Future Value Added Tax (VAT) - guide
06 December 2011by eub2 -- last modified 06 December 2011
The European Commission has today adopted a Communication on the future of VAT. This sets out the fundamental characteristics that it believes must underlie the new VAT regime, and priority actions needed to create a simpler, more efficient and more robust VAT system in the EU.
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1. General background
What is VAT?
VAT is a consumption tax, charged on most goods and services traded for use or consumption in the EU. It is levied on the "value added" to the product at each stage of production and distribution. The "value added" means the difference between the cost of inputs into the product / service and the price at which it is sold to the consumer. VAT is charged when VAT-registered (taxable) businesses sell to other businesses (B-2-B) or to the final consumer (B-2-C). VAT is intended to be "neutral" in that businesses are able to reclaim any VAT that they pay on goods or services. Ultimately, the final consumer should be the only one who is actually taxed. Businesses are given a VAT identification number and have to show the VAT charged to customers on the invoices.
How does the current EU VAT system work?
Currently, a transitional system is in place for VAT on intra-EU transactions. Under this system, when it comes to cross-border sales between businesses, VAT is collected in the Member State of destination (i.e. where the goods are sent to or where the recipient of services is established), in line with the rate and conditions of that country.
This means that the supplier of goods or services does not charge VAT, but the recipient is responsible for paying it. Both the supplier and recipient must conform to special reporting obligations. It should be noted that there are many exceptions to these rules. For example, VAT on transport is paid where the transport occurs and VAT on cultural events occurs where the show takes place.
The rules for intra-EU transactions differ from purely domestic transactions, where the supplier charges VAT and is responsible for paying it to the Treasury.
For goods or services provided to private individuals (i.e. business to customer), the VAT is paid by the supplier in the Member State where the sale occurs or where the supplier is established. However, there are certain supplies for which different rules apply e.g. distance sales, new means of transport, certain services etc.
Why is there still a transitional system in place for VAT?
In 1967, the Council undertook a legal and political commitment to introduce a VAT system tailored to the Single Market and operated across Member States in the same way as within a single country.
To complete the internal market by 1993, the Commission put forward proposals for taxation in the country of origin, with a harmonised rate structure, and a clearing mechanism for the redistribution of VAT receipts to the Member State where consumption takes place.
However, given the lack of consensus and the need for goods to be able to pass freely within the EU while still allowing Member States to collect the tax revenue, the Council instead adopted a transitional system. The transitional system has enabled controls of goods at the EU's internal borders to be abolished whilst allowing tax to be collected in the Member State of destination at the rate and under the conditions of that country.
This system was only supposed to last for 4 years, but Member States have been unable to come to agreement on a more permanent system based on taxation in the Member State where the goods originate. Today's Communication concludes that agreement on a system based on the principle of origin is politically unattainable. Therefore, given the need for a stable and definitive system, the Commission will work for a properly functioning VAT system based on the principle of destination.
Why does the VAT system need to be reviewed?
Value added tax (VAT) is a major source of revenue for national budgets, and is likely to be proportionally even more so as the economic crisis and aging populations take their toll on other taxes (such as labour and capital). Many Member States have recently increased their VAT rates as part of their consolidation efforts. Consumption taxes are considered, in general, to be a more stable revenue source, and more growth-friendly, than certain other taxes such as profits and income.
However, the VAT system currently in place is not well-fitted for today's society. It was designed over 40 years ago, when services, modern technologies and globalisation had a far less prominent role in the economy than they do today. There are numerous shortcomings in the current VAT system which create obstacles to the Internal Market, cause huge administrative burdens for businesses and prevent Member States from benefiting from the true potential of this tax. To give an example, shared service centres or central European inventory did not exist as business concepts in 1967.
While the fundamental idea behind VAT is to have a broad-based, globally applied consumption tax, the wide and divergent use of reduced rates and exemptions by Member States mean that only part of final consumption is being taxed at the standard rate. Moreover, new questions have arisen; such what the VAT treatment should be for products available in both digital and physical formats. Finally, the current VAT system is relatively vulnerable to fraud.
Taking into account the above weaknesses, the VAT system needs to be reviewed to ensure that it is as efficient, robust and flexible as it can possibly be. A reform of the VAT system could greatly contribute to delivering on the EU's 2020 Strategy, strengthening the Internal Market and supporting Member States' budget consolidation.
Is there a common EU VAT rate?
In the EU, there is a minimum standard VAT rate of 15%, above which Member States are free to set their own national VAT rates. Member States decide how to spend the revenue they receive from VAT receipts, except for a small percentage of this total which is paid towards the EU budget.
2. Revenue
How much revenue is raised through VAT every year in the EU?
In 2009, total VAT receipts in the EU were around EUR 783 billion. VAT receipts accounted for 21 % of the national tax revenues of EU Member States (including social security contributions), a rise of 13% since 1995. It is thus a major source of revenue for national budgets and in many Member States it is the main source. VAT receipts represented in 2009 on average 7.4% of the GDP of a Member State, a figure that has increased by almost 10% from 1995.
How much of this revenue goes towards the EU budget?
VAT is part of the own resources of the EU budget, and Member States pay a small percentage of their total VAT receipts to the EU. Currently, this contribution from Member States is based on rate 0.3% of the national harmonised VAT base, with temporary reduced rates over 2007-2013 of 0.225% for Austria, 0.15% for Germany and 0.1% for the Netherlands and Sweden.
In 2010 it represented EUR 14 billion.
Does the Communication look at revising the role of VAT as an "own resource" to the EU budget?
The Communication on the future of VAT is about making the VAT system as a whole simpler, more efficient and more robust, to ensure better quality revenues for whatever purpose they are then used for. A separate exercise is currently underway regarding VAT's contribution to the EU budget own resources. The current VAT own resource is very complex and does not affect all Member States uniformly. The Commission therefore proposed on 9 December to replace it with a simpler VAT own resource that would be more transparent and fairer to all. The idea is to apply a single EU rate of 1 percentage point on all the goods and services currently subject to the standard rate in all EU Member States. The new VAT resource would not be a parallel system to the national VAT system. The rate applicable for the new resource will not be added to the current national VAT rates, but rather integrated into them. Therefore, it would not have an impact on consumers or on businesses dealing with VAT.
Will the reformed EU VAT system raise more revenue?
The Communication points out that broadening the tax base, restricting the use of reduced rates and reducing the scope for fraud could indeed increase revenues for the Member States.
3. What would the reformed VAT system look like?
Will the minimum EU VAT rate change?
Under the current VAT system, a minimum standard rate of 15% has been set, with regular review of this rate. Member States are free to set their own rate at or above this minimum. This minimum rate helps to avoid substantial variations in Member States' VAT rates which could lead to distortions of competition between high and low rate countries and put the smooth functioning of Single Market at risk.
There are no plans at the moment to change this rule.
What is envisaged with regard to reduced VAT rates?
Under EU rules, Member States have the option of applying one or two reduced rates to a restricted list of goods and services. The reduced rate cannot be less than 5%, and the list of eligible goods and services must be strictly interpreted.
Some examples of goods and services eligible for a lower rate include: foodstuffs, medicines, medical equipment for the disabled, books on all physical means of support, newspapers, periodicals, passenger transport, admission to shows, theatres, museums, etc.
In addition, there is a multitude of derogations on the application of zero rates, super-reduced rates (lower than 5%), and reduced rates for products or services not usually eligible (table or rates). This makes the whole system complicated and open to misinterpretation. Many stakeholders pointed out in the consultation process that differences in VAT rates lead to additional compliance costs. An economic evaluation carried out by the Commission also confirmed that the use of reduced rates is often not the most suitable instrument for pursuing policy objectives, particularly for ensuring redistribution to poor households or encouraging the consumption of a good that is deemed socially desirable. In fact, the existing application of reduced rates translates into significant subsidies.
The current economic and financial context, which demands a strong fiscal consolidation of national budgets, is a further reason for limiting the use of reduced rates, rather than increasing the standard rates. Nonetheless, the potential benefits of a restricted use of reduced rates, if rationally defined and applied, are worth considering too.
A review of the VAT rates structure seems therefore to be justified. The Communication sets out the following guiding principles for such a review:
Abolition of those reduced rates which constitute an obstacle to the proper functioning of the internal market;
Abolition of reduced rates on goods and services for which the consumption is discouraged by other EU policies;
Similar goods and services should be subject to the same VAT rate and progress in technology should be taken into account in this respect;
The Commission will launch this assessment in 2012 and will subsequently make proposals along those lines after ample consultation with stakeholders and Member States by the end of 2013.
How should the rules change with regard to VAT exemptions? What is exempt and why?
Examples of current exemptions from tax include certain activities in the public interest (medical care, school education, non-profit making organisations etc.), certain insurance and financial services, and passenger transport services depending on the means of transport used. Reasons behind the exemptions vary. They include the fact that at the time the exemptions were granted, the activities were only carried out by public authorities; or the taxable base was too difficult to determine in order to charge VAT.
However, as the market and nature of many of the services have evolved, the justification for certain exemptions have become questionable. A recent economic study highlighted the shortcomings of the current rules – namely, their lack of neutrality, the distortions of competition that they create and their complexity.
Phasing out existing exemptions could have a significant impact on the cost of public goods or social security. Therefore, the Commission advocates a gradual approach if such a phase out is to be considered. The Commission will prepare a proposal which will concentrate on activities with a greater degree of private sector involvement and a heightened risk of distorted competition. The Commission will also propose a more neutral and simpler VAT framework for passenger transport activities.
What is the principle of taxation at destination?
Taxation at destination means that the supplies are in principle taxed in the Member State where the goods arrive or where the recipient of the services is located. Compared to the origin system, the main feature is that VAT revenues accrue directly in the Member State of consumption according to its domestic rates, exemptions and conditions.
Why has the Commission decided to abandon the idea of taxation in the country of origin, and work on a destination-based system?
A wide consultation process and discussions with Member States confirmed that taxation at origin i.e. an EU VAT system functioning in the same way as domestic systems, remains politically unachievable. Therefore, in order to ensure that progress can be made in creating a stable and improved VAT system for the EU, work will now be focussed on creating a properly functioning destination-based system.
4. Benefits for citizens and businesses
How will citizens benefit from the reformed EU VAT system?
Broadening the tax base, limiting the use of reduced rates and reducing fraud will generate new revenue streams or, alternatively, will enable a significant reduction in the current standard rate without affecting overall revenue. A more efficient VAT system therefore could reduce the VAT finally paid by the citizens if the Member States decided to reduce their standard rate in a revenue-neutral way.
Moreover, the financial crisis has created a two-fold challenge for Member States: to foster sustainable economic growth and to consolidate public finances. As recognised in the Annual Growth Survey 2012, taxation policies have a key role to play in meeting these challenges. Consumption taxes such as VAT are considered to be "growth friendly", and therefore a more effective, efficient and fairer EU VAT system will play an important role in helping the EU to emerge from the financial crisis in a strong and sustainable manner.
How will companies benefit from the reformed EU VAT system?
Businesses that want to operate cross-border within the EU face additional VAT obligations and must apply special VAT rules which do not affect businesses working only at domestic level. This creates higher compliance costs and administrative burdens for businesses working in more than one Member State, and can act as a deterrent for businesses (in particular SMEs) from taking full advantage of the Internal Market.
The reformed EU VAT system will improve the situation by ensuring that doing business across the EU is as simple and as safe as engaging in purely domestic activities. It will reduce the VAT compliance costs and administrative burdens for cross-border activities, harmonise rules and obligations, allow businesses to deal with only one tax administration and re-adapt to modern business models.
Among the first measures envisaged for a more business-friendly VAT are expanding the one-stop-shop approach for cross border transactions; standardizing VAT declarations; and providing clear and easy access to the details of all national VAT regimes through a central web-portal.
Broadening the tax base and limiting the use of reduced rates will also create a level playing field for business across the EU and strengthen the Internal Market for them.
How will the reformed VAT system help promote growth in the EU?
First, it will help increase revenues, or allow Member States to maintain the current revenue level while reducing the tax burden on citizens. Second, it will remove obstacles that currently exist for businesses engaged in, or wishing to engage in, cross-border activity. For SMEs in particular, the current VAT system can be a complete deterrent to expanding within the EU. A simpler, more harmonised VAT system, more adapted to modern business models and new technologies, would create a better environment for business and enterprise and a more attractive market for investment. Third, consumption taxes are recognised as more growth friendly than some other taxes (such as labour or corporate taxes). A modernised, efficient VAT system would make it all the easier for Member States to shift taxes away from more distortive areas towards consumption, thereby enhancing the contribution that their tax policies make to growth.
5. Mitigating risks
How much is lost every year because of VAT fraud?
Although, due to the very nature of fraud, it is difficult to put a precise figure on VAT losses due to fraud, it is thought to be several billion euro each year. In a study on the EU VAT gap, the Commission compared what Member States actually got in VAT receipts with what they could have expected. While this VAT gap covers more than just fraud (also legal avoidance and insolvencies), the study set the gap at €106.7 billion in 2006 within the EU-25. This represents an average of 12% of the net theoretical liability although several Member States were above 20%.
VAT fraud does not only affect the financial interests of the Member States and the EU. It also has an impact on honest businesses which find themselves unable to compete on a level playing field in those sectors which are affected by a significant amount of VAT fraud.
What has the Commission done to address the problem of VAT fraud?
In 2008, the Commission set out a coordinated strategy to improve the fight against VAT fraud in the EU. This Strategy included a series of targeted measures, including plans for legislative proposals (which have now all been put forward), and a longer-term reflection on how to fight the problem. One key element was to see how administrative cooperation between tax administrations could be improved, and to establish a network of national officials to detect and combat new cases of cross-border VAT fraud. This network – Eurofisc – is now operational and working to coordinate data exchange and establish an early warning mechanism against fraud.
What further measures to tackle VAT fraud does the Commission foresee?
First, the Commission intends to monitor the full implementation of the abovementioned Anti-Fraud Strategy, making sure that all instruments in place against fraud are functioning to full potential. It will examine ways to extend the automated access to information, and will assess whether anti-fraud mechanisms, such as Eurofisc, need to be strengthened. In 2014, it will report on whether further action is needed to strengthen or complement these measures.
In addition, the Commission will embark on a number of new anti-fraud projects. For example, it will explore the possibility of setting up a EU cross border audit team, attached to Eurofisc, composed of experts from national tax authorities, to facilitate and improve multilateral controls. It will propose a quick reaction mechanism in 2012 which will allow Member States to take immediate national measures to stop certain fraudulent practice.
As the success of any anti-fraud measure depends directly on the administrative capacity of the national tax authorities, the Commission will intensify its monitoring of the efficiency and effectiveness of the tax administrations of the Member States. It will also encourage the exchange of best practices in combating fraud in high risk sectors.
The future of VAT - EC Communication
Source: European Commission
