Modern warfare

The European Commissions proposals for modernising the VAT rules applied on financial and insurance services, writes Laszlo Kovacs


At my instigation, the European Commission on November 28, 2007 adopted a set of legislative proposals for modernising the VAT rules applied in the banking and insurance sectors.

The VAT Directive generally exempts most financial services and insurance from VAT. In consequence, these industries do not charge tax on the services which they supply but in consequence they are also generally unable to recover the VAT they pay on the goods and services which they acquire to operate their businesses. This non-recoverable tax is thus a source of revenue to the tax administrations of the member states. It is also one which has grown as financial and insurance institutions have increased their use of specialist third party service providers (outsourcers) or consolidate their operations on a cross-border basis (such as through shared cost centres).

The legislation has never been revised since it was adopted in 1977 and has been showing its age recently. We have found increasing evidence of problems in ensuring a clear and consistent application of the exemption across the Community. This is mainly attributable to how the industries have become more sophisticated and complex over the last 30 years but also in how the move towards a single pan-European market for these services 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.

This ambiguity has led to a significant growth in litigation and the ECJ has been asked to interpret the legislation with increasing frequency. This, however, is a slow and cumbersome way of delivering clarity and the outcome is often uncertain. For tax administrations, there are risks and long-term uncertainties about revenue flows while for businesses, uncertainty inhibits long-term planning and causes the diversion of significant resources to the resolution of tax problems. Modernising the definitions therefore has become a priority. Ideally, this should be achieved as far as is reasonably possible in a tax neutral way that respects both the general limits of the current exemption and the relevant jurisprudence of the ECJ.

Higher costs
We have also found that the EU’s financial services and insurances industries are less efficient than their international competitors. As a consequence, the 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.

Improving the competitive environment for European financial and insurance companies was therefore a key factor in this exercise but must be balanced against the need to assure tax revenues. This inevitably has limited the room for manoeuvre.

The preparatory work also demonstrated that leaving the VAT rules as they are is not an option. The status quo is not stable both because of the increased dependence on the European Court and because the process of market-driven change can impact negatively on existing tax revenues. It is much better to pre-empt this by reforming outdated legislation, even if only to assure the stability of the current arrangements.

All these concerns were expressed during the very broad consultation that we undertook before finalising the current proposal and the preparatory steps have been particularly transparent. We have listened carefully to the views of the industries and the tax administrations through an extensive programme of conferences, seminars, stakeholder meetings as well as direct discussions with representative organisations. Over 100 contributions were received to an online public consultation, a record for a tax consultation.

We contracted for independent studies on the economic consequences of exemption and the way in which VAT recovery rules are applied across the Community in these sectors. Finally, however, the Commission decided not to propose any radical move away from the existing exemption model. We had looked at this in the past and concluded that it would be unworkable. Therefore the proposal concentrates on improving the working of the existing system and addressing some of its negative economic effects.

The first priority was to increase legal certainty for all concerned, from the business sector to national tax administrations and thereby to reduce their administrative burden in correctly applying the VAT exemption. These changes will also ensure a more consistent application of the tax and deliver a level playing field in the internal market, at least as far as VAT is concerned. A second priority was to allow businesses to manage better the impact of non-deductible VAT on their activities, while ensuring equal access to tax relief across the internal market.

Addressing the first priority, I am proposing a modernised set of definitions of exempt financial and insurances services. The scope of the exempt services is being restated in order to ensure that the exemption better reflects the complexity and diversity of the modern industries, while 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. In addition to updating the VAT Directive, we are also proposing detailed implementing regulations which will expand the definitions in a manner which will apply directly in all member states.

Two separate measures respond to the second of these priorities. I am proposing to allow the banking and insurance companies to opt to tax their services if they wish. Such an option to tax already exists in the VAT Directive but is currently at the discretion of member states and not widely used. Its limited availability is distortive in practice and can serve as a basis for undesirable tax competition. On a level playing field basis, I would therefore like to see more general access to this measure and feel strongly that it should be equally accessible across the Community. This will allow institutions to reduce their exposure to non-recoverable tax. It is difficult to gauge likely take-up but it may be particularly attractive in the B2B area. 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 proposal also contains an industry specific exemption from VAT on cost sharing arrangements, including those which are cross-border. Cost sharing relief has been a feature of the VAT system since 1977 but the existing provision is unclear and not uniformly implemented. This change will enable institutions to pool their operations and to share costs between themselves without creating additional non-recoverable VAT. It will for example allow groups of financial or insurance institutions to achieve economies of scale or establish centres of excellence without additional VAT being incurred.

Putting these proposals in place will probably demand some limited VAT revenue trade-offs for the member states, to the extent that financial or insurance institutions take up either of the relief measures just mentioned. I believe however that in the medium-term any such losses will be compensated by the increased competitiveness and output of the sector. The Commission is acutely conscious that the non-recoverable tax is a significant source of revenue to member states and does not want to disrupt this unnecessarily.

However, we are also convinced that the balanced package of measures being proposed is the best option for VAT reform in the financial and insurance sectors, addressing in particular the issue of competitiveness. It will increase certainty for the industries as well as improve budgetary security for member states by reducing the potential for legal challenge. It will also improve the competitiveness of the EU banking and insurance companies by allowing them to manage better their operations without hidden VAT.

When they opt for taxation, banking and insurance institutions will be able to reduce the costs of non-recoverable VAT as well as the cost of their services to EU business. I would not expect that there will be any increase in the cost to consumers here but rather that increased efficiency will benefit them in the longer-term. I now hope that in the Council, member states rapidly start discussions at technical and political levels in order to have these new rules implemented as soon as possible.