The report, produced in collaboration with the Ernst &Young /SKOLKOVO Institute for Emerging Markets Studies, defines the middle class as people earning between US$10 and US$100 per day. At this level, consumers start having the kind of disposable incomes that will allow them to buy the cars, televisions and other goods.

People in this income bracket can be considered a “global middle class” – middle class by the standards of any country.

In Asia alone, 525 million people can already count themselves as middle class – more than the total population of the European Union. Over the next two decades, it is estimated that the middle class will expand by another three billion, coming almost exclusively from the emerging world.

A significant proportion of the new Asian middle classes are also expected to be at the upper end of the income bracket and boast impressive spending power.

Alexis Karklins Marchay, co-Leader of Ernst & Young’s Emerging Markets Center, says:

“By 2030, as more and more people enter the middle class it is hoped that this growing cohort of consumers with new money and new demands can help to keep the floundering global economy afloat.”

Chinese middle class expected to reach one billion by 2030

China and India will become the powerhouses of middle class consumerism over the next two decades although other rapid-growth markets such as Mexico and Brazil will also contribute. Nevertheless, the Chinese and Indian contributions will be substantial.

Today, China has around 150 million people who are considered to be part of the global middle class within the next decade this expected to have reached 500 million. By 2030 around one billion people in China could be middle class – as much as 70% of its projected population.

India’s global middle class, meanwhile, is much smaller at around 50 million people, or 5% of the population. EY estimates that this group will grow steadily over the next decade, reaching 200 million by 2020.

After this, India’s middle class growth is really expected to accelerate, reaching 475 million people by 2030 and adding more than the Chinese to the global middle class worldwide after 2027.

A changing world

By 2030, there will be a much broader distribution of incomes around the world. While millions have been brought out of poverty over the last few decades it is only recently that we have begun to see the impact of the rising middle classes across the emerging markets.

However, the report suggests that despite the growth of spending in emerging markets far outstripping developed market spending in recent years, there is still some way to go before contributions reach parity.

Although emerging markets consumption is not sufficient to cause a return to pre-2008 global growth rates, it may be enough to prevent a return to global recession in the next few years (providing that consumption in developed markets does not decline).

Alexis comments:

“The emergence of a new middle class, with spending power to match developed nations, will offer tremendous opportunities to businesses. These opportunities can arise very quickly, and multinationals need to be ready to respond.

“Business opportunities will not be confined to consumer goods: the emergence of a wealthy middle class will also open up the markets for financial services or the health sector, for instance, in new territories.”

Read more: Hitting the sweet spot – the growth of the middle class in emerging markets

Questions or comments? Contact T Magazine and Ernst & Young

In recent years, some of the major life science companies have begun to focus on this area in order to reduce net VAT cost and optimize cash flow.

Industry leading practice

A number of factors are causing multinational businesses to focus on managing VAT more globally, including better awareness and understanding of both the complexities and amount of VAT to be managed and the benefits of having higher standards of VAT management.

Better management minimizes the risks of large VAT assessments, of which there have been many in the industry, while increasing the ability to secure refunds, improve cash flow and reduce cost.

Not only is VAT throughput, use of shared service centers and VAT cash flow of ever increasing importance in the complex supply chains of the life sciences industry, an ability to manage significant irrecoverable VAT costs in key areas such as clinical trials and emerging markets only add to the increasing importance of VAT in the sector.

On the operational side, apart from the ongoing challenge of building the complex supply chains in ERP systems or tax engines, another critical development is the use of shared service centers. Invariably these centers offer great savings due to the unified processes and lower labor costs.

However, from a VAT point of view, local knowledge is often lost and errors with processing invoices are, in fact, increasing. This requires a stringent process and control environment characterized by specific VAT automation, data analytics and workflow management.

The key here is to find the technology solution that fits the business and means that a strategy should be developed to make the right choices.

Greater patient connectivity — the VAT impact

As supply chains move toward more business-to-consumer (B2C) flows, there will be a significant impact on a life science company’s VAT footprint, especially if these changes are combined with a centralized cross-border selling model.

Within the EU, sales to private individuals are subject to VAT in the country of dispatch, unless registration limits are exceeded in the member state of the customer or where a voluntary registration is sought.

In the latter case, VAT is charged in the country where the customer resides, resulting in the possibility of multiple VAT registrations in many EU member states and adherence to local administrative rules. This will affect a company’s ERP system and setup, increasing the overall compliance burden.

It is therefore important that the tax or finance function is made aware of such critical business model changes in a timely fashion to ensure compliance with the rules of each state.

VAT exemptions on personalized medicines

The shift to more personalized medicines brings possible VAT exemptions. While this is good news for the customer, the downside for companies is that all associated VAT on costs, including research and development (R&D), will be non-recoverable.

This may have a severe impact on the company’s cost model. The gross margin of the new product will come under pressure and could be negative in some cases. We expect this trend to continue, especially in the EU, with some member states already applying such an exemption on personalized medicine.

VAT on clinical trials and CRO management

As more and more clinical trials move to emerging markets, there is an increase in irrecoverable VAT due to the high import rates on pharmaceutical products. These amounts are irrecoverable because the importer does not take title to the clinical materials or resell them in the market, which is a usual condition for VAT recovery in emerging markets.

This applies whether the importer is a clinical research organization (CRO) or local affiliate. It is therefore important to verify local rules on recovery, try to utilize specific applicable regimes to minimize VAT, or attempt to restructure the transaction to recover VAT through an affiliate.

Another method for managing indirect tax is to develop a global policy around valuations for “non-commercialized” shipments, such as clinical trial materials.

VAT issues on major acquisitions and disposals

With the sector experiencing increased mergers and acquisitions activity, careful consideration should be given to the increasing technical complexity surrounding VAT recovery on acquisition costs and share deals.

For example, the European Court of Justice case law is becoming more and more stringent on this point. Proper structuring of the deal in advance is critical to prevent unexpected VAT costs later on.

Optimizing VAT throughput in complex pharmaceutical supply chains and changing business models

Supply chains within the life sciences industry remain very complex, with legislation struggling to keep pace with developments. This often results in complex VAT outcomes and difficulties in setting up transactions in ERP systems.

When this is coupled with centralized selling and manufacturing models, it often means that a single entity requires a multitude of VAT registrations with an increased administrative burden. It is still possible to plan and utilize certain reliefs that mitigate cash flow, but obviously proper consideration is crucial prior to implementation.

Conclusions

In conclusion, while VAT is, in essence, a simple tax, individual country rules and interpretations result in a complexity that is likely to test the tax management resources of any organization.

Historically, while the response by business to managing the tax has been varied, many companies have left the accounting and compliance responsibility for VAT to the finance department and have relied on the tax department to deal with issues as they arise. This is a reactive approach, meaning in many cases that it is too late for appropriate action to be taken to secure refunds or mitigate penalties.

Given the amount of VAT that has to be managed each year by companies in the life sciences sector, and the industry-specific additional VAT issues that must be dealt with, there is a clear and direct benefit from taking a proactive approach to managing VAT for the benefit of the organization.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

Questions or comments? Contact T Magazine and Ernst & Young

An OECD “forum” is a special form of government meeting used by the OECD to enable the association of non-OECD economies in particular areas of the organization’s work.

The first Global Forum on VAT brought more than 85 country delegations from all continents together with international organizations and academics to explore key policy trends and their impact for tax administrations and businesses.

A few business representatives, including Ernst & Young, were also invited to a part of the meeting. This is the largest meeting ever organized worldwide at the governmental level with respect to VAT/GST. The organization of this historic event illustrates the growing importance of VAT/GST and its recognition by governments worldwide.

The first Global Forum on VAT

• Implementation of VAT from a global perspective: The aim was to set the scene by providing an overview of current policy and administrative developments in the implementation of VAT in both emerging and developed economies and by presenting the EU experience of operating VAT in a regional trading bloc.
• Applying VAT to international trade — the challenge of economic globalization: This session explored the challenges to the principle of “taxation at destination,” the standard for applying VAT in an international context where exports are zero-rated and imports are taxed in the importing country at the VAT rate applicable to domestic production. This principle creates particular challenges with the growing international trade in services and intangibles as these items are not subject to border controls.
• The OECD International VAT/GST Guidelines: Panelists presented the ongoing work on the development of the OECD International VAT/GST Guidelines, intended to become the internationally agreed standard for a consistent VAT treatment of cross border trade. The presentation focused on VAT neutrality in an international context and the allocation of taxing rights on international trade in services and intangibles.
• Designing efficient and equitable VAT systems: As VAT is a major source of government revenue, the design of VAT regimes can potentially have a significant impact on a country’s economic performance. In this context, the main drivers discussed were the tax base (revenue and economic effects of broadening VAT bases), the rate structure (single rate versus reduced rates), the determination of an appropriate registration threshold and, more generally, the distributional impact of VAT, while bearing in mind the political obstacles to eliminating reduced rates and exemptions.
• Managing VAT administration and compliance: This session explored the possibility to measure VAT compliance costs (as VAT is regarded as the most burdensome of all taxes for businesses) and different approaches to tackling VAT fraud and avoidance. The key question addressed was whether it is possible to develop an effective strategy against VAT fraud and avoidance without imposing excessive administrative burdens and compliance costs on businesses.

Business representation

Although the Global Forum on VAT is a meeting at governmental level, businesses were given the opportunity to participate and to report on their concerns about having to deal with VAT.

The business representatives who were invited to make a presentation explained that their main concern in conducting cross-border trade is the neutrality of VAT (i.e., that it should not be a burden on businesses).

They set out their view that this neutrality can be achieved only through the widespread application of the destination principle and efficient VAT refund mechanisms. Businesses reported to governments that VAT has now become a major driver for investment decisions and that VAT can even turn out to be a “show-stopper” to investing in some countries.

Conclusions

The Global Forum concluded that there is a strong need for internationally agreed principles on VAT.

It set out that its key objective should be to build the largest worldwide consensus on the OECD International VAT/GST Guidelines as the future international standard for applying VAT to cross border trade with a view to minimizing risks of double taxation and unintended non-taxation.

The OECD International VAT/GST Guidelines should be completed by 2014 and will be presented for endorsement by the Global Forum on VAT at its next meeting, expected to be held in early 2014.

We will continue to actively support and contribute to the work of the OECD in this important area of indirect tax policy, and we will report on progress and developments as they evolve.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

Questions or comments? Contact T Magazine and Ernst & Young

Given this environment, our clients often ask us if one organization can provide a truly global payroll solution. In other words, is global payroll a myth or a reality?

We decided to seek some answers by starting with just a single question on LinkedIn to find out if client and vendor organizations believe a single, consistent global payroll model exists:

Do you believe there is a single provider in the market today, regardless of the service delivery model, that can support the payroll needs of a global enterprise actively engaged in 90+ countries?

The responses were almost evenly divided: while service providers strongly believe that global payroll was a reality, most organizations (or buyers) strongly disagree.

One could easily debate the point from both sides:

• Organizations (buyers) are looking for the confidence delivered by a truly global service delivery model using standard, consistent systems and processes that are compliant with local regulations delivered by a single global company.
• Service providers (vendors), however, argue that they can deliver the best solution for their customers by diligently managing and overseeing their global network.

As a result of these opposing perspectives, Ernst & Young sponsored this survey to gain a better understanding of how organizations perceive global payroll within the context of their cultures and governance models.

The survey focused on the experience of organizations with delivering payroll either in-house, via external vendors, or a hybrid of both. It was designed to understand the operations and processes currently in place in multinational organizations and to explore what might be needed in the future.

Whether global payroll is a myth or reality, the fact is organizations, both public and private, need to pay their employees in a timely, accurate and compliant manner.

Thus a question remains: what are the best practices for multinational organizations, especially those entering new or perhaps emerging markets?

Conclusions

As the survey revealed, many organizations continue to be skeptical about whether any payroll provider can deliver a comprehensive global payroll solution. While that skepticism has some validity, the survey results also suggest that some organizations do not see the value add in straying from historical payroll practices.

We find that attitude somewhat surprising considering that 85% of all respondents desired improvement in their current payroll policies and practices. Almost any other business process that had similar levels of dissatisfaction would witness transformative initiatives to address the issue.

Accepting the status quo in payroll solutions may have worked in the past, but it is no longer adequate for companies that need to compete and expand in the global marketplace. Managers responsible for global payroll need to build the business case based on risk and compliance to improve payroll operations.

To that end, it may be time for organizations to begin viewing payroll as a critical business process that requires a global solution with local flexibility. As organizations debate whether to run payroll in-house or with an outsourcing provider, there are a number of questions to consider:

Your business strategy

• Is your global payroll model aligned with the overall business strategy and vision for support services?
• Do you have a five-year plan for your payroll operations, and do you have buy-in from HR and/or finance (dependent on your structure)?

If you operate an in-house model

• Do you have a good source of skilled payroll technicians with both traditional and newly required payroll competencies?
• Have you championed the implementation of employee selfservice, remembering that self-service will not absolve you of responsibility for errors in the eyes of your employees?

If you have a hybrid model

• When was your model last reviewed? Do you have sufficient governance in place to validate the effectiveness of retained and outsourced processes? You should be seeking to enhance effectiveness, mitigate risk and produce efficiencies.
• Have you validated the art of the possible? In other words, have you fully assessed which aspects of your operations can be outsourced and which should — for strategic or risk management reasons — be kept in-house?

If you have a fully outsourced model

• Has your outsourcing approach yielded the anticipated savings and/or process improvements?
• Are your key performance indicators and SLAs measuring things you believe to be truly indicative of your payroll’s quality?
• Are there any other governance steps you need to put in place to ensure you are getting the value and effectiveness of the services provided?

Read more: Global payroll: myth or reality?

Questions or comments? Contact T Magazine and Ernst & Young

Operators of gaming machines sited in the UK will need to carefully consider their position in advance of the implementation of MGD in the UK effective 1 February 2013.

MGD will replace the existing indirect taxes that apply to gaming machines (VAT and amusement machine license duty — a fixed amount calculated by reference to the category of machine).

MGD rates

Effective 1 February 2013, there will be two rates of MGD:

1. The standard rate of MGD will be calculated at 20% of net gaming machine income (stakes received less winnings paid) of Category A, B and C gaming machines. These categories cover machines typically found in pubs, casinos, bingo clubs, betting shops, adult gaming centers and family entertainment centers. The rate will also apply to the majority of skill with prize machines such as IT boxes that offer cash prizes.
2. A lower rate of MGD (5%) will be applied to Category D machines where the stake (amount charged to play) and cash prize thresholds do not exceed £0.10 and £8, respectively.

Who is liable for MGD?

The person liable for accounting for MGD will typically be the license holder of the premises where the machines are sited. For tenanted pubs, the liability to register for and account for MGD will fall on the tenant of the pub rather than on the company that owns it.

It is anticipated that operators will report and pay MGD on a calendar quarterly basis with returns and payments falling due 30 days following the period end. Companies are, however, entitled to apply for alternative MGD accounting periods to coincide with internal financial reporting requirements.

The UK tax administration, HM Revenue and Customs (HMRC), has introduced an online registration system for machine operators that became available on 1 November 2012. If machine operators fail to register and account for MGD, other parties taking a share of the profits generated by machines, such as machine suppliers, may be jointly and severally liable for MGD on income received.

The additional reporting requirements will mean that operators are likely to have to implement or update accounting systems and processes. Current resource levels will have to be reviewed, and training may be required to ensure awareness of the rules and regulations relating to the new regime.

Interplay with VAT exemption

The implementation of MGD will see machine income become exempt from VAT (with no credit for related input tax). While machine operators will no longer have to account for VAT on machine takings, the majority of them will no longer be entitled to recover VAT incurred on machine-related expenditures such as the purchase or rental of machines (either by way of a fixed rental cost or by reference to profit share), maintenance and collection charges.

In addition, machine operators will have to consider the VAT rules relating to partial exemption. They will have to perform detailed calculations to determine whether they are required to restrict their recovery of VAT incurred on costs related to general business overhead expenditure, including head-office costs.

Any increase in the amount of VAT that operators are unable to recover on either direct machine-related costs or on general business overheads (including capital expenditure) will impact earnings before interest, tax, depreciation and amortization (EBITDA) and budgeted capital spend.

Operators that are already partially exempt for VAT purposes (e.g., by virtue of existing VAT-exempt activities such as operating bingo clubs, casinos and betting shops) will need to review their current VAT partial exemption methods to ensure that they adequately reflect the changes to the business that MGD will bring.

This is likely to be the most significant area for operators to consider as the VAT rules relating to partial exemption can be extremely complex.

Machine operators should consider carefully the potential financial impact to them of the implementation of MGD. In particular, they should review the nature of costs incurred within their businesses to determine whether the VAT partial exemption rules apply to them.

If the partial exemption rules do apply, analyzing their costs will assist them in evaluating the most appropriate methods for partial exemption calculation.

What if the irrecoverable VAT amounts are negligible?

Gaming machine operators may be able to ignore the impact of their exempt income if exempt income falls below certain de minimis limits. Under these rules, if exempt income falls below the limits, the taxpayer is entitled to treat itself as fully taxable for VAT purposes and recover all VAT incurred on its business-related expenditure.

VAT on capital goods

Special rules apply to the recovery of VAT on certain high-value capital items. Under these rules, the amount of VAT that can be recovered for certain capital goods is reviewed over a number of years, as the taxpayer’s partial exemption position may change in that time.

The introduction of MGD presents a risk that machine operators may have to repay an element of VAT previously recovered in this area. Under the current rules, this provision could require businesses to revisit property-related expenditures as far back as 2004.

As such, it will be necessary for affected businesses to consider the implications of MGD not only on their partial exemption position but also on the capital goods rules.

Conclusions

A number of trade associations and major machine operators have vociferously contended that their members will be subject to a significant increase in the level of indirect taxes that they pay as a result of the new legislation, and the industry continues to lobby the government for a review of the MGD rates before implementation.

What is clear is that, based on the legislation as it stands, operators of gaming machines will need to carefully consider the potential financial and administrative consequences of the MGD regime and take appropriate action.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

Questions or comments? Contact T Magazine and Ernst & Young

The recession that began in December 2007 resulted in significant declines in US state and local tax revenues, from which states have largely recovered in the past fiscal year.

The report Total state and local business taxes: state-by-state estimates for fiscal year 2011 (FY2011) sets out estimates of the state and local taxes paid by US businesses across a wide range of taxes. The FY2011 study is the 10th annual report on this subject prepared by Ernst & Young’s Quantitative Economics and Statistics (QUEST) practice in conjunction with the Council on State Taxation (COST).

Key findings of the study include:

• After falling by 0.8% in FY2009 and 0.6% in FY2010, state and local business taxes grew US$27.9 billion (4.5%) in FY2011, with total state business taxes increasing by 9.8% and total local business taxes declining by 0.8%. Property taxes on business property decreased by an estimated 1.5% this year, totaling US$244.9 billion in FY2011, or 38.0% of total state and local business taxes. Sales tax on business inputs and capital equipment totaled US$129.7 billion, or 20.1% of business taxes, which is an increase of 5.2% from FY2010. The property tax and a significant portion of sales taxes paid by business are taxes on capital invested within a state.
• Although the corporate income tax has been the focus of significant debate in a number of state legislatures during recent years, FY2011 collections were US$46.3 billion, only 7.2% of total state and local business taxes. Corporate income tax collections grew by 8.5% in FY2011. Individual income taxes on pass-through business income account for 5.6% of total state and local business taxes and grew by 10.0% in FY2011.

Total state and local business taxes in FY2011

Property taxes: The report indicates that property taxes on real, personal and utility property owned by businesses account for the largest share of total state and local business taxes, 38.0% or US$244.9 billion. Property taxes decreased 1.5% in FY2011, after growing 1.3% in FY2010 and 10.5% in FY2009. Typically, the local property tax is a stable source of tax revenue growth for local governments, but decreased in FY2011 due to declining property values.

Sales and use taxes: Sales and use taxes paid by businesses on purchases of inputs, including capital equipment, totaled US$129.7 billion, or 20.1% of all state and local business taxes. Sales and use taxes collected on sales to final consumers are excluded; only the taxes paid on businesses’ operating inputs and capital equipment purchases are included in the total business tax estimates.

Corporate income taxes: Corporate income tax collections were US$46.3 billion in FY2011, an increase of 8.5% from FY2010. This increase in corporate income tax receipts in FY2011 follows a decrease of 8.5% in FY2010. Corporate income taxes accounted for 7.2% of total state and local business taxes in FY2011, up from 7.1% in FY2010.

Unemployment insurance: Employer contributions to unemployment insurance (UI) (unemployment taxes) were US$41.2 billion in FY2011, an increase of 27.1% (US$8.8 billion). This increase accounts for nearly one-third of the overall increase in total state and local business taxes in FY2011. State unemployment trust funds have been depleted by the recession, and states are facing large debts to the federal government for loans used to pay unemployment benefits. States have responded to this fiscal pressure by increasing taxable wage bases and contribution rates, resulting in increased effective UI tax rates in 43 states since 2010.

Excise taxes: Excise taxes paid by business were an estimated US$35.0 billion in FY2011. Excise taxes attributed to business include a portion of motor fuel taxes and other excise taxes, such as taxes on hotel and rental car expenditures by business, as well as health care provider taxes on the revenue of hospitals and other providers of health services. Health care provider taxes have grown rapidly over the past two years in response to increased state Medicaid funding pressures. Total estimated excise taxes, which include health care provider taxes, grew by 14.9% in FY2011. These estimates exclude excise taxes on tobacco, alcoholic beverages, amusements and pari-mutuels, which are allocated entirely to households.

License taxes: Business and corporate license taxes totaled US$37.3 billion, including US$27.2 billion of general business and occupation license taxes and US$10.1 billion of motor vehicle taxes.

Individual income taxes: Individual income taxes paid by owners of pass through entities (e.g., partnerships, sole proprietorships, limited liability companies and S-corporations) totaled an estimated US$36.3 billion in FY2011. Individual income taxes on pass-through business income were more than three-quarters the size of corporate income taxes and represent 5.6% of total state and local business taxes.

Insurance premium and public utility taxes: Taxes on insurance premiums and public utility gross receipts totaled US$46.0 billion in FY2011, an increase of 1.1% due to increased insurance premium tax collections. These taxes are generally based on business gross receipts, and because they are generally levied in lieu of property or corporate income taxes, they are allocated solely to business.

Severance taxes on natural resources: Severance taxes are imposed on natural resource industries in 35 states and include taxes on oil, natural gas, mining and other extractors of natural resource. State severance taxes grew by 30.9% to US$14.8 billion in FY2011. The increase in severance taxes was US$3.5 billion, or 13% of the overall increase in state and local business taxes.

Conclusions

Total state and local business taxes increased by 4.2% in FY2011, signaling a return to growth after two fiscal years of declining revenues. In contrast to previous economic cycles, which were marked by stable local property tax collections, the current recovery has been accompanied by declining property taxes.

Local governments, which rely significantly on the property tax, are generally unable to diversify their revenue mix and will likely be forced to confront stagnant revenue growth in the near future.

At the state level, many of the revenue sources tapped for growth during FY2011 are special-purpose taxes on specific industries or used to fund specific activities and may not be sources of long-term revenue growth.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

Read more: Total state and local business taxes: state-by-state estimates for fiscal year 2011 (FY2011)

Questions or comments? Contact T Magazine and Ernst & Young

• “Confidence paradox” – three quarters expect deals to rise in next 12 months, yet only 29% plan acquisitions of their own
• Corporate confidence doubles in six months
• Renewed focus on growth – up from 41% to 52% since October
• Strong deal fundamentals and narrowing valuation gap create opportunity for first-mover advantage

The surge in confidence, fueled by positive expectations around economic growth, corporate earnings and credit availability, sees 87% of companies now viewing the global economy as either stable or improving. Fifty-one percent now believe the global economy is improving outright – more than double the 22% recorded in October 2012.

This increased confidence has fostered a strong consensus among global corporates that M&A volumes will increase – 72% expect global deal volumes to rise over the next 12 months. However, even with a renewed focus on growth (52% cite growth as a priority), only 29% of major companies expect to make acquisitions in the next 12 months, with organic growth measures (45%) the major strategic preference for executives.

Pip McCrostie, Ernst & Young’s Global Vice-Chair, Transaction Advisory Services, says:

“Though this positive sentiment would normally translate into significant capital investment and M&A activity, the current situation can best be described as a “confidence paradox” — with planned activity contradicting expectations. In the past few years, global M&A volumes have de-coupled from historical indicators of deal activity.”

“There are signs of improvement but caution remains. While almost three quarters of corporates expect deal activity in the market to increase over the next year, far fewer have an intention to buy. This could actually create a first mover advantage opportunity for those willing to take action and secure assets ahead of the competition.”

The modest improvement in the number of companies planning acquisitions (from 25% in October) is largely driven by an increasing number, and higher quality, of acquisition opportunities.

Thirty-nine percent of companies say there are quality acquisition opportunities available compared with 30% six months ago; 50% feel more confident about the number of opportunities available, versus only 37% six months ago.

A world of difference

There are clear differences in sentiment towards M&A across countries – in Brazil 45% of executives expect to acquire, while in Russia only 12% have similar expectations – illustrating a mixed mood within a complex macroeconomic climate, even within emerging markets. Elsewhere, in developed markets, 27% of UK executives plan to acquire assets compared to 29% in the US.

Interest in acquiring assets in emerging markets continues with China retaining the top slot as an investment destination. India and Brazil are second and third respectively, while the US remains in the top five.

However, while emerging markets remain critical to growth agendas, 60% of companies now say they are reconsidering their strategies in emerging markets where growth has slowed, and will apply greater rigor to investment decisions and processes.

Sectors most likely to see acquisitions are: technology, automotive, life sciences, consumer products and oil and gas. The least acquisitive are power and utilities, mining, financial services and diversified industrial products.

Consistent with sentiment over the past six months, deals across the board are likely to remain smaller in size as caution remains despite record amounts of available cash and improving credit conditions. In total, 88% of companies planning acquisitions expect deals to be under US$500m.

Divesting for value

Mirroring exactly the number of would-be buyers, 29% of companies are planning a divestment within the next 12 months or have one in progress. The reasons for a sale – and the types of divestment – are increasingly complex and not necessarily driven by the traditional motivation of raising capital – focusing on core assets and enhancing shareholder value rank more highly as selling rationale.

Mrs McCrostie continues:

“Despite growing optimism, companies are largely focused on lower-risk value creation strategies — much more cautious approaches than one would expect given increased confidence and credit availability. Divesting is increasingly a part of that mix – a strategic tool to create value that many see as less risky than an acquisition.”

“These approaches have become the “new normal” in the post—financial crisis world. Companies want sustained evidence of an upturn before making major investments.”

Window of opportunity for first-movers

The valuation gap – often a barrier to deals – has narrowed in the past six months with most respondents (82%) saying the gap is 20% or less, compared with 68% in October 2012.

However, expectations for increased valuations are now at their highest level in the history of the Capital confidence barometer. Forty-four percent of companies expect price/valuations to rise in the next year, up from 31% in October 2012. Just 7% of companies expect valuations to decline, compared with 27% six months ago, suggesting the market has stabilized.

“We may now be nearing equilibrium between what buyers will pay and what sellers will accept”, says McCrostie. “This equilibrium is vital, signaling the deal markets are at an inflection point and ready to rebound. The pendulum is primed to swing the other way – toward higher prices for buyers, and more profitable exits for sellers.

When does risk aversion become a risk?

McCrostie concludes:

“Given the surge in confidence and strong deal fundamentals, it is somewhat surprising that we haven’t seen a stronger appetite to acquire. Executives are continuing to wait for a sustained recovery before engaging in M&A. However, we may be nearing the point where this sustained caution itself becomes risky.

“Economic confidence, credit conditions and valuations — along with a recent rise in shareholder activism — all signal an opportunity to act. While prudence, discipline and governance, are necessities in this environment, now may be the time for boards to pursue a more accelerated growth agenda.”

“History shows that first movers in any economic cycle can create differential value and position themselves for sustained market leadership. Now might be the right time to invest and grow forward.”

Read more: Capital Confidence Barometer April 2013 – October 2013

Questions or comments? Contact T Magazine and Ernst & Young

India proposes to replace the current indirect taxes with a reasonably comprehensive goods and services tax (GST). The aim is to boost efficiency. Meanwhile, the Japanese VAT reform focuses on additional revenue generation.

GST in India

India proposes to introduce a dual GST to be levied concurrently by the Central and State governments, with the standard features of a classical VAT. The GST could provide significant impetus to industry and economic growth.

However, its implementation has seen long delays due to strong differences between the Central and State governments about the GST design and other issues. The GST would rationalize and simplify the consumption tax structure at both Central and State levels.

It would replace almost all indirect taxes, minimize exemptions and do away with the current multiplicity of taxes. By ensuring a smooth flow of input tax credit, it would eliminate the cascading of taxes that add to the burden of taxpayers.

Since the GST would be levied uniformly on all supplies of goods and services throughout the supply chain, it would make the supply chain tax neutral irrespective of the nature of the product or distribution chain.

The decisions of individual businesses about inventory and distribution management could thus be determined on the basis of operational efficiency rather than tax considerations.

The GST would also lead to uniform treatment of domestic and exported goods. It would substantially reduce competitive distortions between competing products. Most importantly, it would facilitate the integration of India as a seamless common market by removing the current fiscal barriers and ensuring the free flow of goods from the point of origin to final consumption.

For government, the GST would simplify compliance and yield greater revenues. And, for the overall economy, GST is expected to bring significant macroeconomic dividends by removing current distortions that inhibit businesses and investment

VAT in Japan

Japan has a comprehensive VAT, which in many ways is one of the better models of GST. The Japanese VAT is applied to a comprehensive base, with the notable exception of financial services, and it has a single rate. Even though Japan does not require invoices to support input tax credit claims, it has enjoyed high compliance, thanks to the low rate of tax (3% at inception and 5% currently).

The policy discussions in Japan have been focused on the tax rates to meet the rising revenue needs. Japan’s gross public debt in the last two decades has more than tripled to almost 200% of gross domestic product (GDP). The main factors behind the rising debt have been the steady rise in social security spending due to an aging population and weak economic growth.

This is evident from Japan’s tax-to-GDP ratio of 27.6%, which is among the lowest in the OECD countries.

Given the grim fiscal situation, the IMF recommended a gradual increase in the VAT rate from the existing 5% to 15% over the medium term to restore Japan’s fiscal health. It was felt that an increase in VAT rate was likely to be less distortive than other taxes.

Also, since Japan has a relatively simple tax with a broad base, low rate and strong compliance, it would be efficient and easy to administer. VAT was perceived as more suited to addressing the fiscal pressures of an aging society because it would provide a robust source of revenue as private consumption and spending grow and as the population ages. Japan has previously raised its VAT rate from 3% to 5%.

In August 2012, it passed a bill for increasing the VAT rate in two phases – from 5% to 8% from April 2014 and then from 8% to 10% from October 2015. This doubling of the VAT rate was not without controversy and came with a clause that the new, higher rate may be suspended if the “comprehensive economic condition is not appropriate for the tax hike.”

One of the key concerns was the burden of the rise on lower-income households, which may require the imposing of a lower rate for “necessities.” Creating a lower or special rate would reduce the revenue productivity that makes the VAT rate increase the most compelling instrument for containing the deficit.

Conclusions

India could learn from Japan’s VAT system, which has a low tax rate and strong record of compliance. Japan has withstood political pressures for multiple VAT rates, which invariably lead to a higher standard rate. In the next few months, it will be interesting to watch how the two economies tackle the multiple pressures of reform.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

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How big is the tax gap?

The truth is no one really knows – if every taxpayer, corporate and individual made an honest declaration of their finances, or the tax authorities had perfect information, assessing the difference between total tax due and total tax paid would be simple. But then there probably wouldn’t be a tax gap to speak of.

Still, Benjamin Franklin’s oftenquoted warning that nothing in life is certain but death and taxes could do with updating. It’s just as certain, wherever in the world you look, that not everyone pays all the tax they should.

In the UK, the latest estimate of the tax gap is that HM Revenue & Customs (HMRC) collected £32b less tax last year than it was owed. In the US, the IRS’s most recent figure is $350b.

Two elements are clear in the tax gap

Across the Eurozone as a whole, the current estimate is that the tax gap could be as high as €1t. In each case, the gap comprises two distinct elements:

1. There is tax lost to evasion – clearly illegal behavior
2. And there is tax lost to avoidance – tax planning strategies that stay on the right side of the law with each step of a transaction, but overall nevertheless deprive authorities of revenues they had been expecting to collect

In an ideal world, the tax authorities would seek to narrow the gap by targeting both evasion and avoidance. But the crackdown on corporate tax avoidance that is so marked around the world suggests the focus has been more targeted.

This is an odd strategy given the breakdown of the tax gap figures.

1. Far more tax revenue is lost to evasion than avoidance – that €1t Eurozone tax gap, for example, may well be 85% evasion.
2. Corporate tax avoidance is only a tiny part of the total. In the UK, for instance, HMRC puts the amount lost to tax avoidance strategies at large companies at less than 3% of the total tax gap. In almost all economies, indirect taxes and direct taxes on individuals account for far greater sums.

The figures suggest, in other words, that multinational companies may not offer the richest pickings for authorities in closing the tax gap, even if they are the easiest political target.

Not that the figures should be taken entirely at face value. Even the statisticians who compile tax gap data concede that they are, at best, well-informed “guesstimates”.

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• Mixed fortunes for the RGMs despite overall growth
• Government intervention leading to exchange rate swings could impact RGM competitiveness

Shifting valuations could have an impact on trade which is becoming increasingly important to the prosperity of nations. However, the early months of 2013 have seen RGMs start to recover after last year’s downturn with growth expected to accelerate from 4.7% in 2012 to 6% in 2014 reflecting a more stable backdrop.

Yet the fortunes for RGMs even within the same region are mixed. Latin America, Mexico and Chile are carrying strong momentum into the middle of the year, while Brazil’s recovery is fragile. Meanwhile, weak demand from the Eurozone still hampers emerging Europe.

As trade picks up Turkey is benefiting from its strategic geographical position and economic integration is supporting activity in Africa. Middle Eastern emergers are expanding trade with other RGMs. In Asia while recovery in Korea has been patchy, Chinese growth is set to accelerate from 8.2% this year to 8.5% in 2014.

Alexis Karklins-Marchay, Ernst & Young’s Co-Leader of the Emerging Markets Center comments:

“There is relief all around as the global economic outlook appears to have improved compared to this time last year. And as the world emerges from the financial crisis, it is more globalized than ever. International trade will drive world growth over the coming decade, and RGMs are set to play an ever more influential role.”

Carl Astorri, Ernst & Young’s Senior Economic Adviser to Rapid Growth Markets Forecast explains:

“Although the RGMs have come through the worst of the crisis relatively unscathed concerns still remain. Accommodative policies introduced to accelerate growth in developed markets and to sustain it in rapid-growth markets may now need to be reigned in to prevent the RGMs competitiveness being damaged.”

Among the BRIC economies, Russia’s exchange rate has moved roughly in line with the Euro, while China’s and India’s have responded to domestic factors (including intervention) rather than just appreciating in value as the Yen and Dollar fell. Brazil, however, has been suffering from an uncompetitive currency for some years and has seen another bout of appreciation, prompting renewed accusations of currency wars.

Even with interest rates at a record low in Brazil, rates are still higher than in the majority of RGMs, attracting international investors seeking higher returns.

Asian RGMs are likely to be affected more by the recent weakness in the Yen, particularly if they have close trading links with Japan or if they compete with Japanese companies in export markets. The Yen’s weakness has damaged competitiveness in several countries, particularly in South Korea and China.

Intra-RGM trade spurring growth

Despite current concerns around competitiveness RGMs across the globe have learned to trade their way to growth. Sluggish developed-world growth, and the growing weight of RGMs in the global economy, is spurring them to trade with each other.

Today, exports from RGMs exceed 10% of world GDP – more than twice their share a decade ago. In another 20 years, their share will approach 20% – double that of advanced economies.

The advanced economies will also look increasingly to RGMs for growth. Eurozone exports to RGMs were worth US$895b in 2011, up from US$230b in 2000. And in 20 years time, they will have overtaken intra-Eurozone trade.

The machinery and transport equipment sector (which includes consumer electronics and durable goods, as well as industrial goods) will make the largest sector contribution to trade over the next 10 years.

Information and communications technology (ICT) equipment will account for most of the growth. This reflects both the anticipated in demand for consumption and investment goods from the RGMs, and the potential to fragment supply chain.

It is not only trade in goods that will grow rapidly over the next 10 years. By 2020 Europe will be exporting more services to emerging Asia than to North America. And exports of services from the US to Latin America will also expand quickly, reflecting strong growth and increasing economic diversification in Latin America.

Alexis comments:

“Banking, insurance and other financial services sectors in RGMs will grow as the economies mature and the middle classes expand, offering new opportunities for trade. Demand for more sophisticated financial services is already growing rapidly as wealth levels rise.”

Lower trade barriers to boost growth

Lower trade barriers will boost exports and, ultimately, growth particularly in Southeast Asia. The proliferation of regional trade agreements will enable the free movement of capital, services and people.

Alexis comments:

“Many governments in RGMs are negotiating away decades of trade barriers and market distortions in pursuit of larger markets, lower prices and entrepreneurial opportunity. At the same time, they are putting in place the infrastructure to help goods cross borders and reach, or arrive from, far-flung continents.

“It is the rising importance of RGM economies and their increasing commitment to trade, which will shape profound changes in patterns of world production and demand.”

Meanwhile, Indonesia, Malaysia, Thailand and Vietnam continue to benefit from a mixture of resilient domestic demand and rising across Southeast Asia.

Moving away from the dependence on commodities in Latin America

Resource-rich countries in Latin America escaped relatively unscathed from the 2008-09 global financial crisis. This was partly thanks to rising commodity prices.

However, commodity prices are subject to large cyclical swings over time, and can fall as well as rise. The report indicates that there will be a shift away from the reliance on commodities that characterized export growth from 2000-10, toward more manufactured products.

However, currently growth in Chile is underpinned by stable macroeconomic conditions and the stronger world demand for copper, its main export. Growth is expected to be 5% this year and next.

Mexico is benefitting from its lower trade barriers and last year its export sector was one of the strongest performers among the RGMs. RGMF expects that transport equipment and vehicle exports will expand rapidly as demand rises in the RGMs. Although Mexican growth slowed toward the end of last year, the report predicts that momentum to build throughout 2014.

Short-term growth prospects in Brazil are constrained by structural bottlenecks and lingering competitiveness challenges despite record low interest rates and efforts to boost the economy with tax cuts and credit incentives. Therefore RGMF has cut its forecast for growth for Brazil from 3.9% to 3.1% for this year.

Asian commodity demand benefiting Africa but growth prospects in European RGMs remains low

Asian commodity demand is benefiting Africa, especially oil producers Nigeria and Ghana. However, domestic activity in South Africa has weakened.

The Middle East continues to gather momentum as a commodity exporter, manufacturer and market, with growth more than doubling between 2012 and 2014. Eastern European RGMs are still hindered by the weakness in their Eurozone neighbours. Contraction is likely this year in the Czech Republic. Poland will grow but slowly and the Russian economy will remain softer.

Looking ahead

Alexis concludes:

“The RGMs have had a good start to the year and this is expected to continue as downside risks to growth recede. RGM countries must now focus on making the most of the new trading opportunities that arise and will be best placed to secure strong and sustainable growth for the future.”

Read more: Rapid-Growth Markets Forecast: April 2013

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Audits and exchange of information In Europe, where VAT rates are highest, high-profile cases of missing trader or carousel fraud, involving organized criminal gangs exploiting how VAT applies to cross-border trade, have shown that VAT systems are vulnerable to such attacks and they have alerted governments to the need for vigilance.

As a consequence, tax administrations in all parts of the world are putting a greater focus on indirect tax compliance and enforcement. Our recent survey of Indirect Tax professionals in 39 countries indicates that, in the large majority of countries, the number of tax audits has increased in recent years and is likely to increase further in the future (Figure 4).

Only six countries reported that audits had decreased; even then, in some cases, while the number of audits carried out was said to be lower, the amount of additional tax levied due to tax audits is still increasing. This finding seems contradictory, but it can perhaps be explained by tax administrations carrying out more targeted audits; 24 out of the 39 countries already use specialized IT tools such as audit software to detect irregularities or suspicious patterns in taxpayers’ tax returns.

In our survey 16 countries indicated that the tax administration exchange information about taxpayers’ VAT affairs with other countries. These countries are mainly found in the EU, where the common VAT system requires an extensive information exchange.

On a global scale, the multilateral Convention on Mutual Administrative Assistance in Tax Matters, which is open to all interested countries, facilitates exchange of information on all compulsory payments to the general government except for customs duties. In the last two years, more than 50 countries have either become signatories to the convention or have stated their intention to do so. This will lead, without doubt, to increased international cooperation.

But, even if countries do not (yet) share information, they increasingly exchange information internally, between different authorities and departments (e.g., with customs or social security authorities). Only four out of the 39 countries we surveyed do not share any information at all.

Targeting fraud but hitting “honest” taxpayers too?

There is nothing to be said against stricter compliance enforcement if it actually helps to fight fraud. Fraudulent behavior damages the overall economy and tax compliant businesses, which suffer competitive disadvantages. The other side of the coin, however, is that tax administrations have generally become more wary toward all taxpayers; they are less open to entering into discussion, and it is more difficult to reach mutual agreement on specific issues.

Tax administrations increasingly apply a strictly formal approach not considering specific economic and business issues. This is bad news for all “honest” businesses, which want to be compliant, even more so as our survey shows that formal mistakes (e.g., missing information on invoices) are still by far the most frequent reason for indirect tax adjustments, be it an additional tax charge or the denial of input tax recovery (Figure 5).

In addition, we observe a tendency for tax administrations to pay out input tax surpluses with increasing delay — if at all — or to reject an input tax claim based on bad faith, stating that the claimant should have known that his supplier did not correctly handle the tax. At the same time, many countries are applying stricter penalty regimes in the case of non-compliance and mistakes.

In our survey, 27 of the 39 countries reported that penalties are increasing, and only three saw a decrease (Figure 6). Fines are generally imposed faster and sooner and the fines are higher than in the past. Increasingly, fines are enforced for timing issues, such as late payment, where in the past tax administrations were more lenient on these issues (for example, Austria, Germany, Pakistan and New Zealand).

What should taxpayers do?

Indirect taxes are not easy to manage. For example, excise duties, such as carbon taxes, change quickly and represent a high compliance risk because they typically operate differently in each country.

Taxpayers who collect VAT/ GST from final consumers on behalf of the state run increased risks of carrying the tax burden and eventual penalties themselves if they do not correctly manage the tax. With tax administrations assessing taxes more thoroughly and using powerful and efficient tools, the chance that mistakes will be found has risen considerably and will remain high.

Also, as indirect tax rates increase, the consequences of mistakes become more severe. This is particularly true for businesses that do not recover VAT/GST in full (e.g., because of VAT exempt activity) such as banks and insurance companies.

But higher rates also have an increased cost or cash flow impact on companies that incur VAT/GST in foreign jurisdictions, which is not refunded quickly or, which they do not or cannot recover (e.g., because of an absence of refund schemes for non-residents or because of complicated refund procedures). As indirect tax administrations are turning increased attention to enforcement — including joint audits with other taxes and even other countries — these activities may disrupt business activity.

Large assessments for underpaid tax or penalties for late filings not only have an impact on profitability, they may draw unwanted adverse publicity, even for compliant businesses. More than ever, it pays to proactively manage indirect taxes.

Establishing a clear indirect tax strategy aligned to your overall business strategy will help you keep your business up to date with the rapidly changing tax environment and avoid additional costs and risks of poor compliance or missed opportunities.

Read more: Indirect tax in 2013 – A review of global indirect tax developments and issues

Questions or comments? Contact T Magazine and Ernst & Young

The Slovak Parliament has approved an Amendment to the Slovak VAT Act, which became legally effective on 1 October 2012. Besides other anti-avoidance rules, considerable changes to the documentary proof required to support VAT exemption for intra-Community supplies of goods were introduced.

These changes will affect all businesses that make cross-border sales of goods from the Slovak Republic to another EU country. According to the new rules, if the transport of goods is arranged by a third party, the supplier has to have a transport document combined manifest report signed by the customer or its representatives confirming receipt of the goods.

Obtaining this document could be an issue for many businesses, for a number of reasons, e.g. freight forwarders who are not ready to cooperate, customers who have not had physical receipt of the goods or customers not willing to confirm in their receipt in writing. More strict rules apply when the transport of goods is arranged by the supplier or customer directly.

The supplier must have documentation confirming acquisition of the goods by the customer, which has to include the following information:

• The identification of the customer (name, seat and place of business, etc.)
• A description of the supplied goods
• The amount of the goods
• The place and date when the goods were taken over by the customer (if transport is performed by the supplier)
• The place and date when transport was finished (if transport is performed by the customer)
• The name and surname of the driver performing transport and his signature and his registration
• The number of the vehicle that was involved in transport

Conclusions

The requirements for proof for intra-Community supplies under the new rules are much stricter than applied previously. Taxpayers should review their current documentation practices and assess whether they comply with the new rules, as a matter of priority.

If the correct documentation is not received, the supply may become liable to Slovak VAT as a domestic sale at the appropriate rate (currently 20% or 10%), resulting in additional costs and potentially interest and penalties.

Suppliers may find it hard to add the VAT to agreed contract prices with EU customers who will apply reverse charge VAT on the intra-Community acquisition, so accounting for VAT will reduce the supplier’s profit margin.

If the purchaser does agree to pay an additional VAT, it may not be able to recover the tax from the Slovak authorities as input tax. The Slovak tax administration’s strict position could potentially be challenged under Community law and in the light of the European Court of Justice (CJEU) cases.

Arguably, according to EU legal principles, exemption should be granted in all cases if it is certain that the goods have arrived in another member state, even if the documentation does not comply with the rules set out by the tax administration. However, taxpayers should not rely on this defense.

Finally, multinational businesses should be aware that the Slovak Republic is not the only EU member state that is tightening its documentation requirements to support the treatment of intra- Community supplies as VAT exempt.

Taxpayers who operate in several member states may want to look at their processes and documentation policies across the EU as a whole to improve efficiency and reduce potential risks.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

Questions or comments? Contact T Magazine and Ernst & Young

Over 550 China professionals interested in VAT responded to our survey. Key findings are as follows:

The China VAT myth — not just a low risk “pass through” tax

• Almost 70% of respondents said that VAT risks were higher or similar to corporate tax, an area where most companies have dedicated resources.

  In terms of “risk,” how do you compare VAT to corporate income tax in your organization?

  

• Some respondents believe VAT carries inherently lower risk levels because the VAT related accounts are netted together under the Tax Payable — VAT Payable sub-account and the resulting balance may fall below a materiality threshold.
• Over 50% responded that the VAT opportunities were higher or similar to corporate tax while only 32% believed the opportunities were lower, indicating there are benefits waiting to be found.

We would assert that VAT may be one of a company’s largest tax risks with huge unknown costs. On the other hand, it may also be one of your largest unexplored tax opportunities.

Changing VAT regulatory landscape

• More than 76% of respondents said they were not closely monitoring the regulatory changes or needed more time and assistance to understand how the changes impact the organization.
• Over 85% of respondents welcomed the expansion of VAT to absorb BTable services, while 15% did not welcome the expansion because it required them to adapt to the changes.

The rules and regulations governing VAT and BT in China have been under continuous review for years and subject to frequent update and interpretation. It would be advisable to allocate more resources to be responsible for VAT so they can keep up to date and proactively address issues.

Major areas closely aligned?

• Only 16% of respondents have dedicated staff strategically managing the VAT function.
• 69% of respondents stated that they are not able to directly use their ERP or accounting data directly for VAT return processing.
• Nearly 80% would be very interested to increase the interaction with their in-charge VAT authority, showing that they are seeking even more guidance.

There are many different parts of the company that must be synchronized in order to have a compliant and efficient VAT operation.

Read more: Managing China’s VAT risks and opportunities

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In general, the draft amendments resemble the old provisions that applied until the end of 2011 much more than the new ones.

Under the German VAT law, an intra-Community supply of goods is exempt from VAT only if it complies with the requirements that the sale is supported by evidence from the supplier’s accounting records as well as by the delivery documents.

If the taxpayer cannot demonstrate that these requirements have been met, the German tax authorities will treat the intra-Community supply as a domestic supply, which generally is subject to German VAT. Thus, failing to comply with the documentation requirements bears the risk of additional VAT and interest payments.

Current requirements on documentation

The documentation requirements, as stipulated in the German VAT Implementation Ordinance, were tightened with effect from 1 January 2012 to the extent that the confirmation of arrival or entry certificate is the only possible evidence to support an intra-Community supply.

This confirmation of arrival requires that the recipient confirm the place and time of delivery and sign the document (if it has not been sent in digital format). According to the Ordinance, other substantiating documents, such as delivery or consignment notes, are no longer acceptable as proof.

However, after much criticism of these new rules, the Federal Ministry of Finance has issued a “safe harbor” rule that tax payers may invoke. It provides that the tax authorities will still accept substantiating documents under the legal provisions previously applicable until 31 December 2011.

However, this safe harbor rule will expire when the amended provisions are enacted, which is currently expected to be 30 June 2013. In essence, the new regulations will have no effect at all if the taxpayer chooses to use the safe harbor until the amended rules supersede the current tightened regulations.

Significant upcoming changes under the proposed amended rules

The most significant revision of the draft regulations is that confirmation of arrival is no longer the only possible proof for an intra-Community supply. However, the drafted German VAT Implementation Ordinance still views it as the main form of proof.

The confirmation of arrival document itself is not defined by a certain format but by certain items that have to be contained in it. It requires the following details:

• The name and address of the recipient
• The quantity and description of the goods according to custom and usage
• In most cases, the place and month of supply
• The date of issue
• The signature of the recipient or his delegate

This final requirement is waived if the confirmation of arrival document is transferred and received digitally.

In turn, the digital confirmation of arrival has to provide some indication that it stems from the recipient’s sphere of control. How this can be proven is not stipulated in the VAT Implementation Ordinance.

The supplier must ensure that the confirmation of arrival includes all the required information, especially the full address of the recipient and the place and time of delivery.

Care should also be taken to comply with the German Principles Concerning Data Access and the Auditability of Digital Documents— as is the case with all tax-related data that is transferred or created digitally. After receipt, the electronic confirmation of arrival must also be stored electronically in the original format.

Furthermore, a summary of batch confirmations is permissible if several separate deliveries are made to the same recipient. The new draft specifies that the batch confirmations may comprise all the deliveries made in a period of up to a quarter, but not longer.

We recommend that taxpayers who want to use batch confirmations should select the batch period on the basis of whether the taxpayer files its advance VAT returns on a monthly or calendar quarterly basis.

Other substantiating documents

Apart from the confirmation of arrival, other documents are permissible. For example, for dispatch deliveries, a dispatch voucher is sufficient. However, it must contain certain specified information, and it must indicate that the recipient has confirmed receipt of the item and the date of such receipt.

An exception for digitally transferred vouchers is not stipulated. However, any other document customary in trade is permissible to prove the intra-Community supply for dispatch deliveries.

If the proof is transferred digitally, a signature is not required. In turn, the digital confirmation of arrival has to provide some indication that it stems from the recipient’s sphere of control. If the item is transported by an independent courier service, the requirements for proving an intra-Community supply are met if the following documents are available:

• A written order (containing certain specified information)
• A record of the acceptance and delivery of the item (tracing protocol) prepared by the courier

Furthermore, the German VAT Implementation Ordinance specifies special documentation for:

• Items that are transported by a postal operator
• Excisable items
• Supplies of certain vehicles

Outlook

Even if the tax authorities are to accept other forms of evidence under the draft amendments on the Ordinance, taxpayers should consider using the new confirmation of arrival document as primary proof as it may offer the advantage of increased legal certainty regarding the VAT exemption of an intra-Community supply.

It should be taken into account that the electronic confirmation of receipt, in particular, may be a practical and speedy means of proof.

This makes the confirmation of receipt not just a potential curse but also a potential blessing. It remains to be seen whether the German Federal Ministry of Finance will issue an interpretative letter that comments on the new rules and gives further guidance.

Under the current time schedule the amended regulations will become effective 1 July 2013, but we will keep our readers informed of further developments.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

Questions or comments? Contact T Magazine and Ernst & Young

Changing law and practice

Many countries are currently in the process of refining their indirect tax systems. In developed markets, longstanding VAT systems need to adapt to the demands of a 21st century digital economy.

In emerging markets, which are experiencing economic developments at a fast pace, indirect tax systems need to adapt to keep pace. In India, for example, a new nationwide GST is ready to be implemented and only awaits agreement between the central and state governments.

The new Indian system is intended to replace almost all existing indirect taxes levied at the state and national levels, minimize exemptions and do away with the current multiplicity of taxes. Similarly, China is in the process of replacing its current business tax on services with a broader-based VAT through a series of VAT pilots.

In the end, it is intended to amalgamate all forms of China’s turnover taxes into the VAT.

In the EU, the European Commission has launched a comprehensive reform of the existing VAT system. The Commission has identified no fewer than 26 priority areas for further action in the coming years.

The aim is to move to a more modern VAT system, which should be simpler, more efficient and more robust. Significant changes can be expected in the near future, such as the adoption of a onestop-shop registration for all taxpayers’ duties or a standardized EU VAT return.

The United States (US) is still far from implementing a federal VAT. Currently, states apply their own consumption taxes, most of which are single-stage taxes on the sale of goods. But, even in the US, a trend can be seen toward states extending the scope of their current sales taxes.

While sales taxes, by definition, only apply to purchases of physical goods, it is the market in electronically supplied services (such as digital music distribution, internet downloads or telecom services), which is growing fastest. An increasing number of states are, therefore, trying to expand their current sales tax to cover electronic goods and services or are trying to create a “nexus” for out-of-state vendors to constrain sellers to collect sales taxes on remote sales.

With more than 150 countries now operating a VAT/GST system and international trade still growing, it is becoming more important than ever to provide a global framework for a consistent interaction of all these different systems. For a number of years, the OECD has been working on developing international VAT/GST guidelines, which could provide the basis for such a framework.

This initiative gained momentum following the OECD’s Global Forum on VAT, held in November 2012. The forum brought together more than 85 country delegations from all continents together with international organizations, academics and businesses to explore key policy trends and their impact for tax administrations and businesses.

Improving tax administration

Finally, governments have discovered that also on the administrative side, the efficiency of VAT/GST systems can be drastically improved — which increases tax revenues. There are many approaches taken by governments, but an important one is to create common interfaces and reduce gaps in the system. This is (among others) one reason why many governments are enforcing the use of electronic data transmission and filing.

In December 2012, we conducted a survey of Ernst & Young Indirect Tax professionals in 39 countries and asked them about indirect tax compliance requirements.

Twenty-five, of the 39 countries surveyed require VAT/GST returns to be filed electronically on a mandatory basis, 12 states have an optional electronic filing (e-filing) facility and just two countries do not offer or require e-filing (Figure 3).

The impact on business

The reason for this trend is clear: e-filing considerably eases processing of VAT/GST returns for tax administrations and makes administration faster and more efficient. In addition, having electronic data enables tax administrations to use IT-based audit tools more easily, which can help to combat fraud and evasion.

Most taxpayers can also benefit from increased efficiencies arising from e-filing, but dealing with multiple tax administrations’ different requirements and tax administrations’ increased audit capacities means that greater focus must be given to the accuracy and efficiency of indirect tax compliance processes to avoid an increased risk of incurring penalties.

Read more: Indirect tax in 2013 – A review of global indirect tax developments and issues

Questions or comments? Contact T Magazine and Ernst & Young

Many key indicators for the sector are expected to return to modest growth in the next 18 months, and banks in particular should be in a position to start lending and help drive the economic recovery in 2014.

• Bank deleveraging slowing but total assets still to fall by €500b in 2013
• Bank lending will stabilize this year and should pick up in 2014
• Non-performing loans to peak this year at 7.2%, driven by high rates in the periphery
• Interest rate rises remain an outside risk but insurers need to plan a response

Andy Baldwin, Head of Financial Services, Europe, Middle East, India and Africa (EMEIA) at Ernst & Young comments:

“The market response to the Cypriot debt crisis was actually fairly encouraging in that it demonstrated that the major European economies are now quite well insulated from national crises in smaller states. The financial services sector remains the principal mechanism for distributing investment capital to the wider economy and it now needs to play a vital role in the economic recovery.”

“There is a sense that the industry as a whole is close to turning a corner, however the forecast is divided between north and south, and also between systemically important financial institutions (SIFIs), which continue to strengthen, and smaller national banks, for whom the near-term outlook is less certain.”

The most destructive phase of bank deleveraging is over

After contracting by €856b last year, total assets in the Eurozone banking sector are forecast to fall by €500b in 2013 before returning to growth in 2014. Total assets have already broadly stabilized in Germany, France and The Netherlands, while Italy and Spain are expected to follow next year.

Marie Diron, Senior Economic Adviser to The Eurozone Financial Services Forecast says:

“Although on aggregate deleveraging in the Eurozone will continue at some pace this year, we believe the most destructive phase has now passed and that banks in the stronger economies have already turned the corner. 2013 should be the last year of asset shrinkage, and 2014 is looking much healthier.”

Lending to fall by 0.5% but to return to growth in 2014

Lending to businesses and households fell 1.7% across the Eurozone last year and this contraction is expected to continue in 2013, but at a slower rate of 0.5%.

There is still a pronounced north-south divide in the cost of bank borrowing and as a result the peripheral economies will experience a more marked contraction in lending this year. Lending in Spain is forecast to contract by 5.1% in contrast to positive growth of 0.8% in Germany and 0.6% in France. However, total lending across the Eurozone is expected to start to grow again in 2014 at a rate of 2.9%, which includes a modest (0.9%) return to growth in Spain.

Marie says:

“Banks’ access to wholesale funding markets is continuing to improve, and private sector deposit flows in the periphery appear to be stabilizing, allowing banks to gradually transition away from central bank support, but credit conditions are likely to remain tight for some time, which will weigh on investment and consumer spending.”

Non-performing loans will peak this year, driven by peripheral economies

As a result of the rise in Non-performing loan (NPL) rates in the peripheral economies NPLs in the Eurozone will peak at a Euro-era high of 7.2% this year, up from an estimated 6.7% at the end of 2012. NPL rates are already declining in France, Germany and The Netherlands this year but will climb to a peak of 10.2% in Italy and are forecast to reach 12.8% in Spain, notwithstanding the recent transfer of problematic assets to SAREB.

Interest rate rises remain an outside risk but insurers need to plan their response

Concerns that the economy could gather pace more quickly than anticipated under our baseline forecast, causing the European Central Bank (ECB) to increase rates more quickly should be taken seriously by insurers.

If the Eurozone does not shrink this year and grows by 1.7% in 2014, which is faster than the 1.1% baseline forecast, inflation would then hit 2.8% by the end of 2014, causing the ECB to increase interest rates from 0.75% to 1.25% in 2015, rather than keep them on hold until the middle of 2017. Ten-year Eurozone government bond yields would rise from 3.4% in mid-2014 to 4.7% by the end of 2015.

Andy says:

“Despite the low probability of interest rates rising, the effects are sufficiently large to warrant scenario planning by insurance companies. The rapid rise in interest rates and higher financial stress would hit insurers through their bond-heavy balance sheets.  Insurer’s core business would also be affected with lapse rates likely to rise, for example, as customers switched into alternative products offering higher yields, and new business would suffer as the economy slows.”

Life insurance loses out to banking products as premiums fall 7.3%

Eurozone life insurance premiums are estimated to have fallen 7.3% in 2012.  Sales in Italy and Germany declined for the second year running and sales in France declined sharply in part due to competition from banking products. Growth in life premiums is now expected to be subdued, forecast as 1.6% in 2013, and then growing by c.2.6% a year until 2017.

Marie says:

“Our forecasts for household income and unemployment in the Eurozone are pretty weak and so life insurance premiums are going to grow at historically low rates reflecting the weak economic growth forecast for the Eurozone.”

Multi-asset funds will manage 40% more assets than hedge funds or fund of funds

Multi-asset funds grew assets under management (AUM) by 30% last year, which means that AUM growth for multi-asset funds has outpaced both Eurozone-focused hedge fund and fund of fund AUM growth over one, three and five years.

In 2007 hedge funds and fund of funds managed 50% more money than multi-asset funds but by the end of 2017 multi-asset funds are forecast to manage 40% more assets than the other two fund types.

Marie concludes:

“In just a decade the tables will have turned and multi-asset funds are benefitting from demand for smaller pension funds wishing to outsource asset allocation as the investment landscape becomes more complicated and the regulatory environment becomes more onerous.”

Read more: Ernst & Young Eurozone Forecast: Spring 2013 – Outlook for financial services

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Information technology goods have generally enjoyed duty-free access in the EU since the 1996 implementation of the World Trade Organization (WTO) Information Technology Agreement (ITA).

However, a recent European Court of Justice (CJEU) judgment serves as a reminder that not all components qualify as parts and accessories and thus may be subject to duty.

Duty-free components

In the EU, the ITA tariff exemption has been partially implemented in Heading 8486 of the customs tariff, which covers machines used for the manufacture of inter alia semiconductor devices and integrated circuits. As a result, products classified under certain subheadings of Heading 8486, which include parts and accessories, can be imported duty-free into the EU.

Components of semiconductor manufacturing machines excluded from duty-free treatment in the EU

On 19 July 2012, the CJEU delivered its judgment in a customs case concerning the tariff classification of polishing pads intended for semiconductor waferpolishing machines.

The pads, in the form of discs that measure approximately 40 cm in diameter and 3 mm thick, are adhesive; they are made up of different plastic layers, and they are intended for polishing machines for working semiconductor materials.

The issue that the CJEU considered was whether these polishing pads should be classified under either:

• Tariff Code 8466 91 15, as parts or accessories suitable for use solely or principally with the machines classified under Headings 8456 to 8465
• Tariff Code 3939 90 10, as a self adhesive flat shape made of plastic on the basis of its constituent material

We note that the case also involved imports prior to 2007, when the customs tariff was modified. For purposes of this article, we focus on the current tariff classification codes.

According to the CJEU, the polishing pads should be classified under Tariff Code 3939 90 10 for the following reasons:

• In principle, there are arguments to classify the polishing pads at issue under Chapter 39, considering their physical characteristics.
• The notion of “parts” implies a whole for the operation of which the part is essential, and the notion of “accessories” implies an interchangeable part designed to adapt a machine for a particular operation, to increase its range of operations, or to perform a particular service relative to the main function of the machine.
• The polishing pads cannot be considered to be “parts” or “accessories” suitable for use with semiconductor wafer-polishing machines and cannot therefore be classified under Heading 8486 of the customs tariff.

The definition of “parts” and “accessories” was given in earlier CJEU judgments with respect to network cards and ink cartridges, which considered classification under the duty-free Heading 8473 (i.e., parts and accessories of Heading 8471). However, this is the first judgment in which the court has applied these criteria in practice to parts and accessories of Heading 8486.

In this case, polishing pads are excluded as “parts” of wafer-polishing machines by the Court because they are not essential for the operation of wafer-polishing machines. Hence, the argument that the polishing pads are exclusively intended to be fitted on certain types of wafer-polishing machines is not decisive to conclude that the concerned product is a part or accessory.

Accordingly, these components of semiconductor manufacturing machines have been excluded from duty free treatment in the EU. Practical consequences Based on this CJEU judgment, importers should not rely on the component’s “sole or principal use” with a product classified under 8486 to classify the product as a duty-free part or accessory of this heading.

Rather, the definition of “parts” and “accessories” as provided in this case should be referenced in the classification determination. In a broader sense, the judgment may trigger examination not only on components classified as parts and accessories of Heading 8486, but also on components classified as parts and accessories under other headings in Chapter 84.

This is an area that may attract additional customs scrutiny, particularly in the event of a customs audit where the company can face significant exposure for underpaid duty. Component suppliers and importers should review their tariff classifications, particularly where such products have been classified as parts and accessories of products in Chapter 84.

Importers should also consider applying for a Binding Tariff Information from the Customs authorities to obtain certainty with respect to the tariff classification of a product.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

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By Jonathan Berr

The path of the whistleblower can be a lonely one. Just ask Michael Lissack, who helped uncover billions worth of fraud in the municipal bond market in the mid-1990s.

The experience cost him his job, his marriage and many friendships with former colleagues, not to mention having to endure a costly and draining legal battle with his former employer.

If someone asks him whether it’s worth the trouble to report wrongdoing to the authorities, Lissack inquires if they have a family. “If I had kids, I never would have done it,” he says.

Whistleblowing can be a stressful experience but it can also be a lucrative one, at least in the United States, following changes to the law regarding the level of payments that plaintiffs can receive. Prior to 2006, the US Internal Revenue Service (IRS) capped awards for whistleblowers at US$10m.

But, since 2006, when the IRS overhauled its policy toward whistleblowers as part of the Tax Relief and Health Care Act, the administration is now able to pay as much as 30% of the collected proceeds as a reward.

Perhaps the most high-profile award of recent times is the US$104m that the IRS paid to the UBS banker turned whistleblower Bradley Birkenfield for his role in helping the Government to uncover a tax evasion scheme set up by the bank. Birkenfield also paid a heavy personal price for his whistleblowing, spending 40 months in jail for his part in the tax evasion conducted at UBS.

Nevertheless, Erika Kelton, a partner at Phillips & Cohen, who has represented whistleblowers for more than two decades, thinks that the scale of the award sends a powerful message that the IRS Whistleblower Office is open for business. “What you are seeing is more cases and higher value cases as people get more comfortable with the program,” she says.

Senator Charles Grassley (R-IA), who led the push for the Tax Relief and Health Care Act of 2006, says that ongoing scrutiny is essential to ensure continued progress.

“It’s preferable to have more whistleblowers than fewer whistleblowers,” he says. “The cases that resulted in payouts so far have resulted in the collection of taxes that the IRS otherwise would not have known to pursue.”

For those companies that have not already established clear guidance on ethics and codes of conduct, the emergence of greater rewards for whistleblowers is just another sharp driver to establish these, along with supporting mechanisms, such as hotlines. One important step is to establish their own hotlines to enable whistleblowers to escalate concerns internally so that they can be identified and remedied more quickly.

A company that has mechanisms in place to report wrongdoing will be able to address issues more quickly, as well as being looked on more favorably by regulators. “It is in the best interest of companies to be proactive in this respect,” says Cornelius Grossmann, Ernst & Young’s EMEA Law Leader.

Daniel Westman, a litigation partner with Morrison & Foerster, who represents management in whistleblower cases, says that companies need to “win the hearts and minds of employees” by creating an environment that shows that their concerns are being taken seriously. “Companies are in control to the extent that employees perceive their concerns are being addressed,” he says.

But even with the right mechanisms in place, the scale of the rewards on offer from the IRS program could encourage people to contact authorities first rather than trying to bring their concerns to management.

“If a disgruntled employee tries to damage a company’s reputation by disclosing confidential information that is not based on merit, there is very little a company can do against such behavior,” says Grossmann. “The best approach is to keep publicity out of any such incident to the extent possible. The handling will be delicate and can be advised only on a case-by-case basis.”

For its part, the IRS Whistleblower Office is likely to find itself with a heavy workload of highly complex cases. In 2007, the IRS received 2,751 cases but, four years later, that number had mushroomed to 7,411. The staff handling this workload has grown but remains small.

As of the end of fiscal year 2011, the Whistleblower Office had a staff of 18, including 10 analysts, according to a report submitted to US Congress. That staff has since doubled to about 36. The IRS Office of Chief Counsel has also appointed a senior attorney to serve as Special Counsel to Steve Whitlock, the veteran IRS official who is director of the Whistleblower Office.

Developing the cases that are brought to the Whistleblower Office can take considerable time and effort. According to a 2011 report from the US Government Accountability Office, about 66% of the claims submitted in the first two years of the program were still in process.

The first payments under the 2006 law were made in fiscal year 2011. The agency paid awards on 97 claims, although it adds that they were covered under provisions that pre-dated the whistleblower law.

Only four of those cases involved awards that exceeded the whistleblower law’s US$2m threshold. By 2011, it had cases involving 732 taxpayers that reached that limit, according to data the agency provided to Congress last year in a report.

Attorneys who represent whistleblowers paint a sympathetic picture of the IRS office, which is headed by Steve Whitlock, a veteran IRS official. The department must sift through mountains of complaints that fail to pass legal muster for one reason or another.

Some may come from a whistleblower with a personal vendetta against a taxpayer, such as a former business partner or spouse. Neither can the IRS pay any awards until all the taxpayers have exhausted their legal appeals. Understandably, the process can be frustrating for everyone involved.

Mark Matthews, a former IRS enforcement head who is now a partner in private practice at Caplan & Drysdale, says that many whistleblowers think the IRS is concealing information from them, even though they may be trying to help as best they can. “IRS agents were generally advocates of paying the award as soon as possible because they want the program to work,” he says.

The situation at the IRS is undoubtedly improving. One reason is that Acting Commissioner Steven M. Miller has made the performance of the Whistleblower Office, which has been criticized in government audits, to be a priority.

In June, Miller wrote a memo that spelled out procedures to ensure the timely review of whistleblower complaints, including having initial reviews conducted within 90 days. “Timely and comprehensive evaluation of information provided by whistleblowers is essential to the success of this program,” he wrote

In today’s economic climate, where cash-strapped governments are looking for every last nickel of revenue, whistleblowers are seen as an effective tool to help uncover tax evasion and fill the tax gap. And with rewards on offer of the scale awarded to Bradley Birkenfield, there will be no shortage of plaintiffs willing to come forward.

The challenge for the IRS, and other tax administrations that adopt a similar approach, will be to separate genuine cases from invalid ones, and to ensure that they keep pace with a growing backlog.

For the whistleblowers themselves, the decision will always be a complex one. Financial rewards undoubtedly offer some compensation, but potential personal costs should never be ignored.

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This trend continues around the world as countries continue to conclude a growing network of various kinds of trade agreements. The WTO currently has 158 members (the most recent, Laos joined at the start of February 2013) and it reports 546 active and pending reciprocal regional trade agreements among its members.

This number does not include unilateral preference programs, that is, trade preferences granted to products imported from identified countries without reciprocal benefit, such as the Generalized System of Preferences (GSP) in the EU and the US, which provide dutyfree treatment to many products from developing nations.

A number of new free trade agreements (FTAs) are expected to enter into force in 2013, thus further reducing the amount of customs duties imposed on global trade; examples include the agreement involving the EU and Peru and Colombia, Montenegro and the European Free Trade Association, and Hong Kong with the European Free Trade Association, and Indonesia and Pakistan.

Nearing completion are, among others, the trade agreements between Costa Rica and Peru and between Canada and India, and negotiations are in various stages of completion for a range of others.

Duties still a significant source of revenue and cost

However, the situation is not always that straightforward. Although customs duty rates are generally reducing for international trade, these taxes still play a very significant role in meeting countries’ budgetary needs. In many cases, duty rates on many goods and materials remain high.

Unlike VAT/GST, duties charged at one stage in the supply chain are not offset against taxes due at later stages, so duties form part of the cost base of affected goods. In addition, customs clearance procedures can add to the time and related costs of moving goods crossborder.

And even where FTAs exist, many businesses are not actually obtaining the potential benefits offered because they cannot or do not meet the qualifying conditions.

Protectionism

More generally, global trade may be hampered by the current economic climate, which is encouraging protectionist tendencies, as evidenced by the current difficulties encountered in the Doha Rounds. Non-tariff barriers have grown substantially in recent years, many in the form of health, safety or environmental requirements.

The WTO reported 184 new trade-restrictive measures enacted between October 2010 and April 2011 and 182 between October 2011 and May 2012. In addition, where countries are not bound by FTAs, import duties are still a common and often-used means to steer trade and production.

For example, to boost the development of sugar cane production toward meeting the raw sugar needs of domestic sugar refining companies, effective 1 January 2013 Nigeria now applies a 0% import duty on machinery for local sugar manufacturing industries, but it has increased the total tariff on imported refined sugar to 80% from 35%, and raw sugar tariffs increased from 5% to 60%.

Read more: Indirect tax in 2013 – A review of global indirect tax developments and issues

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Complexity in the world’s tax systems has grown in tandem with the challenges of doing business in an increasingly connected global economy. Today, the application of many of those laws lags business innovation.

As a result, some laws do not operate as originally intended, or create uncertainties that were not foreseen. At their extreme they can impede desirable business activity.

In other instances, taxpayers may be seen as taking advantage of some laws in ways that tax administrators find undesirable. These resulting uncertainties can limit economic growth and impede tax administration.

Many countries have taken steps to modernize their corporate tax systems to align better with rapidly shifting business models. Several countries have reduced their corporate tax rates and have moved to a more territorial approach to taxing business income.

The United States, home to a large number of the world’s largest multinational corporations, continues to debate whether a switch to a territorial tax system will be a central part of the tax reform that leaders in both political parties say they want, while countries such as Japan and the United Kingdom have moved closer to territorial taxation.

A widening anti-abuse net

The globalization of business and the mobility of capital, however, continue to challenge tax administrators who worry about the potential exploitation of what are perceived to be unintended tax benefits. Emerging markets such as Chile, China and India are making headlines by widening their tax net and, in some cases, disregarding holding company entities.

And some countries that are enacting reforms aimed at increasing their competitiveness are at the same time considering antiavoidance measures that may actually increase uncertainty.

A global effort

The recent focus on tackling “tax abuse” can also be attributed to the rising deficits and falling tax revenues that have resulted from the global financial crisis. Governments have been spurred to act by multilateral organizations, including the G20, the Organisation for Economic Co-operation and Development (OECD) and the European Commission.

Tax activist groups have turned a spotlight on tax havens, high-net-worth individuals and, now, the seemingly low effective tax rates reported by some multinational companies. A series of steps, including increased information exchange, expanded disclosure requirements, and joint and simultaneous tax audits have been put in place to address what countries view as unacceptably aggressive tax planning.

A wave of national change

Many countries are now taking a different and more dramatic approach. Countries such as the United Kingdom, India and China have either proposed or adopted broader anti-avoidance statutes that empower authorities to challenge what they perceive to be “aggressive” tax planning or “treaty abuse.” Countries including Ireland and South Africa are flexing GAARs long on their books, becoming bolder about threatening to apply them or actually applying them.

And countries that have been testing the judicial limits of their anti-avoidance statutes for decades, such as Australia, are becoming even more assertive in the wake of economic adversity and are looking to further tighten their rules.

Other countries, including emerging economies, are watching these developments and contemplating their own policies, either to replicate what they see as leading practices or as a defensive measure in response to other countries’ use of such legislation.

Feeding uncertainty

Businesses increasingly fear that countries that once used GAAR only reluctantly, and in the most extreme circumstances, are beginning to use it more extensively than it was originally designed to be used. They have good reason to be worried.

While judges in several GAAR cases have defended businesses against overly broad application of the rule, some countries that lose in court have responded by proposing new laws to make their GAAR tougher and, in the case of India, retroactive. In countries without a GAAR, tax authorities are increasingly challenging business arrangements on the grounds that they lack substance, even if such arrangements comply with the applicable law.

GAAR’s rise as a favored enforcement tool, however, has the potential to increase the uncertainty businesses already feel operating in the challenging global economy; a poorly designed or administered GAAR is in neither the taxpayer nor the government’s interest.

The proliferation of anti-avoidance rules amplifies the uncertainty global businesses already feel as they operate in this intensely interconnected and interdependent economy. Such rules can breed distrust where cooperation would more likely generate mutually satisfactory resolution to controversy, as evidenced in the headline of an October 2012 Reuters news agency story about the new GAAR proposal in the United Kingdom:

“Businesses spooked by UK tax avoidance clampdown.” Adding to the complexity of this new environment is the fact that GAAR approaches vary from country to country, along with the penalties they may carry and the administrative procedures for appeal and relief.

Jean-Baptiste Colbert, Controller-General of Finances under France’s King Louis XIV, once described taxation as the art of “plucking the goose as to obtain the largest possible amount of feathers with the smallest possible amount of hissing.” With so many challenges from so many directions now facing multinational corporations, the hissing is getting louder.

The rise of GAAR — and the growing interest by multilateral organizations and other interest groups in targeting what they perceive as overly aggressive tax planning — represents part of the next chapter in this evolving tax enforcement story.

In this report, we look at the growing number of countries developing such measures, the characteristics of these measures, how and when the measures may be invoked, and what companies can do to mitigate risk in each phase of their tax risk management.

Read more: GAAR rising: mapping tax enforcement’s evolution (pdf, 2.12 MB)

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Ernst & Young’s Global IPO pipeline analysis also indicates an additional 31 IPOs are scheduled before the quarter’s end and should raise an additional US$5b.

• Q1 Global IPO capital raised likely to be 30% higher than in 2012
• US most active region while Asia IPO activity drops by almost half
• Europe shows positive momentum in some countries
• Real estate sector leading activity globally

The largest deal so far this quarter was the listing of a US pharmaceutical business (carve-out), Zoetis Inc for US$2.6b. Globally, there were five IPOs raising over US$1b, compared to only one in Q1’12 and nine in Q4’12.

Average deal size increased 75% to US$154m, compared to US$88.2m in Q1’12. Two IPOs have been postponed and 15 withdrawn in Q1’13, compared to two and 51 IPOs respectively for Q1’12.

Maria Pinelli, Ernst & Young’s Global Strategic Growth Markets Leader comments:

“Q1’13 posted strong results compared to activity this time last year. The pipeline is robust and we are aware of a minimum of 300 new companies globally that are actively preparing to list in 2013. In addition, institutional investors have returned to the IPO markets as an asset class, with more than 82% investing in IPOs in 2012, compared to only 18% who last invested in 2010 and 2011, as evidenced in a recent Ernst & Young’s study of institutional investors.”

US market very positive

In Q1’13, US stock exchanges have so far raised US$6.7b from 24 IPOs, accounting for 37% of global capital raised this quarter and making the US the most active region globally. Capital raised was up 4% compared to Q1’12 (US$6.4b from 41 IPOs).

If the additional US$1.2b via eight IPOs in the pipeline for the remainder of March is successful, the US will be on par with Q4’12 (US$8.9b from 33 deals).

In March, the Dow Jones Industrial Average reached its highest point since October 2007. With macroeconomic conditions also improving, this means that market sentiment in the US is very positive.

Strong momentum is expected for the US IPO market for the rest of 2013, provided that stable macroeconomic conditions exist: a concern for investors. Real estate, life sciences, technology and oil and gas will lead the US IPO markets and these industry sectors account for more than 50% of the US IPO pipeline.

Conditions in Europe improving

In Q1’13, European stock exchanges have so far raised US$2.7b from 15 IPOs (accounting for 15% of global capital raised this quarter). Europe contributed the second largest IPO globally, the real estate company, LEG Immobilien AG from Germany which raised US$1.5b.

Ernst & Young’s Global IPO pipeline analysis indicates there are an additional 11 IPOs with expected proceeds of US$2.0b to price before the end of March. If successful, this will increase capital raised by 68% compared to Q1’12 (39 deals raised US$2.9b).

IPO activity in Germany, UK and the Nordics is particularly active. Other parts of Europe are not expected to recover until the second half of 2013.

Maria Pinelli comments:

“Cash strapped governments will likely seek capital through initial public offerings of state-owned enterprises in 2013. In addition, new government initiatives to foster market access for fast-growth firms and entrepreneurs will also be important for the remainder of 2013.”

“This combination of a supportive regulatory environment, together with strengthening market indices, mean conditions has improved significantly for the region. However, the Eurozone’s political and economic difficulties are casting a shadow across the capital markets.”

Asia off to a slow start

Deal volumes have reduced dramatically in Asia in Q1’13. Asian stock exchanges raised just US$5.1b in 58 IPOs, accounting for 28% of global capital raised this quarter. Capital raised was down 38% compared to Q1’12 (US$8.4b raised, from 97 deals) and a 40% drop by deal number.

The decline is due to a halt in listings on Chinese exchanges since November 2012. The new proposal for additional scrutiny of potential listings when markets reopen is likely to slow activity. There were no Chinese IPOs on mainland China exchanges in Q1’13, and a slight reduction in deal volume in Hong Kong (US$1b, from 9 deals) in Q1’13 compared to Q1’12 (US$1.4b via 14 deals).

The IPO markets in Singapore and Japan fared better. Stock exchanges in these markets accounted for 62% of capital raised in the region in Q1’13. Interest in REITs (real estate investment trusts) remained particularly strong.

Several large REIT listings, including the US$1.4b Mapletree Greater China Commercial Trust on Singapore exchange and the US$1.1b Nippon Prologis in Japan, were dominant. Attractive yields and tightening market conditions in commercial real estate drove their successful IPO performance.

Maria Pinelli says:

“The Asian market will be lower in the first half of 2013, but is expected to be more active in the latter half of the year with entrepreneurial IPO activity. We are seeing a reduction in the number of state-owned enterprises in the IPO markets from China; other markets within Asia have been more active in state-owned IPOs.”

IPOs by sectors

Real estate dominates the sector picture in terms of funds raised – accounting for over a third (34%) of global IPO activity (US$6.2b) and by number of deals (15%, 18 deals). Reflecting the Zoetis IPO, healthcare (15%, US$2.8b) and industrials (9%, US$1.6b) were also active by capital raised. In terms of number of deals, industrials ranked second (14%, 16 deals) followed by consumer products (10%, 12 deals).

“Real estate IPOs will dominate globally in Q1’13. We also expect life sciences, technology and oil and gas to lead the US IPO markets. In Asian markets we will continue to see materials, industrials and financial services IPOs coming to market. In Europe, real estate and financial services will dominate in terms of the number of deals,” concludes Pinelli.

Download: Global IPO highlights 2013 Q1 [INFOGRAPHIC]

Read more: Investment appetite up for IPOs among institutional investors

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Biotech companies encounter various customs issues at different stages of their evolving business. One current hot topic for these companies operating in this sector is how to deal with the customs considerations for clinical trials in China.

In this article we set out some of the issues and report on how Ernst & Young (China) Advisory Limited is taking an active role in promoting dialogue between pharmaceutical companies and the Chinese customs administration on this topic.

Chinese duty rates for trial materials

In recent years, there has been an increasing spread of clinical trials to emerging markets, such as China; the reasons for this expansion range from significantly lower per-patient costs to wider patient pools and more patients who have never previously taken drugs for treatment.

Unlike Europe and the US, dosage-form clinical trial materials are mostly subject to import duty in China. The duty rates range from 4% to 6.5% in addition to 17% value-added tax (VAT), which is mostly unrecoverable because the materials are not sold as part of normal commercial business.

Customs valuation issues

One challenging area is to provide all the necessary declaration data to import clinical trial materials into China. Considering that these are noncommercialized shipments usually not the subject of a sale/purchase transaction, the determination of an acceptable customs value can be a complex exercise since transaction value, the most widely used methodology, is not applicable.

This is a common area also observed elsewhere in the world, but the Chinese customs administration (China Customs) has recently been more active in challenging the appropriateness of the prices and may seek to apply a higher value to the clinical trial medicines.

While different companies appear to have adopted different valuation methodologies for their trial material imports — ranging from variations of cost-plus to resale-minus — import values often run into millions of dollars and must be supportable if queried by the local customs authorities.

Given the applicable customs duty and import VAT rates, this can result in significant indirect tax costs on clinical trial activities that may not have been factored into the initial budgeting process.

Dialogue with China Customs

The complications of conducting clinical trials in China generated much discussion during a recent industry forum hosted by Ernst & Young (China) Advisory Limited.

The program, which included a member of China Customs and Ernst & Young (China) Advisory Limited representatives from the Indirect Tax and Transfer Pricing practices, discussed a variety of customs duty and VAT issues specific to the pharmaceutical and medical device industry, including proactive strategies that pharmaceutical companies are seeking to adopt to deal with these issues, such as:

• Assessing in a strategic manner the sourcing of dosage materials at the outset
• Determining in advance the technical basis on which to assess the customs value, working in conjunction with tax and transfer pricing colleagues
• Planning trial time scales that allow the company to take advantage of existing customs relief programs that can alleviate these costs
• Working collaboratively with the authorities to consider introducing a duty or VAT relief on such products in the future
• Engaging in proactive discussions with China Customs to agree to an acceptable customs valuation methodology in advance to mitigate risks and potential penalties

We anticipate more dialogue with China Customs and the industry on this topic but also through these types of events in China.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

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In this changed environment, CFOs at consumer products companies have to get to grips with five key challenges:

1. Uncompromising stakeholders present companies with dilemmas
2. Consumers take hold of the conversation and demand greater value
3. The new age of the consumer demands a revitalized approach to brand management
4. Unprecedented complexity demands greater flexibility of supply
5. The fast-changing environment requires a new style of leadership.

Implications for CFOs

Winning in the brand new order requires companies to make far-reaching changes to their business. Many of these changes fall within the remit of CFOs, or at least have some link to their roles and responsibilities. Companies need to:

Reframe strategic choices

The scale and pace of change creates what appear to be paradoxes for decision-makers. Companies must invest to maintain market share in sluggish mature markets, but also allocate funds and resources to capture growth in rapid-growth economies.

They must get closer to consumers in specific markets, but also figure out how to derive economies of scale at a regional or global level. They must also determine a long-term vision for the company and be able to react quickly to sudden changes in the business environment. For CFOs, resolving these paradoxes lies at the heart of strategic decision-making.

Deciding how and where to compete, and where to focus in order to create value, is increasingly difficult. A key decision for CFOs, which is explored in the Ernst & Young report A tale of two markets, involves the timing and extent to which they should reallocate assets and resources away from developed markets to rapid-growth ones. Finance leaders play a key role in determining:

• The right mode of entry
• The nature of the investment
• How quickly to scale it up in the context of other parts of the portfolio

At the same time, CFOs must be aware that developed markets still have profitable potential, despite their problems, and ensure that the right assets and resources remain in place to maintain or grow share in these more established markets. Managing this portfolio of assets globally requires CFOs to make decisions over where to centralize and where to globalize. Companies must strike a careful balance between the need for local dynamism and global scale.

CFOs must also be able to communicate these plans to investors and other stakeholders. Building and maintaining trust at a time of great change requires complete transparency. Finance leaders must be clear about the risks and opportunities facing the business, and be consistent in how they report them.

Realign the value chain

As companies expand their geographical footprint and manage a proliferation of channels, they inevitably face a dramatic increase in complexity. This requires a robust and resilient value chain. The increasing cost and scarcity of natural resources adds to the challenge, placing an even tighter squeeze on margins and stretching many operating models to breaking point.

These pressures, along with broader globalization and technology trends, require companies to reassess the balance between centralization and localization in the supply chain. CFOs can analyze the merits of each approach. Rising costs across the supply chain can erode the benefits of manufacturing in a low-cost jurisdiction.

One alternative is a shift to a regional supply chain model, which can help to offset rising shipping costs while still maintaining proximity to local markets. There may also be tax advantages with this approach, because there is less need for components or commodities to cross borders.

In addition to dealing with a complex bricks-and-mortar retail infrastructure, companies must also manage other fast-growing channels, including e-commerce. CFOs need to assess the value that each of these channels brings and ensure that the company has a multi-channel strategy that meets performance metrics and goals.

Social media channels increasingly provide a way for consumers to express their approval, or disapproval, of brands. This trend enables companies to leverage engaged consumers as brand ambassadors, but it can also pose risks.

From the CFO’s perspective, awareness of these opportunities and risks is crucial. In addition, finance leaders must start to develop ways of measuring the performance of social media and determining the return on investment from this growing portion of the marketing budget.

Ruthlessly execute to capture value

The difference between success and failure often comes down to how a company implements its strategic vision. Companies need an operating model that supports agility, a ruthless approach to costs and a strong focus on continuous improvement. They also need a highly rigorous focus on talent, which is by far the most critical barrier to execution.

CFOs must lead from the top in ensuring that these assets and capabilities are in place, and that the company has the right resources in the right places to support the strategic vision. This includes resources in the finance function, which are themselves evolving rapidly against a backdrop of increased change and complexity.

The rapid pace of change requires local managers, who may be thousands of miles away from corporate headquarters, to make decisions every day. Ensuring that these are appropriate and aligned with strategic objectives requires CFOs and risk teams to put in place robust controls frameworks that place decision-making within agreed parameters. Performance management tools are also essential to measure progress toward strategic goals and identify problems with execution.

Over the past few years, CFOs have become accustomed to seeking out cost-efficiencies and containing costs. Strong pressure to continue with this work remains, particularly against a backdrop of structural cost increases.

CFOs should work to implement a broader culture of continuous improvement, so that there is a permanent focus on driving out waste and cost from the business. At the same time, they must take care to prevent taking out costs that consumers value.
Yet cost containment should not be the primary focus. CFOs and other members of the management team also need to explore ways of improving pricing power to create more sustainable long-term value.

Download: Disrupt or be disrupted – the CFO perspective

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In Europe, in particular, all three important groups of “classic” excise duties (alcohol, tobacco and mineral oils) have seen significant increases, with the only decrease in fuel excise duties implemented in Slovenia in 2012.

This year, excise duties on tobacco and/ or alcohol have increased or will soon increase in most EU countries, Guernsey, Moldova, Norway and Switzerland. This trend can also be seen in other parts of the world; in Africa higher excise duties are being imposed on these items, e.g., in Benin, Gambia and Zimbabwe. In the Americas, Aruba, Canada, Costa Rica and Mexico have also raised taxes on alcohol or tobacco, as have Fiji, New Zealand and the Philippines in Asia-Pacific.

Influencing consumers

While the main purpose for excise duty rate increases — and the original reason for the introduction of excise duties — is to raise revenue, these taxes are also increasingly being used to discourage consumption of certain products considered to be harmful, thus influencing consumer behavior in a number of areas.

A relatively new trend is the introduction of excise taxes on health-related products (other than alcoholic beverages and tobacco products) such as snack taxes on “unhealthy” food. For example, Benin, Costa Rica, Norway and the Philippines have all increased excise duties on soft drinks, Finland has introduced an excise duty on sweets and ice cream, and in France a specific contribution has been introduced on suppliers of beverages (sodas) with added sugar or sweeteners.

Over the last decade, environmental issues have also played an increasing role in determining the nature and application of taxes, e.g., on road fuel, motor vehicles and CO2 emissions. This type of measure includes tackling issues such as waste disposal, water pollution and air emissions.

With support from the OECD, whose analysis seems to confirm the advantages of environmental taxes, 2 many countries are introducing or increasing such taxes? For example, Germany has introduced a tax on nuclear fuel, Austria and Germany have introduced a duty on airline tickets for airplanes leaving from domestic airports, Ireland has introduced a tax on CO2 emissions and South Africa is currently working on a framework for a carbon tax for which legislation is expected in the latter half of 2013.

Taxing financial transactions

Finally, there is a noticeable trend toward increasing the tax burden on financial transactions. Although there seems to be a common and widespread belief among countries that the financial sector should contribute its fair share in remedying the damage arising from the financial crisis, there is no common approach as to how this should be achieved.

Some countries have increased supervision of the industry and tightened regulations. However, in Europe, in particular, the preferred approach has been to levy taxes on financial transactions.

France introduced a financial transactions tax in August 2012, and on 1 January 2013, Hungary introduced a tax of 0.1% on the amount involved in any payment service. Italy will follow in March 2013 with a tax on the transfer of shares and derivatives and high-frequency trading.

In addition, 11 EU member states have agreed to introduce a common transaction tax on the exchange of shares and bonds and on derivative contracts, which could be introduced as early as 2014.

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However despite the signs of improving global business confidence since the beginning of the year many economic fundamentals in the euro area remain weak and unpredictable, according to the spring Ernst & Young Eurozone Forecast (EEF).

The forecast predicts a mid-year turning point. Despite economic growth picking up in the second half of the year, an overall decline of 0.5% in GDP is still expected for 2013, after a similar fall in 2012. Sluggish growth of 1.1% is predicted for 2014. This will be followed by slow-paced expansion in subsequent years averaging 1.4% per annum from 2014-17, almost a full percentage point below the 2.3% average in the eurozone of a decade before.

The contrast between low growth in the core eurozone nations and ongoing recession in the peripheral countries will remain stark this year, although productivity improvements in the latter will narrow that gap in 2014.

The eurozone still faces challenges that could undermine even this fragile confidence.

The inconclusive elections in Italy and political challenges in several other eurozone countries remain sources of uncertainty as does the continuing high levels of unemployment, weak business and consumer spending and fiscal tightening.

However with both the US and Asian economies showing a real sense of momentum and the ECB’s gauge of systemic risk having fallen sharply since July, and now back to levels last seen in 2007, there is a sentiment that the worst may be over.

Marie Diron, senior economic adviser to the Ernst & Young Eurozone Forecast comments:

“There is no doubt that the eurozone is looking in much better shape than it was six to nine months ago and we are seeing that improvement reflected in share prices across Europe. There remains however a significant lag between the relative exuberance we have seen in the financial markets and confidence in the real economy. We do expect confidence to return in businesses and households, but much more gradually than recent financial market movements would imply.”

Mark Otty, Ernst & Young Area Managing Partner for Europe, Middle East, India and Africa comments:

“There have been many false dawns along the road to recovery in the eurozone and this may yet prove to be another. However the sense we have from companies across Europe is that corporates are beginning to raise their expectations in terms of plans for future investment. There remains a huge amount to do though in terms of improving longer term productivity and innovation if European economies are going to compete with other developed markets and new emerging players.”

Closing the gap between the core and periphery

Despite the contrast in growth between the eurozone core and periphery there are some tentative signs that the situation beyond the core nations is improving. EEF expects the pace of contraction in the periphery to slow from 1.9% in 2012 to 1.4% in 2013, before a return to growth in 2014.

This is primarily due to painful work being undertaken by certain countries in the periphery to reform their economies which is already yielding results in the form of improving international competitiveness.

Since 2008, employment in the periphery has fallen by 9% or 5 million people. In the case of Spain, Ireland and Portugal, employment has fallen further than output, thereby providing a boost to productivity. The falls in relative unit labor costs have made the goods and services produced in these peripheral economies more competitive than they were five years ago.

By 2014, EEF expects the peripheral eurozone countries with the fastest export growth to be Greece, Ireland and Spain – 9.3%, 4.4% and 4.1% respectively. These are the three countries that have seen the largest improvement in their relative unit labor costs, and hence competitiveness, since 2008. This will help these countries exit recession and allow gains in economic activity to accompany job creation.

Marie comments:

“The return to very modest growth that we expect to see in the peripheral countries in 2014 will initially be driven by business investments and exports and subsequently, once the labor market starts to improve, by consumer spending.”

A slow decline in unemployment expected from 2014

A further rise in unemployment in the short term, and only a slow decline from 2014 is likely to be an impediment to growth. EEF predict that unemployment in the eurozone will reach a record high of 12.4% by the end of 2013, with the jobless rates in Spain and Greece at more than 26.5%.

Even with recovery, the number of people out of work across Europe will remain stubbornly high. By the end of 2017, EEF estimates the unemployment rate will remain above 11%, and the number of unemployed will be around 6.5 million higher than a decade before.

Consumers’ willingness to make new purchases will be hampered by further increases in unemployment in 2013. Ongoing fiscal tightening and austerity measures will also have an impact on household spending. Consumer spending is expected to fall again in 2013, by 0.6%, before starting to grow slowly by an average of just 1% a year in 2014-17.

Banking sector deleveraging will also continue to constrain growth over the forecast horizon. Although the banking system is now much less of a systemic threat to the broader economy than a year ago, it is not yet in a position to drive an economic upswing through rapid lending growth. Generally, tight credit conditions will weigh on investment and consumer spending.

Strong euro unlikely to pose threat to growth

Although the economic climate remains difficult, confidence among businesses and consumers should return gradually, as some of last year’s major threats recede. But business investment is still expected to shrink by 2% in 2013, before recovering slowly to post average growth of 3.5% a year in 2014-17.

Over the last six months there has been a marked decline in risk premia priced into eurozone financial markets. EEF thinks that markets have risen too strongly, given that many economic fundamentals remain weak at best and the ongoing political uncertainty in several countries.

The euro has already surrendered some of its earlier gains, but it is still up by 8% against the US dollar and 8.5% on a trade-weighted basis since mid-2012. In the current climate the impact of the appreciation will be mitigated by the fact that it is accompanied by a more stable environment. However, the export sectors from the periphery may suffer from the appreciation of the euro and if sustained it may undo some of the painful work undertaken to restore competitiveness.

Despite these concerns, EEF has not lowered its growth or export forecasts as it does not expect the rate to stay at its current level for long. EEF estimates that the euro is overvalued by a little under 10% at present. But, as uncertainty about the US fiscal stance clears and the pickup in growth there and in emerging markets becomes more obvious, EEF expects the euro to depreciate again towards US$1.25 by the end of this year.

Marie says, “It is unlikely that the ECB will intervene unless the strength of the euro continues and a significant impact on activity becomes evident. However, if the rise does persist the ECB many need to intervene, perhaps even with an interest rate cut, to stem any further appreciation. A stronger euro does pose a new threat to the eurozone outlook but it is one that businesses are accustomed to so it is unlikely to have a major impact.”

Fiscal tightening to cut 1% off GDP growth

Fiscal tightening is also expected to be a medium-term drag on growth. EEF estimates that fiscal tightening will amount to more than 1% of GDP again this year, which will cut around one percentage point off GDP growth. From 2014 onwards, the pace of fiscal tightening should lessen, but at around 0.5% – 1% of GDP a year, it will continue to dampen growth.

Marie explains:

“After several years of austerity, one of the key challenges now facing policy-makers in the eurozone – both in the peripheral countries and most others – is to apply public sector reforms in a way that does not continue to undermine growth.”

In the peripheral countries particularly, a range of measures have been proposed and implemented. This restructuring has involved broadening tax bases, increasing tax rates, improving tax collection, reducing public sector wage bills, and lowering the scale and duration of welfare payments. Competition laws have also been strengthened which have shown signs of reducing bureaucracy and made it easier to start businesses.

Two steps forward, one step back

Marie concludes:

“As has often been the case with the eurozone since we began our forecasts in April 2010 recent developments have been two steps forward and one step back. As soon as the outlook improves and volatility declines, fresh concerns appear and new threats rear their heads. If there is to be a recovery later this year – and we believe on balance there will be – it will be a fragile one and policy makers need to keep a close eye on political and economic developments and be prepared to again respond quickly and effectively to deal with any potential crisis.”

Read more: Ernst & Young Eurozone Forecast & Outlook for financial services

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With more goods and services being sold to private consumers by remote sellers, who may be based anywhere in the world, tax administrations are challenged with the tasks of keeping pace with technological change and protecting precious revenue receipts.

How do the EU and the US compare?

The basic principle of EU VAT is that it is a tax on consumption. Sales and use taxes, as applied in the US, are in principle no different, although the mechanics of collecting them are quite different.

EU member countries may require that if consumption occurs within their borders, then VAT should be properly allocable there. For that to occur on a uniform basis, all the EU countries must agree on the mechanics of doing so.

In the US, adoption of a uniform national standard would in theory be much simpler, since only a mere majority of Congress and approval by the President would be required. Yet Congress has done little to establish uniform national standards, leaving states and taxpayers with a series of US Supreme Court decisions establishing outside limitations on the ability of states to enforce collection of their consumption-based taxes.

The European Union approach

Summary of the EU VAT rules

• A business within the EU that sells and delivers goods to private individuals in the EU should collect and remit VAT in its customers’ EU countries subject to certain thresholds. There currently is no single point of registration scheme for such sales, and businesses operating in the EU may have multiple VAT registration and remittance procedures to follow.
• A business that sells and delivers goods from outside the EU may not have such requirements, but customers resident in the EU are required to pay VAT on imports of such goods, subject to certain low-value thresholds and if they are declared as importers of record.
• A business established in the EU that sells ESS to private individuals is required to collect and remit VAT in the EU country where the business supplier is established. However, from 2015, it will be required to collect and remit VAT in the EU country where the private individual buying the ESS is resident.
• A business established outside of the EU is required to collect and remit VAT on sales of ESS to private individuals resident in the EU, charging VAT at the rate in the EU country where the customer is resident. VAT on sales of ESS to private individuals resident in the EU can be reported and remitted through the single point of registration regime.
• Similar rules apply in Iceland, Norway and Switzerland. A business established outside of these countries is required to collect and remit VAT in each if it supplies ESS to private individuals resident in these countries.

Sales and use taxes in the US

The US is the only OECD member country that does not impose a VAT. Also, the US does not impose a general national consumption-based tax. Instead, state and local taxing jurisdictions impose sales and use taxes.

Largely confined to the taxation of retail sales of physical goods, these taxes are designed not to apply to intermediate transactions (i.e., from manufacturer to wholesaler and retailer) as VAT does, but only to retail sales to the end consumer.

Sales and use taxes are imposed by 45 of the 50 US states and the District of Columbia. Unlike the EU, harmonized, uniform standards on the application of these taxes do not exist, and, subject to the limitations established under the US Constitution, each state administers its sales tax independently. Items subject to tax in one jurisdiction may be excluded in others.

Although a few states permit sales and use taxes to be imposed only at the state level, a large majority allow local jurisdictions to impose rates in addition to the state rates. However, in most of these jurisdictions, collection and enforcement is delegated to a single state authority, and the rules applicable to transactions subject to the tax are uniform throughout the state.

Thus, while application of the tax is the same throughout these states, the rates may vary depending upon the specific jurisdiction to which the transaction subject to tax is sourced. Although just 46 state-level jurisdictions impose a sales tax, when localities are considered, there are more than 7,600 taxing jurisdictions throughout the US. As such, administering sales tax on a multistate basis is a daunting task.

Conclusions

In general, the EU seems to have developed more effective ways of taxing e-commerce consumption. An important element of the EU system is that it allows the 27 member states to collect VAT on most consumption by private individuals if it occurs within their borders, regardless of whether the sellers of the goods and services have any physical connection to that particular member state.

In most cases, cross-border transactions are taxed in the same way as domestic transactions, which reduces revenue shortfalls and distortions of competition. By contrast, the US state and local sales and use tax rules seem mired in the past when trade was localized and limited.

As there is no federal sales tax, cross-border trade in this context not only includes international transactions, it also applies to interstate deliveries. As a result, as business-to-consumer commerce moves increasingly toward a “remote seller” model, US state and local governments continue to lose tax revenue.

Meanwhile, sellers are faced with an enormously complex system of US state and local sales tax reporting, collection and jurisdictional rules. Taken together, the more modern approach of the EU arguably inflicts less suffering on the business community and may offer some interesting possibilities for addressing the problems that affect tax administrations.

The full version of this article was first published in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.96 MB)

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Based on a survey of senior executives from 641 companies in 21 countries; Business Pulse: Exploring the duel perspectives of the top 10 risks and opportunities in 2013 and beyond is the latest report in a series started in 2008 to track the risks and opportunities facing businesses globally.

Pricing pressure is the biggest risk highlighted by companies in 2013, with the C-suite now accepting that they must find new ways to be profitable in response to shrinking developed markets. This is reflected in companies turning to innovation and rapid-growth markets in order to create new opportunities.

This contrasts with 2011 when companies were focused on the risks associated with regulation and compliance, and the most significant opportunity came from the execution of operational strategy.

Commenting on the report’s findings, Randall Miller, Ernst & Young Global Risk Leader says:

“With anemic developed market growth, and fierce price competition, the world has long looked to new markets for expansion opportunities. But to exploit these rapid-growth markets, companies must relate the opportunity directly to their degree of risk tolerance. It is not a question of how companies get into these markets; it is a question of how they win.”

Operational agility: tuning for greater performance

High wages and input costs, as well as significant new regulatory burdens on various sectors, mean that cost cutting and the related pressure on profits is cited by respondents as the second-biggest risk they face, with companies needing to make tough decisions on how to cut costs without damaging product and service standards.

For multinational organizations trying to balance the desire for cost competitiveness in key markets, as well as growth in new markets, rethinking the cost and location of operations from a global perspective can create opportunities. As a result, operational agility is crucial to surviving and flourishing in a volatile world economy, with executives in developed markets citing this as their second-biggest opportunity.

The number one opportunity is innovation, especially within the rapid-growth markets, both in terms of new products or services and within operations. This is reflected in research and development spending in rapid-growth markets growing four times as fast versus developed markets.

Steve Watson, Ernst & Young’s Global Performance Improvement Leader says:

“Innovative organizations drive a culture and set up policies to promote and reward innovation systematically. Having a clear vision of what this means for your business is key. External contributions such as commercial and academic partnerships can help too, as innovation often occurs through networking and critical mass.”

Customer reach: in search of the new

Companies are also embracing the emergence of new marketing channels, such as social media, which is ranked as the fourth-greatest opportunity for business, up from eighth overall in 2011. This was especially true of companies operating in rapid-growth markets, but inevitably, there are risks too, and emerging technologies are still considered a top 10 risk in ninth place, although this is down from fifth place in 2011.

Paul van Kessel, Ernst & Young Global IT Risk and Assurance Leader comments:

“When companies are thinking about emerging technologies, there’s a danger that they will overlook the related risks. For all the steps that companies have taken in virtualization, cloud computing, social media, mobile and other emerging technologies, they continue to fall behind with taking information security measures, creating an information security gap that grows ever larger.”

Stakeholder confidence: broader considerations emerging

Looking at a macro-level, the increasing role played by government in business is now cited as the sixth-biggest risk faced by companies, up from seventh place in 2011. This is driven in part by tightening regulation, notably in the financial sector, but it is also prevalent in rapid-growth markets where governments are playing an increasingly active role.

This can reshape the nature of competition and in China for example some multinationals are required to work in partnership with local firms, as the country seeks to support its local industrial base. As a result, government policy, and maintaining good relations with government, is increasingly important for businesses.

Following on from government involvement, regulation and compliance is listed as the seventh-biggest risk facing companies, down from first place in 2011. However, companies’ broader sense of accountability in the post-crisis world is also reflected in the opportunity to leverage CSR and public confidence.

It is a new entry to the list, ranked eighth, with many institutional investors now demanding greater transparency in areas such as environmental and social issues, which can impact on the viability of long-term investments.

Jonathan Blackmore, Ernst & Young Europe, Middle East, India and Africa (EMEIA) Risk Leader comments:

“On the ground, this shift in thinking is clear enough – shifting from a backwards –looking view of risks to a forward-thinking view. Companies are now seeking to understand what regulations impact their business and working out how they can manage and control those compliance issues within each market as part of a “business as usual” model to keep costs down, as opposed to treating each regulation as a special project.”

Looking towards 2015 and the challenges ahead for companies, Miller concludes:

“As our research highlights, companies are increasingly reconciling themselves not only to a long-term downturn in developed markets, but also to their increased exposure to a volatile world economy and markets. In turn, this new status quo brings with it several emerging risks and opportunities that companies must actively engage with and plan for, as many of these major economies are closely interconnected and waiting for an end to global economic uncertainty is no longer an option.”

Read more:  www.ey.com/businesspulse

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The trend in rising VAT rates has been particularly strong in Europe, especially in the European Union (EU), where, as a result of the consistent rises, between 2008 and 2012 the average EU standard VAT rate increased from around 19.5% to more than 21% (Figure 2).

The upward rate trend in Europe continues as Cyprus, the Czech Republic, France, Finland, Italy, Poland and Slovenia have already increased rates recently or have announced increases later in 2013 and 2014.

In Asia-Pacific, the upward VAT/GST rate trend is less explicit, but still noticeable. Japan, for example, which is struggling with massive budget deficits, decided in August 2012 to increase the current VAT rate from 5% to 8% effective 1 April 2014 and to 10% effective 1 October 2015. Thailand has also announced a rise in the VAT rate from 7% to 10%, to happen by October 2014.

By contrast, VAT/GST rates in the Americas remain relatively stable. In South America, where VAT systems are widespread and have been in use for some time, rates have not changed much in recent years. One exception is in the Dominican Republic, where the rate is set to increase from 16% to 18% this year and next year.

Broader base

The scope of VAT/GST is also widening in many countries. This is being achieved through the “reclassification” of certain goods or services to apply a different rate and by removing exemptions.

Examples of countries where the scope of the zero-rate (0% rate) was reduced in 2013 include Croatia, Norway and Kenya; while in the Dominican Republic, Jamaica, and Zambia, exemptions have been removed, and in Iceland, Italy and Poland, the application of the standard rate has been widened to goods that were previously taxed at reduced rates.

The impact on business

The significance of this trend for final consumers is clear: retail prices rise. But its impact on businesses is equally important: higher VAT/GST rates increase the compliance risk.

Companies must ensure that all the increases are properly dealt with in their accounting and reporting systems, which often results in a range of IT and administrative costs. Errors frequently arise when rates change, resulting, for example, from incorrect product or tax codlings or confusion about the correct rate for supplies that span the change.

EU businesses supplying VATable and VATexempt goods and services do not generally recover all the VAT paid on business costs and overheads. However, the amount of input-VAT individual taxpayers can recover varies depending on location and VAT-recovery calculation method. This article examines the EU VAT deduction principles for partially exempt taxpayers and the practical application of the rules in selected member states.

Taxable businesses must collect VAT from final consumers and report and remit it to local tax authorities. VAT paid on purchases and expenditure (input-VAT) can be deducted from VAT payable (in principle). Thus, businesses only pay VAT on value added.

However, this concept is not applicable to businesses involved in VAT-exempt activities. From a VAT perspective, these businesses are treated as final consumers, since the VAT they pay on purchases and expenditure is irrecoverable.

Businesses engaged in both taxable and exempt transactions play a dual role:

• They collect VAT on taxable transactions on behalf of governments
• They are treated as the final consumer for exempt transactions

The EU VAT Directive allows businesses to deduct input-VAT related to taxable transactions or certain exempt transactions. Therefore, input-VAT related to exempt transactions not specifically mentioned in Article 169 is non-deductible.

Any input-VAT that cannot be directly attributed to taxable or exempt transactions is normally referred to as residual VAT. Business can only deduct input-VAT related to taxable transactions.

This is calculated on a pro rata basis where the nominator is total taxable transactions and the denominator is taxable and exempt transactions. However, EU member states may:

• Allow businesses with suitable records to compute a sector-specific pro rata
• Oblige a business to compute a sector-specific pro rata and keep sector-specific records
• Allow or oblige a business to make the input-VAT deduction based on the use made of all or part of supplies received
• Allow or oblige a business to apply the pro rata to all purchases and expenditure used for business purposes
• Apply a de minimis rule to non-deductible VAT

The EU VAT Directive aims to harmonize VAT within the EU, but member states have some individual leeway. The Directive does not currently contain any rules regarding input-VAT deduction on revenue generated outside the country of establishment.

However, the Crédit Lyonnais case currently before the Court of Justice of the European Union (CJEU) may provide clarity on this issue. Crédit Lyonnais sought to include the value of loan interest provided by the head office to non-EU branches in its pro rata calculation.

Arguing that the head office and branches are the same legal entity, French tax authorities refused to allow the inclusion. The CJEU’s verdict will have far-reaching implications for VAT recovery for business sectors where full VAT recovery is impossible.

EU member states: current positions

Germany

• Applies a stepped pro rata system where input-VAT related to taxable supplies is fully deductible, but non-deductible from exempt supplies. The deductible portion of the residual VAT must be estimated.
• Turnover-based value estimation is only permitted in the absence of another allocation method.
• In April 2005, the German Government issued new guidance on this issue for banks.

• A specific pro rata applies to each business sector. Banks can apply a modified turnover pro rata where a margin is considered, rather than actual interest.
• For a bank’s own equity business, a fictitious margin instead of equity values is acceptable.
• Various methodologies are acceptable, but all taxpayer actions must be economically justifiable
• Taxpayers are bound by their chosen methodology – switching for VAT benefit is unacceptable.

United Kingdom

• Applies a “standard method” as per UK VAT regulations for calculating deductible input tax for all UK businesses.
• A proportion of input tax incurred for both taxable and exempt supplies is attributed to taxable supplies.
• If a “fair and reasonable” input tax recovery is not given by the standard method, businesses can seek approval to use a special method that separates the residual input tax between different areas or sectors. Normally, a sector-based method is appropriate because there are different business activities that use costs differently. Therefore, bigger businesses are more likely to find a sector-based method appropriate.

The Netherlands

• VAT incurred on goods and services is initially attributed to either VATable or VAT-exempt activities. Where VAT cannot be directly attributed a turnover-based pro rata calculation is used. However, different VAT-recovery methodology is acceptable if it is more accurate.
• Currently, no specific guidance on accounting for foreign branch turnover; however, in practice the tax authorities have allowed it to be included.
• Dutch branches of foreign companies should apply a pro rata calculation separate from the foreign company’s calculation. Where the branch receives income only from its head office this doesn’t apply; instead the head office’s VAT recovery rate should be applied for the recovery of Dutch VAT.

Italy

• Taxpayer activities involving both taxable and exempt transactions require pro rata-calculated VAT deduction, even if goods and services are exclusively attributable to taxable transactions.
• However, an alternative regime using specific pro rata calculation and record-keeping specific to each business segment is available. Insufficiently related goods and services must be apportioned according to objective criteria.
• Under the “36 bis” regime, available to companies carrying out mainly exempt activities, invoicing and recording VAT-exempt transactions is not required. In exchange, companies cannot deduct VAT on goods and services purchased and imported, regardless of their pro rata.

The full version of this article is available in the Ernst & Young Indirect Tax Briefing, Issue 6, December 2012 (pdf, 4.10 MB)

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