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VAT - Looking Ahead

10 November 2008 / Peter Jenkins

PETER JENKINS, global head of indirect tax at Ernst & Young, examines current VAT treatment of public bodies and the exempt sectors and how it may change as part of the European Commission's work programme to reform the Sixth Directive.

PETER JENKINS, global head of indirect tax at Ernst & Young, examines current VAT treatment of public bodies and the exempt sectors and how it may change as part of the European Commission's work programme to reform the Sixth Directive.

FROM AN ECONOMIC point of view, the effects of non-business treatment (often referred to as outside the scope of VAT), exemption and reduced rates are broadly similar: output tax need not be charged but input tax not recovered under the first two scenarios while in the third, output tax is charged at a rate below the standard rate, and input tax is recovered in full. Exemption with refund (zero rating) is another matter altogether, as it produces a fiscal privilege. Achieving neutrality between exemption and a reduced rate is possible, but the level of the reduced rate required for this will depend on the level of the standard rate (applying to inputs) and the pattern of expenditure of the body concerned, i.e. how much of the 'cost components' attributable to its reduced rate outputs are VATable, and at what rate. For a charity, the 'neutral' effect may be produced by a reduced rate of between two and three per cent; for a bank with higher VAT bearing expenditure, it may be between four and five per cent. For a bank in Sweden, where the standard rate is 25 per cent, and there are few relieved inputs, the neutral rate for a bank may be as high as six or seven per cent.

The purpose of this article is to explore the connections between the three types of relief allowed in the European Union VAT system, and what may be in store as the European Commission moves to the next stage of its work programme designed to reform the Sixth Directive.


Taxable activities


Activities of state, regional and local government authorities, and other bodies governed by public law acting as such, are outside the scope of VAT even if they collect specific fees and charges, e.g. passport fees (Article 4(5) of the Sixth Directive). Private persons fulfilling functions for the state are generally subject to tax and the fact that the duties are regulated by law in the public interest does not alter the situation. See for example, the Dutch notaries case, European Community Commission v Netherlands (Case C-235/85) and the Spanish case concerning private tax collectors, Ayuntamiento de Sevilla v Recaudadores de las Zonas Primera y Segunda (Case C-202/90) [1993] STC 659. Public bodies providing services for fees which compete with private provision must account for VAT on those services (for example the Italian Comune case (Case C-231/87) [1991] STC 205 where the local authorities provided funeral services in competition with private traders). The activities listed in Annex D are automatically treated as taxable, even if they are carried out by a public or state body. This includes, for example, telecommunication services, but there must be consideration.

There are some problems with borderlines. For example where air traffic control bodies provide a monopoly service in the skies over their country, and are in the public sector, is there a case for saying that nonetheless they should be treated as taxable persons because some air traffic controls, e.g. in Germany, have been privatised and once registered can recover VAT on their costs, so making their charges to airlines cheaper? This argument was accepted in the United Kingdom, where, following intensive lobbying by Ernst & Young on behalf of the major international airlines, taxable treatment was granted to the United Kingdom air traffic control body while it was still in the public sector.


Privatisation issues


What degree of privatisation turns a public body into a private one for Article 4(5) purposes? How should legally separate subsidiaries and affiliates of public bodies be treated? In particular, what is meant by the phrase 'governed by public law'?

Activities exempted in Article 13A include financial services, insurance, postal services carried out by the public postal services of a Member State, private health and dental care, and a wide range of social welfare provision including education and the care of the old and sick, as well as certain cultural, fund-raising and sporting activities. The United Kingdom was slow to realise that subject to various conditions applicable to the scope of exemptions, they are all mandatory (see for example the effect of Yoga For Health Foundation v Commissioners of Customs and Excise [1984] STC 630) in requiring the proper implementation of Article 13A(1)(g).

Postal services

Postal services are on the Commission's target list for reform, and the clear intention is to remove the exemption to prevent distortion of competition with carriers (particularly of parcels) in the private sector. Sweden and Finland already treat all postal services as taxable, except, following protests from other Member States, for international postal settlements between postal authorities.

A draft postal services directive has been expected for some time, but there have apparently been political difficulties with this, and the Commission is still considering the requests of some Member States to allow a continuing exemption for the letter post for social reasons. The proposal may get swallowed up in a more general review of public bodies and, if it does proceed separately, there is no certainty that it will be unanimously agreed by the Council of Ministers in the near future.

However, as postal services are put through the process of privatisation in different stages in the Member States, real questions arise about how far down a change of supply the exemption should apply. For example, in the case of public postal authorities, should wholly owned subsidiaries taking over from former divisions be treated as part of the public postal services if they are semi-privatised in the sense of having a commercial structure and objectives and not being wholly controlled and managed by the state? Again, what degree of privatisation would take a postal service out of public sector treatment under the current rules? It is already the case that only the national postal authority enjoys exemption in a particular Member State, so that if, for example, the French post office provides services to customers in Belgium, they will not enjoy exemption.

Financial institutions

The exemptions for financial and insurance services in Article 13B are essentially a form of taxation, probably equivalent to about a five per cent impost on the outputs of financial institutions at the United Kingdom standard rate. Substituting the exemption for some form of margin scheme is in principle an attractive option for the Commission, because it removes a major complexity and source of dispute in the operation of the tax (partial exemption) and, above all, achieves greater neutrality (because taxable persons would no longer be burdened with hidden VAT on exempt charges by financial institutions).


Professor Poddar


Hence extensive studies by Professor Poddar of Ernst & Young, Canada were commissioned. The professor's conclusion was that a margin scheme based on the cost of borrowing and the cost of lending measured against the true interest rate could be the basis of a successful application of VAT to banks and insurance companies on their outputs, and would be compatible with a credit invoice system operating on the full value of inputs and outputs applicable to other traders. It could moreover be applied successfully to all types of financial services, not just borrowing and lending, including all types of insurance and derivatives trading.

However, the economic impact of Poddar's scheme would be to remove VAT on banking costs for taxable persons, and significantly to increase the VAT paid by final consumers, especially in sensitive areas like credit cards where interest rates tend to be extremely high measured against the cost of borrowing measured by the true rate of interest (for which a convenient proxy is the cost of borrowing to the Government). Although it would remove the complexity in the complications of partial exemption, the banks, not so much in the United Kingdom but certainly in countries like Germany, have proved very hostile to Poddar. It is unlikely that a Poddar style margin scheme, even on a simplified basis, will be acceptable to the financial sector or prove politically acceptable in the near future.


Health and social exemptions


The Commission would also like to begin reviewing and reforming the health and social exemptions in Article 13, particularly where precise definitions and borderlines are unclear and where, as a result, Member States are applying different treatment. For their part, many charities and voluntary bodies have come to dislike exemption because of the effect it has on their input tax recovery, especially where they make supplies to taxable persons or, in the Member States where this is applicable, to local authorities and other state bodies with special rights to recover input tax. At least in theory, a different VAT model, based on moving voluntary bodies squarely into the tax, a model would produce a demonstrably better result for charities. This would involve removing the exemptions, extending the scope of business treatment to cover any case where outputs occur and charges are made (even in the realm of social welfare), and allowing full input tax deduction for fund-raising activities and activities such as sea rescue where no charges are made.

However, as discussed above, the rate charged on charities' outputs would have to be a reduced rate for this system to be neutral, and a major difficulty is that the reduced rate would have to be no greater than two to three per cent in the United Kingdom, in other words below the five per cent minimum reduced rate allowed in the Rates Directive. The Commission's view is that the Member States collectively would not find this acceptable; but a five per cent reduced rate on charity outputs would almost certainly lead to them paying more tax, particularly in countries such as the United Kingdom with a relatively low standard rate and substantial VAT relief on inputs, particularly for charities, through zero rating.

It looks therefore as if a trade-off between exemptions and reduced rates for social welfare charities would not be achievable, essentially because Member States would find the super reduced rate necessary unacceptable.


Reduced rates


Turning to the reduced rates in Annex H (which are at present entirely at the discretion of each Member State), the current position is that they are on the Commission's work programme to review at the end of 2003, when the experimental reduced rate for intensive service industries comes to an end and will be reviewed.

The Commission's present thinking is that there should be a core of mandatory reduced rates not lower than five per cent applicable in all Member States, and then a wider but still fairly restricted number of reduced rates, e.g. for the tourist industry, which would be applicable in Member States that wanted to use them. There is likely to be a good deal of disagreement and debate between the Member States over what should go in the core list. The present Annex H was relatively easy to negotiate because it was purely discretionary. However, there can be considerable political pressure for the reduced rates available to be implemented in particular Member States, particularly where there is a strong and active lobby, as there was in the United Kingdom for one pharmaceutical product, sanitary protection. At one stage, this cause produced more pink 'MP case' files in Customs than any other, and thinking up new arguments for standing firm against a concession was the first task of most graduate recruits.

On a comparison of Annex H and Article 13, there is potentially significant overlap between particular reduced rates allowed under Annex H, and mandatory exemptions in Article 13. An example of this is the reduced rate for charities in Category 14, although this does include the proviso 'in so far as these supplies are not exempt under Article 13'. Since most social welfare activities are covered by the exemptions in Article 13 when supplied by charities, what exactly is the point of Category 14? Given that the legislator is presumed not to have drafted in vain, the only logical explanation is that Category 14 is intended to cover certain limited trading activities of charities, for example the sale of goods produced in workshops for the blind. But could the category also cover fund-raising sales, for instance of Christmas cards? Other clear overlaps are Category 7 with Article 13A(1)(n), and Category 13 with Article 13A(1)(m). However, on analysis there are many other potential overlaps and confusions.




It is clear that from an economic point of view the VAT system would work more efficiently and more neutrally if, so far as possible, special treatment for public sector bodies was removed, and the exemptions replaced either by a margin scheme (in the case of financial services) or by a switch from exemption to reduced (or super reduced) rates. It is doubtful, however, if this logical process will be politically acceptable, certainly as long as unanimous consent is needed to pass Community Directives dealing with taxation.

From the Commission's point of view, the current system is a mess, made worse by differences of interpretation and treatment by the Member States of the provisions. A particular problem as far as the Commission is concerned is the fact that around six Member States have special rules for the recovery of VAT on non-business activities by state bodies which are outside the VAT system (for example our provisions for local authorities and the National Health Service - see sections 33, 33A and 41, VAT Act 1994). This difference in treatment between the Member States makes reform particularly difficult, as the economic and fiscal impact of any change in the treatment of public bodies would differ according to whether Member States had such a scheme or not, and this could lead to huge budgetary problems.

Similarly, while a switch from exemption to reduced rates may be logical and appealing for those wishing to reform the tax and make it more neutral, it is unlikely to be acceptable to the health, education and charity sectors unless its effect is kept neutral, which would in many Member States mean allowing super reduced rates below the five per cent minimum currently allowed. Nor do the Poddar proposals for a margin scheme for financial services look like having much serious chance of making progress.

In short therefore, the exemptions are likely to remain, perhaps with some tidying up, and the real focus therefore will be on the reform of the treatment of public bodies generally and the reduced rates in Annex H. The Commission's proposal for a mandatory core list of reduced rates will lead to major lobbying opportunities in the United Kingdom, where the use of reduced rates is still low (and until recently there were none). The continuation of zero rating in the United Kingdom is probably safe for the time being (because of its political sensitivity here and because the transitional period under which it is allowed shows no signs of coming to an end), but this may have blinded some industry sectors, e.g. the pharmaceutical industry, to the possibility of lobbying hard for their products to be given a reduced rate, particularly where most Member States already do so.

To be effective, this process should begin now, should be informed by accurate information about the situation in the Member States, and should where possible be co-ordinated and directed on a pan-European Union basis rather than just in the United Kingdom.

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