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

1. 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

2. 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 VAT on Financial Services

3. 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 VAT on Financial Services

4. 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 VAT on Financial Services

5. The Current Situation in the EU VAT on Financial Services

6. 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 VAT on Financial Services

7. 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 VAT on Financial Services

8. Scope of Current Cost-Sharing Groups VAT on Financial Services

9. 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 VAT on Financial Services

10. Scope of Current Options to Tax VAT on Financial Services

11. 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 VAT on Financial Services

12. 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 VAT on Financial Services

13. Option to Tax: Incentives to Take up Option? Economic framework: EU-based seller(s) of VAT-exempt financial services EU-based purchaser (B or C) Foreign e.g. US seller of VAT-exempt financial services VAT on Financial Services

14. 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 VAT on Financial Services

15. Option to Tax: Incentives to Take up Option? Example VAT on Financial Services

16. 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)) VAT on Financial Services

17. 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) VAT on Financial Services

18. Irrecoverable VAT: How Big is the Problem? VAT on Financial Services

19. Option to Tax: Revenue Losses VAT on Financial Services

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? VAT on Financial Services

21. 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 VAT on Financial Services

22. 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 VAT on Financial Services