Saturday, March 16, 2013

VAT Fraud



VAT Bill (V-bill) The Writer's website
[Original draft created by Lal Silva (Deputy Commissioner General, Inland Revenue Sri Lanka) on 25th July 25, 2011 – This is being revised and rewritten]

Standard System
A trader usually buys articles and sells them. When he buys, pays VAT. When he sells, collects VAT. If the collected VAT is more than what he paid he will have to remit the excess to Inland Revenue. If the collected VAT is less than what he paid he will get a refund from the Inland Revenue.
Normal cross border transaction cycle
NOTE: -F refers to foreign and -L refers to local



·         Exporter-F exports goods to Importer-L.
·         Exporter F gets a refund from Government-F.
·         Importer-L sells goods to Supplier-L and collects VAT.
·         Importer-L pays VAT to Government-L.
·         Supplier-L sells goods to Exporter-L and collects VAT.
·         Supplier-L pays VAT to Government-L.
·         Exporter-L exports goods to Importer-F
·         Exporter-L gets a refund from Government-L.
·         Importer-F pays VAT to Government-F.

Inland Revenue employs various methods to stop giving fraudulent refunds arising out of these invoices. VAT experts suggest to random check invoices and give severe punishments to perpetrators. This method has several drawbacks. It is not a useful method because implementation of the rule of law falls short in most countries.

Some countries including Sri Lanka utilize a method to track the transactions by matching the vouchers. This seems very difficult to implement. It consumes a large amount of resources, manpower and computing. It tries to refuse the refund instead of punishing the wrongdoer – this leads to further corruption. Real punishment is not blocking the fraud. It will not deter the doer in repeating and others from not doing it.
Broad outline of the proposed system
·         Issue of an IOU—called V-bill— Instead of VAT a refund by the Inland Revenue is the first step. The person who claimed Rs. 350,000 refund would receive three V-bills with value Rs. 100,000 each—here the claim should be only Rs. 300,000 for the current period and keep balance Rs. 50,000 to claim in the next period.
·         Dealing the V-bills in the market by traders is the second step. They can trade these instead of cash when they pay VAT on their purchases.
·         Redemption of the V-bills by Inland Revenue accepting V-bills along with cash as VAT payments is the last step.

A typical example to explain the system

Instead of the refund Sunil will get four V-bills each worth Rs. 100,000 — treatment of the balance Rs. 40,000 is explained later.  Sunil will transfer these V-bills together with Rs. 4,600,000 to settle the debt he owes Kamala. In the end, Kamala will surrender the V-bills in lieu of paying her VAT to Inland Revenue.
Cross Border transaction cycle with local V-bill
NOTE: -F refers to foreign and -L refers to local




·         Importer-L will purchase goods from Exporter-F.
·         Exporter-F will get a refund from Government-F.
·         Importer-L will pay VAT/V-bills to Government-L.
·         Importer-L will sell goods to Supplier-L and collect VAT/V-bills from him.
·         Supplier-L will sell the goods to Exporter-L and collect VAT/V-bills from him.
·         Then Supplier-L will pay the VAT/V-bills to Government-L.
·         Exporter-L will export goods to Importer-F and collect V-bills from Government-L.
·         Importer-F pays VAT to Government-F.

Issue of V-bills
·  Taxpayer gets a refund in the form of V-bills when input VAT is greater than output VAT.  ­­
·  The refund claimer will have to produce the necessary invoices for checking in order to obtain the refund.
·   This system will stop issuing cheques as refunds arising from VAT input credit — some rare refunds on erroneous returns and payments made by cash will be issued by cheques.
·   Digital V-bills can be issued by large taxpayers who can use it to reduce workload and facilitate business to business transactions. These will have digital signatures and have all the data usual paper V-bill has.
Denomination of V-bills
·  Because of the sheer number of sales vouchers, circulate in the market, cross matching them becomes difficult. By bundling a set of vouchers into a single document (V-bill) that has a fixed denomination will solve this. It will simplify the matching process. There will be only one denomination (say Rs. 100,000). The system will process only these V-bills and not the sales vouchers.
·  The face value will be in only one denomination preferably Rs. 100,000/- only.
·  Trader can schedule the invoices so that the claim is just above multiples of Rs. 100,000.
·  In Sri Lanka VAT system issues refunds averaging to Rs. 500m per month. Consequently around 5,000 V-bills will be issued per month. The workload of Inland Revenue can be kept at reasonable limits by keeping V-bill denomination to Rs. 100,000.

·  When a taxpayer claims a VAT refund he will be issued only VAT Bills to the nearest Rs. 100,000/- of the refund.
·  V-bills can be used to make payment for purchases. It will be allowed to make use V-bill to pay for the full value of the invoice —it will not be limited to VAT value of invoice. V-bill value is for Rs. 100,000 which is fairly a high value. If this is allowed for VAT potion only it will be difficult for small taxpayer to use it in their limited purchases. It can be said that by allowing the V-bill to pay not only VAT but also the full purchase value might lead to frauds. But system of V-bill will not be operational and too cumbersome if the full value is not allowed.
·  Taxpayers who do not have a refund worth Rs. 100,000 in a single tax-period, can keep the invoices without claiming until the total refund is over Rs. 100,000. Then present it for refund. One-year period will be given for them to use the invoices. However, refunds will be rounded down to nearest Rs. 100,000 — If the totals of the invoices are Rs. 115,000 he will get only one Rs. 100,000 V-bill. Taxpayer will have to schedule their invoices and make the claim to get the maximum benefit. They will be allowed one year to make the claim on an invoice.  
·   Split VAT Invoice: Legal provision has to be created to issue two VAT invoices for a sale of a single item. This will allow the buyer to claim one invoice in one tax period and the other invoice in another tax period. This will help a buyer to round-up his input credit to nearest Rs. 100,000. By allowing this the buyer can get the full benefit of the input credit while allowing Inland Revenue to manage their data in neat Rs. 100,000 units.
Maximum of only two split invoices could be used in a refund claim for a taxable period. The responsibility of it should rest on the buyer not the seller. A written request should be made by the buyer to the seller. Each buyer can make only one such request to any of his sellers for a taxable period —e.g. he cannot make two requests from two different sellers.

·         To overcome the difficulty of exchanging the high denominated V-bill following concessions regarding the time limit of dealing and redeeming are permitted:
            A trader can keep the purchase invoices for one year before claiming credit.
            It will have a validity period of preferably one year. It has to be redeemed with Inland Revenue before that date.
            V-bill can be transacted for a previous purchase done within the one year of the date of V-bill— issue date.
Dealing in V-bills

                If money has been paid regarding a purchase to the seller before the issue date of the V-bill it can be transacted for money.
                If there is a debt —unpaid invoice value— V-bill can be used to settle the debt.
·   There will be no limit to the number of exchanges of a V-bill from a seller to a purchaser. But only genuine purchases can utilize it.

·   Parties negotiating with V-bills will have to do it on trust. It will be similar to cheques in Sri Lanka. We accept cheques only from people we trust. This trust is the main safeguard against fraud to Inland Revenue.
·   It can be endorsed by parties negotiating with it or any guarantors.
·   It will have the qualities of a chose in action or a nonnegotiable but transferable instrument — similar to a crossed cheque — an IOU issued by the Inland Revenue.

·   V-bill will be issued to a purchaser — VAT registered— only after the purchase, therefore, the chance of using it to settle the debt —or VAT potion — arising from the same purchase is little. By not limiting it to the VAT fraction, it can be used in a future purchase. This will increase the chance of redeeming it. Alternatively, the traders can agree to charge only the net value —without VAT— from a sale and after the buyer gets his refund use the V-bill to settle the VAT potion of the transaction.
·   Banks can create a business of V-bill guarantying. They will endorse the V-bill for a charge. They will check the business and vary the charge accordingly. It will be an insurance against Inland Revenue rejecting the V-bill.
·   Credit-Rating agencies can be created like CRIB to rate the vendors. This will help identify a rate that should be applied in discounting the V-bills.   
·   This will create the concept of ‘careful trader’, who now assumed joint and several liability for his actions and possibly those of others.
·   It will not be compulsory for a trader to accept a V-bill; it is voluntary. He accepts it if it helps him to do his trade. E.g. he may not be able to affect the sale if he does not accept it. On the other hand, he has to be careful because of the danger of incurring a loss by a rejected V-bill.
·   Inheritance in case of ownership passing due to death, marriage, divorce, liquidation, etc. And whether gifting should be allowed in limited circumstances should be studied. Legal provision is necessary to allow the person inheriting it to make an application to Inland Revenue to permit a transfer outside the scope of normal transfer. This is an asset how to define its ownership may have to be studied further. It has a limited life and scope to pass ownership. It has limited method of redemption. If there is a breech at any point in the chain of ownership, the value of it will become nil.
Enforcing of V-bills
·    This will check data and other information to detect possible fraud cases for investigation.  
·    In the event, V-bills that are issued but later found to be incorrect Inland Revenue will issue assessments against the V-bill presenter as well as it’s original owner.
·    When Inland Revenue detects a breach of terms of a V-bill, it will, reject it,  issue assessments disallowing it, transmit it —In case of fraud, certificated copy will be given —to the taxpayer for damage recovery purposes from other parties. Unless there is a breach of terms or a fraud, the V-bill will remain valid not withstanding any issue of assessments.
·    If V-Bills can legally be exchanged solely in lieu of purchases made, additional advantages will creep into the V-bill system. The path of a V-bill from the time it is issued at the time it is redeemed can be traced. A computer system will be able to identify unusual paths —e.g. a V-bill issued to a textile exporter, redeemed by a construction company appears uncommon. The limitation, V-bill holder can deal it only with his suppliers curtails frauds.   
·    Inland Revenue will record at two points the transactions of each V-bill. To whom it is issued and who redeems it.
·    It will be possible to use Artificial Intelligence and fuzzy logic programs to identify suspicious transactions. Inland Revenue needs good data to tackle fraud; V-bills will supply it. Though minor random frauds may go, undetected, large-scale frauds like the VAT fraud case will be indicated by the system. The deviation in data patterns can be identified and suspicious V-bills can be investigated.

·    2D or 3D bar code can be incorporated to the V-bill leaf. It will be possible to insert security data to these bar codes. In addition unique number with security can be printed on it so that V-bills cannot be created by other than Inland Revenue.
·    Inland Revenue website will have a facility to check whether V-bill has already redeemed.
·    All presented V-bills will be image scanned to keep a record of the persons who has endorsed it.
·    It may be necessary to create a separate Act by Parliament to deal in VAT Bills.


Liability Chain
·   The persons buying the V-bill for cash and take possession of it and their guarantors will be joint and severally liable for damages by innocent parties or assessment by Inland Revenue on the value of the V-bill.

Fraud illustration: The initial owner of a V-bill is A, and it will change hands to B, C, D, and E respectively. E the final owner presents it to Inland Revenue claiming credit. Later, Inland Revenue detects that A obtained this V-bill fraudulently. Inland Revenue will issue two assessments one reversing the credit given on the V-bill to E and the other reversing fraudulent refund made to A. Further to that A will be prosecuted for fraud. B, C, D and E are innocent parties involved in the chain of V-bill transaction. Here, each transferee can sue the transferor —including guarantors — of the V-bill.
Breach illustration: A breach occurs when the term of a V-bill is violated. The violation occurs in a transfer in lieu of a purchase for a value less than Rs. 25,000. Suppose in a transfer C will give the V-bill to D. D will give Rs. 80,000 —or may be less because of the crooked transfer— and goods worth Rs. 20,000. While A, B and E are innocent parties, both C and D are not. E will be assessed by Inland Revenue because the V-bill presented by him is void. A and B there is no liability. However, since E is an innocent party, he can sue D for damages.



Anti Fraud Enforcement
·  Best way to combat VAT fraud is to make the VAT refund go back the value addition chain in case of zero rated supplies.
·  Advantage of the V-bill is that it will reduce fraud but will not hinder the smooth operation of businesses like the current VAT system.
·  This will ensure government fund security. Even when a fraud takes place, V-bills will stop VAT refunds siphoning out government funds —famous VAT fraud. In case of fraud revenue from VAT will reduce, but leakage of government funds will not occur.

Redeeming of V-bills
·  It can be presented in lieu of VAT payments to Inland Revenue —only VAT, not other taxes. Nevertheless, the original receiver can use it to pay any tax administered by Inland Revenue.
·  If V-bill is more than the VAT payable over payment will be carried forward to be set off against a future date before V-bill expires. Nevertheless V-bills will not be issued in place of redeemed V-bills.
·  Inland Revenue will not allow any VAT credit on the expired V-bills. To get value for a V-bill it must be presented before the due date, failing that, it is not possible to set off even on behalf of VAT charges  that fall due before that date
·  V-bills can be used to settle differed VAT at Custom point. It will not be necessary to have a separate voucher system for VAT differed at Customs. Taxpayers can use the same V-bills. With this simplicity, it will make things easier for Inland Revenue and Customs. Simplifying will also reduce fraud.
·  Inland Revenue and Customs need to have procedures to handle redeeming of V-bills. Some suggestions are:
o       Inland Revenue will set up a counter similar to a shroff counter or bank counter where anyone can submit V-bills with a voucher indicating the VAT number. This will be like a counter where cash is accepted for tax payment.
o       It is possible to outsource the above operation to a bank.
o       Similar operation like in teller machines, V-bills will be inserted in a special sealed envelope and indicate on the envelope the details of the taxpayer redeeming the vouchers. A back-office operation will count V-bill s in the envelope and record the necessary transactions.

What It will Do
·   Current system in Sri Lanka refuses the buyer his refund if the seller has not paid his VAT. A buyer pays genuine cash (VAT included) to purchase some item. Then when he tries to claim credit Inland Revenue will say, “look! The seller has not paid the VAT. Therefore, we can’t pay your refund” In other words, there was a VAT fraud, we — Inland Revenue— can’t bear the loss you have to bear it. These types of arguments are outrageously inequitable because at the time of purchase the buyer cannot know whether the seller will pay his VAT due in future — needs divine knowledge, however, this is the current law.
·   With the V-bill system, address this problem in a different way. The claimer will first get his V-bill and will try to negotiate it with the seller for past or future purchases. The fraudulent seller unwilling to declare his correct output tax will be reluctant to get the V-bills since it will be of no use to him since he is not paying any VAT and cannot utilize V-bills. If the buyer trade V-bills with other parties for money it is illegal and there is a chance of getting detected by the computer system since the transaction is an unusual one. This will make the buyer reluctant to buy from that seller and will do business with genuine ones. In the end, the seller will lose customers.
·   The seller also will be cautious in dealing with other than money. The emphasis shifts from a normal trading activity to a financial transaction. The set of rules that apply will be different now. He will not like to deal in V-bills if he doesn’t trust the purchaser is genuine. Inland Revenue may refuse to give credit to the V-bill if the purchaser is legitimate. On the other hand, he might lose his business if he doesn’t accept the V-bill. He will also have the option of requesting the purchaser to ask someone whom the seller trusts to guarantee the V-bill. Therefore, diverging forces will work and at some point the business practices will get adjusted and have an equilibrium for the benefit of both parties the taxpayer and Inland Revenue.
·   Still, the seller can declare output only up to the value of V-bills and under declare the balance sales. Nevertheless, even here there will be no revenue leakage due to refunds. Furthermore, this type of activity may be flagged in the computer system as suspicious.
·   If the public can deal in V-bills like a typical bill of exchange, then, it will, turn into an alternative currency, people can discount it through a bank, be an extremely flexible instrument, it can be exchanged in lieu of money, be greatly convenient to the taxpayers. Such a Bill will separate standard VAT, and VAT created refunds. It will stop taxpayers siphoning non VAT government funds through VAT system —VAT fraud. Even so, if such dealings are allowed V-bills advantage will stop at that point because it will not stop reducing of VAT revenue by claiming credit not due.
What it will not do
·  V-bills will not stop altogether the frauds that can be commuted making bogus invoices. However, making transferability of V-bills limited only to genuine purchases by law will force the seller to accept the V-bill on trust. Accepting V-bills from untrustworthy persons makes the acceptor liable for assessments or damages. As a rule, it can be said these frauds are committed with connivance. Usually several persons in the chain of the transaction are involved in the fraud. Therefore, acceptors of the V-bills will make sure that they accept only from genuine persons.
·  It should be noted, V-bills will not stop bogus claims altogether. Say a person buy something for his personal use and claim it as input credit. V-bill system will not be effective in detecting these types of fraud. But it will help identifying the main fraud in VAT, committed by submitting bogus invoices to Inland Revenue to get refunds.
Problems Of Euro zone
·   Usually when someone imports anything, VAT has to be paid at the Customs point. The importer will be able to claim input credit for the VAT paid by him when he sells the goods.
·   Inside Euro Zone, VAT is not collected at the Customs point. Therefore, the importer when he sells has to charge the VAT and pay it to the government.
·   Though Customs do not collect VAT when goods cross the border, the exports are treated as zero rated for VAT purposes and exporter will get a full refund of the VAT paid by him in manufacturing the goods.
·   Therefore, if the importer does not pay the VAT collected by him —missing trader— the revenue loss is the whole VAT value, whereas if a normal trader does not pay VAT, the revenue loss is only for the value addition done by him.
·   With V-bills missing trader fraud will be limited only to the VAT slice since the missing trader will have paid for his purchases or his imports through Customs —unlike Eurozone, Sri Lanka collects VAT at the border.
·   Carousel fraud will stop completely. Because there is no cash refund. See http://en.wikipedia.org/wiki/Missing_trader_fraud
·   "Innocent parties" - the 'Bond House' decision (http://en.wikipedia.org/wiki/Missing_trader_fraud#.22Innocent_parties.22_-_the_.27Bond_House.27_decision) With V-bills innocent parties are protected. And Tax Authorities need not try to minimize tax losses by disallowing input credit to innocent parties.
Future of VAT Bills
In the future, the fixed denomination V-bills may change to variable bills. It may be possible to operate an account like a bank account for the V-bills. Therefore, purchasing using V-bills will be made easy.
Cross Border V-bills
Cross border accepted V-bills will make V-bills go forward the supply chain. Usually when it is dealt with the local supplier, it will go back the supply chain. In future V-bills will be used to deal with the foreign importer allowing it to go forward in the supply chain. The laws will have to change allowing V-bills to be sold across borders.


Cross Border with V-bill
NOTE: -F refers to foreign and -L refers to local

·         The Extended V-bill System can be applied by two or more willing governments by accepting each other’s V-bills. This can reduce fraud (missing trader and carousal frauds). Periodically, governments will balance the dues to each other. This is similar to balancing Balance of Payments.
·         Suppose an Exporter-L zero rated taxpayer — A VAT registered person that exports and does not have to pay VAT to Inland Revenue, but his expenses will include VAT — and has VAT paid invoices in his possession where he can claim input credit but is unable, for some reason, to exchange it locally.
·         Exporter-L sells goods to foreign Importer-F.
·         Then exporter-L is allowed by law to sell these V-bills to Importer-F —may be a limit like 25% of export value may be necessary for control purposes.
·         Importer-F can use it to pay his VAT dues to his Government-F.
·         Later, Government-F will balance with Government-L the V-bills.


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