Why capturing the correct FX rate is crucial to VAT success of domestic invoices using foreign currency

When businesses receive domestic invoices in a foreign currency they may face unexpected complications, especially when it comes to determining the correct amount of tax to report and recover.

One key issue arises when the invoice determines a positive tax rate, such as a standard VAT rate, rather than a reverse chargeWhen the Reverse Charge (mechanism) is in effect, the recipient of goods or services assumes responsibility for reporting both the purchase and the supplier’s sale in their VAT return. mechanism.

In such cases, it’s crucial to use the FXThe foreign exchange market, commonly known as Forex or FX, is a global marketplace for trading one nation's currency for another. rate provided by the supplier to ensure accurate tax reporting and recovery. Failing to do so can lead to discrepancies between the tax amount reported by the supplier and the amount reported and recovered by the customer.

The importance of using the supplier’s FX rate

When a domestic supplier issues an invoice in a foreign currency, the law often requires them to show the exchange rate used to calculate the tax.

This is especially true in countries like Germany, where VAT compliance is strictly monitored.

The supplier calculates the VAT based on their own FX rate and reports this to the tax authorities. If the customer receiving the invoice uses a different FX rate for their own records, it can lead to discrepancies in the VAT amounts reported and recovered.

Example scenario: German entity receiving a USD invoice from a German supplier

Consider the following example to illustrate the issue:

A German entity receives an invoice from a domestic supplier for $119 USD. The supplier is required to apply the standard German VAT rate of 19%. In this case, the supplier uses an exchange rate of 1.10 USD to 1 EUR and reports the VAT amount accordingly.

Here’s how the supplier would calculate the VAT:

• Total amount in EUR (at the supplier’s FX rate): $119 / 1.10 = 108.18 EUR
• VAT at 19%: 108.18 EUR * 19% = 20.55 EUR

The supplier will report this VAT amount (20.55 EUR) to the German tax authorities.

However, if the customer enters the invoice using their own exchange rate of 1.20 USD to 1 EUR, their calculations would look like this:

• Total amount in EUR (at the customer’s FX rate): $119 / 1.20 = 99.17 EUR
• VAT at 19%: 99.17 EUR * 19% = 18.84 EUR

In this case, the customer would report and recover 18.84 EUR in VAT, which is lower than the 20.55 EUR reported by the supplier.

Although this discrepancy might seem minor, it can lead to complications during tax audits, especially if these differences accumulate over multiple transactions or if you recover more VAT than was available. Furthermore, the customer may inadvertently under-report or over-recover VAT, leading to non-compliance with local tax laws.

How will failing to use a supplier’s FX rate affect your business?

Failing to use the supplier’s FX rate when entering invoices into your system can have several negative consequences:

• Tax Compliance Issues: If the VAT amounts you report and recover don’t match those reported by the supplier, it could raise red flags during a tax audit. Discrepancies in VAT reporting can result in fines, penalties, or the need for corrective filings.
• Over or Under-Recovering VAT: In the example above, the customer would under-recover VAT by 1.71 EUR. In other cases, using the wrong FX rate could lead to over-recovery of VAT, which may have more severe consequences, such as additional interest charges or penalties imposed by tax authorities.
• Financial Reporting Discrepancies: Not aligning your FX rates with the supplier’s can cause inconsistencies in your financial records, leading to inaccurate profit-and-loss statements and other financial reports.

Consequences of over-recovering VAT

The penalties and fines for recovering more VAT than a company is entitled to vary by country, but in general, the consequences can be severe, especially in jurisdictions like the EU where VAT compliance is closely monitored.

Outcomes range from interest charges on the over-recovered VAT to fines, audit risks, reputational damage and repayment of overclaims.

Here are three examples of the penalties a business can face in different countries:

1. United Kingdom (HMRCHis Majesty's Revenue and Customs is a non-ministerial department of the UK Government responsible for the collection of taxes.)

• Careless mistake: 0% to 30% of the overclaimed amount.
• Deliberate error (without concealment): 20% to 70% penalty.
• Deliberate error (with concealment): 30% to 100% penalty.
• Interest is charged on the overclaimed VAT until it is repaid.

2. Germany (Federal Central Tax Office – BZSt)

• Late filing or misreporting: Fines typically range from 5% to 10% of the unpaid VAT, plus interest. In cases of VAT fraud, the fine can be up to 100% of the VAT overclaimed.
• Repeated offenses: Can lead to criminal prosecution and additional penalties.

3. European Union VAT Regulations

Each EU country enforces VAT differently, but penalties generally follow the same pattern of fines, interest, and, in severe cases, criminal charges.

If a company is unsure about VAT claims, it is always advisable to seek advice from tax professionals and use reliable software tools to ensure compliance.

Best practices for handling domestic invoices in foreign currency

To avoid these issues, it’s important to follow these best practices when handling domestic invoices that use a foreign currency and you are charging a tax rate above 0%.

• Always use the supplier’s FX rate: Ensure that the exchange rate used by the supplier is captured and used in your payables system to avoid discrepancies in tax reporting and recovery.
• Automate the process: Many modern accounts payable solutions allow you to automate the capture of FX rates directly from the supplier’s invoice. This can eliminate manual errors and ensure compliance with tax regulations.
• Reconcile VAT amounts and FX used: Periodically reconcile VAT amounts between your records and the supplier’s invoices to identify any potential discrepancies early. This will allow you to correct any issues before they become larger problems during an audit. A simple way to do this is to check if your ERPEnterprise resource planning (ERP) is a type of software that organisations use to manage main business processes. uses a corporate FX rate and if they do and it is applied to any transaction where the currency is different and the tax amount from the vendor is not zero.
• Monitor currency fluctuations: While this issue is less about currency volatility, keeping an eye on significant exchange rate changes can help ensure that your internal policies for handling foreign currency invoices remain accurate and up to date.

Conclusion

When handling domestic invoices in foreign currencies, using the FX rate provided by the supplier is essential for accurate tax reporting and recovery.

Discrepancies between the FX rates used by suppliers and customers can lead to under-reporting, over-recovery of VAT, and compliance issues during tax audits. By ensuring that the correct FX rate is captured, businesses can avoid these problems and maintain financial accuracy.

Adopting best practices and leveraging technology to automate the process can streamline your invoice management, reduce risks, and ensure that your business remains compliant with tax regulations.