Making tax digital: What does it mean for your tax returns?

man at desk with laptop taxes
(Image credit: Shutterstock)

Making Tax Digital is the woefully abject name for the government's latest attempt to modernise the way we submit our taxes. It's not as if we've been filing with quill and parchment until now, after all.

However, stale branding isn't the only problem with the new system. Parts of Making Tax Digital have predictably fallen behind schedule, while even the parts that have been introduced this spring have been fudged. Still calculating your VAT returns in spreadsheets? You might get away with it for a little bit longer.

Whether you're a small business owner or just filing your own income tax return, you'll eventually be forced to defer to the government's desire to do everything via accountancy software. Not much to fear there for the average reader, perhaps, although HMRC has plenty to gain when it comes to avoiding costly errors and detecting tax fraud.

There's also an upside for small business owners. With the software doing the drudge work that your accountant used to spend hours poring over and billing you for – they can now concentrate on helping you grow your business.

We find out what the recent changes mean for your business, evaluate the software that can help you submit your taxes and find out what it all means for business owners.

VAT's the way to do it

The Making Tax Digital (MTD) programme set out with a bold timetable. However, as with most government IT projects, things haven't quite gone to plan. "The timeline changes a lot because of HMRC getting behind on the building of the software," said Chris Barnard, tax manager at accountancy firm UHY Hacker Young. "Originally it was meant to be VAT for everyone next year and then the year after that was going to be self-assessment, but that seems unlikely now. I can see that being three, four years away now."

VAT has at least made it out of the starting blocks, although only businesses with a taxable turnover of more than £85,000 are required to keep their records digitally and submit their VAT returns using MTD-compatible software.

Filing online isn't new, of course. Anyone running a VAT-registered business will be familiar with logging on to the HMRC website once a quarter and filling in the nine different boxes that confirm the amount of VAT you've charged on sales, the amount of VAT you're reclaiming on purchases and so forth. Well, now you need a piece of government-approved software to fill those boxes for you.

You might be surprised to learn that's all the information the government wants – at least for the time being. Although software such as Xero, QuickBooks or Sage will have all the detailed transaction data on every sale you've made that quarter, none of that info is currently being passed to HMRC. Instead, the software will simply populate the VAT return figures automatically, rather than you having to enter the figures by hand or copy and paste them out of your accountancy software.

That might sound like a lot of fuss about nothing, but Ed Molyneux, CEO of accountancy software provider FreeAgent, told us that simply preventing copy and paste errors will be make a big difference to the Revenue. "Where errors tend to occur is in transcribing one thing to another," said Molyneux. "You know what it's like, it's easy to swap digits or miss a digit here and there. [MTD] is better than people fat-fingering numbers into a form."

But it's not just about cutting out the typos. "One of the other parts of the rules is those nine [VAT return] boxes have to be digitally linked to the underlying accounting record," said Barnard.

If you were already submitting your VAT returns using accountancy software, that was already the case, but as Barnard said: "There are tens of thousands of businesses that are just using Excel sheets to do their accounting records, but when HMRC want to do an inquiry, they don't have the confidence that the numbers they've got actually mean anything."

Xero's director of partner and product, Damon Anderson, also believes the new legislation will prevent other familiar tax problems for both business owners and the Revenue. "This new legislation enables taxes to be filed digitally and quarterly with greater accuracy and speed," Anderson said. "As a result, this prevents the end-of-year scramble to harmonise Excel spreadsheets or find paper receipts, making businesses more efficient and more transparent to business partners and to HMRC."

Wither Excel?

Does that mean Excel is no longer an acceptable means of keeping your company's books? Not quite. Companies that want to continue to manage their accounts in spreadsheets can do so for the time being, but they will need a piece of "bridging software" to submit the return. Most of the big accountancy software firms are already offering this. "As Excel spreadsheets cannot interact with MTD software, Xero has also developed a bridging software solution to ease the transition for those that aren't fully online and are worried about looming deadlines," said Anderson.

The bridging software basically takes the calculated figures from your spreadsheet and populates the VAT return, but the operative word here is "calculated". You can't just type figures into a spreadsheet and have them uploaded to HMRC: the Revenue wants to see that you're doing your sums properly, even if you don't have to upload the transaction data itself.

"At first, they [HMRC] didn't want to have spreadsheets at all, but after consultations it was decided that as a compromise, the use of spreadsheets would still be allowed for a limited amount of time," said Barnard. "If you have a tab for sales, the total sales figure will have to digitally link to the VAT return. You upload the spreadsheet to whatever bridging software you're using and then you put a cell reference into the bridging software, and that picks a number up from the spreadsheet."

Eventually, however, businesses will need to migrate to approved accountancy packages.

The bigger picture

Many businesses have been reluctant to move to Making Tax Digital because they fear the Revenue will have access to all their transaction data, according to Barnard. As we explained earlier, that's not yet the case -- MTD only requires the same, sparse VAT data that you were forced to submit previously.

However, there's no doubt that the long-term goal is to gain access to granular detail of companies' accounts. That will, of course, provide an enormous fillip for the Revenue's efforts to clamp down on tax fraud. "Down the road, what is now voluntary information – individual invoice transactions or expenses – will at some point be mandatory parts of the legislation," said Barnard. "That's probably two to five years away.

"HMRC is looking to be smarter in the way they do inquiries. In the past it was a random exercise, and they spent a lot of money going out to businesses to do inspections and realising there was a typo on the VAT return or it was absolutely fine. They want to move to artificial intelligence systems like the banks have used to spot trends. If there's a certain business and their submission falls out of the normal criteria of what that business should be submitting, it will flag up an alert."

Demanding that businesses use accountancy software instead of Excel spreadsheets has another advantage – there's an online invoice trail. Whereas businesses might sometimes offer to do a "cash job" and not bother to report the work for VAT purposes, "it's more difficult now not to record those transactions in the system," said Barnard. "A lot of the time, a client will want an invoice. That invoice will be sent from Xero or whatever and once it's in the system that invoice automatically goes on the VAT return."

Benefits for businesses?

Clearly the government is set to benefit from Making Tax Digital, and it must be good news for the accountancy software firms too: tens of thousands of businesses are now being practically mandated to use their software.

What business owners are probably asking themselves is: what's in it for us? With accountancy software costing hundreds of pounds a year in subscriptions fees and all the hassle of learning how to use it, is there any advantage to being forced to do your books in this fashion, instead of dumping a pile of paper invoices and receipts in your accountant's lap once a year and leaving them to get on with it?

Because almost all of the major software packages do a lot of the accountant's legwork for them – such as automatically creating VAT returns, balance sheets and end-of-year corporation tax calculations – your accountancy fees should (in theory) be reduced, as your accountant doesn't have to spend as much time doing all that work themselves.

Of course, if there's one thing accountants are pretty good at, it's making money, so even if your fees don't go down, "your accountant should be able to provide a better service", according to Barnard. "When I first started training, you'd talk to your client about once a year at the end of their accounting year and you were always working with data that was about 18 months old. The client didn't know what was going on right here, right now. With cloud accounting, they can get management accounts from the software right away. The accountant can explain what the management accounts mean, in detail, and provide recommendations off that, provide more tax advice, and tax planning. There's a lot more services accountants should be providing now".

Molyneux agrees that the software should free accountants to make a more meaningful difference to firms. FreeAgent recently surveyed accountants and found that the worst parts of their job were "chasing clients for data, having to fix errors in clients' data, transcribing stuff into [different] systems and filing tax returns," according to Molyneux. "The bit they don't get to spend enough time with their clients on is how to make the business more successful."

Molyneux says many sole traders and small business owners are spending "hundreds, if not thousands of pounds a year, just to pull together a set of numbers to file a tax return and stay out of prison".

"Accountants are saying 'I can't sell advisory services to people who bring me a shoebox of receipts every year. But I can sell them those services if we can basically assume the numbers are taken care of," Molyneux added.

And talking of staying out of prison, Molyneux adds that using accountancy software may in fact indicate to the authorities that you're running your accounts properly, lowering the risk of the dreaded tax inspection. "Just the knowledge that the data has come from a trusted source, like a bank transaction feed, and has not just been keyed into a system... with plenty of scope for distortion is a big step in the right direction for them [HMRC] being able to trust that data. If you've got a system that meets certain criteria in its trustability or auditability, you might even get a bit of a green light through the filing system."

Barry Collins

Barry Collins is an experienced IT journalist who specialises in Windows, Mac, broadband and more. He's a former editor of PC Pro magazine, and has contributed to many national newspapers, magazines and websites in a career that has spanned over 20 years. You may have seen Barry as a tech pundit on television and radio, including BBC Newsnight, the Chris Evans Show and ITN News at Ten.