Modernising VAT rules applied on financial and insurance services - guide

29 November 2007
by eub2 -- last modified 29 November 2007

The European Commission adopted on 28 November 2008 a proposal for a European Union Directive aiming at modernising and simplifying the complex VAT rules for financial and insurance services and securing a level playing field in the pan-EU market for these services as far as VAT is concerned. These services are generally exempt from VAT but the exemption dates from 1977 and the legislation has not kept abreast of developments since then. Today, the exemption is not applied uniformly by the EU Member States and thus frequently the European Court of Justice has been asked to fill the legislative gap and clarify the correct interpretation. The proposal will create more certainty and security for Member States and for financial and insurance institutions by setting clear modern definitions of exempt services. It will also allow these institutions to manage the costs of non deductible VAT by allowing them to opt for taxation and by clarifying and extending the tax exemption for cost sharing arrangements.

What is the rationale of the proposal?

The legislation has become out-of-date and is increasingly difficult to apply in practice. It has never been revisited since it was adopted in 1977 and has been showing its age in recent time. There are growing problems in ensuring a clear and consistent application of the exemption across the Community. The industries have become more sophisticated and complex over the last thirty years and the move towards a single market has highlighted inconsistencies. New products have been developed as well as new ways of delivering these products to consumers. Institutions build up operational relationships, sometimes with companies who would not normally be considered to be financial or insurance institutions and it is not always easy to see whether these activities should be treated as exempt financial services.

All this has lead to a significant growth in litigation with the European Court of Justice (ECJ) being asked to interpret the legislation with increasing frequency. This is a slow and cumbersome way of delivering clarity and the outcome is often uncertain. For tax administrations, there are risks to revenue here and for businesses, uncertainty inhibits long term planning and causes the diversion of significant resources to the resolution of tax problems. Modernising the definitions should therefore be regarded as a priority, ideally to be achieved in a tax neutral way that respects both the general limits of the current exemption and the relevant jurisprudence of the ECJ.

There are also concerns that the EU's financial services and insurances industries are less efficient than their international competitors, particularly US institutions. As a consequence, EU industry in general faces higher costs for financial services and insurances. There are many factors which contribute to this and VAT is probably some way down the list. Nevertheless, embedded or non-recoverable VAT plays at least some contributory role and certainly increases the cost of financial services to business. This is however to some extent a secondary rationale as the priority has to be revenue protection and the industries are ultimately responsible for their own efficiency and competitiveness.

What are the main objectives of the proposal?

The Commission has identified three main objectives on which the proposal should deliver.

First, to increase legal certainty for all concerned, from the business sector to national tax administrations and therefore to reduce their administrative burden for correctly applying the VAT exemption for insurance and financial services. Legal certainty will secure the taxing rights of Member States and reduce opportunities for aggressive tax planning.

Second, to ensure a more consistent application of the tax and to deliver a level playing field in the internal market, at least as far as VAT is concerned.

Third, to allow businesses to manage better the impact of non-deductible VAT on their activities, whilst ensuring equal access to tax relief across the internal market.

Which measures does the Commission propose?

The proposal, which consists of both a directive and a regulation, contains a modernised definition of the exempt financial and insurances services. The scope of the exempt services will be redefined in order to ensure that the exemption better reflects the complexity and diversity of the modern industries, whilst staying broadly within the limits of the existing provisions. Furthermore, by giving a clear definition of the exempt services, the proposal will certainly increase the legal certainty and, over time, reduce the need for litigation.

It also increases the opportunities for banking and insurance companies to opt to tax their services if they wish. This option is already exists in the VAT Directive but its availability is at the discretion of Member States and not widely used. Its limited availability is distortive it should be equally accessible across the Community, allowing all institutions the same scope to reduce their exposure to non-recoverable tax. This is likely to be particularly attractive for business to business operations and could yield significant cost savings, albeit at the expense of tax revenue. A widespread take-up of this option can only increase neutrality in the tax system and reduce many of the negative consequences of exemption.

The existing cost sharing relief provisions are unclear and not uniformly implemented. To remedy this, the proposal contains an industry specific exemption from VAT on cost sharing arrangements, including those which are cross border. This change will enable institutions to pool their operations and to share costs between the group members without creating additional non-recoverable VAT.

What is the expected impact of the proposal for private consumers?

These are exempt services and the likelihood is that there will be no change in the cost to consumers, notwithstanding wider access to the option to tax. The proposals mainly aim at transactions to business clients, not private consumers.

Even in those limited cases where the option to tax is exercised today, there is no evidence of price increases for consumers but the experience is rather that increased efficiency attributable to VAT recovery is, in part at least, passed on to the customer. A good example of this is in Belgium where most institutions exercise an option to tax for payment services. The outcome is that Belgian consumers have access to an efficient payment system whose costs are among the lowest in Europe.

Given that the proposals will contribute to more efficiency of the sector and more recovery of input tax, the effect for consumers will be as a tendency only be favourable.

What is the expected impact of the proposal on business consumers of these services?

Two of the measures proposed – changes in cost sharing rules and the rules for option to tax – will increase the capacity to increase the VAT recovery rate. There is thus a reasonable prospect of cost reductions over time.

The eventual outcome however depends on the extent to which financial and insurance institutions take up these facultative measures and the extent to which resultant cost savings are passed on the customers.

What is the expected impact of the proposal for the European financial and insurance companies?

Clarification of the definitions of exempt financial services should reduce compliance costs for business. Consistent interpretation will mean that an interpretation applied in one Member State will be valid elsewhere – business has repeatedly made the point that having to renegotiate the interpretation of the exemption with each Member State individually is a major cost and a barrier to pan-European expansion. The Commission expects a considerable improvement here.

In addition, the two other measures proposed would help the financial and insurance companies to better manage the impact of non-recoverable VAT– changes in cost sharing rules and the rules for option to tax. This should reduce costs because of non-recoverable VAT and make companies more profitable or cost of their services lower than they are.

What is the expected impact of the proposal on the international competitiveness of the European financial and insurance companies?

The main purpose of the initiative is to protect the tax revenue of Member States and to reduce opportunities for aggressive tax planning. Efficiency in the financial and insurance sectors is, in the first instance, the responsibility of the people who run these businesses, not the Commission or tax administrations.

Nevertheless, the proposal contains a number of measures - changes in cost sharing rules and the rules for option to tax – which, if constructively applied, should assist in increasing their competitiveness.

What is the expected impact of the proposal for the budget of national tax administrations?

This is a difficult one to answer, not least because Member States have not been particularly forthcoming in releasing information in sufficient detail to determine the exact burden of the existing measures on the sector or the revenue they contribute. Sourcing useful data has been problematic.

The main changes being proposed – those for the definitions of exempt services – should give increased revenue security and reduce the likelihood of legal challenge.

Because the Commission is prioritising a more consistent application of the exemption, it cannot be excluded that for some Member States certain services which they now consider as taxable will be exempt and vice versa. This has revenue implication of course but the Commission's view is that the overall effect will be small or even neutral. Much of the VAT theoretically lost is not actually levied today as operators may minimise this by appropriate (costly) organisational measures. Also, overall efficiency gains leading to higher direct taxes etc. will compensate for limited revenue losses.

The changes in cost sharing rules and the rules for option to tax have potentially negative cost implications for national authorities but this may be necessary to encourage efficiency. It is however difficult to estimate the effect as much will depend on how institutions react to the changes.

For cost sharing, in so far as the newer more accommodating rules encourage businesses to enter into efficiency driven arrangements which they would not otherwise have contemplated, there would not be any loss of VAT. On the other hand, if the arrangements are already in place and suffering VAT, then there may be a reduction in the tax collected because of more extensive relief.

It is also difficult to estimate the impact of changes in the rules on the option to tax. If the main outcome is to bring Business to Business (B2B) business within the VAT net, then there will be a net tax outflow since business customers will generally be able to recover the tax they pay. On the other hand, taxing B2C (Business to Consumer) would certainly produce tax revenue gains but if the scheme remains optional in all its details it is less certain that institutions would take that step.

Which Member States have opted to tax financial and insurance companies?

Belgium allows an option for taxing payment services which is widely used and seems to benefit both institutions and consumers. It is not clear however to what extent the benefits can be attributable to a competitive advantage which the Belgian payment sector exercises over other operators.

France and Germany both allow option generally with varying levels of take-up. In both cases the degree of flexibility afforded seems to favour taxing B2B activities.

In Estonia and Lithuania, the introduction of the option is recent and it is hard to say how it is working in practice.

Which influence does the European Court of Justice play in the interpretation of the current VAT exemption?

Since the adoption of the Sixth VAT Directive in 1977, almost 400 VAT cases have been decided by the ECJ. At first these were not frequent but the last few years, about 25 to 30 VAT cases are decided annually. While obviously not all of these are on financial services this trend is relevant here as well.

Actually, for exempt financial services and insurances, the trend is steadily upwards, particularly since the turn of the century. Their effects can be wide-ranging, particularly and frequently draw attention to inconsistencies between Member States. It is not however possible to say whether the increase in litigation is always attributable to the state of the legislation (where the defined exempt services are not representative of current complexity in financial services) or to the growth in non-recoverable VAT (seen either as a revenue source for governments or a cost to business). Both are equally plausible as contributory factors.

The accepted wisdom in the industries and indeed in national tax administrations is that the level of litigation will, in the absence of legislative reform, continue on an upward curve. This perception is largely fuelled by an identifiable growth at national court level which will over time generate more referrals to the ECJ. The question then arises as to whether, because of legislative neglect, the Court is effectively being asked to determine tax policy. What is clear is that the ECJ is being forced to make judgements on complex modern industries on the basis of outdated legislation and, in the absence of modernising legislation, this will continue.

What are the next steps?

Both proposals for a Council Directive and for a Council regulation need to be agreed unanimously by the Member States, after consultation of the European Parliament. Once approved by the Council of Ministers, the Directive still needs to be transposed in national law while the regulation is directly applicable in all Member States.

Source: European Commission