How tax authorities use digital tools to reshape controversy

E-invoicing, real-time reporting and digital filing requirements amount to a growing list of compliance obligations. Each new mandate brings its own deadlines and technical demands, often requiring a response at the local level.

Yet the changes taking place in tax administration have a much longer history. Doctoral research by David Hadwick, Senior Manager, International Tax and Transaction Services, EY Accountancy & Tax Services, traces an evolution that has been underway for more than two decades.

Hadwick identifies the adoption of compliance risk management in the early 2000s as an important turning point. Tax authorities began to make more systematic use of data to assess taxpayer risk and decide where to focus their resources. Since then, the digitalization of the wider economy and growing availability of transaction-level data have given authorities new ways to monitor compliance, with data analytics, automation and AI extending those capabilities further.

The expansion of e-invoicing and continuous transaction controls is part of this longer evolution. The widespread adoption of enterprise resource planning (ERP) systems and the increasing volume of digital transaction data have also created opportunities for authorities to develop a more detailed view of taxpayer activity.

Digital reporting requirements are still often addressed as country-specific compliance programs. But the information being reported does not necessarily remain confined to the purpose for which it was originally collected. Many tax authorities can now compare information from different sources, including tax returns, accounting records and customs declarations.

Mexico offers an indication of how far this model can develop. Its digital tax administration system has made the electronic invoice central to the way the authority sees and assesses business activity. “The electronic invoice is not just a document,” says Luis Beltran, EY Global Compliance and Reporting (GCR) Transformation Leader. “It is the backbone of the tax administration model.”

Each electronic invoice has a unique identifier linking the commercial transaction with the company’s accounting records and tax position. Beltran points to even routine purchases as an example of the visibility this can create: a transaction can be reported to the authority through the electronic invoice and subsequently linked to the company’s accounting records. In this model, he says, “the electronic invoice becomes the source of truth.”

Other jurisdictions are developing their own approaches and moving at different speeds. What matters for multinational organizations is what happens as digital reporting becomes more established and authorities can draw on a broader range of information about business activity.

Meeting individual reporting obligations remains essential, but businesses also need to understand what their data reveals when information from across the organization is viewed together. As that visibility increases, so does the potential for discrepancies and inconsistencies to attract scrutiny.

That is where the transformation of tax administration begins to reshape tax controversy.

The traditional starting point for tax controversy was a formal audit, followed by requests for information and the review of transactions that might have taken place months or years earlier. In a digital tax environment, authorities may already hold substantial amounts of information about those transactions before an audit begins.

Data reported through e-invoicing systems and other digital channels can be compared with tax returns, accounting records and customs declarations. Where the information does not align, authorities can raise questions without first having to conduct a wide-ranging examination of the business.

Steve Patton, a value-added tax (VAT) partner at Ernst & Young LLP, says this shift is not always recognized by the organizations experiencing it. “I have clients who tell me they have no VAT audits,” he says. “But they definitely do. They do not realize that they are now under ongoing audits behind the scenes by the tax authority each time they submit a return.”

What has changed is the form that scrutiny can take. Patton says businesses may not recognize these interventions as audits in the traditional sense. Instead of a single examination covering a broad range of issues, they may receive targeted requests prompted by discrepancies in their data that need to be answered in days, and if not tax credits are automatically reversed or denied.

The experience of businesses in Mexico shows how this can alter the relationship between taxpayers and the tax authority. An inquiry can begin with an inconsistency the authority has already identified.

“The relationship has changed because audits are no longer only physical or manual,” Beltran says. “Today, the authority already has the information. It can send an electronic audit or a request based on data inconsistencies it has already identified.”

The burden can therefore shift. Rather than beginning an audit by searching for an issue, Beltran says the authority may ask the taxpayer to explain why its view of the data is incorrect.

The growing use of data in tax administration places greater emphasis on an organization’s ability to explain the business activity behind its tax positions. Having the relevant records remains essential, but those records may be of limited value if they are fragmented across the organization or fail to provide a clear account of the underlying transaction. “The new standard is not only having evidence, but having evidence that explains the transaction,” Coronado says.

Companies routinely retain contracts, invoices, accounting records and purchase orders. Coronado argues that the more difficult question is whether those records demonstrate the substance of the transaction and provide the tax authority with a clear account of what happened within the business.

The experience gained from audits and other interactions with tax authorities can provide valuable insight into where business processes or documentation need to improve. Too often, however, that knowledge remains within the teams managing the controversy.

Coronado sees an opportunity to use it more systematically. “The people facing the tax authority are learning what the new standard of evidence looks like,” he says. “The challenge is to bring that knowledge back into the operating model.” If an inquiry reveals a recurring problem with documentation, inconsistent data or the way a transaction is recorded, addressing the immediate request from the authority solves only part of the problem.

Coronado argues that each interaction with a tax authority should leave an organizational lesson. Closing the immediate case is only part of the task; the findings can also inform changes to the processes, controls and responsibilities that contributed to the issue.

The experience gained from disputes can inform decisions made much earlier in the lifecycle of a transaction, when processes are designed and information requirements established. Tax teams can work with colleagues elsewhere in the business to address weaknesses before they result in further inquiries.

This may require tax professionals to become more involved in decisions about systems and data. Digital reporting draws on information generated across the business, often long before it reaches the tax function. Understanding where that information comes from, how it changes as it moves between systems and how it will ultimately appear to a tax authority is becoming an important part of managing controversy risk.

There is also a question of scale. New reporting mandates are often introduced country by country, making a local response the most immediate solution. Over time, however, a collection of separate systems and processes can make it harder to maintain a consistent view of tax-relevant data across the business.

“The biggest mistake is thinking this is an IT issue,” Beltran says. “Technology is necessary, but digital tax compliance is a tax and business issue.”

Beltran argues that organizations should look for common ground between jurisdictions rather than assuming every new mandate requires a wholly separate response. A global strategy, adapted where necessary to local requirements, can help improve traceability and reduce the complexity created by multiple country-level solutions.

For multinational businesses, the issue is whether the tax function can move beyond managing individual reporting requirements to understand and govern the information that connects them.

The answer will shape how well organizations adapt to the next phase of digital tax administration. Keeping pace with new mandates remains essential, but the experience gained through controversy can also be used to improve the way tax-relevant information is produced and managed across the business.

Tax administrations have more information about business activity, can analyze it in new ways and, in some jurisdictions, are able to raise questions much earlier than under traditional audit models.

For multinational businesses, keeping pace with new requirements is only part of the challenge. They also need to consider whether the information available to tax authorities provides a consistent account of how the business operates and whether they can explain that account when questions arise.

By 2030, many tax authorities are likely to have capabilities that are more advanced than those in use today, although the pace and nature of change will vary between jurisdictions. Businesses cannot predict exactly how those capabilities will develop. They can, however, prepare for continued change by examining the quality of their tax-relevant data and using the experience gained from controversy to identify weaknesses elsewhere in the business.

That work is likely to become a more important part of the tax function’s role as digital tax administration develops. The experience of dealing with tax authorities can help shape decisions about the systems and processes that produce tax-relevant information in the first place.

The next five years will bring further changes in technology, reporting requirements and the capabilities of tax authorities. The exact course of that change is uncertain. Businesses should use the experience gained from current controversy to improve the data and processes on which future tax compliance will depend.

This means taking the following actions now:

• Being always mindful that future tax compliance starts with today’s data
• Prioritizing data quality and transaction traceability across the enterprise
• Ensuring tax data can be clearly linked to the underlying business and economic activity
• Pursuing a globally aligned compliance strategy while accommodating local requirements

Summary

Digitalization is changing the relationship between multinational organizations and tax authorities. As more information becomes available at transaction level, tax teams have a broader role in ensuring that business activity is represented consistently. This means closer attention to how tax-relevant information moves through the organization. Findings from tax authority inquiries can also inform decisions beyond the immediate dispute.