Rita de la Feria ( Centre for Business Taxation, University of Oxford) and Ben Lockwood

Opting for Opting In? An Evaluation of the Commission’s

Proposals for Reforming VAT for Financial Services

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

April 27, 2009 VAT on Financial Services

Outline Why are Margin-based Financial Services Difficult

to Tax?

The Current Situation in the EU

The Commission’s Proposals: The “Three Pillars”

The Option to Tax: A Closer Look

The Incentives to Opt In

The Revenue Effects of Opting In

Alternatives to the Commission’s Proposals


Why are Margin-based Services Difficult to Tax? 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

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


The Current Situation in the EU Most insurance and financial services are exempt under Article

135(1) of the VAT Directive 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)

Article 132(1)(f) of the VAT Directive allows cost-sharing groups 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

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

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


The Current Situation in the EUDifficulties for Traders and Tax Administrations Arising

from Exemptions

Legal Economic

Definitional and interpretative problems

Irrecoverable VAT

Calculation of recoverable input VAT and apportionment of tax

Self-supplies vs. outsourcing: bias away from outsourcing

Planning and aggressive planning Foreign vs. EU suppliers: bias towards foreign suppliers

Violation of the consumption tax principle Tax cascading

Loss of tax revenue


Ongoing Review:“The Three Pillars” Growing ECJ case-law: first cases from late 1990s

Previous review attempts (TCA 2000)

Current review process initiated in wake of Accenture ruling (2005)

Consultation paper in 2006

Current legislative proposals presented in November 2007, based on “three pillars”: Re-definition of exemption criteria based on explicit lists Extension / clarification of cost-sharing groups Major extension of option to tax


Re-Definition of Exempt Services Clarification of exemptions applicable to insurance and

financial services through: 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: 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


Scope of Current Cost-Sharing Groups

GROUP MEMBERS

PLACE OFESTABLISHMENT

RIGHT TODEDUCT

ESTABLISHEDIN SAME

MEMBER STATE

ESTABLISHEDIN ANY

MEMBER STATE

FULLY EXEMPT

PARTIALLYEXEMPT

ESTABLISHEDIN THIRD

COUNTRIES


New Cost-Sharing Groups

New proposals extend / clarify current regime, using new terminology: Group members must be established within territory of

Community Eliminated reference to “distortion of competition” Exclusion of transfer-pricing adjustments

Problems/ limitations: Lack of further guidelines likely to give rise to different

national designs - only limitation being that members cannot be established in third countries

Some economic bias remains due to limited scope of measure e.g. outsourcing not covered


Scope of Current Options to Tax

TRASANCTIONS COVERED

TYPECUSTOMERS’

NATUREQUANTITY

ALL EXEMPT TRANSACTIONS

SPECIFICTRANSACTIONS

B2B B2CSUPPLIER

BYSUPPLIER

TRANSACTIONBY

TRANSACTION

TIME SPAN

REVOCABLE IRREVOCABLE


Extension of the Option to Tax New proposals extend current option to tax :

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: 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


Extension of the Option to Tax

Conceptually, can technical difficulties be overcome?

“the option can only be exercised in specific transactions where the supplier invoices a ..taxable amount” (Commission, 2008)

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?

Measure is not likely to eliminate current difficulties connected with exemptions


Option to Tax: Incentives to Take up Option?Economic framework:

EU-based purchaser (B or C)

EU-based seller(s) of VAT-exempt financial services

Foreign e.g. US seller of VAT-exempt financial services


Option to Tax: Incentives to Take up Option?Three scenarios studied:

many EU sellers (perfect competition)

single EU seller (monopoly)

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


Option to Tax: Incentives to Take up Option? Example

opt out Opt in, B-to-C Opt in, B-to-B

Price of input ex VAT

100 100 100

VAT on input 10 10 10

Price of output inc. VAT

200 200 220

VAT on output 0 18.2 20

Profit 200-110 =90 200-110-(18.2-10) =81.8

220-110-(20-10)=100


Option to Tax: Incentives to Take up Option? Conclusions:

Theoretically, strong incentives take-up of the option to tax on B to B transactions

But, this is subject to the constraint that “the supplier invoices a ..taxable amount”

And, may be little take-up of the option to tax on B to C transactions

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))


Option to Tax: Revenue Consequences Member countries are concerned about possible

negative impact on tax revenue i.e. loss of “irrecoverable VAT” on inputs to the FS sector

Lack of detailed data on this

“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)


Irrecoverable VAT: How Big is the Problem?

Table 1: Estimates of Irrecoverable VAT

Country Value of purchases of intermediate inputs, million Euro, 2006

Standard rate of VAT (%)

C-efficiency ratio

Estimated VAT paid on inputs, million Euro, 2006

Estimated irrecoverable VAT, million Euro, 2006

Estimated irrecoverable VAT, % of total tax revenue

1 2 3 4 5 6 France 66907.39 19.6 0.51 6688.06 1337.61 0.15 Germany 85414.57 19 0.54 8763.53 1752.71 0.17 Italy 38064.40 20 0.41 3121.28 624.26 0.05 Netherlands 15407.45 19 0.61 1785.72 357.14 0.14 Spain 22262.86 16 0.56 1994.75 398.95 0.10 UK 163622.63 17.5 0.49 14030.64 2806.13 0.35


Option to Tax: Revenue Losses

Table 3: Estimated Revenue Losses from Allowing Opting In Estimated

irrecoverable VAT, million

2006 Euros

Intermediate demand as %

of total output*

Estimated maximum loss from allowing

opting in, million 2006 Euros

Estimated maximum loss from allowing

opting in, % of total tax revenue

France 1337.61 0.67 896.37 0.10 Germany 1752.71 0.70 1225.50 0.12 Italy 624.26 0.80 498.66 0.07 Netherlands 357.14 0.59 211.07 0.08 Spain 398.95 0.74 293.63 0.07 UK 2806.13 0.58 1624.02 0.20


Option to Tax: Revenue Consequences

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

In turn, this reduces input costs of purchasers of FS, possibly lowering final goods prices

If final demand is elastic, value of final sales will increase and there will be an offsetting revenue rise

But is the GE effect likely to be quantitatively significant?


Option to Tax: Revenue Consequences

We investigate this using a simple general equilibrium model: competitive FS providers sell to another sector (manufacturing), which produces a good for final consumption

The model is (crudely) calibrated using UK input-output tables

The GE effect is small (<25%) relative to the first-round effect


Conclusions: Evaluation of 2007 Proposals Pillar One: “re-definition of insurance and financial services”

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” Legal assessment: limited scope of application Economic assessment: limited scope likely to create distortions

Pillar Three: “option to tax” 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

Rita de la Feria ( Centre for Business Taxation, University of Oxford) and Ben Lockwood

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