| A fresh start for VAT? |
Back |
| The EU Commission has published a consultation paper that may ultimately lead to fundamental changes in how VAT will operate for financial services. VAT, when it was originally introduced, was intended to apply on the broadest possible range of business transactions, with a common taxable base across Member States. The reality for VAT as it operates for financial services today is a system characterised by exemptions, hidden VAT cost, uncertainty in the application of the law and variation in treatment across Member States. The Commission's paper is intended to start the process of addressing these problems, and proposes a range of solutions designed to deal with a system of VAT that has clearly not kept pace with the changing business environment. |
It may surprise readers to know that the basic legislative framework for VAT on financial services has not changed for almost 30 years. In that time, the industry has changed beyond measure. Both the range of transactions undertaken and the way in which the industry organises itself is completely different now to what it was in 1977, when the Sixth EU VAT Directive was introduced. Over that time, the regulatory and legal environment in nearly every other aspect of financial services has seen significant change, but not VAT.  | | John McGlone |
The reason for the stagnation lies partly in the fact that when the Sixth EU VAT Directive was being negotiated, Member States found it difficult to agree on whether it was ever possible to apply VAT to financial services. Their main concern was how to identify the taxable amount (the amount on which VAT should be applied), for credit and similar transactions. There were also difficulties in identifying whether a supply of services takes place at all in areas such as swap transactions. The outcome of that debate was a system of VAT on financial services based on broadly worded exemptions which were left to Member States (and increasingly the European Court of Justice) to figure out.
Non-taxation before the final stage of consumption is an anathema to VAT legislators. This is because exemptions such as those existing for financial services today lead to difficulties in application and distortions arising from the denial of input VAT recovery. However, the Commission also realise that a ‘total VAT’ solution for financial services will not work, politically and practically. For that reason they have sought to propose solutions that recognise the fact that exemptions in some shape or form will remain a feature into the future.
The two main problems that the Commission are seeking to address are as follows : Firstly, exemptions lead to restriction of input VAT recovery before the final stage of consumption, and therefore result in trapped VAT. Secondly, the current list of exemptions are worded in a way that makes it difficult for them to be easily and consistently applied across Member States.
To deal with the first problem of input VAT restriction, the Commission proposes five alternatives. The first of these is a zero-rating for B2B (Business to Business) financial services transactions. In this model, VAT would not be applied to outputs (e.g. interest, commission etc.) on services supplied to business customers, but the service provider would be entitled to reclaim VAT on related inputs. This would be relative simple and fairly attractive way of dealing with the problem from an industry viewpoint.
However, if the ratio of disadvantages to advantages listed in the Commission’s paper is anything to go by, it’s fairly clear that this alternative is not favoured by the Commission. Their main concerns relate to areas such as the proper identification of B2B customers and the fiscal impact for Member States. There may also a more fundamental point for the Commission, namely that, in the list of sins that offend against the true ‘spirit’ of VAT, zero-rating lies a fairly close second to exemption in their eyes.
The second alternative would be to extend the scope of exemption such that suppliers of outsourced services would be able to treat their services as VAT exempt. In some sense this is just pushing the problem back to an earlier stage in the supply-chain. However, it would deal with one of the major difficulties associated with outsourcing, namely VAT being applied to salary costs (employees of the outsource provider) which does not arise when an entity performs the activity in-house. Nonetheless, the Commission foresee certain difficulties in terms of defining exemptions for outsourced services (how far down the supply-chain would you go ?). Adding to the existing list of exemptions might also be seen by the Commission as heading back into the storm rather than away from it.
The third suggestion is an interesting one along the lines of the approach taken by Australia with their GST system (similar to VAT). Under the Australian model, businesses that would not normally be able to reclaim input tax can do so for certain outsourced services. In addition, businesses involved in certain financial services are eligible for a reduced input tax credit (a type of flat-rate deduction), for listed services. This may be an effective solution that deals with both the outsourcing issue and the general restriction on VAT inputs problem.
The Commission however has raised certain potential difficulties with this model. These are mainly around agreeing a uniform flat-rate percentage deduction across 25 Member States, with the further complication of having different standard rates of VAT (ranging between 15p.c. and 25p.c.).
The fourth suggestion is the introduction of an ‘option to tax’ for B2B supplies. This idea is not new in that some Member States already avail of existing provisions within the Sixth Directive that allow for such an option. The idea is that that the option to tax would be updated and apply for B2B supplies only. A supplier of financial services could elect to charge VAT on supplies to business customers and thereby reclaim VAT on related costs. To the extent that the business customer is subject to VAT on their own outputs, the addition of VAT should not give rise to additional net cost for that customer. The supplier of the financial service would benefit from an entitlement to reclaim VAT on the costs related to the supply of that service. The attraction of this alternative for the Commission is that it complies with the principle of ‘fiscal neutrality’, which dictates that VAT should be borne by the final consumer not by business.
The Commission do not specify whether the system would allow businesses an option to tax supplies to individual customers or whether the option would apply generally to a particular service line. Nonetheless, an option to tax would allow businesses a degree of flexibility as to which transactions it wanted to be taxable on and which it did not.
The potential difficulties relate to the costs of implementation for businesses and the need to introduce a requirement on businesses to notify customers in other Member States that the option to tax has been applied (so that ‘reverse-charge’ is accounted for by the customer in the other Member State). There are also some potential practical issues around identifying B2B and B2C (Business to Consumer) transactions. Nonetheless, the fact that an option to tax is the alternative which might be seen as most in keeping with the principles of how VAT should operate, it has to be a serious contender for the new system.
The last alternative is one that looks at VAT on cross-border supplies between related parties in the context of a Societas Europaea (SE) or a ‘European Company’. However, this is very much a long term possibility as the use of such entities in business has not yet gained the momentum needed to be considered as a viable solution to the problem.
Finally, the consultation paper considers ways in which the current list of exemptions can be updated to remove the uncertainty for businesses which has resulted from their being drafted using very non-specific language. The Commission suggest that this should be dealt adding specific descriptions for each exemption, or by having some kind of general principle of interpretation, for example one that would apply exemption depending on the function of the service.
There is no doubt that the VAT world envisaged by the Commission’s paper is one quite different from that today. The Commission is keen to hear from Irish business on what the future for VAT should look like. The closing date for submissions to the Commission is 9 June 2006 and I would urge you to take advantage of the opportunity to define the next era of VAT for your industry. |
John McGlone is a VAT partner with KPMG.
|
| Article appeared in the April 2006 issue.
|
|
|
