Value Added Tax in the GCCInsights by industry | Volume 1Financial Services & Insurance chapter

Ninety years in the Middle East

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Why VAT, financialservices andinsurance are adifficult combination

Chapter 6 – Financial services and insurance industry

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Not much has been said publicly by thegovernments of the GCC as to how theyexpect VAT to apply to the financialservices and insurance sectors, at leastnot in its totality. However, the problem forpolicy makers is that unfortunately tryingto successfully1 apply normal VAT rules (i.e.to tax instead of exempting them) to agood number of insurance and financialservices transactions is exceptionallydifficult to achieve. Theoretically it ispossible to tax all such services, butsufficient practical challenges remain as tomake achieving that objective a somewhatdistant prospect, despite almost fourdecades of governmental effort in thisspace.

These challenges include:

“They are too difficult to tax” The “value” for VAT purposes, particularlyin the context of margin-basedtransactions, is almost impossible todetermine accurately and consistently ona transaction-by-transaction basis.Undertaxation (leaving the treasury out ofpocket) or, worse, overtaxation (taking toomuch out of the pockets of taxpayers)could arise leaving both suppliers andconsumers in an uncertain position withrespect to their obligations and rightsrespectively.

“Taxing financial services andinsurance is to tax the wrong thing” Financial intermediation, and the assetsunderlying it, represents the means ofconsumption and not consumption itself.Moreover, by taxing potentially investableassets you could choke off economicactivity at its genesis, something that isgenerally best avoided. Bearing in mindVAT is designed to be a tax onconsumption, not savings or investment,

an obvious tension exists in this particularcontext.

“Exemption is the preferred approach.Everyone does it”As far back as 1918, banking transactionswere exempted from turnover taxes inGermany. The 29 member states of theEuropean Union have all implemented VAT exemption extensively as requiredunder the Principal VAT Directive and itspredecessors. The legacy of VATexemption is vast, therefore, and wellrehearsed. To some extent the inertia hasat least become somewhat self-fulfilling.

Yet unfortunately VAT exemption createsas many problems as it solves. It is animperfect answer to a difficult questionand, as a result, is a topic that garnersmuch attention from the industry’sprofessional advisors, governments andacademics alike, all of whom object to oneor more of the following impacts, amongstother things:

CascadingThe “locking-in” of irrecoverable VAT into asupply (i.e. it is essentially hidden within aVAT exempt cost), resulting in increasedcosts for borrowers even where theborrower might otherwise normally beable to deduct VAT.

Low-tax VAT regime bias Encouraging financial service andinsurance providers to source servicesfrom jurisdictions that apply a lower rateof VAT, or have no VAT whatsoever.

Liability boundary disputes A costly issue for most businesses lockedin discussions with tax authorities overwhat should or should not be exempted.

1. Success is of course a subjective matter to some extent. In this case we define success as being one inwhich the risk of under or over-taxation of the service has been removed, and that input tax credits canbe accurately attributed to the recipient of the service.

Theoretically it is possibleto tax all such services,but sufficient practicalchallenges remain as tomake achieving thatobjective a somewhatdistant prospect, despitealmost four decades ofgovernmental effort inthis space

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Vertical integration biasVAT costs arising on outsourced servicescreate an incentive to in-source,potentially inefficiently.

Regulatory tension The financial services and insurancesectors, so often required to restructure in part in order to meet new regulatoryobligations, finds itself at risk of bearingadditional VAT costs brought about byreorganization efforts.

Nevertheless, we are witnessing a gradualshift in the trajectory of policy thinking thatis beginning to create a new ‘normal’ forthe industry, particularly in those countriesthat have introduced VAT comparativelyrecently.

Recognizing the inherent challenge ofvaluing, and taxing, individual transactionsoften sold on aggregated interest margins,one obvious place to start is with anythingthat is not aggregated or which is at leastvalued explicitly in the normal course ofbusiness. Generally speaking, agentsarranging supplies of financial servicesand insurance do just this, charging anexplicit fee for their services to theprincipal or the customer, as the case may be. Principals themselves also chargeexplicit fees for a range of financialservices and insurance: cheque bookissuance charges, and credit cardmembership and administration fees, for example.

In the alternative, or indeed incombination with this taxation approach,is the option of simplifying VAT recoveryfor institutions making VAT-exemptsupplies of financial services andinsurance. Essentially this requires thesetting of a guaranteed VAT recovery rate

for institutions2 and the removal of asignificant portion of hithertoirrecoverable VAT costs from their financialstatements. This presumes of course thatthe benefits of VAT recovery are indeedpassed on in the form of lower costs, andthat the institutions themselves revert toinvesting ‘normally’.

More radical approaches include enablingfinancial service and insurance providersto “opt to tax”3 otherwise exempttransactions, or potentially applying azero-rate4 (the transaction is not subject toVAT but the institution is entitled torecover VAT on costs in full) on business-to-business transactions in order tomitigate the risk of hidden VAT cascadinginto borrowing costs and disincentivizinginvestment decisions.

But, no single best practice has emergedas the leading candidate for wholesalerevalidation of the VAT treatment of thesector at this time. To some extent this is

down to a desire to retain simplicity on thepart of governments. In other cases it isdue to the highly theoretical, technical andadministratively cumbersome aspects ofthe alternatives amongst other things. Inshort, the alternatives to exemption createnew challenges.

We are witnessing agradual shift in thetrajectory of policythinking that is beginningto create a new ‘normal’for the industry,particularly in thosecountries that haveintroduced VATcomparatively recently

2. Singapore has implemented a fixed rate recovery scheme for businesses that choose to opt into it3. Certain countries in the EU have implemented this measure4. Only New Zealand has implemented this approach to date

This table deals with the supply-side of the transaction, not the treatment of VAT on purchases

Principal or Agent

Principal

Agent

* Partly through Z/R B2B** Recent development

Charge type

Implicit marginExempt/Option to Tax**

E/OTT**

E/OTT**

E

T

T

T

T

T

Tax model development trajectory

Explicit fee

Explicit fee

1978EuropeanUnion

1997SingaporeSouth AfricaAustralia

1985-2014China New Zealand*

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What does this mean for financialservices and insurance?As a result of the policy challenges,traditionally financial services andinsurance businesses are amongst themost VAT complex businesses. Theyusually end up with multiple challenges all of which are practical issues.

On the sales side, businesses will usuallyend up with multiple VAT liabilities on theirsupplies and for now at least financialservices and insurance businesses willneed to consider a series of variables aswe await the final policies.

That said, inevitably, as discussed earlier,there is a high chance of some form ofexemption. That being the case, thebusiness has to carefully review itsproducts and consider the potential VATliability. Inevitably this leads to a one offexercise during the implementationprocess of categorization and review ofcontracts. However, there is an also anongoing challenge: increasingly financialservices and insurance are being bundledand personalization of the productsprovided is becoming common – what wasprovided yesterday, will change tomorrow.

Unfortunately VAT law very rarely keepspace with the speed of business changeand thus categorizing new servicesbecomes a process challenge. You couldhave hundreds of unique productsespecially if you have staff allowed adegree of latitude in what they sell tocustomers – this can require a dynamicdecision making process and/or guidancefor sales staff which may end uprestricting what they can sell. Finally it isnaïve to think that once a business hasdecided what it thinks the VAT liability is,the tax authority will agree – so it becomesa VAT technical issue with, as we

mentioned earlier, liability boundarydisputes being common and highlycomplex to deal with.

Almost always, even though there is anexemption, because financial services andinsurance businesses are usually veryimportant for foreign trade earnings,government usually allows some form ofzero-rating for exported financial servicesand insurance (exports here probablywould mean outside the GCC but thisremains to be seen). This comes with thebenefit of VAT recovery, but usually thereare conditions attached to achieving zero-rating and identifying those supplies (inorder to enhance VAT recovery) becomesan issue.

Finally VAT has an impact on thecustomers of the financial services andinsurance businesses that has a veryunique effect on them because of wherethey sit in the supply chain.

There are opportunities in this – manybusinesses will be facing cash flow andworking capital demands that neverpreviously existed and therefore demandfor short term financing becomes morecommon place. Financial services andinsurance businesses will need toconsider how they respond to this – andlikewise, what about, as referred to inChapter 4, the short term demand for newcars before January 1 2018 – who is goingto provide all that finance?

There are also challenges – by way of anexample, insurers face a double challenge.The first of these is that if VAT is due onpremiums, can they pass this cost on? And remember, insurance premium tax in Europe has long been seen as theequivalent of VAT for the insurance trade,but it is far more logical to use the VAT

But, no single bestpractice has emerged asthe leading candidate forwholesale revalidation ofthe VAT treatment of thesector at this time

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system, so one must not assume anexemption will apply, though of course this is not known right now.

The second challenge for both the insurerand insured is the cost of insurance (inessence a variation on the cascading issuereferred to earlier). On the retail insurancebusiness, yesterday if you had a caraccident and the insurer paid the bill forthe repair, there was no VAT, tomorrowthere will be. Instantly the insurable valuehas increased and the insurer will need toconsider its premium pricing. In contraston the business insurance side, insurersneed to ask themselves – do I need toinsure the VAT? Surely if the business is

fully taxable it will be able to deduct theVAT it might incur on a repair work to itscar fleet. If that is the case, the premiummay be overstated if this is not identifiedand VAT excluded from the insurablevalue.

Once you have overcome the issues inrespect of VAT on sales of services and

the impact on customers, the next issuebecomes the vexed question of VATrecovery. If there is an exemption, thebusiness will not be entitled to recover VAT that relates to those supplies. Theproblem in the world of services andfinancial services and insurance inparticular is that very rarely is itstraightforward to identify a cost and whatit directly relates to – inevitably there issome debate and a great deal of costsincurred by the business that fall into thecategory of ‘general overhead’. This thenmeans the business needs a process todecide what proportion of the VAT it incurscan be recovered – this adds a furtherburden on the AP function.

In many countries around the world thisbecomes a very complex (effectively)management accounting process oftenrequiring negotiation and agreement with the tax authorities. In a minority of countries there are fixed industrypercentages that can be applied (notablyin Singapore), this is a welcome relief forthose otherwise charged with doing the

calculations, but often such blanketrecovery rates don’t truly reflect the costbase and, whilst simple, often lead tounfairness in terms of the level of recoveryachieved.

Finally, because VAT becomes a cost on purchases, financial services andinsurance businesses inevitably start tothink about how to reduce it. Sometimesthis affects behavior in quite startlingways, and the most startling of these isvertical integration as referred to above.Essentially the benefit of verticalintegration arises from the fact that, veryspecifically, salary costs do not incur a VATcharge. It is therefore more efficient, froma VAT perspective, to employ peopledirectly than it is to outsource. Thetemptation therefore is not to outsource,and in fact to consider insourcing – orbuying the business that was providingyou with services and vertically integratingit thereby generating an overnight savingof 5% of the salary cost of the purchasedbusiness.

What all this means is that along with allthe challenges faced by any otherbusiness, financial services and insurancebusinesses inherently have their own veryspecial issues, which are perhaps amongstthe most complex in terms of VATtechnicalities and business practicalities.They are also faced with perhaps morecomplex uncertainties than many otherbusinesses whilst we await the detail ofthe law and so will be more tempted todelay implementation, whilst, somewhatperversely, having the most complex VATissues.

What all this means is that along withall the challenges faced by any otherbusiness, financial services andinsurance businesses inherently havetheir own very special issues, which areperhaps amongst the most complex interms of VAT technicalities andbusiness practicalities

Deloitte | Value Added Tax in the GCC | FSI industry

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