Tax
Accounting for VAT in Manufacturing Industry: Cashflow and Compliance Challenges
Stransact
The manufacturing industry is a vital part of the Nigerian economy. Based on the sectoral distribution of Value Added Tax (VAT) released by the National Bureau of Statistics (NBS) for Q4 2023 published in March 2024, the VAT derived from the manufacturing sector was about ₦158.9 billion.
This article discusses some of the industry challenges as it relates to accounting for VAT.
What Basis, Cash or Accrual Basis?
Per the provisions of the Value Added Tax (VAT) Act, businesses falling under the category of taxable persons are mandated to submit their VAT returns every month, covering all taxable transactions conducted in the preceding month. However, it is crucial to note that the amount remitted during this process pertains specifically to the net Output VAT. This refers to the VAT sum charged and received by the taxable entity, after deducting any applicable Input VAT from the Output VAT.
In cases where the Input VAT surpasses the Output VAT, the taxpayer is eligible for a refund. This delineates the fundamental principle of remitting Output VAT based on the interplay of VAT collected from customers and VAT paid on purchases, commonly known as the cash basis approach. Consequently, any outstanding amounts yet to be collected are not considered part of the remittance, and adjustments should be made accordingly from the total supplies.
Another perspective posits that the requirement to submit monthly returns for all VATable supplies implies that all Output VAT must be remitted upon rendering the returns, regardless of whether it has been fully collected or not. This approach is commonly known as the accrual basis. In practical terms, businesses have the flexibility to choose between these methods based on the nature of their operations. The accrual method is typically favored in scenarios where invoices are settled at the point of sale or within a brief timeframe, whereas the cash basis is deemed more suitable for businesses with extended credit periods.
Prior to the Finance Act 2019 (which took effect in 2020), the Federal Inland Revenue Service (FIRS) typically insisted that taxpayers remit VAT on accrual basis since this guaranteed a higher VAT revenue for the government. However, this was not a good fit for companies with significant credit sales – a situation that is not new to manufacturing industry. The principle behind the VAT system is that the taxpayer as an agent of the FIRS is to charge, collect and remit the VAT. It was usually onerous for companies (especially manufacturing companies) to remit VAT before they even had to collect it from customers. The accrual basis created cashflow challenges as the companies would use their working capital to finance or fund VAT payments. That is not all; when bad debts (from obsolete goods or sales write-offs) arise, the taxpayers would also lose VAT already paid to the FIRS, and recovery of excess VAT payment is almost a practical impossibility.
Read More: Effects of Multiple Taxation on Business Survival in Nigeria
Tax officials often, in the events of tax reviews or audits, expect the Output VAT to correspond to the VAT per the revenue in the audited account for the period covered. According to IFRS 15, revenue should be recognized when the entity satisfies a performance obligation by transferring a promised good or service to a customer, which occurs when the customer obtains control of that good or service. Revenue is measured based on the consideration to which the entity expects to be entitled in exchange for those goods or services. The revenue per Audited Financial Statements does not necessarily represent cash collected for the period and so should not be basis for the remittance of Output VAT.
The Finance Act 2019 amended section 15 of the VAT Act 2007 to provide clarification that VAT should be accounted for on cash basis. Only VAT that has been collected should therefore be remitted to FIRS. This amendment helps businesses manage cashflow and reduces the risk that a business ultimately bears VAT burden for its customers, particularly in cases of bad debts.
Claiming Input VAT on Inventory
The Nigerian VAT Act limits deductible Input VAT to that ‘incurred on purchase of raw materials used to manufacture products on which Output VAT is charged’ and ‘VAT on goods purchased for resale’. The clear suggestion of this is that the Input VAT incurred on raw material, A, can only be claimed when the corresponding finished good, B, have been sold and Output VAT charged to the customer.
This corresponds with the basic accounting equation in which the “Closing inventory” is typically deducted from the sum of “Opening inventory” and “Purchases for the period” to arrive at the “Cost of goods sold during the period”. The concern here is that most manufacturing companies practically recognize Input VAT as a debit to the VAT payable account once the cost of the raw material is recognized and not necessary when the Output VAT has been charged on the corresponding finished products. Most of these companies use accounting software that have been configured in this manner, and hence it is difficult to track the raw materials whose corresponding finished goods have been sold before Input VAT is claimed.
Good accounting demands that Input VAT incurred on raw material whose finished goods were not eventually sold due to obsolescence, physical damage or pilferage should be written off from the debit side of the VAT payable account and therefore not available for claim against the output VAT resulting from the sales of other goods. It is worth noting that in Nigeria, taxpayers can only claim Input VAT when the VAT paid to a government-registered collecting agent (i.e., a tax-registered vendor or an appointed collecting agent) has been remitted to the FIRS account using the taxpayer’s TIN. The taxpayer's account on TaxPro Max will be credited with the Input VAT only after the vendor or appointed agent has made the remittance to the FIRS.
Recovery of Input VAT where Output VAT is not Collected
Government agencies, Statutory bodies, companies in the oil and gas sector, Deposit Money Banks and some major telcos in Nigeria have been mandated to deduct any VAT charged to them at source and remit directly to the FIRS. Manufacturing companies who sell goods to the above-mentioned entities will not have the opportunity to recover their input VAT. This will constantly put them in a position to receive VAT refunds. This, no doubt, can affect their working capital. Certain goods are classified as VAT exempt and others are classified as zero-rated. Zero-rated goods are taxed at 0%. Companies whose final goods are VAT exempt are not required to claim Input VAT as no Output VAT is charged on their goods. Companies with zero-rated goods can claim Input VAT since Output VAT was charged but at 0%. This will lead to the accumulation of Input VAT and put the company in a steady state of VAT refund.
However, affected companies are allowed to apply to the FIRS for a refund which would typically be subject to a rigorous tax audit exercise. Such audits by FIRS often come with significant administrative costs for the taxpayer as they are protracted, and FIRS would usually raise several other compliance issues to erode the taxpayers’ refund claims. In the light of this, a more efficient way would be for the government to allow affected companies to recover excess tax amounts from any other tax type that is due to the FIRS from the same taxpayer. This will allow companies better manage their cashflow pending a comprehensive review during the periodic tax audits by FIRS.
Conclusion
The huge cost that comes with compliance in Nigeria affects the manufacturing industry negatively. In developed economies, like the UK, there is no restriction to the claim of Input VAT (as claims can be stretched to include the VAT components of cost of services and capital purchases) and the Tax refund processes are quite simple. One major impact of restricting input VAT claims is that the portion of the VAT expensed through the Profit or Loss Statement only enjoys income tax deduction that is limited to the applicable income tax rate. A good tax system should promote fairness and equity. The FIRS must encourage the taxpayers in this industry by addressing these issues as examined in this article, to improve the overall ease of voluntary compliance and doing business in Nigeria.