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What do auditors' questions about VAT due diligence mean?

During financial statement audits for 2023, many companies were surprised by auditors’ inquiries into how these companies complied with their VAT due diligence obligations. What do these questions mean and how does one answer them?
Author:
Łukasz Kempa
Tax Compliance Manager, Tax Advisor

Due diligence in VAT – what do auditors ask about?

VAT due diligence may be defined as a series of actions a taxpayer should take, which will then be evaluated by tax authorities in the context of VAT settlements related to conducted business activity. Maintaining due diligence in transactions with contractors is crucial for the correct calculation of the goods and services tax, enabling the assessment of the taxpayer's right to deduct input tax.

Due to regulations not providing a clear definition of "due diligence,” the Polish Ministry of Finance, on April 25th, 2018, published a document entitled "Methodology for assessing the due diligence behavior of purchasers of goods in domestic transactions" (hereinafter: Methodology), which is a collection of guidelines for tax authorities. It is significant that this document was directed to those authorities, but at the same time, it was made publicly available to taxpayers to assist them in formulating principles for assessing their contractors and counterparties.

Although due diligence in VAT has no regulatory definition, tax authorities require it for retaining the right to deduct VAT.

IMPORTANT

Why VAT due diligence?

According to findings of the Methodology, revoking input tax deduction rights is justified whenever a taxpayer commits fraud or the abuse of tax. However, the right of deduction may also be denied where the taxpayer was aware or could have guessed that their transactions involved VAT fraud.

An important issue is to assess whether the taxpayer exercised due diligence when concluding the transaction, considering objective circumstances indicating a violation of tax law or attempted fraud.

How to exercise due diligence in VAT?

The Methodology indicates three options for exercising due diligence:

  • Carry out the activities recommended in the Methodology.
  • Undertake other activities which, although not mentioned in the Methodology, indicate compliance with due diligence.
  • Use the split payment mechanism when paying the supplier, which provides the broadest protection against the risk of tax fraud – yet does not guarantee 100% security.

As stated by the Ministry of Finance, the scope of verification of a conducted transaction depends on its size, value, and the type of contractor (whether it is a new or existing business partner). According to the Methodology, initiating a transaction with a counterparty means entering into a commercial agreement with an entity with whom the taxpayer has not previously cooperated, or continuing cooperation with a specific counterparty but in a new scope of activity. The Methodology assumes that when verifying a "new counterparty," two types of criteria should be considered: formal ones, such as negative verification of the counterparty's VAT payer status or lack of registration in appropriate registers, and transactional ones, for example, significant differences in delivery terms compared to market norms.

The Methodology also indicates that transactions concluded with a regular contractor should be verified, although with a lower risk of tax fraud. However, tax authorities should consider formal criteria, such as regular verification of the VAT taxpayer status or possession of the necessary licenses, and transaction criteria, such as significant price differences without economic justification.

The Methodology guidelines indicate that the existence of circumstances crucial in assessing due diligence do not always mean that the taxpayer did not exercise due diligence properly. For this reason, tax authorities may also take into account other transactional circumstances that they consider relevant in a given case.

How to answer the auditor's question on due diligence?

To affirmatively answer the auditors' questions on whether we are performing due diligence for VAT, we must be familiar with the due diligence methodology or, with the help of experienced specialists, conduct a "VAT audit" - i.e. assess the situation of the entity in terms of, among other things, VAT due diligence. However, commissioning an accounting office to provide VAT services is not apt in claiming the fulfilment of due diligence. Due diligence requires the possession and critical assessment of information about contractors that emerge during cooperation and can only be possessed by the taxpayer.

Auditors' inquiries about due diligence serve as a "last call" for companies that have not yet addressed this issue to catch up on any overdue matters. With the introduction of the National System of Invoices, if a counterparty is identified as improperly settling VAT, tax authorities will immediately have a list of purchasers of their goods/services deducting VAT as a result—in real time. It will be easy for authorities to act against us; hence, it is essential to ensure that instead of open doors to enforcement decisions, they encounter the barrier of "due diligence."

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