Alba, Cristian E. Rosso, 1995, “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, pp. 335–49.
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Jenkins, Glenn P. and Rup Khadka, 1998, “Value-Added Tax Policy and Implementation in Singapore,” International VAT Monitor, Vol. 9, pp. 35–47.
Poddar, Satya, and Morley English, 1997, “Taxation of Financial Services Under a Value-Added Tax: Applying the Cash-Flow Approach,” National Tax Journal, Vol. 50, pp. 89–111.
Schenk, Alan, and Howell H. Zee, 2004, “Treating Financial Services Under a Value Added Tax: Conceptual Issues and Country Practices,” in Taxing the Financial Sector: Concepts, Issues, and Country Practices, ed. by Howell H. Zee (Washington: International Monetary Fund), pp. 60–74.
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)| false Schenk, Alan, and Howell H. Zee, 2004, “ Treating Financial Services Under a Value Added Tax: Conceptual Issues and Country Practices,” in Taxing the Financial Sector: Concepts, Issues, and Country Practices, ed.by ( Howell H. Zee Washington: International Monetary Fund), pp. 60– 74.
Helpful comments from Barrie Russell and Victor Thuronyi are gratefully acknowledged. The usual disclaimer applies.
The relative size of the financial sector is smaller, of course, in developing countries, but it would still be on the order of about 10 percent of GDP on average.
One important reason for the world-wide prevalence of the invoice-credit method is surely the fact that it is the only method that can accommodate multiple VAT rates, which many countries undoubtedly found attractive at the time of the VAT’s introduction. Most countries, except those in Western Europe, have now moved to a single-rate VAT on account of both efficiency and administrative considerations.
Or on a cash-flow basis—discussed later in the paper—as some have recently proposed.
Israel is currently the only country that taxes the financial sector on the basis of an addition-method VAT. It is essentially a separate tax from the invoice-credit VAT that is applied elsewhere in the economy. Since the addition-method VAT is not a creditable tax for the invoice-credit VAT, Israel’s simultaneous application of the two methods actually results in substantial cascading.
The principles of the VAT in the EU are laid down by its Sixth Council Directive (see Council of the EU (1977)), as amended and modified by later directives. Art. 13(B)(a) and (d) provide for the exemption of financial services (including insurance), although Art. 13(C) allows member states to grant their taxpayers the option to treat such services (not including insurance) as taxable. Financial services (including insurance) are zero-rated if exported to outside the EU (Art. 17(3)(c)).
For a illuminating description of the conceptual and administrative problems encountered by Mexico in apportioning creditable and noncreditable input taxes in the banking industry, see Schatan (2003).
The stipulated proportion of creditable input VAT can vary across different industries, as in Singapore (the creditable proportion ranges from 58 percent (finance companies) to 98 percent (offshore banks)—see Jenkins and Khadka (1998) for a discussion); or fixed, as in Australia (75 percent—see Australia (1999), Div. 70 and Regulation 70–2 and 70–3). It is interesting to note, however, that Australia and Singapore arrived at these proportions based on entirely different conceptual considerations. For Australia, the creditable proportion is designed to neutralize, on average, the self-supply bias that is engendered by a VAT exemption, i.e., the bias an exempt business has towards providing the needed services in-house rather than procuring them from third parties to avoid paying the non-creditable VAT. For Singapore, the various creditable proportions are designed to reduce the forward cascading of the VAT when the output of a VAT-exempt business is purchased by VAT- registered businesses.
This is known in New Zealand as the zero-rating of B-to-B transactions and in Singapore as the special method of obtaining input VAT credits, under which exempt sales are treated as taxable sales (for purposes of crediting the input tax) when made to taxable persons.
In fact, since a VAT-registered business typically produces a mixture of taxable and exempt supplies, as a practical matter New Zealand’s application of the zero-rating of B-to-B transactions is restricted only to cases where the VAT-registered business purchasing financial services has taxable supplies that are at least equal to 75 percent of its total supplies (this threshold effectively rules out the zero-rating of transactions between financial institutions). As of the writing of this paper, it is unclear what guidance New Zealand’s tax authorities would provide to financial institutions to categorize their customers on the above basis.
The idea of taxing financial intermediation services on a cash-flow basis was developed earlier in Hoffman et al. (1987).
For example, European Commission (2000) provides details on how the cash-flow approach would be applied to different security transactions, derivatives, and insurance services. Similar details would need to be worked out under the reverse-charging approach to cover a wide spectrum of intermediation activities carried out by the financial sector. Such details are beyond the scope of the present paper, whose aim is merely to lay down the principle of this approach.
The EU’s Sixth Council Directive contains a reverse-charging provision in Art. 9(2)(e).
This outcome in fact resembles that of a tax on gross interest—a measure adopted by Argentina largely to curb consumer borrowing. See Alba (1995) for details.
Hoffman et al. (1987) also discussed reverse-charging (although this term was not used by the authors) but quickly dismissed it as a possible solution on account of the problem just described.
However, because the interest margin may change during the interim (due to new deposit-taking and lending activities), the net VAT liability on an existing fixed-interest loan may still vary from one period to the next.
To split this tax between depositors and borrowers under the cash-flow approach, Poddar and English (1997) and European Commission (2000) propose the use of an appropriately chosen indexing interest rate that normally would lie between the deposit and the loan rates. The share of intermediation services to be imputed to depositors and borrowers would be determined, respectively, by the excess of the indexing rate over the deposit rate and the excess of the loan rate over the indexing rate.
Huizinga (2002) has recently proposed combining the zero-rating of financial services as business inputs (the New Zealand measure) with taxing only transactions between financial institutions and consumers on a cash-flow basis. This proposal would reduce the scope and thus the complexity of cash flow calculations and yet manage to address the problems of both overtaxation and undertaxation described earlier. However, under this approach, banks would still be required to separate its transactions with registered businesses from those with final consumers, which remains an unnecessary administrative complication.