EC Policy on VAT Assessment for Financial and Insurance Services - Essay Example

EC Policy on VAT Assessment For Financial and Insurance Services: Will the Compromise Solution Work? Introduction The financial services industry encompasses a broad range of organizations that deal with the management of money. These include insurance firms, banks, credit card companies, consumer finance companies, stock brokerages, and some government-sponsored enterprises. In terms of earnings or number of employees, this business sector is not the largest category and is even considered a slow-growth, highly fragmented industry. It follows that the financial services institutions are not as heavily taxed as other fast-moving, high-growth industries engaged in consumer goods, energy or computer technology. Nonetheless, the players in the financial services sector have emerged in recent years as among the largest groups of companies in the world and, despite this fragmentation, financial service companies as a group have become by far the most profitable in the world. For example, the UK-based financial services conglomerate HSBC and Barclays are among the world’s largest corporations. For this reason, the European Commission in the 1990s took up a plan to include financial services and insurances in the value added tax (VAT) system for all member states, with the primary purpose of making the markets for financial services efficient. The plan was embodied in the Sixth VAT Directive of EC, part of the Financial Services Action Plan which was issued in 1977. Under the EC Treaty, all member states are obliged to adopt EC Directives into their own statutes although they can choose the forms or methods by which to implement them1. The 1977 VAT directive, however, was met with hostility by member states, which were reluctant to implement the tax measure. This paper tracks the difficulty of modernizing the VAT system for financial and insurance services for EU that would be acceptable to all and would advance the EC policy of promoting integration and competition in this industry for Europe’s future growth in prosperity and employment. A critical evaluation of the compromise measure proposed by EC is in order as a way of contributing to the consultation process being conducted by the Commission to craft a more realistic and more acceptable VAT system for financial and insurance services. Thus, the paper attempts to present an opinion on whether the new VAT system proposed by EC will be more successful than the first. Problems & Issues Financial markets have developed in such a way that even interpretation of classic terms like credit gives rise to difficulties. The Commission services have been confronted with an increasing number of cases where economic operators and member states had problems in interpreting the definitions of exempt services under the Sixth VAT Directive. These cases often reflect the complexity of financial and insurance products, extending to questions such as whether there is a taxable supply and where the place of supply is located. The most serious objections to the imposition of VAT on financial services and insurance firms were the absence of a readily identifable mechanism for efficiently implementing the tax proposal, and the increase in consumer credit that it is expected to generate. Another issue raised against the imposition of VAT on customers of financial and insurance services was the way it offends political sensibilities2. The financial services industry, being engaged in the management of money, involves public interest because a bank run, for example, can harm a national economy. Thus, governments of EU member states carefully regulate the operation of these companies, such that in UK, the Financial Services Authority has been clothed with greater powers to go after financial services firms that mishandle their affairs and funds3. The difficulty for EC consisted mainly in the impossibility of establishing taxable amounts and the amounts of deductible VAT without generating unacceptable administrative charges and without creating legal and accounting complexity for both economic operators and the fiscal authorities of member states. _____________________________________________________________________ Article 249 of the EC Treaty provides that a Directive shall be binding as to the result sought to be achieved. 2 Noted by the EC Directorate General, Taxation and Customs Union. 3 The Financial Services Development Act 2001 of UK protects the industry from market failures. In the search for that compromise solution, EC in the 1990s opened a round of consultation to generate feedback on the options for changing the basic provisions of the Sixth VAT Directive. Now, EC believed it had the appropriate technical methodology for the imposition of full taxation and input credit on providers of financial and insurance services. Among the proposals considered were those imposing full taxation, input credit and what is called Truncated Cash Flow (TCA) method. The TCA method will fix a zero VAT rate on firms that conduct business between themselves and VAT charges for financial services and insurance firms that transact business with consumers. After an exhaustive consultation process, the proposals were found to be technically feasible but the complexity of the process worked against them. It was also learned that the benefits accruing from the system could not justify the profound system change that they would entail. Because of the legal complexity and the possible administrative charges that the plans would generate, the full-taxation and TCA plans were abandoned, and EC looked for alternative ways. Later, at a seminar In Dublin in 1994, EC adopted the White Paper on Financial Services Policy 2005-2010, whose primary objective is to liberalize the regulatory framework for this industry across the EU member states. To flesh out this new policy tack, EC will work for the gradual but steady dismantling of barriers on tax and legal matters to enhance competition between financial services and insurance suppliers. The focus of the discussions in Dublin was to search for ways to: 1) reduce administrative costs in exercising legal supervision and for financial services and insurance operators in achieving fiscal compliance, 2) create budgetary security for member states and legal certainty for these operators, 3) and address the inconsistencies between the 1977 VAT provision and the more recent regulatory and legal provisions such as those falling under the Financial Services Action Plan. If this approach is enacted, however, the outcome was expected to go against the grain of EC’s basic policy to emplace an integrated, open, efficient and competitive market for these products. For example, the different financial services are likely to compete against each other. Also, the unbalanced change in the VAT system will impact on consumer choice between different investment options. In order to improve the functioning of the internal markets, it was deemed essential that any VAT system must work to ensure a more uniform application. The adoption of provisions implementing Directive 2006/112/EC is a major step forward in that respect. A Regulation, binding and directly applicable in all Member States, will ensure that certain divergences in the application of the provisions of Directive 2006/112/EC no longer occur in the future. This Regulation will only apply when value added tax becomes chargeable after the date of its entry into force. Implementing provisions should ensure the correct and more uniform application of the current VAT system to improve the functioning of the internal market. They are particularly necessary where there is a danger of double taxation of cross-border transactions as the result of differences between member states in the application of the provisions of the 6th Directive governing the place of supply. Since part of the objective of EC’s VAT policy is to encourage competition, the Commission looked into the strategies by which financial service operators improve their own competitiveness and overcome the problems that they encounter towards that goal. The approaches vary considerably between institutions but the most common is the outsourcing of business functions to bring down administrative and labor costs. The basic goal of forward-looking businesses is to source services from countries with cheaper labor costs, meaning less developed economies. This is the essence of outsourcing, which consists of separating parts of a process or service from a main location and having them done more cheaply somewhere else4. Where financial services and insurance operators out-source their requirements, their services are invoiced by the supplier with VAT, which is not deductible for the businesses concerned. These additional VAT costs diminish the cost savings efforts of the operators concerned and counteract to the operators strategies to improve their competitiveness. This is perceived as a major impediment to efficiency for the operators concerned. _______________________________________________________________ 4 Baghavati, et al., 2004. Another problem consists in establishing the amount of deductible tax in cases where the taxable person carries out taxable and non-taxable transactions. For financial institutions, this is not an unusual set of circumstances. In such cases the amount of deductible tax depends on goods and services supplied to him and used for the purpose of his own taxable transactions. Still another problem consists in establishing the amount of deductible tax in cases where the taxable person carries out taxable and non-taxable transactions. For financial institutions, this is not an unusual set of circumstances. In such cases the amount of deductible tax depends on goods and services supplied to him and used for the purpose of his own taxable transactions. Compromise Solution The new alternative VAT system being considered pays careful attention to the four major areas that often bring the business strategies of financial and insurance operators into conflict with existing VAT rules: 1) the definition of exempt services; 2) hidden VAT in supplies between taxable persons in business-to-business transactions; 3) calculation of the amount of deductible input VAT; and 4) interests involved and approach to the problems by markets and by individual member states. An important third aspect considered by the Commission services as critical to the review was to look at the basic structure of the ECJ jurisprudence on the exemption of insurance and financial services. This has to be taken into account in identifying in a subsequent step, the measures which could meet the needs of both economic operators and Member States fiscal authorities within the objectives mentioned above. For the exemptions, the ECJ has developed an extensive jurisprudence, which is based on three main pillars deeply embedded in the Courts consistent stance on other services and on the place of supply of these services5. The exemptions are not limited to the financial and insurance services since the terms used to specify the exemptions under Article 13 of the Sixth Directive are to be interpreted strictly every service provided by a taxable person for consideration is subject to VAT. The nature of the service is important. It does not matter who supplies the service, or how it is supplied. It is also not important to which other services the service in question contributes or of which it is a necessary component The interpretation must meet the requirements of the principle of fiscal neutrality on which the VAT system is based6. Under the compromise measure, the exemptions are also to be interpreted according to the context and the purpose of the rules as set by the legislators and ECJ at the time when the rules were introduced. ____________________________________________________________________ 5 (see Case C-359/97 Commission v United Kingdom, judgement of 12 September 2000, point 63) 6 see Case C-281/91 Muys’ en De Winter’s Bouw- en Aannemingsbedrijf [1993] ECR I-5405. Based on the draft regulation of the new Financial Services Policy, the particular services to be excluded from the definition of insurance services and thus entitled to VAT exemptions are those commitments where; the risk coverage does not achieve a threshold of 5 percent of the total value of the commitment; no indemnification is provided for; - the insurer does not become owner of the premium; or where the taxable services elements in the insurance undertaking exceed the value of the exempt elements covering the risk. The value of other exempt services is disregarded. This liberalizing regulatory framework increases the competition between suppliers of insurance and financial services through the steady dismantling of barriers of a legal nature but also through the examination of other barriers such as those resulting from tax arrangements in the area of clearing and settlement. Conclusion Against this background, it would appear that a possible modernization must address the following issues: 1) it should allow that insurance and financial services suppliers are not left with nondeductible input VAT on supplies which can be allocated to their taxable output supplies while maintaining at the same time budgetary security for member states; 2) reducing the administrative charges for the economic operators concerned and avoiding distortions in competition; 3) it should improve the definition of exempt services, creating more legal security for member states and economic operators and be sufficiently robust to keep pace with the development of new insurance and financial services; and 4) it should remove potential or actual competitive distortions between supplies of insurance and financial services across different member states or between places outside the EU and supplies of those services across Europe. Efficient markets for financial services and insurance firms will benefit European businesses and consumers, and financial integration will contribute to the region’s future growth in prosperity and employment. Thus, VAT must be applied in a manner consistent with a level playing field and, accordingly, any review of existing provisions must address the elimination of competitive distortions attributed to the VAT system. Common to all of these framework conditions is that whatever is proposed by the Commission should be in conformity with the basic structure and principles of the VAT References Bhagvati, J., Panagariya, A. & Srinivasan, T.N. (2004). “The Muddles over Outsourcing.” Journal of Economic Perspectives 18 (4). EC. “Consultation Paper on Modernizing Value-Added Tax Obligations for Financial Services and Insurances.” Directorate General, Taxation and Customs Union, Brussels. European Commission (2007). “Financial and Insurance Services Cross-Boarder Vehicles.” TAXUD/2134/07Rev. 1-EN. 3 FSA (2007). FSA Fines Advisor Firm for Management and Complaints Handling Failings. Press Release, 11 June 2007. Official Journal of EU (2007). “Draft Regulation Financial and Insurance Services.” TAXUD/2146/07-EN. Read More