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EU Commission publishes report on VAT and financial services Back  
The EU Commission has published a report on VAT and the Financial Services industry. Changes may not be imminent but the outline of medium term changes can be seen. The key problems identified by the EU report are obstacles to outsourcing; hidden irrecoverable VAT costs in FS charges to business; competitive distortions due to inconsistent rules; and reduced international competitivness.
The proposals
VAT exemption gives rise to irrecoverable VAT for many FS businesses. No silver bullet single solution is offered to the problem and this is understandable. There is a good reason for their exempt status i.e. the difficulty, amounting to near impossibility in some cases, of defining turnover so as to have a basis for a VAT charge.

Instead a menu of minor solutions is offered, some of them, significantly, not requiring legislation and therefore not subject to Member State objections.

The principal proposals are:
• EU guidance on the interpretation of VAT rules so as to eliminate inconsistent application as between Member States, reduce uncertainty for the FS industry and reduce litigation
• mandatory VAT grouping in all Member States. At present only 12 of the 25 Member States provide for grouping.
• mandatory cross border VAT grouping. According to the report, at present only the UK and the Netherlands provide limited forms of cross border VAT groupings.
• clarification that the exemption for cost sharing arrangements applies to commercial undertakings. The authors of the report believe that despite uncertainty it does apply to cost sharing cooperative or joint venture service arrangements.
• a new method for the calculation of input credit recovery, modelled on systems in Singapore and Australia, would provide a fixed p.c. input credit recovery based on industry studies of the labour and profit element present in certain types of expenses or inputs. It would not be linked to the proportion of taxable supplies made by the claimant business.
• EU guidance on input credit recovery rules which would eliminate national divergences and result in rules that are more analytical and related to the nature of specific FS sectors. Smaller businesses would be permitted to adopt a fixed p.c. recovery regardless of the nature of their supplies, to reduce complexity for them.

The most obvious solution is not proposed ie zero rating of FS supplies. This would allow for full input credit recovery while largely bypassing the need for measurement of turnover. This would have loss of tax revenue implications for Member States which is probably what ruled out such a direct simple solution.

The report acknowledges that it would be possible to extend VAT to a wider range of FS supplies since many are fee or commission based and lend themselves to measurement of turnover. Since a large proportion of FS customers are business customers, such an extension of VAT to a wider range of services would not greatly disadvantage FS customers and would improve input credit recovery.

The nature of the problem
The principle underlying the VAT system is that it should not represent a cost to business but should be borne only by non-business consumers of goods and services. The basic idea is that businesses charge VAT, including on supplies to other businesses but by input credit recovery, they would recover all VAT charged to them.

However an exempt business does not recover all of the VAT charged to it. It becomes a cost to such a business and like all costs, is passed on in some form to its customers. Business customers therefore have hidden VAT costs passed on to them and do not recover such indirect VAT costs through the input credit system. Thus VAT ends up as a business cost throughout the economy and not only in the exempt sector.

But the real, as opposed to theoretical, problem for the FS sector centres on subcontracting. Wages and salaries paid to employees involved in a back office function do not lead to VAT cost for an FS company. However, if the business outsources the function, the service fee can give rise to irrecoverable VAT. Thus outsourcing is inhibited. This can reduce efficiency and impose a burden on smaller companies (for whom internal provision of all services required may lack economies of scale).

The rules for determining which services are exempt and therefore can be outsourced without incurring a VAT cost, are uncertain, open to change as the European Court of Justice produces new decisions on VAT cases, and not consistent in interpretation across the EU.

Grouping to some extent mitigates the problems with outsourcing provided it is kept within the group but cross border grouping is not always possible so business looking to outsource cannot take advantage of lower cost centers in other EU Member States and non-EU countries such as India unless the total savings (including irrecoverable VAT) make the exercise worthwhile.

One surprising finding in the survey is that VAT does not greatly influence location of FS business. Location decisions seem at present to be dominated by market access considerations ie the feeling that a presence is needed in each national market which is targeted. With some notable exceptions, cross border provision of FS services seemed to be the exception rather than the rule in many Member States.

Given the importance of cross border FS business in Ireland, it may be unwise to take that conclusion at its face value. The evidence suggests that national VAT regimes are a consideration in the location of cross border FS businesses. Ireland scores well in the perception of the businesses which were included in the survey on which the report is largely based. The key factors in Ireland's favourable rating are its definitions of FS activity (where there are many divergences across the EU), its VAT grouping, and the guidance available from TALC which reduces uncertainty on VAT treatment of transactions.

The UK and Luxemburg also score well with the UK having almost as high a rating in terms of definition of FS activities as Ireland, and Luxemburg a slightly higher rating on that point. The UK Blue Book is widely seen as important in giving accessible guidance on VAT rules and certainty.
The report makes the very obvious point that high VAT rates are a disadvantage for FS business for whom irrecoverable VAT is a cost. The higher the national rate, the higher the irrecoverable VAT cost. Ireland's 21p.c. standard rate is a high rate by EU standards. A worked example in the report brings out the extra cost Ireland's rate involves for FS business compared to the low 15p.c. rate in Luxemburg.

The report does not discuss the impact of property transactions on the irrecoverable VAT cost of FS businesses or how Ireland would compare with its main competing jurisdictions in that area.
The Revenue have published a consultation paper on proposed reforms to Ireland's VAT regime for property that, if implemented, would have major implications for FS business.

The future
Some of the proposed solutions mentioned above could be implemented quickly since they would not require EU legislation but only administrative action from the Commission. But these measures do not much address the major issues for FS business.

In the meantime, Ireland should concentrate on ensuring that it closes the gap with the UK in terms of perception by cross border FS business as the most favourable regime, and on widening the narrow advantage in perception it may have currently over Luxemburg. The report makes it clear that far from being a harmonised tax, VAT on FS services is widely varied across the EU.

• Ireland should concentrate on taking advantage of options, and local freedoms to improve VAT recovery rates for FS business under the existing EU directives, and on further improving its definitions of FS activity.
• We should explore a more broadly based regime of cross border grouping for FS business.
• TALC is a well appreciated forum for discussion and clarification but we should consider whether a Blue Book on the UK lines would raise the profile of the degree of certainty Ireland offers regarding interpretation of rules.
• A reduction in the standard VAT rate back to the 20p.c. we briefly enjoyed some years ago would be a start in the right direction, even if we will not match Luxemburg's 15p.c. rate any time soon.
Ireland has a low tax policy and has benefited greatly from it. But too often we overlook that policy when it comes to discussing the detailed tax rules as opposed to headline tax rates. Ireland's cross border FS industry is a major industry and a major taxpayer. An investment in lowering the VAT cost for the industry will be repaid many times with an increased volume of business, employment and taxes.

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