VAT for small businesses and setting VAT rates - background guide

18 January 2018
by eub2 -- last modified 18 January 2018

The European Commission proposed on 18 January new rules to give EU Member States more flexibility to set Value Added Tax (VAT) rates and to create a better tax environment to help SMEs flourish.

I. GENERAL QUESTIONS

Why do we need these reforms?

Today's proposals build on the Commission's 2016 VAT Action Plan which aims to broadly overhaul current rules, establishing a robust single European VAT area fit for an increasingly globalised world. The proposed reforms will contribute to the creation of a modern, more efficient and fraud-proof VAT system, while enhancing Member States' ability to collect revenues.

The aims of today's proposals are twofold: to meet demands from Member States to have more flexibility to set rates and to extend VAT exemptions that exist for domestic companies to small companies trading cross-border.

VAT rates

Current rules limiting Member States' freedom to set VAT rates are cumbersome, outdated and restrictive. The current process by which a Member State can seek to alter the rules on rates ultimately requires unanimous agreement by all Member States. There are also historical exemptions that apply in some countries, but not others. In May 2016, the Council endorsed the Commission's intention to come forward with a new proposal granting Member States more flexibility to set rates.

Simpler VAT rules for SMEs

Small businesses are the backbone of the European economy, representing 98% of all EU businesses and contributing to over 65% of employment in the private sector. They currently suffer from disproportionate VAT compliance costs, particularly when trading in other Member States. Today's proposal will cut these costs, helping small businesses to grow and trade across the Single Market. 

II. MORE FLEXIBLE AND EQUAL RULES FOR VAT RATES

How did the VAT rates system evolve?

Current rules under the VAT Directive date back to the 1990s. At the time, Member States unanimously agreed to set a minimum standard VAT rate of 15% for all goods and services. A reduced rate of 5% or higher could be applied to a pre-defined list of goods and services.A number of further reduced rates were allowed in certain countries owing to historical 'standstill derogations' agreed when they joined the EU. This has, over time, resulted in a patchwork of rates that vary from one country to the next. It has also created inequalities within the EU. Some Member States enjoy derogations, while others are not allowed to apply a reduced rate or zero rate to the same products or services.

At the same time, Member States have come under increasing pressure to favour certain sectors when it comes to VAT rates but they can't easily do so. They can't change their VAT policy for products and sectors that are not cited on the list for which reduced rates can apply.

The current rules have also not kept up with developments and digital products. Updates are difficult because decisions must be taken unanimously. That's why in its 2016 VAT Action Plan, the Commission set out plans to modernise the rules, removing outdated legal restrictions, while avoiding potential risks like the erosion of VAT revenues, distortion of competition and a shrinking of the tax base.

Why are you proposing to change the rules now?

In its 2016 VAT Action Plan, the Commission announced its plan to introduce definitive arrangements based on the principle of taxation in the Member State of destination. This is a departure from the current system where VAT is paid in the country where the goods or services originate. For the current system to work, VAT rates in different countries needed to be as similar as possible so that unfair competition between Member States is kept to a minimum. The recent EU decision to move to the so-called 'destination principle', as proposed by the Commission, means that such a restrictive approach becomes unnecessary.

What will happen to existing derogations and reduced rates?

Existing reduced rates, including derogations, that are legally applied in Member States will expire with the introduction of the definitive VAT regime which is currently being negotiated in the Council. Today's proposals mean that, even once these derogations expire, countries will be able to maintain the reduced rates with very few exceptions. It will also allow all other Member States to apply similar derogations if they so wish. 

How will Member States set their VAT rates in future, according to your proposal?

While a minimum standard VAT rate of at least 15% will continue to apply, the harmonised and less restrictive rules will enable all Member States to apply a range of rates to products:

- two separate reduced rates of between 5% and the standard rate chosen by the Member State;

- one exemption from VAT (or 'zero rate');

- one reduced rate set at between 0% and the reduced rates.

At the same time, the Commission proposes to abolish the list of goods and services to which reduced rates can currently be applied. Instead, there is now a list of products to which reduced rates cannot be applied, ensuring that products such as alcohol, weapons, tobacco and gambling will always be taxed at the standard rate or above. That will give Member States more freedom in setting VAT rates, as per their request.

Safeguards will be introduced to avoid potential risks like revenue erosion, distortion of competition, unnecessary complexity and legal uncertainty. Member States will be required to ensure that reduced rates benefit the final consumer and, in order to protect revenues, that the average VAT rate applied to those transactions for which VAT cannot be deducted always exceeds 12%. 

What will change for Member States, business and consumers?

This proposal brings a lot more flexibility and ensures that, for instance, similar types of products get equal treatment. It also allows Member States to continue to apply reduced and zero rates that are already in place, while extending this possibility to those Member States that are currently not allowed to apply them.

The impact on business will depend on how Member States decide to apply reduced rates. Nothing would change if Member States decide not to use the additional flexibility, for instance. However, businesses will gain more certainty in knowing exactly which goods or services benefit from reduced VAT rates with quick and easy access to information through a dedicated, EU-wide web portal.

Consumers are likely to see more products being subject to reduced VAT rates. Member States should ensure that this lower rate is reflected in the final price paid by the consumer.

Who did you consult for this proposal and what are the next steps?

Member States were consulted via the Group on the future of VAT which is an informal Commission expert group composed of representatives of national tax administrations. A public consultation was held from December 2016 until March 2017 resulting in 327 contributions.

The Commission will submit the proposal to the Council, the European Parliament and the Economic and Social Committee.

III. A BETTER VAT SYSTEM FOR SMALL COMPANIES

Why are the current VAT rules a problem for smaller companies?

Under current VAT rules, Member States are allowed to exempt sales by small companies from VAT, provided their turnover is below a national threshold – which is different in each Member State. Member States can also relieve small companies of certain or all VAT obligations relating to identification, invoicing, accounting or VAT returns, for example. Small businesses are free to choose whether to use the exemption depending on their needs. But these simplification measures are only available to those small companies which qualify and use the VAT exemption. They are also only available nationally, meaning that firms that trade cross-border cannot access exemptions and simplification measures in another country. This creates a patchwork of rules which distorts the level playing field for companies.

Lastly, small businesses bear proportionally higher VAT compliance costs than large businesses since many of these costs are fixed, rather than proportional to their turnover. Small businesses that have no access to VAT simplification measures suffer from a competitive disadvantage to those that do.

How will this proposal help?

Today's proposal will introduce an EU-wide threshold allowing many more companies to benefit from simpler rules. It will reduce SME's VAT compliance costs by up to 18% per year, leading to an increase in their cross-border trading activity by about 13%. It should also have a positive revenue impact in the longer term due to the general positive effect on the small enterprises' output.

While the current national exemption thresholds in Member States would remain, today's rules would introduce:

• A €2 million revenue threshold across the EU, under which small businesses would benefit from simplification measures, whether or not they have already been exempted from VAT;
• The possibility for Member States to free all small businesses that qualify for a VAT exemption from obligations relating to identification, invoicing, accounting or returns;
• A turnover threshold of €100,000 which would allow companies operating in more than one Member State to benefit from the VAT exemption.

What kind of simplifications will SMEs enjoy?

All SMEs will benefit from simplification measures. These measures concern their VAT registration and their VAT record keeping as well as the possibility of benefitting from less frequent filling of their VAT returns. In addition, VAT-exempt companies will enjoy the relief from VAT registration or simplified registration and from invoicing obligations.

Who did you consult and what are the next steps?

A public consultation ran from December 2016 to March 2017 and there have been a number of other consultations with industry and small businesses. Contributions received via the REFIT platform and spontaneous contributions have also been taken into account.

Will the proposal include simplification for all SMEs?

At EU level, SMEs are defined according to a Commission Recommendation concerning the definition of micro, small and medium-sized enterprises. However, the simplifications of the VAT Directive target businesses operating on a much smaller scale, which under the general definition would be considered as 'micro-enterprises', namely, those with annual turnover not exceeding €2,000,000. The review of the current exemption scheme will affect in particular a much smaller group of firms, i.e. those with less than €100,000 annual turnover.

Source: European Commission