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«WARWICK ECONOMIC RESEARCH PAPERS DEPARTMENT OF ECONOMICS Opting for Opting In? An Evaluation of the European Commission’s Proposals for Reforming ...»

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Opting for Opting In? An Evaluation of the European

Commission’s Proposals for Reforming VAT on Financial Services

Rita de la Feria and Ben Lockwood

No 927



Opting for Opting In? An Evaluation of the European

Commission’s Proposals for Reforming VAT on Financial


Rita de la Feria and Ben Lockwood


This paper provides a legal and economic analysis of the European Commission’s recent proposals for reforming the application of VAT to financial services, with particular focus on their “third pillar”, under which firms would be allowed to opt-into taxation on exempt insurance and financial services. From a legal perspective, we show that the proposals’ “first and second pillar” would give rise to considerable interpretative and qualification problems, resulting in as much complexity and legal uncertainty as the current regime. Equally, an option to tax could potentially follow significantly different legal designs, which would give rise to discrepancies in the application of the option amongst Member States. On the economic side, we show that quite generally, when firms cannot coordinate their behaviour, they have an individual incentive to opt-in on business-to-business (B2B) transactions, but not on business-to-consumer (B2C) transactions. We also show that opting in eliminates the cost disadvantage that EU financial services firms face in competing with foreign firms for B2B sales. But, these results do not hold if firms can coordinate their behaviour. An estimate of the upper bound on the amount of tax revenue that might be lost from allowing opting-in is provided for a number of EU countries.

 Senior Research Fellow, Centre for Business Taxation, University of Oxford and Professor, Department of Economics, University of Warwick and CEPR Fellow, respectively. We would like to thank Michael Devereux for his helpful comments and discussions on earlier drafts. Earlier versions of this paper were presented at the Seminar on VAT Treatment of Insurance and Financial Services, organised jointly by the Centre for Business Taxation and the European Commission, and held at Oxford, on December 10, 2008;

as well as at the European Tax Policy Forum (ETPF) Annual Conference, held at the Institute for Fiscal Studies, London, on April 21, 2009. We are grateful for the comments received at those presentations, as well as to those of the editor, Antonio Bozio, and of three anonymous referees. The Centre has a number of sources of funding from both public and private sectors, listed on its website at http://www.sbs.ox.ac.uk/centres/tax. This paper forms part of the work undertaken under ESRC Grant RES-060-25-0033. The authors also gratefully acknowledge separate funding from the ETPF for carrying out this research. The views expressed are those of the authors; the Centre has no corporate views.

1. Introduction Within the European Union most financial and insurance services are currently exempt under Article 135(1)(a) to (g) of the VAT Directive.1 Under Article 168 of the Directive, VAT paid on input transactions will only be deductible “in so far as the goods and services are used for the purposes of the taxed transactions of a taxable person”. Thus, where VAT is paid on inputs used to produce exempt financial supplies it will not, in principle, be deductible. The only exception to this rule applies to situations where the customer is established outside the Community, or where the financial transactions relate directly to goods to be exported out of the Community; in these cases, the taxable person will be entitled to deduct any related input VAT, under Article 169 of the Directive.

This situation conflicts with the standard policy advice on VAT, as for example, given in Ebrill et al.(2001): generally, “exemptions are abhorrent to both the logic and functioning of the VAT”. Specifically, from a legal perspective, exemption for financial services gives rise to definitional and interpretative problems, creates difficulties in calculating the portion of deductible VAT, constitutes an incentive for engaging in aggressive tax planning, and has the additional problem of being conceptually incoherent with the general principles of the European VAT system. From an economic perspective, exempting financial services from VAT is regarded by most as a contravention to the principle of VAT as a general tax on consumption (Auerbach and Gordon (2002)). In particular, exempting any good or service results in a break of the VAT chain, tax cascading, bias towards self-supply, bias towards foreign suppliers, possible loss of potential tax revenue, and what is known as “creeping-exemptions” phenomenon (Ebrill et al.(2001), Chapter 8, and de la Feria, (2007), pp. 75-79).

The reason for this gap between reality and policy recommendation is of course, the practical difficulty, discussed in more detail in Section 2 of this paper, of taxing financial services; fundamentally, this is because many products (bank lending, insurance) involve intermediation by the supplier, and thus the value-added of services to the other parties Council Directive 2006/112/EC of 28 November 2006 on the common system of value added tax, OJ L347, 11/12/2006, 1-118, hereafter “VAT Directive”.

e.g. borrower and lender are not clearly distinguished2, and thus cannot be separately taxed.

This problem has ensured that the question of how to treat financial supplies under VAT has remained on the European tax policy agenda. In the mid-1990s the European Commission set out to review the VAT treatment of financial services. Its starting point was the possibility of taxing these services through the cash-flow mechanism proposed by Hoffman, Poddar and Whalley (1987) and Barham, Poddar and Whalley (1987). The method, however, presented some difficulties, not least the potential for high compliance costs. Aiming at establishing whether these difficulties could be overcome, the Commission set up a review. The resulting Report prepared by Ernst & Young and published in 2000, identified a truncated cash-flow method (TCA) method of charging VAT – a modification of the original cash-flow approach - as the most viable solution3.

Although this Report demonstrated that this method could successfully allow full taxation of financial services, and its technical feasibility was further confirmed by field testing undertaken by the European Commission across a range of financial institutions, it was received with little enthusiasm by both legislators and business alike. In 2004, the Commission convened a Fiscalis Seminar,4 the principal focus of which was the VAT treatment of financial services, and in particular the possibility of moving towards full taxation of these services using the TCA method. The seminar reportedly revealed an overwhelming consensus against this move, leading the Commission to abandon in the medium term any attempts to undertake it. The failure to reach an agreement on the introduction of a TCA system did not, however, remove the difficulties caused by exempting financial services. If anything, the need to find a satisfactory solution has increased since the beginning of the Commission’s review process in the mid-1990s (de la Feria (2007)). Now, these rules are once again under review.

These are known as margin-based products.

The cash-flow method, and the TCA method are reviewed in Section 5 of this paper.

Fiscalis is a training programme organised by the European Commission, and directed at the officials of national tax administrations. Its principal aim is to improve the operation of taxation systems in the EU, see Decision No. 1482/2007/EC of the European Parliament and of the Council of 11 December 2007, OJ L330, 15/12/2007, 1-7.

In November 2007, following a lengthy consultation procedure initiated in the wake of the ruling from the Court of Justice (ECJ) in Accenture,5 the European Commission presented two legislative proposals with a view to amending the EU VAT treatment of financial (including insurance) services (Commission of the European Communities (2007a) and Commission of the European Communities (2007b)). Behind the proposals was the wish to enhance the functioning of capital markets and improve the competitiveness of European financial institutions at international level (Borselli (2009),

p. 375). In this context, the objectives were, in the words of the Commission, two-fold:

to increase legal certainty, and to reduce the impact of non-recoverable VAT for financial institutions.

These objectives are to be achieved through what has been designated as “three pillars”:

clarification of the rules governing the exemption for financial supplies, in particular redefinition of financial services which are subject to exemption; introduction of a costsharing group, allowing economic operators to pool investments and re-distribute the costs of these investments to the members of the group, exempt from VAT; and introduction of a compulsory option to tax, i.e. compulsory for Member States to allow taxation, but optional for financial institutions to opt-in for taxation.

The negotiations at the Council of Ministers started soon after the proposal was put forward by the Commission, and have been ongoing ever since.6 Keeping up with the contents of the negotiations is an almost impossible task, but it is reasonable to assume from all official documentation available that negotiations have been difficult, in particular insofar as pillar three, the option to tax, is concerned. Negotiations have concentrated primarily on discussions over the first pillar of the proposal (clarification and re-definition of exemptions), whilst almost no time has been devoted to pillar two (cost-sharing arrangements). Pillar three (the option to tax) has also been the subject of lengthy discussions, but most national delegations, including that from the United See Commission of the European Communities (2006), and case C-472/03, [2005] ECR I-1719. For an analysis of the Accenture ruling and its impact, see de la Feria (2007).

The Council’s Working Party on Taxation Questions – Indirect Taxation (VAT) has met over fifteen times since January 2008 to discuss these proposals, available as Communications from the Council of the European Union.

Kingdom,7 and France (Borselli (2009), p. 382) have reportedly manifested their scepticism as regards any change to the current legal provisions.

The aim of this paper is therefore to consider all measures, and in particular the option to tax, from both a legal and an economic perspective, assessing whether they do indeed constitute an improvement on the current regime. In particular, are these measures likely to address the distortions caused by the current regime, or will they merely substitute the current difficulties with new ones?

In part 2, we discuss the particular challenges of levying VAT on financial services products and estimate the “size of the problem” i.e. the amount of irrecoverable VAT paid by the financial services sector. A legal and economic analysis of the merits and demerits of the Commission’s three pillars will then be undertaken, starting in part 3 with a legal examination of the first two proposed pillars, namely clarification of exemptions and legal definitions, and cost-sharing groups. In part 4 the focus will shift to the third pillar, i.e. the option to tax. Following an analysis of the optional legal regimes currently applicable within the EU, an assessment of the possible legal designs for an EU-wide option to tax will be undertaken. This legal analysis is followed by a detailed economic assessment of the consequences of introducing an EU-wide option to tax, including some estimates of the amount of tax revenue that might be lost from adopting the option.

Finally, in part 5, we discuss two main alternatives to the option to tax: the tax calculation account (TCA) method of Poddar and English, and zero-rating of B2B transactions.

2. Some Background

2.1 Why it is Desirable But Difficult to Tax Financial Services It is now widely accepted amongst economists that on efficiency grounds, financial services should be subject to VAT. For example, the influential work of Auerbach and Gordon (2002) views the financial services sector as providing transactions services (bank accounts, credit cards, etc) that facilitate the purchase of goods and services. In this framework, they demonstrate that under a wide set of conditions, a switch from a labour See Document 15793/08 FISC 156, 14 November 2008 from Presidency of the Council of the European Union to the Working Party on Tax Questions – Indirect Taxation (VAT), at 3-6; and Document 11013/08 FISC 80, 23 June 2008.

income tax to a VAT will leave relative consumer prices unchanged if and only if the transactions services are subject to VAT, with credit being given to VAT paid on inputs to the financial services sector8. There are exceptions to this rule, most importantly, that the timing of tax payments changes, and this can raise real intermediation costs (Auerbach and Gordon (2002), p415). But, nevertheless, the lesson that has been drawn from this academic literature is that inclusion of financial services in VAT is desirable.

But is it feasible? If a financial services company is providing a product that can be priced via the charging of fees and commissions (such as consultancy services, commissions charged by brokers on acquisitions and disposals of securities, etc), this can be made subject to VAT in the normal way. The problem arises with margin-based products, such as bank lending or insurance.

The difficulties are demonstrated by the following example. In the first period, a depositor deposits £100, which the bank lends on to a borrower. In the second period, the borrower repays the principal plus interest at 15%, and the bank repays the principal plus 7% interest to the depositor. In this, case, the value of intermediation services is £15£7=£8, and VAT should be paid on this value-added. The simplest situation is where both the depositor and the borrower are consumers i.e. not liable for VAT. In this case, the value-added could be taxed simply by requiring the bank to pay VAT on the whole margin of £8.

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