Rita de la Feria
( Centre for Business Taxation, University of Oxford) and
Ben Lockwood
(University of Warwick and Centre for Business
Taxation, University of Oxford)
ETPF Conference, London, 27 April 2009

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Why are Margin-based Financial Services Difficult to Tax?
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The Current Situation in the EU
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The Commission’s Proposals: The “Three Pillars”
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The Option to Tax: A Closer Look

The Incentives to Opt In

The Revenue Effects of Opting In
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Alternatives to the Commission’s Proposals
April 27, 2009 VAT on Financial Services

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Theory; consumption VAT should tax the value-added provided by financial intermediation services (FIS), such as bank lending, insurance
But, in practice, difficult to distinguish value of FIS provided to lender and borrower
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Example: bank pays 5% on a deposit of £1000, lends it out at 8%, so total value-added is 3% of £1000 i.e. £30
Not a problem if neither lender nor borrower are liable for VAT; just tax the total of £30
But if one or both are liable for VAT, need to determine VAT that can be reclaimed by each party (borrower, lender) on purchases of
FIS, to avoid breaking the VAT chain
Theoretically, a cash-flow system of taxation with tax calculation accounts (TCAs) can solve this problem. But, has been assessed by the Commission and found unworkable in practice
April 27, 2009 VAT on Financial Services

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Most insurance and financial services are exempt under Article
135(1) of the VAT Directive
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An exception is where the financial service is exported outside the EU; in this case, input VAT can be deducted (i.e. destination-based VAT)
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Article 132(1)(f) of the VAT Directive allows cost-sharing groups
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13 out of 25 current member states have national rules governing these, with considerable variation in in scope and method
National rules vary according to substantially
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Article 137(a) of the VAT Directive currently allows (but does not compel) Member States to introduce an option to tax on all services except for insurance
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Discretion on detail left to member states
So far, only six member states (Austria, Belgium, Estonia, France,
Germany, Lithuania) have opted in, with considerable variation in scope and method
April 27, 2009 VAT on Financial Services

Difficulties for Traders and Tax Administrations Arising from Exemptions
Legal Economic
Definitional and interpretative problems
Calculation of recoverable input VAT and apportionment of tax
Planning and aggressive planning
Irrecoverable VAT
Self-supplies vs. outsourcing: bias away from outsourcing
Foreign vs. EU suppliers: bias towards foreign suppliers
Violation of the consumption tax principle
Tax cascading
Loss of tax revenue
VAT on Financial Services April 27, 2009

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Growing ECJ case-law: first cases from late
1990s
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Previous review attempts (TCA 2000)
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Current review process initiated in wake of
Accenture ruling (2005)
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Consultation paper in 2006
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Current legislative proposals presented in
November 2007, based on “three pillars”:
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Re-definition of exemption criteria based on explicit lists
Extension / clarification of cost-sharing groups
Major extension of option to tax
April 27, 2009 VAT on Financial Services

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Clarification of exemptions applicable to insurance and financial services through:
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Amendments to VAT Directive, with broad interpretative guidelines provided
Inclusion in separate Regulation of two detailed lists of insurance and financial products, one of exempt products, and one other of taxable products
Rationale: to increase levels of legal certainty
Measures are helpful from legal perspective, but not a panacea:
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List will become naturally out of date in short to medium term as new insurance / financial products arise
Approval of amendments will not be straightforward
Listings likely to give rise to interpretative / application difficulties at the “edges” – with consequent planning / avoidance opportunities
April 27, 2009 VAT on Financial Services

GROUP
MEMBERS
PLACE OF
ESTABLISHMENT
RIGHT TO
DEDUCT
ESTABLISHED
IN SAME
MEMBER STATE
ESTABLISHED
IN ANY
MEMBER STATE
ESTABLISHED
IN THIRD
COUNTRIES
April 27, 2009 VAT on Financial Services
FULLY
EXEMPT
PARTIALLY
EXEMPT

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New proposals extend / clarify current regime, using new terminology:

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Group members must be established within territory of
Community
Eliminated reference to “distortion of competition”
Exclusion of transfer-pricing adjustments
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Problems/ limitations:
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Lack of further guidelines likely to give rise to different national designs - only limitation being that members cannot be established in third countries
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Some economic bias remains due to limited scope of measure e.g. outsourcing not covered
April 27, 2009 VAT on Financial Services

TRASANCTIONS
COVERED
TYPE
CUSTOMERS’
NATURE
QUANTITY TIME SPAN
ALL EXEMPT
TRANSACTIONS
SPECIFIC
TRANSACTIONS
B2B
April 27, 2009
B2C
SUPPLIER
BY
SUPPLIER
TRANSACTION
BY
TRANSACTION
REVOCABLE IRREVOCABLE
VAT on Financial Services

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New proposals extend current option to tax :
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Compulsory introduction by all Member States of option to tax
Scope of option to be extended to all exempt services
(including insurance services) BUT no guidelines on either design of option (scope), or method of taxation
Approval of details of option postponed to later stage
Rationale: eliminate all problems connected with exemptions and non-deductibility of input tax
Measure is problematic from legal perspective:
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Lack of further guidelines on design of proposal likely to give rise to very different designs – only limitation being
“type” of services to which option applies, and perhaps the “customer’s” status
April 27, 2009 VAT on Financial Services

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Conceptually, can technical difficulties be overcome?
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“the option can only be exercised in specific transactions where the supplier invoices a ..taxable amount” (Commission, 2008)
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So, two possibilities: either many margin-based products may continue to be untaxed; or problem of taxing financial services has finally been overcome!
If second, why not bring services within scope of full taxation?
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Measure is not likely to eliminate current difficulties connected with exemptions
April 27, 2009 VAT on Financial Services

Economic framework:
EU-based seller(s) of VAT-exempt financial services EU-based purchaser (B or C)
April 27, 2009
Foreign e.g. US seller of VATexempt financial services
VAT on Financial Services

Three scenarios studied:
 many EU sellers ( perfect competition )
 single EU seller ( monopoly )
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EU and foreign seller ( duopoly )
Robust conclusion: EU sellers have an incentive to “opt in” if and only if selling to a business purchaser
 holds whatever the degree of competition in the market
 holds even if facing “unfair” competition from foreign seller
April 27, 2009 VAT on Financial Services

opt out Opt in, B-to-C Opt in, B-to-B
Price of input ex VAT
VAT on input
100
10
Price of output inc. VAT
200
VAT on output 0
Profit
100
10
200
100
10
220
18.2
20
200-110 =90 200-110-(18.2-
10) =81.8
220-110-(20-
10)=100
April 27, 2009 VAT on Financial Services

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Conclusions:
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Theoretically, strong incentives take-up of the option to tax on B to B transactions
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But, this is subject to the constraint that “the supplier invoices a ..taxable amount”
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And, may be little take-up of the option to tax on B to C transactions
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B-to-C is significant proportion of the total: domestic demand for FI services by final consumers is between
45% and 75% of total for EU countries (Huizinga(2002))
April 27, 2009 VAT on Financial Services

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Member countries are concerned about possible negative impact on tax revenue i.e. loss of
“irrecoverable VAT” on inputs to the FS sector
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Lack of detailed data on this
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“approximate figures for the United Kingdom indicate that unrecoverable VAT accounts for roughly 20% of the total UK taxes paid by the sector” (European Commission, 2008)
April 27, 2009 VAT on Financial Services

Table 1: Estimates of Irrecoverable VAT
Country Value of purchases of intermediate inputs, million
Euro, 2006
1
France
Germany
Italy 38064.40
Netherlands 15407.45
Spain
UK
66907.39
85414.57
22262.86
Standard rate of
VAT
(%)
2
19.6
19
20
19
16
163622.63 17.5
Cefficiency ratio
3
0.51
0.54
0.41
0.61
0.56
0.49
Estimated
VAT paid on inputs, million
Euro, 2006
4
6688.06
8763.53
3121.28
1785.72
1994.75
14030.64
Estimated irrecoverable
VAT, million Euro,
2006
5
1337.61
1752.71
624.26
357.14
398.95
2806.13
Estimated irrecoverable
VAT, % of total tax revenue
6
0.15
0.17
0.05
0.14
0.10
0.35
April 27, 2009 VAT on Financial Services

Table 3: Estimated Revenue Losses from Allowing Opting In
Estimated irrecoverable
VAT, million
2006 Euros
1337.61
Intermediate demand as % of total output*
0.67
Estimated maximum loss from allowing opting in, million
2006 Euros
896.37
Estimated maximum loss from allowing opting in, % of total tax revenue
0.10 France
Germany
Italy
UK
1752.71
624.26
Netherlands 357.14
Spain 398.95
2806.13
0.70
0.80
0.59
0.74
0.58
1225.50
498.66
211.07
293.63
1624.02
0.12
0.07
0.08
0.07
0.20
April 27, 2009 VAT on Financial Services

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Loss of tax revenue need not be equal to irrecoverable VAT of the financial services sector, because of second
round/general equilibrium effects;
 opting in reduces costs of FS firms, and thus their output prices in competitive markets
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In turn, this reduces input costs of purchasers of FS, possibly lowering final goods prices
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If final demand is elastic, value of final sales will increase and there will be an offsetting revenue rise
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But is the GE effect likely to be quantitatively significant?
April 27, 2009 VAT on Financial Services

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We investigate this using a simple general equilibrium model: competitive FS providers sell to another sector (manufacturing), which produces a good for final consumption
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The model is (crudely) calibrated using UK inputoutput tables
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The GE effect is small (<25%) relative to the first-round effect
April 27, 2009 VAT on Financial Services

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Pillar One: “re-definition of insurance and financial services”
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Legal assessment: improvement on current status quo, but not a medium term solution
Economic assessment: distinctions between different products likely to create distortions
Pillar Two: “cost-sharing groups”
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Legal assessment: limited scope of application
Economic assessment: limited scope likely to create distortions
Pillar Three: “option to tax”
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Legal assessment: likely to give rise to significant difficulties
Economic assessment: may not be widely used, but even if it is, the overall revenue losses are likely to be small
April 27, 2009 VAT on Financial Services