaration of payment liability or repayment liability. As a minimum the SRC should be encouraging taxpayers to regard the Return as the primary document for Refund/Offset claim and eliminating any need for an application.

The peculiarly Armenian tradition of paying in excess of declared liability will also complicate the automatic refund system with amounts held on the ledger that relate only to, at best some advance non specific payment and a figure that cannot be audited in any particular way than a gift/loan to the Budget.

· Amended Returns.

Another Return issue that has to be addressed is Return compliance criteria, as taxpayers frequently file amended Returns which appear to override the previous one and becoming the primary document which could well be ‘late’ within the rules but because of the ‘amended’ status does not get a penalty and does not appear to be treated as a default in any way. This is bad practice and alteration to the first filed Return figures should be treated as an amendment not simply allow the original declared liability to be secondary in the data base. Any change to the original declaration of the taxpayer’s liability should be treated as an official variance and recorded with details of the new calculations and reasons for the change.

· Synchronize the Return and Repayment Actions for Automatic Repayment issue

As noted previously the lack of current relationship between the timing of the filing of the Return and submitting of the Application will cause many complications for an automated system.

The concept of the automatic refund/offset system is to electronically verify the credibility of the ‘debit’ Return together with the historical credibility of the taxpayer as soon as the Return is filed, to inform the automatic repayment process. This is not easily achieved in Armenia because only Exporters can have refunds and only some inputs will qualify for inclusion in any refund/offset calculation. Additionally some debits will be just a temporary stage in the general VAT payment cycle of a taxpayer and will disappear with the next return.

With the current system the Return is not necessarily identified as a Refund/Offset case until the Application is made and studied. With the proposed system if a debit Return indicates a repayment is due it will be entered on receipt into the VAT Automated Refund System and it will automatically be transferred and assessed in the VAT Refund/Offset sub-system.

· Carry forward excess input tax to next Return

When the policy is only to make refunds to Exporters, any excess of inputs over outputs in one accounting period must be carried forward to the next reporting period as explained above.

Currently the invisible “debit” held on the SRC ledger is not shown on the next Return. Thus only when the taxpayer decided to make application for refund or offset the figure for refund would be the total amount shown on one or more Returns ‘debit’ for refund or offset.

To overcome the problem of taxpayers making “unofficial advance payments” as noted above they should be encouraged to immediately assign the ‘balance’ to the tax they are saving for. This strange excess paying habit only serves to distort the overall revenue receipts of the VAT.

In order to achieve this, the debits indicated on Returns will have to be shown as C/Fwd. B/Fwd. figures and refunds/offsets received by the Taxpayer shown as a balancing figure in the Return when the payment is received.

The recent revised VAT Return form will not fully address these issues and the invisible ‘debit’ will remain.

· The cash accounting and accrual accounting requirements.

When there are different rules of accounting for sales and purchases the cash flow of a business can become distorted and vulnerable. When VAT inputs are subject to cash accounting and VAT outputs are subject to accrual accounting the business is subjected to severe policing of purchase invoices prior to settlement but for sales invoices policing is reversed and payment of tax must be made irrespective of settlement.

The reasons for the current policy are to safeguard the revenue but it is not best practice and VAT has been in force in Armenia long enough for techniques to have been introduced to identify fraudulent invoices rather than forcing all businesses to adopt unfair accounting practices.

Articles involved are; RA Law on VAT, Article 24.1 and 31;

· Review the policy of allowing only some cash transactions to qualify for input credit.

Once again this policy is designed to protect the revenue but the rules are not clear as to what cash paid purchase invoices can be included as inputs. They should be precise and clearer ensuring compliant taxpayers are not penalized due to the dishonesty of a few.

Articles involved are: RA Law on VAT, Article 23.

· Total Export input claim restricted to 20% of export sales value.

This restriction should be used as a credibility check for the claim but it should not be Law. In some reporting periods the sum of the purchase inputs plus the overhead inputs will legitimately exceed 20% of the export value. For example when for some reason the inputs in a period are about average but the outputs are unusually low the excess could well be in over the 20% but outputs being high the following period will not help the loss of the previous period. If the excess is disallowed this will be lost when in subsequent periods the total inputs claimed is well within the 20% limit. This policy effectively causes export prices to be higher as the non repayment of all VAT business expenses will affect the costs and pricing policy of the taxpayer.

Articles involved: Annex 1 to the RA Law on VAT, Clause 9.

· Inputs on Capital Goods

Review the policy regarding purchases of capital goods and the related VAT inputs causing lengthy periods of unrecoverable VAT credits (debits in Armenian VAT Return usage). Currently only some goods on the external economic activity list and specifically selected imports qualify for some level of deferment of VAT payment. This policy is not good for potential investors who will regard this as having large amounts of money tied up in Government tax. Furthermore control of this deferment remains with Customs and it would be more effective and efficient if the deferment monitoring passed to SRC as part of the whole activity control of internal VAT.

Articles involved are; RA Law on VAT, Article 6.1 - 6.

The VAT regime has been in operation for some years now and generally business regards it as being operated by the SRC as a tax on them. In some quarters it is believed that the SRC, the Ministry of Finance and the Government regard it as a tax on business and not a consumer tax at all. Many policymakers do not seem to understand that it is a normal feature of the tax that a large percentage of the gross VAT revenue will be repaid to businesses.

Recommendations

As Armenian taxation policy gradually moves to a full VAT input/output system the need to have a fully synchronized and fully operational refund system in place to cope with the additional workload becomes more pressing. Taking the findings of the above Review into consideration the following items must be addressed to produce a set of Laws, Decrees and Regulations that give clear and unambiguous guidance to ensure sound administration of the full VAT input/output regime.

· It is recommended that the requirement to be registered with the SRC when trading activities exceed the threshold is implemented. Creating a register of VAT authorized taxpayers is internationally common practice and should be adopted in Armenia. The current Law is not firm enough in putting the responsibility on the activity/individual to comply with the Law on VAT. The Registration certificate that would be issued by the SRC would give authorization to charge VAT and issue VAT invoices making it more official and more controlled.

· It is recommended that all references in the Laws, Regulations, Instructions etc. to audit, survey or review needed before Refund should be removed or amended. This will ensure that one single approach is taken for VAT refunds and offsets in the future. (The Annex gives a list of the main Articles involved).

· It is recommended that the Law and current practical applications regarding submission of amended Returns are reviewed to ensure the facility to amend Return details is not abused. This facility is designed to enable the taxpayers who find a genuine error in their legally filed Return to change the details. It is not designed to enable taxpayers to file a Return knowing it will be amended later just to file on time and avoid the late filing penalty.

Articles involved: RA Law on VAT, Article 33.

· It is recommended that excess VAT inputs being applied for, should be synchronized with the current period VAT Return. Although the newly developed VAT Return and Refund Application Form has helped to improve the situation it has not gone far enough in establishing that the Return period and the application must be synchronized. Any excess of VAT inputs must be carried forward each period if an application is not made and it will be this figure that will finally become the figure for the application when made.

· To assist with the above recommendation it is further recommended that the VAT Return be reviewed and simplified to include the brought forward (B/F) and the carried forward (C/F) figures for any input credit arising from the calculations. This will eliminate the current “invisible credit” being held on the SRC database and enable the Return form to need only a tick indicating a refund/offset was required.

· It is recommended that the Article 23 relating to the eligibility of inputs and outputs to be included in the VAT Return be reviewed. Currently there are confusing restrictions as to the eligibility of inputs for credit. (Type and timing) These should be reviewed, simplified and brought more into line with international practices.

· The use of cash accounting for inputs and accrual for outputs plus the exclusion of some cash transactions has a detrimental effect on the taxpayer’s cash flow and leads to the Tax becoming a Tax on businesses rather than the consumer tax it is. (linked to the point above)

· It is recommended that Clause 9 in Annex 1 to the RA Law on VAT relating to restricting the repayment of excess input tax for exporters to 20% be reviewed. The current legislation only applies to exporters but could relate to other activities in the future and the exclusion of some legitimate business expense inputs is not the VAT Law intention.

· It is recommended that the Article RA Law on VAT, Article 6.1 – 6 relating to the refund of input tax on capital expenditure be reviewed and updated. The current time periods for deferments are confused and over complicated as to which goods are eligible. Any large investment in the country has to accept that the VAT paid on import would remain held by the Budget for some considerable time before any offset would be forthcoming. This is not a good policy to encourage investment. The control of deferment should be undertaken by SRC once grant by Customs at import. This would enhance the ‘whole activity’ approach for internal VAT control

· Throughout this element of the Project it has become clear that the quality of Drafting Articles for Amendment and Decrees for Government approval is in need of some modernization and improvement. The legalistic flowing Armenian of long sentences and little punctuation should be curtailed for shorter more clear statements. Both the Taxpayer and Government staff having to deal with implementation would benefit from clear and concise intentions being expressed. The drafting presently follows old rules and traditions but in many instances too much detail is included, restricting implementation and necessitating further amendments. It is recommended that both SRC and Ministry of Finance review their legal drafting responsibilities and standard of work and also review the extent to which internal processes and procedures which can be covered by regulations or instructions are currently being included in high level policy legislation.

Conclusions

The recommendations made above have mainly come from the observations made during the Project task of setting up a VAT automated refund system.

The recent changes to the Law and some current practices have helped move the VAT regime a little closer to a full input/output system but much more needs to be done. The recommendations made will facilitate much of the day to day actions of the VAT function and enable the SRC staff to have clear and unambiguous instructions on how to carry out their responsibilities.

The World Bank and IMF Mission Reports over the years have highlighted the need for the whole VAT framework to be moved to a more acceptable international standard at a faster timescale. But this has not happened. These recommendations go some way to assist in the bigger task but they would certainly make great strides in helping solve the problems in the treatment of VAT inputs and outputs.