'VAT Package' Will Impact Law Firms

As of Jan. 1, 2010, law firms with offices in the EU that make taxable supplies of legal services to business customers in other EU countries have new monthly value-added tax (“VAT”) reporting obligations. Failure to comply with these monthly reporting obligations can result in severe penalties (as much as '500k per annum if you operate in all EU countries).

The EU has announced a package of changes to the VAT rules which mean sweeping reforms to the rules for determining the application of VAT for businesses that supply or purchase services, as well as introducing new monthly VAT reporting obligations.

The main changes that will impact law firms that have establishments in the UK and other EU countries are:

• Changes to the rules on the place of supply of services for most business-to-business transactions; and
• A requirement to complete a monthly EC Sales List for supplies of taxable services to which the reverse charge applies.

Changes to the Rules on Place of Supply of Services

For the majority of the legal services provided by law firms to their clients, there will be no change, i.e., if the service relates to land, the place of supply will be where the land is located. For other “general” legal advice, the current rules apply, but there will be new monthly VAT reporting obligations.

The filing of monthly EC Sales Lists is likely to add significant additional compliance costs and burdens, especially for those that may be unfamiliar with having to report intra-EU transactions.

The change could impact law firms that have different legal entities in other EU countries, a branch network or a mix of both. For example, if your Hungarian firm supplies direct to a UK client or a UK firm/branch, that supply must be shown on its Hungarian EC Sales List. Each EU entity will now be required to report all of its supplies of services on a monthly EC Sales List, including supplies to associate firms.

Also, as of Jan. 1, if the UK or EU entities receive management and/or administration services from the United States, the recipient will be obliged to account for local VAT under the reverse charge, which is a change to the current rule.

New VAT Reporting Obligations: EC Sales Lists

Law firms that operate in the UK/EU and supply services to business customers in other EU countries will be required to file monthly EC Sales Lists (in addition to their VAT returns). At the present time, the UK HMRC have indicated that they anticipate businesses using the same form that is used for reporting goods (VAT 101) and to require the following data:

• Country code;
• Customer's VAT Registration Number;
• Total value of supplies in sterling; and
• An indicator to identify services.

There are, of course, penalties for not submitting the EC Sales Lists on time, and if you operate in a number of EU countries the risk and scale of penalties increases since you will have monthly reporting obligations in each EU country from which you operate.

New Tax Point Rules for Intra-Community Services

In terms of the new tax point rules for intra-Community supplies of services in respect of which the customer is obliged to account for VAT under the reverse charge, the time of supply of such services will be the earlier of when the service is completed or when payment is made. For continuous supplies of services, the time of supply will be linked to the end of each billing or payment period, but where no invoice or other accounting document is issued, nor payment made during the year, the time of supply will be the end of each calendar year. These changes will determine not only when VAT has to be accounted for under the reverse charge, but also when the transaction is to be included on an EC Sales List.

New UK VAT Invoicing Requirements

The UK introduced new invoicing requirements with effect from Oct. 1, 2007, the aim of which is to ensure that UK VAT invoices are compliant with the EU Invoicing Directive.

UK HMRC stated that it was its intention to implement the changes with a “light touch” and not impose penalties for non-compliance. Nevertheless, compliance with these new requirements is mandatory, and HMRC is likely to take a firmer line now that the rules have settled into place.

The main change that is likely to have a large impact on international law firms is for those that operate a centralized billing system. It is now the requirement that UK VAT invoices must contain unique consecutive numbering rather than a “unique identifying number” (as previously applied).

Therefore, if the law firm's billing system operates in such a way that one sequence of invoice numbers is used for all invoices issued by its UK and other EU entities (or even globally), then the invoices issued would not meet the requirements of the new UK invoicing regime, and as such, could expose the firm to penalties in each EU country from which it operates.

International law firms will need to maintain a separate sequence for all VAT invoices issued in respect of supplies made in each EU country in which they operate.

New Penalty Regime

The present VAT penalty regime has often been criticized by both taxpayers and those in professional practice due to the fact that it does not distinguish between honest errors made by businesses and deliberate errors made by less scrupulous taxpayers.

In addition, it has been said that the regime did not deal with taxpayers in an even-handed way, due to the perceived high degree of discretion available to UK HMRC officers to mitigate penalties or even ignore errors in certain circumstances. Taxpayers have also commented that having separate penalty regimes for different taxes is confusing and adds to the administrative burden imposed on them.

As such, UK HMRC decided to introduce a new penalty regime, which it believes will address these criticisms, and is designed to encourage taxpayers to modify the type of behaviors that lead to inaccuracies in the first place. The level of penalty chargeable has been “stepped” and will be higher for deliberate errors than for careless errors.

The range of penalties under the new regime is shown in Figure 1 below.

[IMGCAP(1)]

Reasonable Care

As the new penalties are considerably higher than the present VAT misdeclaration penalty (currently set at 15%), it is obviously best to avoid the penalty system altogether. To this end, UK HMRC has confirmed that inaccuracies that arise from genuine errors by persons who have taken “reasonable care” will not fall within the scope of the penalty regime at all.

While this seems to be a positive statement, taxpayers should be aware that HMRC has not yet defined a minimum standard of what it understands “reasonable care” to mean. HMRC has, on the other hand, confirmed that a taxpayer's risk profile will be considered “in the round.”

Therefore, taxpayers who make frequent errors, even if promptly and fully disclosed, may be considered to be “careless.” This is worrisome for taxpayers who operate complex VAT recovery procedures, since the scope for error ' and the resulting risk of being brought into the penalty regime ' is magnified considerably.

Mitigation for Disclosure

Should a penalty be imposed, HMRC has the authority to mitigate the level chargeable (potentially to zero in the case of “careless” errors). However, HMRC has indicated that any mitigation will depend on the quality of any information given, as well as the necessity to “prompt” the taxpayer to make a disclosure.

Furthermore, the definition of “prompted” disclosure seems to have shifted. Whereas previously, any disclosure made to HRMC that was unconnected with an impending VAT audit (or even often made immediately before a VAT audit) would be treated as “unprompted.” HMRC has indicated that it will be narrowing the scope of what is meant by “unprompted.” For example, disclosures that are made in relation to a matter that was highlighted for review on an HMRC audit plan may be considered to be prompted, even if the error was made after the plan was issued, and the disclosure was made before any visits have been agreed.

As of Jan. 1, 2010, law firms with offices in the EU that make taxable supplies of legal services to business customers in other EU countries have new monthly value-added tax (“VAT”) reporting obligations. Failure to comply with these monthly reporting obligations can result in severe penalties (as much as '500k per annum if you operate in all EU countries).

The EU has announced a package of changes to the VAT rules which mean sweeping reforms to the rules for determining the application of VAT for businesses that supply or purchase services, as well as introducing new monthly VAT reporting obligations.

The main changes that will impact law firms that have establishments in the UK and other EU countries are:

• Changes to the rules on the place of supply of services for most business-to-business transactions; and
• A requirement to complete a monthly EC Sales List for supplies of taxable services to which the reverse charge applies.

Changes to the Rules on Place of Supply of Services

For the majority of the legal services provided by law firms to their clients, there will be no change, i.e., if the service relates to land, the place of supply will be where the land is located. For other “general” legal advice, the current rules apply, but there will be new monthly VAT reporting obligations.

The filing of monthly EC Sales Lists is likely to add significant additional compliance costs and burdens, especially for those that may be unfamiliar with having to report intra-EU transactions.

The change could impact law firms that have different legal entities in other EU countries, a branch network or a mix of both. For example, if your Hungarian firm supplies direct to a UK client or a UK firm/branch, that supply must be shown on its Hungarian EC Sales List. Each EU entity will now be required to report all of its supplies of services on a monthly EC Sales List, including supplies to associate firms.

Also, as of Jan. 1, if the UK or EU entities receive management and/or administration services from the United States, the recipient will be obliged to account for local VAT under the reverse charge, which is a change to the current rule.

New VAT Reporting Obligations: EC Sales Lists

Law firms that operate in the UK/EU and supply services to business customers in other EU countries will be required to file monthly EC Sales Lists (in addition to their VAT returns). At the present time, the UK HMRC have indicated that they anticipate businesses using the same form that is used for reporting goods (VAT 101) and to require the following data:

• Country code;
• Customer's VAT Registration Number;
• Total value of supplies in sterling; and
• An indicator to identify services.

There are, of course, penalties for not submitting the EC Sales Lists on time, and if you operate in a number of EU countries the risk and scale of penalties increases since you will have monthly reporting obligations in each EU country from which you operate.

New Tax Point Rules for Intra-Community Services

In terms of the new tax point rules for intra-Community supplies of services in respect of which the customer is obliged to account for VAT under the reverse charge, the time of supply of such services will be the earlier of when the service is completed or when payment is made. For continuous supplies of services, the time of supply will be linked to the end of each billing or payment period, but where no invoice or other accounting document is issued, nor payment made during the year, the time of supply will be the end of each calendar year. These changes will determine not only when VAT has to be accounted for under the reverse charge, but also when the transaction is to be included on an EC Sales List.

New UK VAT Invoicing Requirements

The UK introduced new invoicing requirements with effect from Oct. 1, 2007, the aim of which is to ensure that UK VAT invoices are compliant with the EU Invoicing Directive.

UK HMRC stated that it was its intention to implement the changes with a “light touch” and not impose penalties for non-compliance. Nevertheless, compliance with these new requirements is mandatory, and HMRC is likely to take a firmer line now that the rules have settled into place.

The main change that is likely to have a large impact on international law firms is for those that operate a centralized billing system. It is now the requirement that UK VAT invoices must contain unique consecutive numbering rather than a “unique identifying number” (as previously applied).

Therefore, if the law firm's billing system operates in such a way that one sequence of invoice numbers is used for all invoices issued by its UK and other EU entities (or even globally), then the invoices issued would not meet the requirements of the new UK invoicing regime, and as such, could expose the firm to penalties in each EU country from which it operates.

International law firms will need to maintain a separate sequence for all VAT invoices issued in respect of supplies made in each EU country in which they operate.

New Penalty Regime

The present VAT penalty regime has often been criticized by both taxpayers and those in professional practice due to the fact that it does not distinguish between honest errors made by businesses and deliberate errors made by less scrupulous taxpayers.

In addition, it has been said that the regime did not deal with taxpayers in an even-handed way, due to the perceived high degree of discretion available to UK HMRC officers to mitigate penalties or even ignore errors in certain circumstances. Taxpayers have also commented that having separate penalty regimes for different taxes is confusing and adds to the administrative burden imposed on them.

As such, UK HMRC decided to introduce a new penalty regime, which it believes will address these criticisms, and is designed to encourage taxpayers to modify the type of behaviors that lead to inaccuracies in the first place. The level of penalty chargeable has been “stepped” and will be higher for deliberate errors than for careless errors.

The range of penalties under the new regime is shown in Figure 1 below.

[IMGCAP(1)]

Reasonable Care

As the new penalties are considerably higher than the present VAT misdeclaration penalty (currently set at 15%), it is obviously best to avoid the penalty system altogether. To this end, UK HMRC has confirmed that inaccuracies that arise from genuine errors by persons who have taken “reasonable care” will not fall within the scope of the penalty regime at all.

While this seems to be a positive statement, taxpayers should be aware that HMRC has not yet defined a minimum standard of what it understands “reasonable care” to mean. HMRC has, on the other hand, confirmed that a taxpayer's risk profile will be considered “in the round.”

Therefore, taxpayers who make frequent errors, even if promptly and fully disclosed, may be considered to be “careless.” This is worrisome for taxpayers who operate complex VAT recovery procedures, since the scope for error ' and the resulting risk of being brought into the penalty regime ' is magnified considerably.

Mitigation for Disclosure

Should a penalty be imposed, HMRC has the authority to mitigate the level chargeable (potentially to zero in the case of “careless” errors). However, HMRC has indicated that any mitigation will depend on the quality of any information given, as well as the necessity to “prompt” the taxpayer to make a disclosure.

Furthermore, the definition of “prompted” disclosure seems to have shifted. Whereas previously, any disclosure made to HRMC that was unconnected with an impending VAT audit (or even often made immediately before a VAT audit) would be treated as “unprompted.” HMRC has indicated that it will be narrowing the scope of what is meant by “unprompted.” For example, disclosures that are made in relation to a matter that was highlighted for review on an HMRC audit plan may be considered to be prompted, even if the error was made after the plan was issued, and the disclosure was made before any visits have been agreed.