[pic] | COMMISSION OF THE EUROPEAN COMMUNITIES |

Brussels, 28.11.2008

SEC(2007) 1554

COMMISSION STAFF WORKING DOCUMENT

Accompanying document to the Proposal for a COUNCIL DIRECTIVE amending Directive 2006/112/EC on the common system of value added tax, as regards the treatment of insurance and financial services IMPACT ASSESSMENT

{COM(2007) 747 final}{SEC(2007) 1555}

TABLE OF CONTENTS

EXECUTIVE SUMMARY 3

1. Procedural issues and consultations of interested parties 6

1.1. Why is there an issue with VAT on financial services and insurances? 6

1.2. Situation today. 7

1.3. Dialogue with national tax administrations of Member States 8

1.3.1. First Fiscalis seminar. 9

1.3.2. Next steps 9

1.3.3. Second Fiscalis seminar 10

1.4. Public consultation and conference 11

1.5. PwC Study 12

1.6. IBFD Survey 13

1.7. Difficulties in sourcing data. 14

2. Problem definition 17

2.1. Uncertainty and inconsistency in the definitions of exempt financial services and insurances 17

2.2. Tension between distortive effects of the exemption and the need to secure tax revenue 20

2.2.1. General 20

2.2.2. Implications for VAT of growth in cross-border delivery of financial services and insurances. 20

2.2.3. Distortive effect of VAT - conclusions 24

2.3. Other problems identified. 24

2.3.1. Tax recovery methodologies 24

2.3.2. Sharia compliant banking and insurances 26

3. Objectives 26

4. Policy options 30

4.1. Doing nothing – why this is not an option 30

4.2. Modernisation of definitions 31

4.3. Structural options identified in public consultation. 32

4.3.1. Zero rating 32

4.3.2. Extending the scope of exempted services. 33

4.3.3. Uniform limited input tax deduction 34

4.3.4. Option to tax 36

4.3.5. Cross border VAT bodies 38

4.3.5.1. Single legal entities and cross-border transactions. 38

4.3.5.2. VAT grouping 40

4.3.5.3. Cost sharing arrangements. 42

4.3.6. Reduced VAT rate for bought-in service 46

4.3.7. Other options 46

5. Analysis of impact 47

5.1. Modernising the definitions of exempt services. 48

5.2. Cost sharing arrangements 50

5.3. Option to tax 51

6. Comparing the options 56

6.1. Cost sharing arrangements 56

6.2. Option to tax 58

7. Monitoring and evaluation 61

EXECUTIVE SUMMARY

Lead Directorate-General: DG TAXUD

Other Involved Services: SG, MARKT, ECFIN, ENTR.

Agenda Planning/Work Programme reference: 2006/TAXUD/008

The VAT Directive exempts most main-stream financial services and insurances. In consequence, these industries are not required to charge tax on the services which they supply but 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 a significant source of revenue to the tax administrations of the Member States. It is also one which automatically increases as financial and insurance institutions increase their use of specialist third party service providers (outsourcers) or consolidate their operations on across-border basis (such as through shared cost centres).

The legislation has never been revisited since it was adopted in 1977 and has been showing its age in recent time. The work undertaken by DG Taxud in the preparation of this impact assessment has demonstrated that there are growing problems in ensuring a clear and consistent application of the exemption across the Community. This is mainly attributable to the way in which the industries have become more sophisticated and complex over the last thirty years but also in how 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.

This uncertainty has lead to a significant growth in litigation with the ECJ being asked to interpret the legislation with increasing frequency. This process can be initiated by either businesses or tax administrations, both of whom are faced with ambiguity and uncertainty. It is a slow and cumbersome way of delivering clarity and the outcome is often uncertain. For tax administrations, they see risks to revenue here and attach importance to re-establishing long-term certainty. For businesses, uncertainty also inhibits long term planning and causes the diversion of significant resources to the resolution of tax problems. DG Taxud has concluded that modernising the definitions should therefore be regarded as 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.

The preparatory work has also shown 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.

Because of the revenue implications, the room for manoeuvre in dealing with the efficiency issue is limited. It will not be easy to persuade the national tax administrations that keeping and encouraging a vibrant financial services industry in and across the EU should be worth limited VAT revenue trade-offs.

Even in the absence of any legislative change however, the development of a pan-European market for financial services will have an impact on the pattern of existing tax revenues. DG Taxud is consequently minded to consider some measures which would mitigate the unintended effect of VAT on business efficiency. These should take particular account to disincentives to cross-border consolidation and could include more extensive cost sharing exemptions or, in limited instances, a wider access to the option to tax.

The Impact Assessment has been amended to take account of the comments received from the Impact Assessment Board in its opinion of 17 July 2007. These changes cover, inter alia :

- A section summarising the main problems.

- A summary of the objectives which are in turn related to the evaluation of specific policy options.

- Inclusion of some selective data, collected by interviewing commercial operators, on the costs occasioned by problems in the existing legislation which are intended to be reduced or eliminated. (This does not totally overcome the issue in relation to quantification of problems and options where enormous difficulties remain in sourcing reliable data.)

- Additional explanations reinforcing the link to the Financial Services Action Plan and the Single Market Review.

- Further analysis of the administrative costs and burdens associated with the tax. In the context of the EU Standard Cost Model, specific administrative burdens on business are not mandated in the VAT Directive but remain the responsibility of Member States. Nevertheless, the proposal could over time produce some costs savings under headings which fall outside the Standard Cost Model but this will continue to depend on how Member States apply the legislation and accordingly it is not possible to assess what, if any, savings might be achieved.

- A summary of policy options has been added.

- The arguments on why the status quo is not sustainable have been further developed.

- The supportive arguments for why the particular policy options have recommended are developed further.

PROCEDURAL ISSUES AND CONSULTATIONS OF INTERESTED PARTIES

Why is there an issue with VAT on financial services and insurances?

Since the adoption of the Sixth VAT Directive in 1977 [1], the EU's common value added tax system has exempted most main stream financial services including insurances and investment fund management. The precise reasons for the exemption have never been set out but whilst it has been variously attributed to economic or social policy considerations, the main one seems to be the technical complexity inherent in taxing financial services. To some extent the Directive reflects an uncertain approach in that it also allows Member States to grant taxable persons the option of taxing these services. Nevertheless, the general practice of the last thirty years has been exemption. Since VAT is a Community tax which functions on a common legal base set out in Community legislation, any changes can only take place at that level.

Intermediation lies at the heart of most financial services and it is not easy to allocate the margin to individual transactions under the normal VAT system (unlike measurement of profit for corporation tax or financial reporting purposes which aggregates the difference between interest received and interest paid by the financial institution). This is an essential requirement if businesses who pay for financial services are to be able to recover the VAT included in the price they pay.

The growing sophistication of the industry has not made it any more amenable to the normal VAT system. In some complex transactions, it may even be difficult to identify who is the recipient of the service for tax purposes. VAT normally functions as a transaction based tax where taxing decisions must be made at the point where the transaction takes place. This requires a high level of certainty on the nature of the transaction.

Difficulties caused by intermediation also present problems in applying VAT to the activities of insurance companies. Additional technical VAT problems would occur in the treatment of claims settlement for private consumers and the existence of insurance premium taxes or other equivalent charges in some Member States is also a potential source of problems for the introduction of another tax.

Whatever about its origin, a significant consequence of exemption is that a business is unable to recover the VAT it bears on its inputs (or purchases) of goods and services. Instead, it becomes a charge which must be absorbed by the business.

The generally held view at the time of adoption of the common VAT system saw exemption as a transient solution to be replaced eventually by a methodology for applying VAT when the technical problems were overcome. This perception of transience allowed for an acceptance of some manifest shortcomings on the basis that they would be rectified in time. Exemptions of this nature (without the right to deduct) are alien to the VAT system because they interfere with the neutrality of the tax and the cascading effect caused by the non-recoverable tax distorts competition. Exemption with deduction (effectively zero rating), whilst resolving the cascading problem, would have been equally alien to VAT.

The Commission services however persisted with the objective of developing a full taxation model which would deal with these shortcomings. A series of reports on this work were published in the late 1990's[2] on what became known as the TCA method (tax calculation account). The methodology was generally accepted as delivering technically on the objective of full taxation, a conclusion confirmed by extensive field testing.

This field testing also confirmed that what was being contemplated was extremely complex, with significantly increased administrative charges and perhaps even reduced transparency. Moreover, the various reports contained rather little to re-assure stakeholders that the benefits of the system could outweigh its costs, in particular the costs of implementing change. The political sensitivities associated with applying VAT to consumer credit, including mortgages, did little to make TCA any more palatable.

Given a uniformly negative reaction from stakeholders, the Commission never took the step of making a legislative proposal to introduce full taxation. Notwithstanding the significant amount of work that had been undertaken, the issue was effectively shelved for the time being. Some further reflections have confirmed the perceived shortcomings in the TCA method. These include difficulties in coping with some more recent market developments such as the delivery of financial services by operators who do not conform to the more traditional models of financial institutions.

To complete this opening picture, it should also be said that no other jurisdiction has found a suitable and straightforward way to tax financial services. All major economies (with the notable exception of the US) have a VAT system[3] but struggle with how to tax financial services. In general, they exempt most supplies whilst trying to incorporate mechanisms to deal with some of the more serious shortcomings[4] where these might have a negative effect on international competitivity. Although it may not pass uncontested, there is a broad professional consensus that exemption is the only workable option at least until something better comes along.

Situation today.

Since then, the evolution of the environment is which these industries operate has meant that the sources of stress inherent in the exemption model for both businesses and tax administrations have become more apparent. The EU is not unique in treating financial services and insurances in this fashion and many of the practical difficulties entailed in interacting with VAT are well known. Here however VAT produces a particular range of problems in its implementation across 27 Member States whose ambitions include the establishment of a single pan-European market. In this respect the application of VAT gives rise to tension points which are not found elsewhere in applying a consumption tax to financial services and insurances.

The existing tax arrangements generate revenues for tax administrations which have grown significantly over the years. Any option for change has to respect this important reality.

VAT rates have moved upwards since 1977 when they averaged 14.5% (across 9 Member States) to today's average of around 19.5% (27 Member States). The real increase in tax yield has however been produced from the increase in the tax base. In 1977 financial and insurance institutions managed most of their own back office and support activities. Institutional structures were nationally based, focusing in the main on supplying domestic markets.

The growth in outsourcing and the trend towards cross-border consolidation within the Community have become important sources of tax revenue for national treasuries. The counter-part of this is of course that the evolution of the industries since 1977, as well as changes in the legal and regulatory environment, has increased exposure to non-recoverable tax. For them, increased tax charges absorb the first benefits from any efficiency gains from cross-border consolidation and outsourcing.

Maximising economic welfare demands a high-performance and efficient financial system. These are ‘special’ industries due to their fiduciary nature, their role as enablers in the wider economy and the imbedded systemic risk in their activities. Public policy decisions, such as those relating to tax, have a role to play in enabling them to deliver. Balancing economic efficiency against stability and fairness in the tax system is not easy, particularly here where the task in hand includes reconciling single market objectives with appropriate taxation of the financial services and insurance sectors.

Given their legitimate expectations of tax revenue, it will be necessary to establish to Member States that it may not be possible to maintain total budgetary neutrality if a viable solution to the VAT problem is to be found. Keeping and further developing a vibrant financial services industry in and across the EU should be worth limited VAT revenue trade-offs.

Dialogue with national tax administrations of Member States

In aftermath of the TCA exercise, Member States showed little appetite to revisit the VAT treatment of financial services and insurances. Concerns about a n impact disproportionate to any problem left many Member States cautious of change. For them, perhaps the best approach was to carry on with the 1977 model, despite all its imperfections, and to deal with any more urgent problems on an ad hoc basis as they arose.

Nevertheless, The Commission was of the opinion that, given the economic importance of the sectors, the issues could not be ignored. The disappointing outcome to the earlier work notwithstanding, the need for reform was becoming obvious. Other options, perhaps less ambitious, needed to be considered.

First Fiscalis seminar.

The Commission services first step was to convince Member States of the need to re-visit the issue and to start a fresh examination of the problems and possible solutions. This was initiated through a Fiscalis[5] seminar held in December 2004.

Apart from the already established issues of lack of neutrality and distortion, the seminar identified concerns about consistency with FSAP objectives (with participation from DG Markt) and the manner in which the legislative vacuum was being filled by the ECJ (with input from the Commission's Legal Service).

The seminar successfully addressed the reluctance of Member States to engage on the VAT issue by demonstrating that modernisation was overdue. As a consequence, the Commission services could commit themselves to further work on problems and potential solutions on the basis of an overwhelming conclusion among Member States that the existing situation was unsatisfactory[6].

Next steps

Given that there was no desire or advocacy for a root and branch overhaul (such as the TCA method), a pragmatic approach dictated that work should focus on identifying the shortcomings in the exemption model, analysing their impact, and then considering what options were realistically available for reform.

During 2005 dialogue with the main stakeholders was intensified. Regular contacts were established with representative groups such as the European Banking Federation (FBE), the Comité Européenne d'Assurance (CEA) and The European Fund and Asset Management Association (EFAMA) as well as professional advisors and other interested parties.

The issues were also discussed bilaterally with a number of Member States, largely at their initiative. These tended to be rather unstructured and general, given that the frontiers of the working space were still being defined.

Consequent to the first Fiscalis seminar, it had been the intention to present an analytical paper to Member States in the VAT No.1 Working Party during the course of 2005. However the complexity of the issues and the need for further investigatory work precluded this. Apart from a developing dialogue with the industry, the case for seeking independent expertise was soon apparent. Accordingly a tender was launched for a study to establish the major problem areas and their impact as well as some options for remedying them.

The contract for this work was awarded to PwC after a competitive tender procedure[7]. The report details are set out in paragraph 2.2.2 below.

A first working meeting with Member States was eventually held in February of 2006. The purpose was to inform Member States of the Commission services thinking. The analytic working paper which was the basis for discussion broadly presaged the consultation paper subsequently released on 14 March 2006 (see 2.2.1 below). For the most part reactions at this initial meeting were muted with most participants simply noting the work of the Commission. A few drew attention to what they saw as the priority of revenue security.

In so far as Member States have expressed their opinions, they have a preference for limiting the current exercise to a modernisation of the definitions of exempt financial and insurance services. They are at best lukewarm, but perhaps even antagonistic to wider structural change which they see as involving revenue losses. Even where there is an openness to debate these issues, they would prefer to treat them separately allowing the Council to handle the definitions issue expeditiously.

Second Fiscalis seminar

A second Fiscalis seminar was held in March 2007 with the objectives of familiarising concerned officials from the national tax administrations with the policies driving change in the general regulatory framework for these industries, and the economic drivers for cross-border financial integration. The programme also covered practical implementation issues in the current legislation.

Contributions from DG Markt confirmed that cross border delivery of financial services and, to a lesser extent, insurances is a reality which can only increase. Cross border consolidation is not driven by tax considerations. It rather has tax consequences although in some configurations (branches as opposed to subsidiaries) these consequences may be reduced. It is more developed in some area than others with investment products ahead of the general curve.

A side effect of cross-border marketing is that the tax revenue generated by VAT on inputs will mainly accrue in the Member State where the service is created as opposed to the Member State where the consumer (business or private) of the service is established. It is not clear if Member States are focused on this phenomenon but its effects will become more pronounced as a pan-European market develops.

Case studies based on actual examples from the financial services industries involving the place of supply of financial services for VAT purposes and whether services were exempt or taxable were discussed by mixed groups of national administrators in workshops. These confirmed the range of diversity in how the current VAT legislation is seen. All but the simplest scenarios showed divergence in interpretation on which services were exempt and which were taxable. It was difficult not to see this as other than confirmation of shortcomings in the definitions of exempt financial services.

The seminar also heard evidence[8] of how financial channels are dynamic and can respond rapidly to competitive distortions (this can include taxes). Business efficiency is the key driver – competitive distortions can retard this process but they usually extract significant economic costs and may divert financial flows into other venues, either domestically or elsewhere. The industry is regulation sensitive and reacts to distortion such as those resulting from non-neutrality in the tax system. An optimum regulatory and tax regime maximises competitive neutrality so that financial activities are driven by the underlying economics.

Other factors which affected the competitive efficiency of the market included a lack of diversity and possible barriers to new entrants. Here the EU markets seemed less vibrant than the US but no evidence was adduced that could attribute this to VAT beyond the more general issue of lack of tax neutrality.

Public consultation and conference

The industries affected by the VAT issue are numerous, disparate and spread across the Community. There are a number of pan-European organisations which represent effectively the views of many of the different sectors and The Commission has established constructive working relationships with them. As already mentioned, there is an ongoing dialogue which has generated essential technical input and which functioned as a sounding board for potential change.

Nevertheless, none of these organisations give a total coverage of the industries and it cannot be excluded that a consensus among their member does not reflect all views. The industries are extremely competitive and are likely to shelter divergent views on key strategic issues. In order to build up a comprehensive view on stakeholder views, the Commission organised an on-line public consultation of business on its intention to modernise the rules for the VAT exemption for financial and insurance services. This was done on the basis of a comprehensive options paper which analysed the difficulties which had been identified in the current system and looked at choices which might lead to their resolution.

This was published on 14 March 2006 with a closing date for responses of 9 June 2006. In response to a number of requests for extensions, replies were accepted until late August.

The consultation paper contained views on the current legal framework and on options for change. It explained why there is a need to review Community legislation. In particular, it looked at why there is a need to ensure that it reflects the world as it is today, taking account of the changes that have occurred in the intervening 30 years. The paper was addressed to stakeholders in the financial services industry generally, including insurance, their professional advisors and indeed to consumers of these services generally. The purpose of consulting the public on this issue was to provide input to the discussion, gather relevant feedback and assist Commission services in developing their thinking on the subject.

In the event, 82 contributions were received – a record for a tax consultation.

The main thrust of the views expressed was that were of the view that the Commission had correctly identified the priorities and options in its consultation paper. Cross border groupings and modernisation of definitions were seen as priorities followed by option to tax with other options attracting less support. There was a notable range of sectoral diversity in the responses, particularly between the banking and insurance industries.

The public consultation document itself and a more detailed summary of the views expressed by respondent's can be found at http://ec.europa.eu/taxation_customs/common/consultations/tax/index_en.htm . These should be considered as annexes to this Impact Assessment. A CD with all the responses received is also available.

As part of the consultation process, DG Taxud organised a public conference held in Brussels on 11 May 2006 in Brussels in conjunction with European Banking Federation. This drew over 400 participants, reinforcing the open dialogue with stakeholders.

The speeches and presentations from the event can be found athttp://ec.europa.eu/taxation_customs/common/archive/news/2006/article_2541_en.htm

PwC Study

The study undertaken by PwC into the economic effects of the VAT exemption of financial services and insurances in the EU25 required that they provide evidence of the distortions caused by the current VAT arrangements and that they identify options to remove these distortions.

The final report was eventually presented to the Commission in November 2006 and concluded as follows:

- EU financial institutions are less profitable than their equivalents in other highly developed economic regions including the US. They suffer significantly more embedded (non-recoverable and cascading) VAT which increases their costs. There is however no clear proven link between embedded VAT and profitability but there must be at least some contributory element. It does however increase the cost of financial services to business[9].

- In so far as service providers require a physical presence in the market in which they wish to operate, VAT based competition was not very strong within the EU. Certain investment management services, which are provided relatively easily on a cross-border basis as a result of their nature and/or regulatory factors, were found to be an exception to this. Given longer term trends however towards borderless markets, the report cautions against complacency as operations become more flexible in terms of where they are located. For the moment, non-VAT constraints on the cross-border provision of financial services draws attention away from the less than level playing field for tax purposes.

- There is some evidence that, in comparison with the US in particular, EU financial institutions use of outsourcing and shared cost centres is at least partially constrained by VAT.

- Because of divergences between Member States in interpreting the VAT Directive on what constitutes exempt or non-exempt financial services, operators face considerable legal uncertainty in making what should be purely commercial decisions. This would appear to be a significant issue in deciding what is outsourced.

- There is evidence that certain FS institutions were suffering relatively high rates of non recoverable VAT as a result of corporate structures based around subsidiaries whilst others were required to put in place structures which might otherwise be considered as less than optimal from a regulatory or corporate tax perspective in order to minimise intra-group VAT charges. Here in effect the report was drawing attention to the lack of neutrality for VAT purposes between institutions which are structured on a holding/subsidiary basis and those on a head office/branch basis.

- Unevenness in the interpretation of the decisions of the ECJ and differences in the calculation of recovery rates were also seen as sources of distortion, contributing to a lack of neutrality.

- To some extent, the VAT issue is overshadowed by more immediate regulatory concerns. In cross-border consolidation and restructuring, supervisory and economic issues emerged in the study as the predominant constraint. However, as these are resolved and absorbed by business, then VAT issues will come to the forefront.

In terms of identified options for change, the report stressed the need for clarity, consistency and certainty in the services which were covered by the exemption. With one exception, the options proposed by the consultants for structural changes in the system which responded to its shortcomings were along the same lines as those mentioned in the Commission's consultation paper. (They are analysed below in paragraph 5.3.)

Pan-European guidance on the correct interpretation of the Community VAT legislation (and also perhaps ECJ decisions) was seen as a possible alternative that would not require any legislative change. Where inconsistencies in application could not be attributed to discretion expressly allowed to Member States, guidance should be given which would lead to their elimination. The report however also acknowledged that guidance alone, without any substantive legislative change would not address all the shortcomings identified.

The full report is annexed to this Impact Assessment.

IBFD Survey

As part of the preparatory work, in late 2006 The Commission asked the International Bureau for Fiscal Documentation to carry out a survey on the methods of deduction of input VAT applied by the Member States on goods and services used by taxable persons operating in the financial services and insurances industries. The finding in the PwC report had been that recovery rates[10] varied from 0% to 74%, notwithstanding that the VAT Directive seems to foresee a degree of harmonisation[11].

The Commission needed to understand better the factors which might affect the rate of input VAT recovery and accordingly asked the IBFD to provide information on the way in which the Member States had transposed the rules in Community legislation. Notwithstanding the aspiration to harmonisation, the Directive also allows Member States a considerable degree of leeway in the methodologies which may be used or enforced for the calculation of the rate of recovery. Similarly, although the Directive also foresees in principle that recovery of input VAT should be linked to the level of taxable transaction[12], it also allows for a range of other circumstances where entitlement to deduct input VAT may arise[13].

The report confirmed that a review of national legislation demonstrated that there were wide variations in the way in which Member States applied the legislation. In addition many have significant concessional practices not reflected in the legislation which effect the eventual right of financial institutions to deduct input VAT.

Several Member States allow financial institutions to waive the exemption and opt to tax their supplies of exempt financial services[14]. The effect of this depends to some extent on the way in which the option is exercised but can lead to a relatively high rate of recovery, including as permitted by the Directive recovery where no taxed supply has taken place.

Variations can also be explained on the basis of the composition of the institution's client base. Where allowed under the Directive, the place of establishment of the institution's customers may have a significant increase in recovery rates. These will increase as the number of clients established outside the EU increases (or in certain circumstances, established in another Member States) as a proportion of the total client base. Unfortunately, the report was unable to source detailed data on this effect, much of it seemingly being protected by commercial confidentiality.

Variations in recovery rates could also be explained by differences in the way in which Member States interpret the scope of the exemption. The report gives some examples of how this can occur. This evidence adds weight to the arguments for modernising the definitions of exempt services so as to ensure consistency and certainty.

Concessional arrangements in some Member States are also likely to be a contributory factor.

The most consistent reason for differences in recovery rates however springs from the ways in which Member States make use of the flexibility which the Directive allows in the ways in which recovery can be computed.

The full report is annexed to this Impact Assessment

Difficulties in sourcing data.

Accessing data has been a recurrent problem in this exercise.

In assessing the impact of the VAT exemption, there are two sets of figures which, if available, would form a vital input to this process. The first is the value of VAT foregone through exempting financial services and insurances and the second is the value of actual VAT receipts which can be attributed to non-recoverable VAT borne by these industries.

This information is not generally available from official published statistics. Member States were asked by The Commissionto supply this information for use in the preparation of this impact assessment. The response has been disappointing. Some Member States have replied to the effect that for a variety of reasons they do not have the data requested. Useable data has been received from a number of Member States although in some cases this is partial and there is a lack of consistency in the manner in which the data is assembled and presented . In asking for data, an undertaking was given that issues of confidentiality would be fully respected. The main facts which can be gathered from the replies received are summarised in an annex to this document but which is not intended for publication..

A check with DG Budg confirms that, despite some efforts in the past, their efforts to capture this data (for Own Resources purposes) have had similarly limited success. Their experience has been that some MSS do not calculate VAT figures for the financial sector, or else make a rough estimate that Budg must accept for want of any better information. In some cases the estimates lump together financial services and other exempt sectors with some taxed activities (e.g. certain public authorities or the property sector). This output adds little to what it available.

Efforts to source useful data from the business sector have not been any more successful. The normal accounting practice for non-recoverable VAT is to subsume it in the general cost structure of an enterprise and, no matter how significant the figures are, there is no practice or requirement which would give rise to their appearance in published reports. In comparison with income taxes, where reporting standards mandate rules for the computation and disclosure of the consequences of the tax[15], VAT is not transparent. Companies such as financial and insurance institutions are however acutely aware of and sensitive to their VAT recovery rates[16] In discussions with these companies, it became very clear the these figures are generally considered as a commercial secret to be closely guarded.

At one point in the PwC study[17] on the economic effects of the VAT exemption for financial and insurance services, reference is made to an unpublished report compiled for the Hundred Group[18] where approximate figures for the United Kingdom indicate that unrecoverable VAT accounts for roughly 20.3% of the total UK taxes paid by the FS sector. The full report is considered confidential and could not be made available to the Commission, making it impossible to put this figure in any context. No similar surveys in other Member States have been identified.

The PWC study showed that unrecoverable VAT increases the cost of financial services to business by up to 4%. This figure came from a fairly small sample of institutions but it can probably be accepted as representative.

Some very limited data on the cost of unrecoverable VAT was made available by individual companies. It tends to confirm that this has become a significant cost for business. Unrecoverable VAT running at 50% and upwards of the corporation tax charge was mentioned as typical, with insurance companies at the higher end. Even on a purely indicative basis, it would be difficult to draw any conclusions as the source base is tiny (less than 10 institutions). The figures were proffered informally and in confidence. Moreover, they possibly came in some cases from sources who felt their VAT costs were unduly high and accordingly should not be considered as representative.

This difficulty with statistical data is a well know problem internationally. In 1999, the OECD undertook a study[19] (with funding from the Commission) which had the objective, inter alia, of quantifying the economic effects of VAT (or GST) exemption on financial services and insurances. Because of limited data availability, this was not a success and the report concluded that " given these uncertainties (due to lack of data), member countries have agreed to await a further report from the European Commission to evaluate the likely economic and revenue effects of any move to taxation before undertaking any further work. " This does not seem to have happened, presumably due to the Commission's subsequent decision not to pursue the TCA model of taxation.

As already mentioned above, The Commission asked the International Bureau for Fiscal Documentation to produce a survey of the recovery of input VAT in the FS industry. Whilst it sets out the rules applicable in the 27 Member States, the authors were unable to furnish any information on tax flows or recovery rates which they admit may be influenced by factors which are not readily identifiable from information in the public domain. The authors conclude that " it should be noted that statistical information on the actual average rate of VAT deduction for institutions operating in the financial sectors of the individual Member States is generally not available. From a perspective of competition, the financial institutions generally consider that type of information as confidential ."

At the beginning of April 2007, The Commissionwrote to Member States asking for data on the impact of the exemption on VAT receipts to be used in preparing the impact assessment. Specific questions were asked in respect of:

- The value of VAT foregone though exempting financial services and insurances.

- The value of actual VAT receipts which can be attributable to non-recoverable VAT borne by these industries.

- Average VAT recovery rates for these industries, where possible broken down by nature of activity.

14 responses were received. 3 Member States were able to provide the data more or less as requested; a further 5 gave partial answers and the others indicated that for various reasons they were unable to supply the information requested. A number of others confirmed orally that they were having difficulty procuring the data in reasonable time. Given the very limited data and the restricted conditions under which it was made available[20], it was not possible to draw any meaningful conclusions.

As in many problems with seemingly straightforward answers, there is a paradox in that it is not certain that ending the exemption for financial services would have any dramatic effect on the revenue collected through VAT. If the current exemptions were replaced by a full taxation model, much of the revenues generated today would be lost because financial institutions would recover input VAT. Tax charged on outputs would produce revenue increases only in so far as it was borne by final consumers or other exempt operators. If final consumers were left untaxed (say for social reasons), there would certainly be a net loss for national exchequers. In the absence of any reliable and consistent statistics however, it will be difficult to convince governments of the potential benefits of any change. Their inability, or unwillingness, to share data is probably a major contributory factor to the difficulty in establishing bench marks against which to measure the effects of potential change.

Problem definition

Summary of the main problems to be resolved

The existing legislation is out of date and deals poorly with the complexity of modern business. It creates uncertainty for tax administrations in their dealings with financial and insurance institutions leading to excessive costs. This uncertainty also produces differences in interpretation and practice across Member States which are both distortive in themselves and impose undue burdens on businesses seeking to operate across several Member States.

There are inherent inefficiencies in exempting these industries from VAT which can only be totally overcome by fundamental changes in the tax model. Given political and technical obstacles which in practice seem insurmountable, it will be necessary to identify possible structural changes which reduce these inefficiencies. This will be difficult without impinging on the revenue raising capacity of the tax.

Some further problems have been identified in the analytical process or in the stakeholder consultation. They are set out towards the end of this section but are considered as having a lower priority than the two abovementioned problems for the purposes of this exercise. In consequence, although recognised, they will probably not be taken up in the current proposal.

Uncertainty and inconsistency in the definitions of exempt financial services and insurances

The VAT Directive provides that financial services and insurances as defined under Article 135.1(a) to (g)[21] are exempt. Since an exemption is an exception to the general rule of VAT, it must be interpreted restrictively. Beyond what is in the Directive, no detailed definitions of the services covered is provided nor or are any explicit references made to definitions used elsewhere in Community legislation or by regulatory bodies.

This lack of precision has been a source of difficulty for both tax authorities and for businesses in defining the scope and application of the exemption. Evidence of this can be found in the growing volume of litigation at national level but, more particularly, in the number of referrals to the ECJ.

The quantative increase in case load caused by more frequent recourse to ECJ aside, the resultant judgements have frequently had a significant impact on the interpretation of the law and on the practical application of the tax. The quest for certainty and legal security has not been helped by national differences in applying these judgements.

In 1977, there seems to have been a reasonable level of concordance between the definitions adopted in the directive and those employed for regulatory purposes in the Member States. The gradual broadening and increased complexity of the range of services and the general evolution of regulatory provisions mean that this is no longer the case.

Financial services and products have become more complex over the last thirty years. Derivative products, securitisation products and structured financing are all examples of products which did not exist in 1977.

Outsourcing has grown in size and complexity and is now crucial to the operations of most financial institutions. The question of what precisely constitutes a financial service in its own right as opposed to a service which is merely an input to a financial service is one which frequently proves contentious. Interpretation issues of this nature arise with regulatory as data handling and control systems within institutions are now heavily dependent on bought-in support. Competitive pressures encourage the pursuit of cost reduction strategies and a trend away from vertical integration towards greater dependence on outsourcing – all of these add to the need for greater clarity.

The increasingly sophisticated nature of financial services in particular has increased the trend to specialisation in core functions with other activities being entrusted to third parties. Where these outsourced services are purely administrative, there is little difficulty in interpreting the provisions of the Directive. However, the obligation to interpret the exemption strictly puts the emphasis on the nature of the service being performed rather than the person performing it. In consequence the possibility arises that the outsourced service itself may benefit from the VAT exemption. The answer to this can be a constant source of tension and uncertainty in the administration of the tax. In its decisions the Court has cast some light in holding that, to qualify for the exemption, the service should meet certain tests. These include services which bring a change in the legal and financial relationship or the parties or services which are considered to be essential and specific to the primary exempt service.

In more developed cases, outsourcing can now extend to the totality of the activities of an institution. The outsourced service provider effectively "stands in the shoes" of the bank or insurance company which itself functions as little more than a shell. Such an arrangement is generally accepted as the supply of an exempt financial or insurance service even though not specifically envisaged in the legislation. The absence of a clear provision in the legislation covering such increasingly common arrangements can be a source of uncertainty for both businesses and tax administrations.

Since the adoption of the Sixth VAT Directive, 379 VAT[22] cases have been decided by the ECJ. 44 of these decisions were handed down in the 14 months between January 2006 and February 2007. In overall terms, VAT cases are currently running at between two and three per month whilst for the first 15 years after 1977, that was about the annual rate.

Only 6% of these cases (24) involve the definitions of exempt financial services and insurances[23]. (19 of these are for financial services or investments and 5 involve issues related to insurances.) The trend however is upwards with just 4 decisions being handed down up to 1990 and in the next decade 8. Since the turn of the century however the Court has addressed these issues in 12 separate instances. The effect of these judgements can be wide-ranging, particularly where the effect is to draw attention to inconsistencies between Member States. It is not however possible to say whether the increase in litigation is attributable mainly 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 is on an upward curve. This perception is largely fuelled by an identifiable growth at national level which will 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.

Notwithstanding the difficulties in sourcing of data mentioned in Section 1.7 above, some information on the cost of uncertainty and inconsistency in the legislation has been made available by operators. Although the data could not be independently verified and may even be selective, there is a degree of consistency which merits its introduction here.

For operators who supply specialised support to financial or insurance institutions (e.g., payment processing, card settlement, etc) and offer a similar package of services across the Community, set-up costs seem to involve a high level of outlay on local VAT compliance advice. A number of operators interviewed in the course of the preparatory work were able to justify costs ranging between €150,000 (for smaller contracts) to over €500,000 (for larger contracts) as being typical for each contract to ensure that it can be treated as a VAT exempt supply of financial services. Most of this is attributable to the VAT Directive being interpreted differently in different Member States and commercial models which qualify for exemption in one part of the Community are not readily transportable but need to be re-validated on every occasion. Similar costs are probably also incurred by their customers (banks and insurance companies) who will need to ensure their own conformity with complex VAT requirements when entering into outsourcing arrangements.

Litigation costs, if difficult to quantify, are also high and, so far, probably largely attributable to the poor state of the legislation.

Tension between distortive effects of the exemption and the need to secure tax revenue

General

Financial and insurance institutions, because of unrecoverable VAT have an embedded tax cost which leads to overall higher costs. The impact of these higher costs varies according to whether the recipient is a business or a private individual.

A business will in normal circumstances recover the VAT it suffers on its inputs but where these services are exempt, non-recoverable VAT must be absorbed in its overall cost structure or passed on to customers. The process whereby non-recoverable VAT accumulates in the chain of business is referred to as cascading. This is accentuated when financial institutions deal with each other and hidden VAT (tax on tax) accumulates through a network of complex inter-bank transactions. In consequence the tax embodied in any financial service will depend on the number of "production stages" (perhaps better expressed in this case as the degrees of intermediation) that it passes through. For a financial institution cascading results either in reduced profitability or higher charges (e.g., increased interest rates) which in turn have negative effects on other businesses.

For private individuals on the other hand, the cascading VAT results in a lower cost for financial services than would be the case if the tax was applied in the normal way to the final retail price of the service where the final consumer must carry the full cost.

Therefore, the exemption of financial services and insurances means that these services are more expensive for business and less so for consumers than would otherwise be the case[24].

By admitting tax cascading, exemption creates incentives to avoid tax by opting for vertical integration (or self-supply). Financial and insurance institutions will thus be more inclined to supply potentially taxable services in-house ( e.g., back office services) rather than from a specialist supplier of outsourced services where non-recoverable VAT would be generated. Because of the effect of tax (non-neutrality), the resultant choice may not be the optimal one in terms of its contribution to overall efficiency.

Implications for VAT of growth in cross-border delivery of financial services and insurances.

By their nature global financial markets have a unique degree of mobility and, when establishing the location of business, an important factor will always be whether the regulatory and tax regime is considerate. Market economics suggest that structural evolution will follow the dictates of institutional comparative advantage. If there are significant economies of scale which can be exploited in the Internal Market, this will in time be reflected in the size of the institutions which develop though consolidation. Opportunities for other economic benefits, either in costs or in revenues, will be reflected in the range of activities they offer. If the creation of a pan-European market leads to commercial linkages can be exploited for profit, then these will be reflected in activities and choice of location of the most successful institutions.

If experience in the EU follows that in the US, market changes will enhance customer choice with the outcome that most financial services can be obtained in one form or another from a wide range of institutions, each of whom in turn will be involved in a broad array of financial intermediation services. Eventually this process of market adaptation will be reflected in consumer choices across a wider geographic area than is the case today – in other words some services will not necessarily be produced and consumed in the same Member State. When the final provision of the service to a consumer is VAT exempt and the service provider is unable to recover input VAT, this has implications for the distribution of VAT receipts.

The PwC report indicates that this process of delocalisation, based on consolidation and market driven development, is not yet at a very advanced stage but will certainly develop over time. Some sectors are likely to adapt more rapidly than others. Early evidence of this trend can be found in certain investment management services, which are provided relatively easily on a cross-border basis as a result of their nature and/or regulatory factors. In time, this process can be expected to feed through to the consumer market for a wide range of banking and insurance products, via the development of cross-border platforms and aggressive cross-selling to take full advantage of consolidation. Because of its relative level of development, investment funds provide a good illustration of the effect on VAT of cross-border market development.

In the marketing of investment funds, the process of consolidation and market driven development will only increase as regulatory changes increasingly facilitate cross-border funds mergers and enable pooling of assets from different funds.

Both tax efficiency (broadly defined, as VAT is not the only tax involved) and the general regulatory environment are significant factors which fund managers consider when selecting a domicile for a new fund. However taxation (including VAT recovery possibilities) is of increasing importance for managers launching alternative and progressive funds where the tax treatment is often less established and more fluid. For such funds, the manager's belief in the ability of a location to offer a clear and certain approach and a stable fiscal environment is of critical importance in arriving at a decision.

The following table illustrates changes in the volume of assets under management by Member States of domicile of the fund in 2006[25].

Member State | Non UCITS € billion - 2006 | UCITS € billion - 2006 | Total € billion - 2006 | Annual % increase 2001 - 2005 | Market Share % |

Luxembourg | 138 | 1387 | 1525 | 11.8% | 23.2% |

France | 116 | 1155 | 1271 | 8.3% | 19.3% |

Germany | 705 | 262 | 967 | 3.5% | 14.7% |

United Kingdom | 131 | 513 | 644 | 2.7% | 9.8% |

Ireland | 121 | 463 | 584 | 22.9% | 8.9% |

Italy | 32 | 382 | 414 | -2.1% | 6.3% |

Spain | 6 | 269 | 275 | 8.4% | 4.2% |

Austria | 48 | 108 | 156 | 11.3% | 2.4% |

Belgium | 6 | 110 | 116 | 5.4% | 1.8% |

Denmark | 42 | 64 | 106 | 25.6% | 1.6% |

Sweden | 1 | 104 | 105 | 4.9% | 1.6% |

Netherlands | 16 | 80 | 96 | -2.4% | 1.5% |

All others (market share below 1%) | 24 | 120 | 144 | n/a | 4.7% |

TOTAL | 1386 | 5017 | 6403 | 7.6% | 100% |

In terms of the overall rate of growth, investment fund assets in Europe have quadrupled in size over the past decade, an average annual growth rate of 15.7%. This growth has not been evenly distributed.

It is probable that some of the changes illustrated can be attributed to the health of domestic demand for investment products or to growth in funds attracted from third countries but this hardly explains the concentration of almost one third of total funds in Luxembourg and Ireland. A significant part of the increase has to be on the basis of funds whose ultimate customers are located in other Member States but where the management of the fund choose not to domicile it there. As such, the figures are simply evidence of a market driven process which can only grow as the remaining obstacles to cross-border marketing of funds are resolved.

By way of illustration, investment in funds (as opposed to the domicile of the fund) is highest in France, Germany and Italy. In the case of the latter two Member States, what is striking is that the figures indicate investment in funds domiciled abroad but promoted by national providers are growing at a multiple of the rate of investment in funds domiciled in the Member State[26].

Whatever about the reasons for choice of domicile (and there is really only slight evidence of VAT being a factor), there are consequences for the VAT revenues received by an individual Member States. Where an investment fund remains domiciled and managed in the same Member State as where the consumer of its services is located (regardless of whether these are institutional or retail customers), there is some assurance that the non-recoverable VAT created in the course of the underlying financial and management operations will generally accrue to that Member State.

This however will not follow automatically when the investment fund is domiciled and managed in one Member State and the customers (investors) are located elsewhere. The tax revenue generated by the non-recoverable VAT on bought-in goods and services will for the most part accrue to the Member State where their recipient is established rather than where the ultimate consumer of the exempt service is established.

Further complexity is added by the growing trend to delegate or outsource all or part of the management function to yet another Member State. This may be driven by capacity pressures in the main financial services centres but, whatever the reason, reduces even more the likelihood that tax revenue from embedded VAT will accrue where the consumer (the investor) is located.

This is a logical and unavoidable consequence of the removal of barriers to the cross-border provision of financial services and the drive of financial institutions to seek efficiencies within a single pan-European market. It will become more in evidence as Community financial services policy over the next five years achieves its objectives and barriers to retail integration and cross-border distribution of retail financial services are dismantled. The commitment to enabling consumers to shop around all over Europe for the best savings plans, for mortgages, insurances and pensions carries long term implications for national VAT receipts.

It is however a process which produces winners and losers in that tax revenues attributable to non-recoverable VAT shift to the Member State where the exempt financial service is generated from the Member State where it is consumed. Today, the evidence indicates that the pace of change is relatively slow except in certain areas such as investment management (where the effects are illustrated above). There are nevertheless other emerging areas of cross border integration in financial services such as for the integrated retail payment markets within the SEPA project. Here, the search for economies of scale in the development of payment processing "factories" will probably mean that the market is serviced from a limited number of locations. Over time, increasing disjunction between Member States where the retained tax accrues and the Member State where the consumption of the service takes place is likely to be a growing consequence of any increase in cross border marketing of financial services.

As long as the exemption model continues to be the norm, there will be implications for tax flows. The place of taxation for VAT generated by an outsourced service or one provided via a cost sharing centre will generally be the place where the business recipient of the service is located. However, the location of the ultimate customer, who receives and consumes an exempt service, is of no consequence as far as VAT is concerned. In the longer run, the only mechanism which will ensure a neutral outcome and that tax accrues where the recipient of a financial service is located would be to move away from exemption towards more general taxation.

Distortive effect of VAT - conclusions

The work done in preparing the Impact Assessment came to the conclusion that the only definitive way of dealing with all aspects of this distortive impact would be through the introduction of full taxation. This applies both in the case of the distortive consequences of exemption for the business itself as well as the distortive effect on the tax flows received by individual national tax administrations. As already explained however, the technical and political obstacles to such a step cannot be easily overcome and accordingly this option is not being pursued.

The distortive economic effect of VAT exemptions in general has been well documented[27]. Nevertheless, the political and practical reality is that exemptions, either in the public interest or for other reasons, will always be a feature of the VAT system.

There may be a case to be made that the problem is not so much the overall level of tax (VAT, corporation taxes, payroll taxes, premium taxes, etc) which is borne by the industry but rather the way in which VAT specifically falls at a point which may inhibit business choices on steps to efficiency. If the same total tax revenue is collected through more general charges, this effect may not be as pronounced.

In accepting that replacing the exemption by full taxation is not a deliverable outcome, the range of realistic options becomes clearer. The best that can be reasonably expected is to make the existing exemption model work better by addressing at least some of its imperfections.

Other problems identified.

In the course of the public consultation and the dialogue with stakeholders, a number of other areas of concern were raised. Some of these could only be considered as peripheral or their resolution would require changes which are disproportionate to the scale of any problem identified.

Two of these however deserve a mention in this part of the Impact Assessment even though, for the reasons stated in each case, they raise issues which are not being taken up in the current legislative proposal.

Tax recovery methodologies

As evidenced in the IBDF survey there are currently significant differences in the VAT recovery methodologies permitted by Member States. This seems to be particularly an issue for financial institutions in the new Member States or for institutions based in the older Member States who expand their business there. The majority of Member States favour the use of simple output value based methods with a pro-rata calculation along the lines set out Article 174 of the VAT Directive (at its simplest, a "single pot" method). Other Member States do however permit the use of direct cost allocation methods which more accurately apportion the actual use of VAT incurred to the specific activities which they support. These may involve the use of floor space, headcount, transaction count, etc as proxies for actual use. These methods are sometimes referred to as "actual use" (the term is used in the IBFD report) but all are to some extent arbitrary.

The ability to use such methodologies, perhaps on a negotiated basis, is seen by many businesses (and indeed a number of national tax administrations) to produce a more accurate VAT recovery rate, particularly in complex businesses, delivering a fair result for all concerned. They also reduce the compliance cost burden in the views of business.

More accurate tax recovery results could also be assured where it is possible to negotiate pro-rata calculations for sectors of a particular business which have discrete activities where relevant accounting data in relation to attributable inputs and outputs can be "ring-fenced".

This is linked to concerns in the industries that the limited methodologies imposed by some Member States (when direct cost allocation is precluded) in this area cause distortion of competition. They also cause significant administrative costs and uncertainties for financial institutions that operate across a number of Member States and it is difficult to see who benefits from the complexity.

In responding to the case for more widespread use of bespoke methods of direct allocation, realistically this could only be considered if it were possible to establish a number of minimal guiding principles at a Community level, which should include inter alia ;

- data to operate the adopted methodology is supported by robust accounting/information systems (notwithstanding that financial or cost accounting is not primarily aimed at determining the correct tax base),

- the methodology employed is readily understandable,

- the methodology is readily verifiable by relevant tax authorities,

- the methodology is readily adaptable to changes in the business, market place, legislation etc,

- it produces a fair and reasonable recovery of input VAT acceptable to both the business and relevant tax authority.

Even reaching agreement on this level of standardisation in methodologies would not however deliver a consistent result although it might assist with moderating excessive compliance costs.

Apart from inconsistencies in computation methods, differences in the acceptable proxies for calculating direct cost allocation are endemic, even among those Member States who prefer an actual use approach in allocating input VAT.

It is not difficult to find examples in practice but one will suffice to illustrate the point. Most Member States will allow an institution to recover VAT incurred on the costs associated with investment funds to the extent that these are considered to relate to non-EU turnover. In some cases the specified proxy is the domicile of the fund – if an EU institution is managing a fund domiciled in for example the Channel Islands, it will be able to recover any input VAT incurred in the process. Other Member States however consider that the correct proxy is the domicile of the investments made by the fund. Under this interpretation, if the EU institution is managing a fund domiciled in a Member State which invests in for example NASDAQ shares, then it will be able to recover input VAT.

Depending on which of these proxies for actual use is applied, the outcome will be two different results for input VAT recovery, even where a direct allocation method is used in each case.

It would seem in consequence that fully harmonising VAT recovery would require a level of detailed guidance in Community legislation which would be difficult to deliver. Even a relatively high level harmonisation of the methodologies allowed would seem to be an unrealistic objective, at least at this stage.

This conclusion is reinforced by discussions with Member States on options for more consistency in recovery rules. Their general view was that this was not to be regarded as a priority and they would prefer to retain the room for manoeuvre which in their view the Directive currently allows them.

There are issues here however which cannot be left to one side indefinitely. Although it is not the intention to address them in the current proposal, the Commission intends to examine further the matter of consistency and transparency in the computation of recoverable VAT, not least since the Directive foresees a harmonised treatment here.

Sharia compliant banking and insurances

VAT issues associated with Sharia[28] compliant financial services and insurances were mentioned tangentially in the Consultation Paper and taken up by a small number of financial institutions in their comments to the Commission. Their objective is to seek exemption for transactions involving the provision of goods and services carried out under Sharia law to the extent that there is equivalence (economically and intent) to transaction falling under the exemption in Article 135.1(a) to (g).

Without going into detail here, it is by no means clear whether this is possible under the existing VAT rules.

However, notwithstanding some evidence of political commitment at national level to resolve these problems and to ensure that this niche activity can prosper within the Community, it is not intended to address this issue now. This is a specialist area and the market is still relatively underdeveloped, limited to a small number of Member States. The VAT consequences, if any, require further study and rather than delay the current exercise, The Commission will in the very near future consider what steps need to be taken in conjunction with the Member States concerned.

Objectives

What are the identified objectives?

In the consultation paper of March 2006, the Commission's starting point was to set out three objectives for the current exercise. They remain valid and any possible legislative measures should be considered against this background:

- Reducing the administrative costs for administrations in exercising fiscal supervision and for economic operators in achieving fiscal compliance

- Creating budgetary security for Member States and legal certainty for economic operators.

- Addressing inconsistencies between the 1977 VAT provisions and more recent regulatory and legal provisions such as those falling under the Financial Services Action Plan.

It was not considered appropriate or practical to establish a hierarchy of objectives. From an early stage in the work, it was clear that the emerging options for change could deliver solutions which met some, or some part of, these objectives. In consequence, a pragmatic approach was to consider each of the identified policy options in terms of what it would contribute to achieving the aforementioned objectives.

Reducing the administrative costs for administrations in exercising fiscal supervision and for economic operators in achieving fiscal compliance.

In tax literature, a common understanding of what constitutes administrative and compliance costs has achieved widespread acceptance[29]. Here administrative costs are the costs incurred by the tax administrations of Member States in collecting VAT and enforcing tax regulations, including collecting, administering, and managing the tax system. Apart from these direct costs they also include indirect costs incurred by judicial and quasi-judicial bodies responsible for settling disputes between taxpayers and the government up to and including the ECJ.

The total array of costs for business is usually described as compliance costs. For financial and insurance institutions, these are the expenses incurred by them to comply with tax regulations. These include the time and expenses to maintain proper records (particularly where these are not aligned with normal business accounting procedures), tax planning costs, reporting and remittance costs, etc. In the course of the public consultation, stakeholders put most stress on the legal and consultancy costs, including litigated solutions, occasioned by the uneven and uncertain nature of the current legislation.

For business, this broad notion of "compliance costs" goes much wider than the concept of administrative costs considered in the EU common methodology foe assessing administrative costs imposed by legislation[30]. The intended proposal will not impose any new obligations on enterprises or create any new legal obligations for them to provide information on their activities, either within the broader or more restrictive understanding of the concepts.

VAT does of course impose costs on enterprises in meeting their legal obligations. These however are not set out in Community law but rather determined in national legislation where such choices, reflecting a subsidiarity based approach, are left to Member States. The results here are unfortunately a very real source of concern for pan-European businesses faced with different administrative obligations wherever they have a business presence but this is a horizontal issue, not specific to financial services and insurances and is not addressed here[31].

In assessing the costs or savings associated with modifying tax systems, the accepted methodology among tax administrations is that compliance costs for business should be weighted rather less heavily than administration costs. The main reason for this is that this perception of compliance costs includes expenditure on tax planning which is often open ended and notoriously difficult to monitor.

A significant objective in cost reduction however is to achieve a reduction in the level of litigation caused by disputes or uncertainty in the interpretation of the VAT provisions. This will undoubtedly benefit both tax administrations and businesses and stands out as a win-win achievable outcome. Achieving a significant decrease in litigation remains the paramount objective in modernising the definitions of exempt financial services and insurances.

The process of meeting some of the other objectives (listed below) may however give rise to additional administrative requirements as there are inherent tension points between the two objectives which follow and which need to be balanced. These however are essentially at the discretion of Member States and it would be impossible to put a cost on them in advance of knowing what is entailed.

Reconciling the VAT system (with its focus on national tax revenue) with the broader objectives of a single market for financial services can only be achieved if the integrity of the tax collection system is secure. It is possible that this may involve additional record-keeping and reporting obligation, highlighting the lack of compatibility between those imposed by Member States at national level. The responsibility for administering any additional administrative burden falls however to the Member States. Although this seems at odds with the objective of reducing administrative costs, it may be the cost which has to be paid in delivering on the remaining two objectives.

Any wider approach therefore may impose fresh compliance costs, although it should be stressed that the measures being contemplated are optional. To some extent it may be possible to leverage these obligations off the existing accounting and compliance systems but this will need to start with a detailed description of what any additional reporting requirements would entail.

Such opportunities may in any event be limited as standard financial and cost accounting techniques serve other priorities. Views expressed by the main suppliers of business accounting and reporting software to the FS industries, confirm that tax compliance and reporting requirements are seldom integrated within the end-to-end data and management information platforms which are increasingly used in financial institutions.

As far as EU VAT is concerned, this incompatibility can be largely attributed to 27 different sets of reporting and compliance obligations across Member States. In addition, there are no established norms for internal cost management systems off which a standard set of tax reporting obligations could be leveraged. The result is that different networks or software applications are required for tax purposes, often resulting in expensive errors or omissions in tax returns and difficulties in reconciling them with financial statements, all of which create practical difficulties in keeping compliance costs under control. It will not be easy to generate much improvement but, as mentioned, this is not an aspect specific to the activities under consideration here.

Creating budgetary security for Member States and legal certainty for economic operators.

As indicated above (Section 3.4), it is not easy to put a figure on the budgetary receipts generated by VAT from the financial services and insurance industries. It is clear however that the tax administrations of Member States regards these receipts as an important source of revenue and will legitimately expect that Community legislation does not put them at risk.

Here it is necessary to draw a distinction between budgetary security and absolute budgetary neutrality. It may not be possible to maintain the latter if a viable solution to the VAT problems is to be found. Keeping and further developing a vibrant financial services industry within the EU should however be worth limited VAT revenue trade-offs that will be compensated by increases in other taxes and contributions. Ensuring that financial services and insurances remain EU based and thus continue to generate tax revenue must be a key contribution to achieving this objective.

Significantly, the status quo is by no means secure because of the potential for budgetary risks associated with leaving the interpretation of legislation to the ECJ in circumstances where the likely outcome is not always sure. Certain recent decisions of the Court have been a source of discomfort to some Member States and, given the potential budgetary significance, retaining the present situation cannot be considered a robust long term strategy for budgetary security. Moreover, internal market developments (see Section 2.2.2) will also lead to re-distribution of existing tax revenues between Member States.

There is a direct linkage between budgetary security and legal certainty for businesses. The current legislation often leaves them in a position where the absence of a clear and consistent understanding of the legal provisions in the Directive is a constraint on long term planning, particularly in pan-European projects. Increased legal certainty and uniformity in interpretation has been a consistent demand in the dialogue with stakeholder.

Addressing inconsistencies between the 1977 VAT provisions and more recent regulatory and legal provisions such as those falling under the Financial Services Action Plan.

The Community VAT system should, "eliminate, as far as possible, factors which may distort conditions of competition, whether at national or Community level"[32]. It should consequently be compatible with the objectives of the FSAP and the Lisbon Agenda which hold that a single market for financial services is essential for the EU's global competitiveness.

Better regulation is an important element of the renewed Lisbon strategy. In the area of VAT, the Commission has already made several proposals aimed at improving the regulatory framework so as to remove obstacles to market functioning and to introduce more competition.[33] The current proposal will seek to build on this.

However some of the more intuitive steps which might affect the financial services and insurances sectors – i.e., by bringing more neutrality to the VAT consequences of cross-border consolidation – will have budgetary consequences for some Member States. Nevertheless, when VAT creates obstacle for institutions or groups which operate across several Member States, thus inhibiting the growth of a single market for financial services, reasonable efforts should be made to rectify this.

A major challenge for the current proposal will be to reconcile the legitimate aims of tax administrations with Community policies which are based on the premise that the more integrated EU financial markets become, the more efficient will be the allocation of capital and long term economic performance. Enhancing competitiveness should not be restricted by the tax system as the long term consequences would only be detrimental to both the industries and the public purse.

POLICY OPTIONS

Within the established and identified constraints, the policy options available for consideration can be summarised under the following headings:

- Leaving the existing situation unchanged.

- Modernising the definitions of exempt financial services and insurances in a manner which ensures their consistent application across the Community.

- Proposing one or more targeted structural changes to the way in which the current tax system operates in offset the largely unintended negative economic consequences and barriers to efficiency.

These options are set out in more detail in the following sections which point the way towards a balanced set of legislative changes, drawing on the second and third of these options.

Doing nothing – why this is not an option

One outcome of the transparent manner in which this issue has been treated is the near-total consensus that has developed on the need for change. The existing situation is unstable in that it inevitably leads to an increased reliance on litigated solutions.

The legislation which has been in place for 30 years, its provenance is even older and it was never seen as a long term fix. Neither was it intended to handle a complex and sophisticated industry which spreads across 27 Member States and works within a radically re-focused regulatory system.

The external pressures on the tax system are developed elsewhere in this document and there is every indication that they will grow over time. The well documented increase in litigation is a continual destabilising factor, bringing uncertainty to existing interpretations and practices in many areas. Even a decision to retain the status quo would in all probability require legislative intervention.

A more intensive and systematic policy of infringement proceedings on the Commission's part would do little in the longer term other than to highlight further the shortcomings in the legislation.

There is inevitability about change and the only real decisions which remain are about what the nature of the changes should be. The choice is between a laissez faire stance, leaving the future to the courts and to market forces, or to embrace the process constructively on the basis of clear and ambitious policy objectives.

Reliance on the courts as the sole or main instrument for developing the application of tax law in this area carries the risk of future crises. The decisions of the ECJ have sometimes favoured taxpayers and sometimes tax collectors. It is far from inconceivable that a future decision of the Court might put in question the revenue raising process in a fundamental way. The Community legislative process is not attuned to dealing with emergencies and it would be negligent in the extreme to wait until one arises before addressing the underlying issue.

In so far as the objectives set out in Section 3 are concerned, the effects would be as follows:

- Reducing administrative costs . The uncertainty inherent in outdated legislation will continue to create excessive costs for both tax administrations and businesses. This will particularly apply to businesses with a presence in more than on Member State.

- Budgetary security and legal certainty . In an increasingly litigation-based environment, Court decisions will continue to generate unpredictable consequences for Member States' budgets and for business.

- Addressing inconsistencies . Leaving things as they are will do nothing to further other Community objectives such as those of the Lisbon Agenda and the FSAP.

Modernisation of definitions

There would seem to be no doubt about the universal consensus on the need for a significant re-write of the 1977 definitions of exempt financial services and insurances.

This modernisation should address the shortcomings in the existing legislation – these include lack of clarity, failure to keep abreast of commercial developments, unevenness in application and the already mentioned need for more frequent recourse to the Court for clarification.

The modernisation should take due account of the interpretative jurisprudence of the Court which has given good guidance in many instances.

Some measure of selectiveness is however needed. Whilst some decisions bring useful clarification (e.g., the SDC[34] case, by focusing on the essential and specific nature of bought-in services which qualify as exempt) others have served to highlight the problems caused by deficiencies in the legislation and need a different reaction. .

This has happened where wording generally considered as helpful in the 1970's in achieving its objective cannot always be seen as such in today's context. An example here is the Andersen[35] case where for insurances the specific mention of brokers and agents has led to what many Member States (as well as business) consider to be the wrong result for intermediation by highlighting inconsistencies that were never intended. There would seem to a strong case that intermediation in insurances was never intended by legislators to be any different to intermediation in financial services generally.

The approach identified as optimal by The Commissionhas been to modernise the definitions of exempt services within the boundaries of the existing exemption framework with the objective of making them more robust and reflecting modern business practice. A considerable increase in the level of specific detail is warranted by the need for consistency. This is being achieved through a combination of an updated directive augmented by implementing regulation.

Although the broad intention should be a revenue neutral solution, lack of uniformity in the implementing measures is likely to mean that achieving conformity will be at the cost of some changes in tax flows.

This point is dealt with in Section 5.

In so far as the objectives set out in Section 3 are concerned, the effects would be as follows:

- Reducing administrative costs . Both tax administrations and businesses incur significant costs in dealing with the current legislation. Modernising the definitions of exempt services, both by amending the Directive and by putting implementing regulations in place, could have a positive impact on these costs.

- Budgetary security and legal certainty . The current legislation is both unpredictable and unstable. The effect of ECJ decisions cannot be known in advance and the reality is that they are an increasing factor in the application of the tax. Their outcome can have significant effects on tax flows – in either direction. Both administration and businesses are at one in calling for greater certainty in the system.

- Addressing inconsistencies . In so far as the definitions of exempted services remain within the same broad boundaries, it will do little to redress lack of neutrality in the exemption model. However, the mere fact of greater consistency should not be discounted as a significant contribution to single market objectives.

Structural options identified in public consultation.

Zero rating

There are a limited number of examples of zero rating within the existing EU VAT system, all of which are seen as aberrations which should disappear in time. For the most part, whatever limited justification can be found for their continued existence is invariably linked to social policy considerations. Introducing a fresh range of zero rating into what is the most mainstream of all commercial activities would require exceptional justification.

Although it gets rid of the problem of input tax not being deductible, it is difficult to find arguments in favour of an option which effectively singles out the financial services and insurance industries for a general subsidy.

The zero rating of financial services in New Zealand and Hong Kong[36] cannot be seen as a serious option for the EU. In both of these cases, zero rating is placed in the context of a significant fiscal re-engineering exercise which is not on any agenda here and which deals with factors specific to relatively small "special case" economies.

Zero rating would be an expensive step for Member States, replacing one set of distortive consequences with something probably worse. It would subsidise business as well as household consumers of financial services. As a relatively general undiscriminating measure, it would be difficult to identify specific efficiency gains which might justify other more targeted changes. In the absence of demonstrable and significant buoyancy in wider tax receipts, there is a risk that any revenue shortfall having to be made good by increased taxes on other goods and services.

Accordingly, this option will not be pursued any further.

In so far as the objectives set out in Section 3 are concerned, the effects would be as follows:

- Reducing administrative costs . It is not clear that zero rating would lead to any improvement in administrative burdens. The introduction of additional VAT rates is usually seen as imposing burden on business and it is unlikely that the outcome would be any different here.

- Budgetary security and legal certainty . Zero rating would lead to major revenue losses for Member States. It would also lead to demands for more zero rates in other, perhaps perceived as more deserving, fields.

- Addressing inconsistencies . There are no convincing arguments that subsidising the financial services and insurance industries (which would be the outcome of zero rating) would assist other policy objectives such as those of the FSAP or the Lisbon Agenda.

Extending the scope of exempted services.

In general, the existing exemption extends to mainstream financial and insurance services but also such additional outsourced services as are considered to be essential and specific to generating the main exempt service.

Other outsourced services, which do not fall within these categories, will incur VAT which may not be recoverable in many or most cases. Widening the scope of the exemption would be one way of bringing such services within the scope of the exemption and eliminating or reducing embedded VAT.

Although there would seem to be a superficial benefit for the industries in reducing such non-recoverable VAT, the borderline definitional problems would still remain. In reality it would spread the problems associated with exemption to other businesses, creating further complexity and increasing the number of entities which have to deal with the administrative complexities of partial exemption. The problems associated with the cascade effect would not disappear but rather acquire extra layers.

The range of potential additional qualifying services is large and it would be difficult to discriminate between them. Their inclusion would also have effects which are difficult to quantify on existing limited recovery possibilities.

Because of the lack of clearly identifiable benefits and the potential for increasing both uncertainty and complexity, this option for change is not being pursued any further.

In so far as the objectives set out in Section 3 are concerned, the effects would be as follows:

- Reducing administrative costs . Simply shifting the boundary of the exemption will do little in itself to ease administrative burdens.

- Budgetary security and legal certainty . Determining the exempt and non-exempt would remain an issue and thus little contribution would be made to security or certainty. Widening the exemption would increase the range of transactions not subject to tax but would also reduce recovery possibilities on inputs.

- Addressing inconsistencies . This would have little effect here.

Uniform limited input tax deduction

The uniform limited input deduction model has its basis in a system designed by the Australian tax authorities to ensure a degree of neutrality in outsourcing decisions. The so-called RITC (reduced input tax credit) method allows providers financial services in that country to recover a fixed 75% of the input tax incurred on certain back office services.

This percentage was arrived at on the basis of an estimation of that part of the cost of a representative bundle of outsourced service which related to salary costs plus the service supplier's added value. The residual figure is considered to be that part of the operation which would in any event have attracted tax had it been performed in-house. It is designed as a means of levelling the playing field between larger businesses that are able to undertake functions in-house, whereby non-recoverable VAT is not incurred on labour costs, and smaller operators that have to use external suppliers where they inevitably incur higher levels of non-recoverable VAT.

A more refined version of this system is used in Singapore[37] intended to reflect the variation in labour content in different kinds of financial services. In both cases however it is linked to a significant narrowing of the range of exempt services compared with the EU legislation.

This narrowing of the exemption when combined with RITC leads to higher recovery rates for institutions[38]. There is also a general perception that the system has also eliminated much of the legal argument that might otherwise have arisen on the scope of the exemption for financial services in relation to service providers who are not themselves financial institutions and thus contributing a significant reduction in compliance and administrative costs.

Notwithstanding the ostensible benefits (at least for businesses) that it seems to have created in these two countries, the conclusion was that this method of containing non-recoverable input VAT is not readily transferable to the EU.

In both these cases, there is a homogenous domestic labour market with negligible variation in labour costs. This allows for the establishment of reasonable accurate percentages of the labour cost elements in typical financial services without which the RITC type model would not work.

This essential pre-requisite does not however exist in the EU and there are significant differences in unit labour costs between Member States. A composite recovery rate would be unworkable in these conditions.

It could be conceivable in principle to develop sector specific recovery rates (along Singapore lines). However rates which accurately reflect differences in labour cost (which are in themselves a significant competitive factor in the outsourcing market) would be so difficult to compile in practice as to make the system impossible to administer at Community level.

Although this option registered a degree of support among some respondents to the public consultation, none of the respondents could identify a way to handle unit labour cost variations within a uniform deduction system.

A further concern here is that permitting such a formula for financial services and insurances might lead to pressure to extend it to other exempt services with consequential risks of revenue losses, although this is not confirmed by experiences elsewhere.

Against the background of practical difficulties, there seems to be no point in pursuing this option.

In so far as the objectives set out in Section 3 are concerned, the effects would be as follows:

- Reducing administrative costs . The technical concerns mentioned above would be very difficult to overcome, leading to high set-up costs. Ongoing costs would however probably be reduced.

- Budgetary security and legal certainty . Would reduce tax receipts from non-recoverable VAT on financial services and insurances as well as risk possible knock-on effects in other exempt or partially-exempt sectors.

- Addressing inconsistencies . Would restore some measure of neutrality in so far as labour costs would be treated in an equal manner for VAT, whether in-house or out-sourced.

Option to tax

As already mentioned, the Directive allows Member States to implement an option to tax financial services[39]. In the Member States concerned, this allows financial institutions to waive the exemption and opt to tax their supplies of exempt financial services[40]. This option does not currently extend to insurances.

Option to tax for B2B allows the financial institution to charge VAT to customers who will then generally reclaim the tax under normal VAT rules. The institution itself, to the extent that it supplies taxed services will be able to claim back more VAT, increasing its recovery rate. Clearly the use of the option is intended to create a taxed supply to allow for recovery in full of any directly related input tax, notwithstanding that it adds legal and economic complexity in the relationship of the two parties in a business transaction. In many cases it would only generate partial recovery of VAT, with some limited reduction in administrative complexity. In Member States such as Germany where the option can be exercised on a case-by-case basis, the financial institution will use the option to tax for customers entitled to deduct input VAT.

Several practical problems arise. An immediate problem is in trying to identify what are B2B transactions. Grey areas arise in transactions with governments or public bodies, non-VAT registered businesses, other exempt entities such as schools and hospitals etc and possibly even other financial institutions.

The economic outcome may not always be so clear. Although the financial institution will be able to reclaim an increased proportion of the input tax it incurs, there is no way, apart from relying on competition, to ensure that this saving will be passed on to business customers in the form of reduced costs. There is always a risk that commercial constraints will spread the cost saving unevenly across the entire client base with business customers still carrying a part of the cost of non-deductible VAT.

In practice however there is confirmation that higher recovery for the financial institution and lower costs for the business customer are the usual outcome. As the supplier has to generate a VAT invoice, this inevitably creates expectations of a cost saving on the part of the customer. Effectively, the benefits for both participants are financed by the exchequer – when the option to tax is exercised, it seems that the outcome will ever be thus.

Experience with the option to tax in the property area has not been uniformly positive but rather is seen as having created the need for a considerable body of anti-avoidance legislation at national level. In some cases this even leads to requests for derogations from the provisions of the Directive itself in order to combat potentially serious avoidance of VAT. This may colour the perception of certain Member States when considering the wider application of the option to financial services although there is no evidence of similar experiences in the Member States where the option to tax financial services is currently available.

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