VAT on financial services and FinTech: The story of the CFO and the need for reform
George Liasis 11:41 - 14 March 2023
For my intervention at the 6th IMH Cyprus International Tax Conference, held a couple of weeks ago, I was supposed to cover the subject of VAT on financial services and FinTech from a VAT technical perspective. I was the only speaker on VAT, in a house full of direct tax people, and this made me fear I would be in the receiving end of significant booing.
So, I decided to trick them by disguising a technical presentation inside a story. The story of the CFO. Here it is…
The year is 1977. The CFO of an EU bank, going through the news headlines, reads that EU lawmakers, after reaching an agreement have adopted the sixth VAT directive, aiming to introduce a harmonised VAT law throughout the troubled European Union.
The life of this CFO was hard overall, but he was happy that VAT was not going to be one of his big concerns. You see, when VAT was introduced, because of the difficulty in taxing margin based financial services, and for other socioeconomic reasons, it was decided by European policymakers that financial services should remain VAT exempt.
The EU VAT directive included therefore, seven simple, generic definitions, which covered, as VAT exempt, the financial world of that era. Income wise therefore, our CFO had minimal worries. He had of course the side problem of non-recoverable input VAT on expenses, but that was not a significant issue for him because, you see, back then, banks and other financial institutions, predominantly insourced all their needs.
As the years passed and the financial liberalisation arrived, from the mid-80s to the millennium, the life of this CFO became much more complex. His bank now provided many more financial services in the sphere of securities, derivatives, underwriting, participation in M&As, private banking and many, many more, including the very difficult area of transactions concerning money, payments and transfers, requiring significant investment in technology.
Most importantly, his Bank was rethinking its operating model. She was going cross border rapidly, started focusing on core functions, outsourcing non-core and slowly but steadily started going digital, purchasing a variety of services from different sources. All these expenses had VAT charged on them which remained a cost.
The CFO now had too many items in his plate, and, sadly, VAT was becoming one of them.
The 1977 definitions were too generic to fit this new world of financial services. There was huge uncertainty in terms of defining what is VAT exempt and what is subject to VAT. Different European countries applied the definitions differently. Harmonisation on this matter was thrown out of the window. In addition to the uncertainty, the irrecoverable VAT cost of the Bank, skyrocketed. This CFO was living a nightmare. His CEO and his Board of Directors were furious. Music in the ears of VAT consultants who did help but did not have all solutions after all. He had to find a solution but there was none.
In 2007 there was light at the end of the tunnel. The European Commission took the initiative to solve the problem. They proposed an EC Regulation with refined definitions, aiming to capture the modern world of financial services, alleviating the uncertainty that existed from the generic definitions. The Commission also proposed tools aiming to limit the impact of irrecoverable VAT cost. Such tools were in the likes of an enhanced VAT grouping regime, a cost sharing arrangement exemption applicable for Financial Services, and a refined Option-to-Tax mechanism, whereby Banks and financial services businesses could select which of their supplies they could forfeit the exemption and render them subject to VAT, earning therefore the right of input VAT recovery.
Being a businessperson, our CFO thought to himself, we are now in 2007, logically by the end of 2010 this should be over. The Gods of Politics started laughing.
Fast forward 16 years to today, the CFO of our story is now retired, enjoying a good old single malt he saved from back in the day, yet, the VAT rules for financial services are exactly the same as they were the day they were introduced back in 1977. They don’t stand a chance against the modern financial world, new operating models and FinTech. The problems of uncertainty and the irrecoverable vat cost are exponentially higher. The European Court of Justice takes the role of law maker, which is a problem in its own regard. Even worse, the VAT rules are affecting the way financial services organisations are structuring their business in order to optimise their VAT position. For example, they choose to work with fixed establishments instead of setting up different entities or even refrain from outsourcing so as to avoid the corresponding VAT cost. This is counter intuitive for a pro-entrepreneurship European Union and a pro-business…pro-tech-business Cyprus.
One of the main challengers of the reform was the UK. You see, irrecoverable VAT was one of the largest taxes paid by the sector in the UK. This continues to be the case also today. The European Commission – post Brexit – and as part of the 2020 Tax Action Plan – restarted the initiative with aggressive plans to help in tackling the problems. The pandemic, the war in Ukraine, the energy crisis and of course the inflation and the resulting interest rate increases, once again pushed back the reform to an unknown horizon. Our hero – the CFO – looking at the situation – appreciates retirement even more.
Now; I do appreciate that this is just a story and, in reality, the CFOs of Banks and FinTech’s have much bigger problems to deal with and, regardless of how badly I want this to be true, they don’t really lose sleep for Value Added Tax.
Irrespective of this, the FinTech world took us by storm. The services we see being offered are so complex, the uncertainty when it comes to application of VAT on these businesses is tremendous and this must be appreciated.
The high levels of technological advancement, the trends towards outsourcing and the fragmentation of supply chain in various activities and specialised operators increase dramatically both the uncertainty and the VAT cost.
If the CFO of our story was in Cyprus – and many of them are – he would have faced the same issues and potentially even more. This cannot be the case for a country like Cyprus.
Devotees of status quo will logically ask; Isn’t this a pan-European issue with little to nothing we can do as a small country? Indeed, this might be the case. There are plenty we can do however to make the system more attractive and fairer for such businesses and fulfil our vision of being a destination for technology companies including technology companies of the financial and insurance sectors.
First and foremost, we need a stable and consistent system. We cannot issue Orders changing the whole landscape for a given area in one night, without consultation and without transitional measures. We cannot be seen as hindering Tax Justice.
We need to adopt pro-business practices. For example, we already have in our VAT system, in our current VAT law, the concept of a VAT group but practically we restrict application, denying its benefits to the VAT exempt financial sector. The reasons behind this practice are appreciated but, must be reconsidered in line with the overall tax strategy of the country.
On the other hand, the European VAT directive, and again, the current EU VAT directive, as it is now and not as we hope it will be after a reform, has various tools and options which can be considered for introduction in the Cypriot VAT legislation. One such tool is the Option-to-Tax for financial services, which if applied positively, it can be a differentiating factor for Cyprus in the attraction and retention of FinTech, in conjunction of course with other tax measures and incentives we already have in place.
Am I proposing adoption of an option-to-tax? No! but, I am proposing consideration, consultation and assessment, of this and other points of law. We have examples from other member states. Poland for instance introduced an option-to-tax for financial services during 2022. To the best of my understanding, it has introduced the option restrictively, resulting in limited adoption. France on the other hand, had for years applied a restrictive option-to-tax and within 2022 loosened the rules with an aim to boost the competitiveness of French businesses operating in the sector. We can learn from their experiences.
From 1 March we will have a new and promising Government. From the pre-election messages of the President-Elect and the presence of his accompanying political office reps at this very tax conference, it is obvious that taxes, including indirect taxes, are high on their agenda.
If I could convey a message on behalf of all of us, the VAT practitioners of the VAT committee of the Institute of Certified Public Accountants of Cyprus, a committee which I proudly chair, that would be a plea for inclusion of the area of VAT in the so much advertised upcoming Tax Reform. We need at last to see matters holistically.
And its not only for FinTech businesses. It is also for Funds, Shipping and many more. The UK for instance is as we speak undergoing consultation for a reform of the VAT rules on Funds which is another area of comparable competitive advantage for Cyprus. Rumour has it that next in the UK is a reform of the VAT rules for financial services overall in line with developments in the sector.
This is a call for action; and we are here to help.
The actual intervention at the Tax Conference ended with a small but valuable technical discussion on how we approach VAT for complex financial services and FinTech according to the current rules. That part is not covered in this article but as I always say; we are a phone call away.
George Liasis, Partner, Tax Services, EY Cyprus