EXPLANATORY MEMORANDUM

1.CONTEXT OF THE PROPOSAL

•Reasons for and objectives of the proposal

The current initiative is part of the Fair Taxation package for the creation of a single EU value added tax area (VAT) announced by President Juncker’s letter of intent accompanying the State of the Union Address 2017. The package includes two proposals to modify the VAT Directive, one as regards the definitive VAT system for cross-border trade and one adopted together with this initiative as regards small enterprises, and a proposal for a Council Regulation on combating fraud in the field of VAT.

VAT is Europe’s longest-standing consumption tax. In 1967, the commitment was made to establish a definitive VAT system operating within the European Community in the same way as it would within a single country without agreeing specific rules on VAT rates apart from the application of a standard VAT rate. Member States were allowed to apply an unlimited number of reduced and increased VAT rates and no lower or upper rate limits were imposed.

The abolition of fiscal frontiers between Member States by the end of 1992 made it necessary to reconsider the way in which trade in goods was taxed within the Community. The goal was that goods would be taxed in the country of origin, perfectly reflecting the idea of a genuine internal market. Since the political and technical conditions were not ripe for such a system, transitional VAT arrangements were adopted.

The transitional system required rules on VAT rates to avoid distortion in cross-border shopping and trade following the abolition of fiscal frontiers. In October 1992 the Council agreed on rules limiting the discretion of Member States to set VAT rates. Member States were required to apply a standard VAT rate of 15% or more, and could apply one or two reduced rates, no lower than 5% to certain specified goods and services (Annex III to the VAT Directive). Member States were allowed, by way of derogation, to continue to apply any lower rates, including zero rates and also to apply a reduced rate to any goods or services not included in the list, if such rates were already in place on 1 January 1991.

The objective of these derogations was to allow, during a transitional period, for national laws in specified fields to be gradually adapted to the common rules, seeing that harmonised rules were required to fully establish a definitive VAT system based on taxation in the country of origin. Therefore, these derogations had to expire at the time the transitional arrangements for the taxation of trade between Member States would be replaced by such a definitive VAT system.

In July 2003 the Commission proposed to simplify the rules on reduced VAT rates by abolishing all reduced rates applied to goods and services outside the scope of Annex III, but the Council could not agree on this partial abolition of derogations and until today all derogations remain in place.

The abolition or expiry of derogations was justified as long as the definitive VAT system was envisaged to be based on the principle of taxation in the Member State of origin, which requires an approximation of VAT rates.

In 2012, however, given the lack of meaningful progress on rate convergence, the Commission, with the agreement of the Council and the European Parliament, decided to abandon the objective of an origin-based definitive VAT system in favour of one based on the destination principle.

Meanwhile, the place of taxation of services had also progressively changed to the country of destination since 2010. The decision was taken in 2008, when the Council adopted a proposal with a view to prevent distortions of competition between Member States operating different VAT rates. As a result, today supplies of services are nearly all taxed according to the destination principle. The final implementation of destination-based taxation for services took place in 2015. Since then, all B2C (business-to-consumer) supplies of telecommunications, broadcasting and electronic services have been taxable at the place where the customer resides and no longer where the supplier is located.

This all led the Commission in its 2016 VAT Action Plan to propose replacing the current transitional arrangements for the taxation of trade between Member States by definitive arrangements based on the principle of taxation in the Member State of destination in order to create a robust single European VAT area. At the same time the Commission announced that taxation at destination would allow to grant Member States more flexibility in setting VAT rates and that all currently existing reduced rates, including derogations, legally applied in Member States should be maintained and could be made available to all Member States, ensuring equal treatment. A legislative proposal with regard to VAT rates was included in the Commission’s Work Programme for 2017.

The Council in its conclusions took note of the direction of action set out by the Commission in the VAT Action Plan with regard to the VAT rate system and its intention to submit a legislative proposal in 2017, proposing a reform to give more freedom to Member States in setting rates. The Council welcomed the intention of the Commission to present a proposal for increased flexibility, so that Member States could benefit from reduced and zero rates as they existed in other Member States. It however stressed that a sufficient level of harmonisation in the EU remains required and that the adopted solution has to be carefully balanced to avoid distortion of competition, rise in business costs and negative impact on the functioning of the single market.

On 4 October 2017 the Commission adopted the first proposal introducing the definitive system for the taxation of trade between Member States and outlined successive steps and sub-steps for introducing this system in its communication on the follow-up to the Action Plan on VAT. The Commission confirmed in its communication that it would propose a reform of VAT rates, which would be consistent with the definitive arrangements based on the destination principle that would gradually replace the current transitional arrangements. With goods and services being taxed in the Member State of destination, suppliers derive no significant benefit from being established in a lower-rate Member State and diversity in VAT rates therefore no longer disrupts the functioning of the single market, provided it is accompanied by safeguards to avoid potential risks like revenue erosion, distortion of competition, complexity and legal uncertainty.

In line with the VAT Action Plan and taking into account the mandate by the Council, amendments to the VAT Directive are proposed. These should coincide with the entry into force of the definitive VAT system so as to avoid that the expiry of derogations would prevent Member States to maintain around 250 existing reduced rates and exemptions with deductibility of the VAT paid at the preceding stage.

In a definitive VAT system all Member States would be restricted by the same rules and be granted equal freedom in setting VAT rates. The harmonised and less restrictive rules would enable all Member States, in addition to the two reduced rates of a minimum of five percent and an exemption with deductibility of the VAT paid at the preceding stage currently allowed, to apply another reduced rate between five and zero percent. Instead of extending the already extensive list of goods and services to which reduced rates can be applied, Annex III would be replaced by a negative list to which reduced rates cannot be applied.

While being less restrictive, these new rules would allow a wider application of the fiscal neutrality principle, which in the todays' transitional VAT system is overruled by the provisions of Annex III and the temporary derogations, which are restricted in scope. Under the new harmonised rules Member States would also be required to ensure that reduced rates are for the benefit of the final consumer and that the setting of these rates pursue an objective of general interest. Furthermore, Member States would need to ensure that the weighted average VAT rate applied to those transactions for which VAT cannot be deducted always exceeds 12%.

Before the new harmonised rules enter into force the Commission commits according to Article 100 of the VAT Directive to a review of Annex III to take account of specific requests by Member States. The review would take place within the VAT Committee and would be followed by a legislative proposal by the Commission to adapt Annex III.