Chapter

5 Financial Services and the Value-Added Tax*

Author(s):
Howell Zee
Published Date:
April 2004
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Author(s)
Alan Schenk and Howell H. Zee 

The value-added tax (VAT) has been adopted in over 100 countries. While the VAT base has been expanded in many countries to cover a wider range of goods and services, most countries with a VAT have not brought most financial services within the VAT net, especially financial intermediation services and other financial services rendered without explicit fees.

Most VATs in use today are European-style, credit-invoice VATs. A taxable business files VAT returns that calculate net tax liability as the difference between output tax less credits for input tax. Output tax is taxable sales multiplied by the applicable VAT rate. Input tax is the VAT paid on taxable business purchases (and imports) of inputs used in making taxable sales. A credit-invoice VAT thus relies on explicit charges for sales to calculate output tax (and the corresponding business purchases to calculate input tax). Banks and other financial intermediaries, however, often bury the charges for intermediation services in interest rate margins between loans and deposits and in charges for other services in other types of margins, such as the margins between the buy and sell rates of different currencies for the commissions for currency conversions. Measuring such buried charges (or implicit fees) in bundled financial services for the application of a credit-invoice VAT thus poses formidable conceptual and administrative challenges. This paper reviews and assesses the different approaches to the VAT treatment of financial services in different countries.1

Nature of the Problem

Financial institutions often provide, in addition to intermediation between depositors and borrowers, a host of services, such as asset management, investment advice, and a variety of insurance products. Some of these services may be bundled with intermediation services or rendered for explicit fees. As noted earlier, VAT complications are associated largely with the intermediation services and services rendered for implicit fees. If the value of certain financial services is to be taxed, the service provider must identify and value the taxable services, including the implicit fees. Furthermore, under most VAT regimes, if a bank or insurance company provides both taxable2 and exempt services, the firm must allocate the business inputs between the two categories of services because only the VAT on inputs attributable to taxable services qualifies for the input credit (but see Australia and Singapore below). In either case, the correct application of the VAT would be problematic.

Intermediation Services

Banks provide intermediation services to both depositors and borrowers. The value of these services can be measured by the spread between the interest received on deposits and the interest charged on loans. For example, assume that the deposit rate is 3 percent and the loan rate is 8 percent and that what is referred to as the pure cost of funds (such as the rate on short-term government securities) is 5 percent. The spread of 5 percent (8 percent less 3 percent) is then the value of the total intermediation services provided—split between the borrower (the 3 percent premium he pays relative to the pure cost of funds) and the depositor (the 2 percent interest he forgoes relative to the pure cost of funds).

Under a credit-invoice VAT, as explained earlier, a registered person’s tax liability is generally measured by the difference between the tax charged on taxable sales and the tax paid on taxable purchases for the tax period, on the basis of special VAT invoices issued by registered persons. Banks cannot use this traditional method to compute their tax liabilities because many of the costs that should be considered business inputs (such as deposits received) are purchased from consumers who are necessarily unregistered persons for VAT purposes and are therefore not permitted to issue VAT invoices. Another problem associated with taxing intermediation services is that there is no accepted method for calculating the value of these services on a transaction-by-transaction basis in a manner that allows the banks to impose the VAT and notify their business customers of the amount of the VAT so charged. Absent this calculation and notification, business users are denied input credits for any VAT component in the cost of taxed intermediation services. If these services are exempted from the VAT because they are buried in interest rate margins and are, therefore, administratively impractical to tax, then (except for the practice adopted by Australia and Singapore—see below) banks are denied input credits for the VAT paid on their purchases used in providing exempt intermediation services. Exempting such services is thus equivalent to breaking the credit chain—and results in cascading—whenever they are purchased by businesses as inputs in making taxable sales.3

Financial institutions other than banks may also provide intermediation services. For example, finance subsidiaries of automobile companies and home builders may finance consumer car and home purchases. The VAT treatment of these services should be uniform across all service providers to prevent the creation of incentives to channel funds through particular types of financial institutions.

Financial Services with Explicit Fees

Explicit fees for services rendered by banks and other financial institutions (for example, nonlife insurance companies) can be easily included in the base of a credit-invoice VAT without imposing significant administrative and compliance costs on either businesses or the tax authorities. If a VAT is charged on such fees, businesses can claim input credits for the VAT paid on purchases of services used in making taxable sales. For example, if a bank charges fees on cash withdrawals from an automated teller machine (ATM), such fees can be subject to the VAT. Since the bank is rendering a taxable service, it can claim input credit for the VAT paid on purchases used in providing the service. If the ATM service is purchased by a consumer, the consumer bears the VAT on this service. If it is purchased by a business for use in making taxable sales, the business can recover the tax charged on this service by claiming it as an input credit on its VAT return. Hence, financial services with explicit fees can be taxed just like any other taxable goods and services.

Financial Services with Implicit Fees

The difficulty in taxing financial services that charge implicit fees—for example, brokerage commissions on purchases of certain stocks (not listed on a national exchange)—that are reflected in higher prices for the purchased securities is formally equivalent to that in taxing intermediation services. If these implicit fees were exempt, the exemption would result in cascading for much the same reason that exempting intermediation services produces cascading. In addition, if the business providing exempt financial services with implicit fees also renders taxable services (domestic services with explicit fees or zero-rated exports), the business and the tax authorities bear additional administration and compliance costs. These costs occur because the service provider must calculate the proportion of the input tax that is not creditable—that is, the tax on purchases used in rendering the exempt services. The tax authorities must verify that this allocation is correct. Experience in a number of countries indicates that there are frequent disagreements between financial institutions and the tax authorities over the calculation of creditable input tax.

Granting an exemption for financial services rendered for implicit fees creates the same incentive for the service provider to vertically integrate as it does for any supplier of exempt goods or services. Financial institutions may attempt to provide many of the inputs they need in-house to avoid paying noncreditable VAT on such purchases used in rendering exempt financial services. Thus, for example, instead of purchasing bank forms and stationery from an outside printer (and paying the VAT on the purchase), a bank could operate its own print shop if doing so would be less costly on account of the tax saving. Suppliers to banks may thus protest the loss of business resulting solely from the VAT rule.

Some countries attempt to discourage vertical integration by imposing the VAT on the value of self-supplied inputs (known as a “self-supply rule”).4 For example, a bank may be required to report as a VAT-able sale the value of the forms and stationery it supplies to itself. The difficult problem is, of course, to identify which inputs are subject to the self-supply rule. For example, should a business that hires an outside cleaning service to maintain its offices and then replaces the outside service with its own employees be subject to the self-supply rule on the value of the service rendered by its employees? Should a bank that purchases the building that it previously leased for a branch operation be subject to the self-supply rule on the rental value of the branch office?

To date, no country with a VAT has found it administratively feasible to tax banks and other financial institutions on the value of intermediation services or other services with implicit fees rendered to their business customers in a way that provides the latter, on a transaction-by-transaction basis, with an input credit for the VAT attributable to these services.

Alternative VAT Treatments of Noninsurance Financial Services

A number of different approaches with varying merits and limitations—with respect to revenue, administrative and compliance costs, and economic distortions—are available to address the difficulty in taxing financial services under the VAT. Country practices also vary: they span the spectrum from exemption of most financial services (whether rendered for explicit or implicit fees) to the zero rating of financial services rendered by financial institutions. A brief assessment of these approaches and practices is given below.

Basic Exemption

Description

The difficulty with identifying the value of intermediation services and other financial services with implicit fees has led most countries with a VAT to adopt the exemption approach. Under this approach, financial services are generally exempt from the VAT, except that limited fee-based services rendered by financial institutions are taxed, and exported financial services are zero rated. This is the approach adopted by the EU and followed by many other countries. In the EU, member states are required to harmonize their VATs in compliance with the Sixth Directive,5 which mandates the exemption of a broad range of financial services (including insurance),6 while allowing member states to grant their tax-payers the option to treat such services as taxable.7 Belgium, France, and Germany have availed themselves of this option to a limited extent.

While practices vary, most member states of the EU exempt “core” financial services that relate to lending; bank accounts; and dealings in money, shares, and bonds. However, they tax certain explicit fee-based services (so-called “secondary” services) rendered by financial institutions, such as financial advisory services and safe deposit boxes. Financial services are zero-rated if supplied to customers outside the EU or linked directly to exported goods.8 Thus, financial institutions can claim input credits for taxes paid on purchases used in rendering exported financial services. By and large, the EU model has been adopted by most countries in the Organization for Economic Cooperation and Development (OECD).9

Merits and Limitations

Exempting financial services clearly avoids the necessity of ascertaining the value of intermediation services and other services with implicit fees, thus lowering both the administrative costs of the tax authorities and the compliance costs of businesses subject to the VAT. However, as noted earlier, since financial institutions are denied input credits for the VAT paid on inputs associated with the provision of these exempt financial services, the credit chain of the VAT is broken, thus resulting in cascading when these exempt services are purchased by taxable businesses as inputs. The exemption of financial services also results in price distortions that affect households and businesses differently. The consumption of such services by the former would be undertaxed relative to other taxed goods and services (because the value-added by the providers of the exempt services would escape the tax net), while consumption by the latter would be overtaxed (because of cascading). To the extent that the value of explicit fee-based services rendered to consumers and exempt businesses can be readily ascertained, exempting them unduly narrows the tax base and reduces revenue.

While the basic exemption approach lowers the administrative and compliance costs of valuing financial services, exempting financial services increases costs for financial institutions that render both taxable and exempt services because they must calculate the creditable portion of input tax that can be allocated to the taxable services. The complexity of computing allowable input tax credits naturally increases with the complexity of the product lines and activities of the financial institutions.

Reduced Exemption

Description

South Africa follows the EU approach in exempting core financial services but goes beyond it by taxing (since October 1996) almost all explicit fee-based financial services, including nonlife insurance (see below), that are supplied to domestic customers (exported financial services remain zero rated). To effect this outcome, South Africa’s Value-Added Tax Act exempts the supply of any financial services (Sect. 12(a))—unless zero rated (Sect. 11)—but defines most of such services as those supplied without explicit fees (Sect. 2(1)).10

Merits and Limitations

By taxing almost all explicit fee-based financial services, the reduced exemption approach limits the scope of exemption to only intermediation services and other financial services with implicit fees. Compared with the EU’s basic exemption approach, this approach leads to less distortion and a lower degree of cascading on services rendered to businesses making taxable sales. At the same time, however, financial institutions would have an incentive under this approach to bundle more explicit fee-based services provided to consumers with other exempt services to take advantage of the exemption of implicit fees (this incentive is likely to be marginal, however, if the VAT rate is low). Likewise, a distortion can be introduced between different types of financial institutions—some traditionally more explicit fee-based than others—that offer similar services.11 For example, in countries where interest rates are not regulated, banks will probably continue to charge explicit fees for many of the services they provide—even if doing so would render them taxable—to avoid adversely affecting their competitive positions on the loan and deposit rates they can offer.

South Africa’s approach does not eliminate the administrative and compliance costs of the EU’s approach in dealing with the problem of apportioning allowable input tax credits between the remaining exempt services and taxable explicit fee-based services.

Exemption with Input Credits

Description

Singapore, like the EU, exempts a broad range of core financial services if supplied domestically (and zero rates them if exported).12 However, such services are taxable when arranged, brokered, underwritten, or provided with advice in return for a brokerage fee, commission, or other similar consideration.13

To reduce the cascading stemming from exempting financial services used as business inputs—and thus to preserve the competitiveness of the financial sector—Singapore allows financial institutions to claim input credits under either a “special method” or “fixed input tax recovery method.” Under the special method, the regulations treat as taxable supplies exempt supplies made to taxable persons.14 This method requires financial institutions to segregate exempt supplies made to taxable persons but, in effect, zero rates these supplies. In contrast, under the fixed input tax recovery method, a financial institution can claim credit for fixed percentages—differentiated based on industry norms by type of financial institutions—of total input taxes.15 Administratively, the fixed input recovery method is much simpler than the special method, as the fixed VAT recovery ratios apply to all the VAT paid on inputs, obviating the need to compute allowable input tax credits based on taxed services, exempt services, and exported services.16

Following the EU approach, Australia exempts core financial services, but, like Singapore, it also provides partial input tax credits for these exempt services. However, as noted earlier, the intention of Australia’s input tax relief (to limit vertical integration) differs somewhat from that of Singapore’s (to reduce cascading in general). Providers of exempt financial services in Australia are allowed to recover a stipulated 75 percent of the input tax paid on purchases (referred to as “reduced credit acquisitions”) used in rendering such services.17 For example, if a bank’s VAT on inputs used in rendering exempt financial services is $500,000, the bank can claim input credit for 75 percent, or $375,000, of the input tax.

Merits and Limitations

The approach adopted by Australia and Singapore strikes a good balance between policy correctness and administrative simplicity. It addresses in one measure two of the most serious limitations of the exemption approach (irrespective of the basic or reduced variants): cascading and the administrative complexity of apportioning input credits between taxable and exempt sales of financial institutions. This approach does, however, leave some residual cascading in the system, since not all input VAT paid by financial institutions is recoverable. To eliminate all cascading would require the zero rating of financial services (discussed below), which, in addition to imposing a higher revenue cost on the government, has its own distortive effects.

As different types of financial institutions typically have different proportions of taxable and exempt sales, Singapore’s differentiated (by type of financial institutions) fixed input tax credit recovery method based on industry norms seems conceptually preferable to Australia’s method of applying the same fixed recovery ratio to all financial institutions.

Taxing Gross Interest

Description

Argentina imposes the VAT on gross interest on loans. Lenders cannot reduce the taxable interest charged by the interest they pay on deposits. Argentina’s decision in 1992 to tax gross interest was designed to reduce inflation by curtailing consumer demand.18

The standard VAT rate in Argentina is 21 percent. However, interest on loans made by financial institutions covered by the Banking and Financial Institutions Law (BFIL) is taxed at a lower rate of 10.5 percent. Unlike the Israeli approach (see below), Argentine businesses that use loan proceeds in their taxable activities can claim input credit for the VAT imposed on their taxable interest.19 However, consumers and others who make debt-financed purchases and are not able to claim input tax credits must bear VAT on the cash price of their purchases and on the gross interest paid on the loans obtained to finance the purchases.

BFIL institutions charge VAT on a host of services. For example, they charge VAT on investment and financial advice, accounting, investment management, debt collection and credit control, and portfolio management services.20

While gross interest is generally taxed in Argentina under the VAT, a number of exemptions are specified, most notably, interest paid on bank deposits in BFIL institutions, interest paid to certain recognized pension funds, and interest on loans made to consumers to finance home purchases or improvements. The exemptions generally focus on loans that are not related to financing consumption (except housing).

Merits and Limitations

The taxation of gross interest charges simplifies the compliance costs for lenders, especially if they are not permitted to reduce this output tax by their costs of funds used in making these loans. However, it is precisely this simplicity that creates the most significant drawback of this approach: since the gross interest charged by a bank on a loan incorporates the bank’s cost of funds, gross interest exceeds by a wide margin the value added of the intermediation services performed by the bank in making the loan. Hence, this approach significantly overtaxes such services provided to consumers and borrowers making exempt sales.21

Addition Method

Description

While difficult to ascertain directly on a transaction-by-transaction basis, the value added of financial services contributed by a financial institution can nevertheless be calculated by the sum of its wages and profits (the so-called “addition” method of determining value added). The VAT can then be applied directly to this sum.

Israel currently taxes the full value of financial services rendered by financial institutions (including nonlife insurance companies) on the basis of the addition method. This tax is administered by the income tax authority outside the regular (credit-invoice) VAT regime. As a consequence, banks are not allowed to claim input tax credits for the regular VAT paid on their purchases, nor can the tax on the services provided by the financial institutions be recovered by registered businesses that purchase such services.

Merits and limitations

Israel’s approach allows financial services provided by banks to households to be taxed at relatively low administrative and compliance costs, since the tax base can be computed directly from the banks’ accounts. However, this approach results in more cascading than the EU’s basic exemption approach for financial services that are supplied to businesses making taxable sales. Under the EU’s approach, cascading is limited to the banks’ purchased inputs (inclusive of any VAT paid), whereas, under Israel’s approach, cascading extends to the value added originating from the banks themselves.

Zero Rating

Description

To overcome the difficulty of directly taxing intermediation services and other financial services with implicit fees under a credit-invoice VAT, obviate the need to allocate input tax credits between taxable and exempt services, and avoid the problem of cascading if such services are simply exempted, a country could zero rate these services (explicit fee-based services would still be taxable as usual). With zero rating, all financial services are formally in the VAT net, thus allowing financial institutions to claim full input tax credits on their purchases.

New Zealand has recently proposed adopting a limited zero-rating approach—financial services would be zero rated only if they are supplied by a VAT-registered person to another VAT-registered person, except when the recipient of the services is a financial intermediary. At the same time, the definition of financial services would be narrowed. Taken together, these changes are designed to reduce cascading resulting from the exemption of financial services when such services are used as business inputs and the incentive for financial intermediaries to self-supply services that they would normally have sourced from third parties had they been able to mitigate the VAT on these services.22

Merits and Limitations

The zero-rating approach would not only eliminate cascading completely, it would also substantially reduce administrative and compliance costs, since no apportioning of input tax credits would be needed. The value added of zero-rated financial services purchased by businesses making taxable sales would not escape the tax net, since the value of the services is incorporated into the value of the output of the businesses that purchased the services as inputs. However, financial institutions would not bear any burden of the VAT, since input tax credits are fully recoverable by them. The competitiveness of the financial sector is, therefore, preserved.

The zero-rating approach does have limitations. First, the entire value of financial services provided by financial institutions (including the value of taxable purchases by them) escapes the tax net when the services are purchased by households and businesses making exempt sales to final consumers, thus distorting the relative prices of financial services and other taxed nonfinancial goods and services purchased by the same consumers. To the extent that financial services have no close substitutes, this distortion is probably minimal. Second, compared with the exemption approach, the zero-rating approach has a revenue cost. The magnitude of the revenue cost depends on the applicable tax rate, the value added of the financial sector, and the degree of cascading entailed by the exemption approach that is being eliminated by zero rating.23 Finally, if explicit fee-based services are taxed but other services are zero rated, financial institutions would have an incentive, as under the exemption approach, to favor zero-rated services.

By limiting zero rating to business-to-business supplies of financial services, New Zealand’s proposed approach aims precisely to minimize the problematic aspects of the full zero-rating approach, possibly at the price of some administrative complexity.

Cash Flow

Description

A novel cash-flow approach to taxing financial services (inclusive of intermediation services and other financial services with implicit fees) has been proposed by Poddar and English.24 The basic principle can be illustrated by a relatively simple example. Assume that a bank charges 8 percent on its loans and pays 3 percent on its deposits, so that the interest spread is 5 percent. The cash-flow method taxes (say, at 10 percent) the bank on all its inflows and provides a credit on all its outflows. For a deposit transaction of 100, the bank incurs a tax of 10 when the deposit is received but gets a tax credit of 10.3 when the deposit (100) plus interest (3) is withdrawn. The combined tax effect of this deposit transaction is a net tax credit of 0.3. However, the bank typically engages in a loan transaction associated with the deposit. When the loan of 100 is made, the bank gets a tax credit of 10, but it incurs a tax of 10.8 when the loan (100) is repaid with interest (8). The combined tax effect of this loan transaction is a net tax of 0.8. Taking both the deposit and the loan transactions into account, the overall tax effect is thus 0.5, which is the 10 percent tax rate on the 5 percent interest spread. In general, these financial flows have mirror images in the depositor’s and borrower’s accounts, which, for simplicity, have been omitted from the above description. Exported financial services can be zero rated as usual under this method.

Merits and Limitations

While the cash-flow method does allow the taxation of all financial services under a credit-invoice VAT without generating cascading, it is not without limitations. Rules are required, for example, to distinguish between debt and equity flows—equity flows being outside the scope of the VAT. Furthermore, all taxpayers rendering financial services—not just the financial institutions—would be required to calculate the tax on their cash flows. The administrative and compliance costs associated with this requirement are unclear but could be substantial.25

The cash-flow method of taxing financial services as proposed by Poddar and English was commissioned by, and submitted to, the European Commission. No country has so far adopted it. There is, therefore, substantial uncertainty about its administrative implications.

Alternative VAT Treatments of Insurance

In discussing the different VAT treatments of insurance, it is important to distinguish between life and nonlife insurance. The reason is that, while all types of insurance are explicit fee-based financial services (the fees being a part of the insurance premiums), a significant part of life insurance premiums represents savings of the insured and, therefore, should not be taxed under a consumption-type VAT.

Life Insurance

Life insurance is universally exempted from the VAT, irrespective of a country’s VAT treatment of other financial services. This exemption would not lead to cascading, because the purchaser of such insurance is typically the final consumer. However, to the extent that the bulk of the premium of a life insurance policy should not be taxed at all, simply exempting it from the VAT would still allow some VAT elements to remain in the premium. Since life insurance premiums include the value of the intermediation services rendered by insurance companies, the exemption approach represents a compromise that allows the government to collect some revenue on the service provided.

Nonlife Insurance

For VAT purposes, most countries treat nonlife insurance like other financial services. Hence, nonlife insurance is exempt in the EU; taxable in South Africa, where almost all explicit fee-based services are taxed; and taxable in Israel under the addition method. It is also taxable in Australia, New Zealand, and Singapore, which tax explicit fee-based financial services to a lesser extent than South Africa. The economic and administrative consequences of exempting nonlife insurance, including those related to cascading and costs of administration and compliance, are substantively similar to those of exempting other financial services. If nonlife insurance were fully taxed under the VAT (the VAT is payable on the insurance premiums, and the VAT paid on purchases by the insurers is creditable), insurance services would be overtaxed, since a part of the premiums covers expected losses and does not represent value added. To overcome this problem, New Zealand (the leader in taxing nonlife insurance under the VAT), in consultation with accountants and the insurance industry, granted an input credit to insurers for claims paid, based on grossing up the indemnity payments by a “deemed” VAT.

New Zealand’s approach to taxing nonlife insurance can be illustrated as follows. The VAT is charged on insurance premiums. If the insured is a VAT-registered business, then the VAT on the premiums can be recovered as input tax credits under the normal credit mechanism of the VAT. The VAT on the premiums is not recoverable if the insured is a nonregistered person (a final consumer or a business making exempt sales). When an insured makes a claim of 1,000, the indemnity payment is grossed up to 1,100 (assuming the applicable VAT rate is 10 percent) on account of the deemed VAT. The insurer suffers no burden from the grossing-up procedure because it recovers the 100 in deemed VAT as an input credit. If the indemnity payment is received by a VAT-registered business, it must report the deemed VAT as output tax. Hence, neither the tax revenue nor the registered insured is affected by the grossing-up procedure. If the recipient is a final consumer or business making exempt sales, the government recovers the revenue loss (stemming from allowing the insurer to claim a tax credit for the deemed VAT) when the insured uses the proceeds of the indemnity payment (inclusive of the deemed VAT) to purchase taxable replacement goods. Again, the grossing-up procedure has no impact on either the tax revenue or the insured.26

Australia, Singapore, and South Africa follow a similar approach.

Concluding Remarks

In theory, there is little reason to treat the value added generated by financial services differently from that generated by other economic activities. In practice, when the value of financial services is bundled with other charges, it is difficult to measure the value of these services on a transaction-by-transaction basis, necessitating compromises. The choice among the different approaches to taxing financial services (other than nonlife insurance) under the VAT described in this paper—the basic exemption of the EU, reduced exemption of South Africa, exemption with input credits of Australia and Singapore, taxing gross interest of Argentina, addition method of Israel, and, finally, zero rating—must ultimately be made after weighing the revenue consequences against economic distortions and the administrative and compliance costs of each approach. None of the alternatives clearly dominates the others in all aspects. The cash-flow approach is appealing in conceptual terms, but its administrative implications are still unclear. Overall, the exemption-with-input-credits approach adopted by Australia and Singapore, which amounts to a hybrid of the basic exemption and zero-rating approaches, seems more effective than others in limiting cascading in an administratively simple manner. Hence, it deserves the attention of policy-makers. New Zealand’s recent proposal to zero rate business-to-business supplies of financial services is intriguing and holds promise, but its administrative implications are yet to be assessed.

As regards nonlife insurance, New Zealand’s approach should be considered by countries that currently exempt this service.

*This paper was originally published under the title “Treating Financial Services under a Value Added Tax: Policy Issues and Country Practices,” Tax Notes International, Vol. 22 (June 2001), pp. 3309-16. Minor modifications have been made to reflect recent developments in New Zealand, as well as for editorial purposes.
1For additional discussions of these issues, see Peter R. Merrill, Taxation of Financial Services Under a Consumption Tax (Washington: American Enterprise Institute, 1997); Alan Schenk, “Taxation of Financial Services Under a Value Added Tax: A Critique of the Treatment Abroad and the Proposals in the United States,” Tax Notes International, Vol. 9 (September 1994), pp. 823-841; and Alan Schenk and Oliver Oldman, Value Added Tax: A Comparative Approach, with Materials and Cases (Ardsley, N.Y.: Transnational Publishers, 2001).
2Taxable services include zero-rated exports of financial services that are exempt if supplied domestically.
3For a numerical illustration of how breaking the credit chain would lead to cascading, see Howell H. Zee, “Value-Added Tax,” in Parthasarathi Shome (ed.), Tax Policy Handbook (Washington: IMF, 1995), pp. 86-99. It is important to note that the concept of cascading means much more than a tax-on-tax effect (which may well be quantitatively insignificant). Breaking the VAT credit chain actually involves, in addition, the multiple taxation of the same value added.
4The Sixth Directive of the European Union (EU) contains a self-supply rule. Australia attempts to limit vertical integration by providing targeted partial input tax credits associated with exempt supplies. Singapore also grants partial input tax credits to exempt financial service providers but largely for somewhat different reasons, as discussed later.
5Treaty Establishing the European Economic Community, March 25, 1957, 298 U.N.T.S. 11, 76, Art. 99. This rule is incorporated in the recently signed Treaty of Amsterdam, May 1999, Art. 93. See also the Sixth Council Directive of May 17, 1977, “On the Harmonization of the Laws of the Member States Relating to Turnover Taxes—Common System of Value Added Tax: Uniform Basis of Assessment,” Official Journal No. L145.
6Sixth Directive, Art. 13(B)(a) and (d).
7Sixth Directive, Art. 13(C). Member states may restrict the scope of this right of option and shall fix details of its use.
8Sixth Directive, Article 17(3)(c).
9For a survey of OECD country practices, see OECD, Consumption Tax Trends (Paris, 1995).
10For a detailed discussion of the VAT treatment of financial services in South Africa, see Chris Beneke (ed.), Deloitte & Touche VAT Handbook, 4th ed. (Durban, South Africa: Butterworths, 1997).
11The extent of this distortion would clearly depend on the degree of substitutability between such services (for example, between an account in a deposit bank and one in an asset management firm), which tends to correlate positively with the depth and breadth of the financial sector.
12See Goods and Services Tax Act, Sect. 21 and 22 and Fourth Schedule. In fact, Singapore allows input credits for tax on purchases attributable to supplies in currency exchange and loan, credit, or advance transactions that are made outside Singapore by overseas branches. See Reg. 31(l)(b) of the GST (General) Regulations.
13See Goods and Services Tax Act, Fourth Schedule, Para. 4(1).
14Reg. 30(2) of the GST (General) Regulations.
15Authority for these exceptional methods is provided by Goods and Services Tax Act, Sect. 20.
16For 1997, the fixed VAT recovery ratios ranged from 58 percent (finance companies) to 98 percent (off-shore banks). See Glenn P. Jenkins and Rup Khadka, “Value-Added Tax Policy and Implementation in Singapore,” International VAT Monitor, Vol. 9 (March/April 1998), pp. 35-47.
17See A New Tax System (Goods and Services Tax) Act 1999, Div. 70 and Regulation 70-2 and 70-3.
18For this argument and a discussion of the recent history of the taxation of financial services in Argentina, see Cristian E. Rosso Alba, “Taxation of Financial Services Under the Value Added Tax: A Survey of Alternatives and an Analysis of the Argentine Approach,” International VAT Monitor, Vol. 6 (November/December 1995), pp. 335-49. The Argentine VAT does not tax imports of financial services and zero rates such services when they are exported.
19Argentina does not refund excess input credits. Businesses with large loans that are in an excess credit position can carry forward these input credits only to offset future VAT liability.
20See Alba (1995), “Taxation of Financial Services Under the Value Added Tax.”
21Business borrowers that use the funds in making taxable sales are not penalized by this approach, however, as the input credit eliminates the VAT burden on the loan.
22For details, see GST and Financial Services: A Government Discussion Document (Inland Revenue Department, New Zealand, 2002).
23Of course, the difference in the revenue cost between the two approaches could be small if, under the exemption approach, exempt financial institutions are still allowed, as in Singapore, a partial recovery of their input taxes.
24See Satya Poddar and Morley English, “Taxation of Financial Services Under a Value-Added Tax: Applying the Cash-Flow Approach,” National Tax Journal, Vol. 50 (March 1997), pp. 89-111. The authors’ proposal has formed the basis of a detailed report recently submitted by Ernst & Young to the European Commission entitled The TCM/TCA System of VAT for Financial Services. This report is available directly from the EU.
25To alleviate such costs, Poddar and English have proposed a system of tax suspense accounts (known as “tax calculation account,” or TCA) for registered taxpayers that essentially obviates any actual tax payment before a financial transaction is unwound. However, since an intertemporal dimension is being introduced in this regard, the “time value of money” needs to be taken into account, which, in turn, necessitates the problematic choice of an appropriate discount rate.
26For more detailed discussions, see Thomas S. Neubig and Harold Adrion, “Value-Added Taxes and Other Consumption Taxes: Issues for Insurance Companies,” Tax Notes, Vol. 61 (November 1993), pp. 1001-11.

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