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
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
April 27, 2009
VAT on Financial Services
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
April 27, 2009
VAT on Financial Services
The Current Situation in the
EU

Most insurance and financial services are exempt under Article
135(1) of the VAT Directive


Article 132(1)(f) of the VAT Directive allows cost-sharing groups



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)
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
April 27, 2009
VAT on Financial Services
The Current Situation in the
EU
Difficulties 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
April 27, 2009
VAT on Financial Services
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
April 27, 2009
VAT on Financial Services
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
April 27, 2009
VAT on Financial Services
Scope of Current CostSharing Groups
GROUP
MEMBERS
PLACE OF
ESTABLISHMENT
ESTABLISHED
IN SAME
MEMBER STATE
April 27, 2009
ESTABLISHED
IN ANY
MEMBER STATE
RIGHT TO
DEDUCT
ESTABLISHED
IN THIRD
COUNTRIES
VAT on Financial Services
FULLY
EXEMPT
PARTIALLY
EXEMPT
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
April 27, 2009
VAT on Financial Services
Scope of Current Options to
Tax
TRASANCTIONS
COVERED
TYPE
ALL EXEMPT
SPECIFIC
TRANSACTIONS TRANSACTIONS
April 27, 2009
CUSTOMERS’
NATURE
B2B
B2C
QUANTITY
SUPPLIER
BY
SUPPLIER
VAT on Financial Services
TRANSACTION
BY
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
April 27, 2009
VAT on Financial Services
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
April 27, 2009
VAT on Financial Services
Option to Tax: Incentives to
Take up Option?
Economic framework:
EU-based seller(s)
of VAT-exempt
financial services
Foreign e.g. US
seller of VATexempt financial
services
April 27, 2009
VAT on Financial Services
EU-based
purchaser (B or C)
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
April 27, 2009
VAT on Financial Services
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-(18.210) =81.8
220-110-(2010)=100
April 27, 2009
VAT on Financial Services
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))
April 27, 2009
VAT on Financial Services
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)
April 27, 2009
VAT on Financial Services
Irrecoverable VAT: How Big
is the Problem?
Table 1: Estimates of Irrecoverable VAT
Country
Value of
purchases of
intermediate
inputs, million
Euro, 2006
1
France
66907.39
Germany
85414.57
Italy
38064.40
Netherlands
15407.45
Spain
22262.86
UK
163622.63
April 27, 2009
Standard Crate of
efficiency
VAT
ratio
(%)
2
19.6
19
20
19
16
17.5
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
VAT on Financial Services
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
Option to Tax: Revenue
Losses
Table 3: Estimated Revenue Losses from Allowing Opting In
Estimated Intermediate
irrecoverable demand as %
VAT, million
of total
2006 Euros
output*
France
Germany
Italy
Netherlands
Spain
UK
April 27, 2009
1337.61
1752.71
624.26
357.14
398.95
2806.13
0.67
0.70
0.80
0.59
0.74
0.58
Estimated Estimated maximum
maximum loss loss from allowing
from allowing opting in, % of total
opting in, million
tax revenue
2006 Euros
896.37
0.10
1225.50
0.12
498.66
0.07
211.07
0.08
293.63
0.07
1624.02
0.20
VAT on Financial Services
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,
lowering final goods prices

If final demand is elastic, value of final sales will increase and
there will be an offsetting revenue rise
possibly
But is the GE effect likely to be quantitatively significant?
April 27, 2009
VAT on Financial Services
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 inputoutput tables

The GE effect is small (<25%) relative to the
first-round effect
April 27, 2009
VAT on Financial Services
Conclusions: Evaluation of
2007 Proposals

Pillar One: “re-definition of insurance and financial services”



Pillar Two: “cost-sharing groups”



Legal assessment: improvement on current status quo, but not
a medium term solution
Economic assessment: distinctions between different products
likely to create distortions
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
April 27, 2009
VAT on Financial Services