gst and financial services

Research Paper

GST & FinancialServices

Irian ur Rehman KhanThe University of Sydney, Faculty of Law, Sydney Law School

June 2005

GST & Financial Services

GST and Financial Services

Abstract:

In this paper the Goods and Services Tax (GST) treatment of financial services has been

examined. The GST on financial supplies in Australia has been compared to the same in

overseas regimes. It is argued that treatment of financial supplies has been unnecessarily

complicated resulting in distortions in the taxation policy and structure in Australia. The

reasoning of exempting the financial supplies is contested. Key issues have been

discussed.

examined and alternate proposals on taxing financial services have been briefly ,i3--ii .

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/c (~"f~1. Introduction:

The Goods and Services Tax CGST) is a tax on consumption. Therefore, consumption of

financial services is also taxed like other goods and services. However, unlike other

services, the application of GST on financials services is a thorny issue and it raises many

technical problems for tax designers and administrators. For most goods and services,

there is an explicit price charged for the supply, allowing the GST to be directly applied/.t.'r!L l'. c."-i!.d,~i(,I., .'i.i..J.i.4:.d t(),L~.)t..< /r.s, ;t;;~ .~ ~+!tz." /icA'-e.:-t,'C· t·,d~-t:tI. to the price for the specific transaction. In contrast, the charge for financial services is

often an implicit charge, which is not directly observable and is not compatible with the

imposition of a transaction-based tax. For example in the case of banking services, the

value of the financial service provided by the bank is not the full interest rate charged to

the borrower, rather the consideration for the service of linking the lender and the

borrower arises implicitly as the spread between the interest rates. Although, the

aggregate value of the financial intermediation services, computed as the gross margin of

the financial institution can be measured, this is not normally thought to be adequate for

an invoice-based GST. The normal form of such taxes requires tax to be allocated to

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specific transactions, so that registered business purchasers can claim input credits for the

GST collected. Given to the technical complexities of applying GST on financial services

that is compatible with a credit-invoice GST, most of the GST regimes have preferred to-

exempt' financial services from GST2• However, this creates distortion in the structure of

GST design. It affects the decisions by the financial service provider whether they out-

source or in-source their intermediary services for financial supplies. In fact, the GST

regimes have to choose between the policy of simplicity at the cost of efficiency or

efficiency at the cost of simplicity. GST experts have developed modern approaches like

the Reduced Input Tax Credit scheme, the Cash flow method, the Zero-rating and the

Reverse charge method to tackle the issues of GST on financial supplies.

2. What are Financial Supplies: In Australia, financial Services are input taxed '

under the GST Act which means that there is no GST liability on making financial

supplies however, there are also no input tax credits admissible on acquisition for making

the financial supplies. Therefore, the definition of financial supplies has implications for

implementing the GST Act in Australia. In the GST Act, financial supplies have not been

defined in the primary sections of the Act but in the Regulation". The Regulations define

financial supply by excluding and including various types of transactions involving

itemized interest. In addition schedules in the Regulation set out examples of transactions

which are intended to fall with the term of the Regulations. Prima facie, there is a

financial supply if the transaction is described as a financial supply with in the terms of

I In Australian GST legislation, the term input tax is used instead of exempt.2 As an exempt supply, there is no GST applied on the financial services provided by financial institutions,and these entities are not permitted to recover the GST they pay on their purchases for use in providingthese services.3 Section 40-5(1) of A New Tax System (Goods and Services Tax) Act 1999.4 Regulation 40-5.08 of the GST Act 1999.

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the relevant Regulations. There is a financial supply also if the supply is an "incidental

financial supply.' A supply which is not a financial supply is also described in the

Regulation 7.

2.1 Preconditions for a financial supply": In Australian GST Act, to be a financial

supply there must be the provision, acquisition or disposal of an interest such a provision,

acquisition or disposal must be for consideration, in the course of or furtherance of an

'r- enterprise; and connected with Australia. In addition, the supplier must be registered or

required to be registered for GST; and a financial supply provide/in relation to the supply

of the interest. It is also required that the interest referred to above must be an interest in

or under one of the items mentioned in the relevant Regulations in the GST Act". The

term "interest" has been defined as "anything that is recognized at law or in equity as

property in any formJO".

In view of the above, the provision, acquisition or disposal of the interest must be for

consideration II. In addition, the provision, acquisition or disposal of the interest should

be in course of carrying on an enterprise'< and must be connected':' with Australia. A

financial supply is neither the supply of goods nor real property therefore, a financial

supply will only be connected with Australia when either the thing is done in Australia or

5 Regulation 40-5.096 Regulation 40-5.10, Often a financial supply may partially have a taxable component which is difficult toseparate from the primary input taxed supply. In such a situation, such a partial supply, which is incidentaland directly connected with the main financial supply. Such a supply does not have a separate considerationand therefore deemed to be a financial supply for all practical purposes. An example of financial supplycould be the provision of advice by the lender or borrower in connection with the loan arrangement. Suchan advice shall be an incidental financial supply.7 Regulation 40-5.12 of the GST Act8 Regulation 40-5.09.9 Regulations 40-5.09(3) or as described by regulation 40-5.09(4)10 Regulation 40-5-02 of the GST Act.11 The concept of consideration is defined in s 9-15 of the GST Act.12 The concept of enterprise is defined in s 9-20 of the GST Act.13 Connected with Australia is defined in s 9-25 of the GST Act.

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the supplier makes the supply through an enterprise that the supplier carries on In

2.2 Financial supply provider versus financial supply facilitator: Australian GST

system discriminates between a financial supply provider and a financial supply

facilitator15• Therefore, third party who is arranging the financial su:pl: ~.e;. t~e :~~a~~ial

q".'/J . .A d""{li"d-rli,'t:.., .';/ .•t~J v (.Ildl-h )supply facilitator'" is not entitled to the benefits of iJ\pht tax supplies. Supplies made by

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financial supply facilitator are taxable supplies. This is unique to Australian legislation as

approach of merely listing certain types of supply. Contrary to the simple shopping list

against the legislations of ED and other countries where a shopping list approach has

been used to render financial supplies exempt. The overseas legislations adopt a simple

approach of overseas legislation, the Australian definition of financial supply adopts a

complex structure which is preconditioned by something being financial supply if it is the

provision, disposal or acquisition by a financial supply provider of an interest or under

certain itemized dealings and concepts.

2.3 Non Financial Suppliest': The Australian GST Act explains not only financial

supplies but also the supply of interests which are not financial supplies. In this way, the

legislation has a negati ve list of supplies which are not financial supplies. This amount of

emphasis and detail in explaining what is not a financial supply is unique to Australia

GST when compared to overseas treatment of financial supplies. In Australia, a range of

supplies that are sometimes associated with financial transactions, and other supplies that

are themselves financial in nature, are excluded by the regulations from being financial

14 Supplies connected with Australia are defined in s 9-25 (5) of the GST Act.15 Financial supply provider is explained in Regulation 40-5.06 of the GST Act

16 Financial supply facilitator is explained in Regulation 40-5.07 of the GST Act.,17 Regulation 40-5.12 of the GST Act.

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supplies. These supplies will be taxable supplies unless specified to be GST-free, input

taxed or otherwise not taxable under another provision of the GST Act.

There are certain common elements to the treatment of financial services across all GST

jurisdictions. However. the differing approaches taken by GST authorities in defining the

scope of the exemption illustrates the lack of clear guiding principles in the design of the

GST rules for the financial sector.

3. Whether Or Not To Exempt Financial Supplies? As Poddar (2003) notes that

there are two basic rationales for exemption under a GST (1) that the items to be

exempted are used disproportionately by low-income people, and therefore exemption

makes the GST less regressive; and (2) the items to be exempted are merit goods, such as

medical care and education. Poddar observes that exemption of financial services may

result in making the GST system more regressive rather than less regressive. Therefore,

the reason of exempting financial supplies is not on the theoretical but practical basis.

Although, financial services generally are exempted from the GST on practical and

administrative grounds, some argue that financial services should be exempted, or zero-

rated, for conceptual reasons, even if it were not so difficult to apply the GST. It is argued

that financial services used by consumers are not consumption goods and therefore

should not be in the base of a consumption tax (Grubert and Mackie 2000) 18. The basic

premise is that consumption goods directly yield utility to the consumer, and financial

services do not directly yield utility rather, the latter are properly considered as a business

expense, part of the price of an investment. In the future, the consumer sells the "saving

good" and uses the proceeds to fund fully taxable consumption, much in the way that a

18 See also Chi a and Whalley, 1999, Chi a and Whalley (1999) make a somewhat weaker statement. Theydo not assert that it is inappropriate to tax financial services because they do not directly enter the utilityfunction, but rather that it may be inappropriate to tax financial services. They explicitly hold open thepossibility that the optimal rate at which to tax financial services may be at a positive rate, albeit somewhatlower than the standard rate

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real investment (a machine, say) is not taxed, but rather the future consumption financed

by the machine is taxed. Any advice one receives in how most profitably to use the

machine represents a part of the machine's total cost, and is properly expensed. Since

financial intermediation services are part of the cost of investing, the fees must be

exempted in order to avoid distorting the consumer's relative valuation of present and

future consumption. Since on average about a quarter of the GDP in developed countries

originates from the financial sector (Table 1), (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), exempting this sector from the VAT can give rise to

significant economic distortions Zee (2004). Due to distortions created by the exemption

of financial services, a number of countries in recent years have been motivated to

deviate from the exemption approach.

4. GST Treatment of Financial Supplies in Other GST Regimes: It is worth

examining how other GST jurisdictions such as the UK, Canada, New Zealand and the

EU have tackled the issues of financial supplies in the realm of GST. The Australian GST

is somewhat comparable to the aforementioned jurisdictions because of similar legal,

institutional and social-economic backgrounds. The aim is to compare various GST

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regimes' response to financial services.

Table 1. Value-Added of the Financial Sector ill OEeD Countries, 2001

(Percent of GDP)

Australia 26.2Austria 27.0Belgium 293Canada 1/ 25.7Czech Republic 16.7Denmark 23.4Finland 22.9France 30.5German').' 30.8Greece 23.6Hungary 20.5Iceland 'u 20.2Ireland 3/ 17.9Italy 28.4Japan 23.9Korea 23.8Lu ..xernbourg 57.9Mexico 12.1Netherlands 27.6New Zealand 1i 29.2Norwav 19.4Poland 14.2Portugal 21.0Slovak Republic 19.4Spain 22.9Sweden 24.0Switzerland 3/ 29.5Turkey 14.7United Kingdom 29.9United States 3/ ').., -r

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Average 24.7Memorandum item:

EU average 27.8...Source: z-, l2()04).

4.1 The Definition of financial Supplies: Australian definition of financial supplies

does not enumerate the supplies which are financial supplies rather the GST legislation

sets out preconditions and supplies fulfilling that criteria are deemed to be financial

supplies.

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In the UK legislation'", financial supplies can be found in the schedule of exempted

supplies'" of the UK VAT Act. It is obvious that the United Kingdom regime is simpler

in structure than the Australian regime. Exemption is conferred by a series of simple

descriptions in a schedule to the primary legislation (Edmundson, 2001). There are no

preconditions for the supplies to qualify for exemption. In fact, the financial supplies in

the UK are included in the schedule by describing a series of dealings or transactions

which are intended to be exempt. Also the EU legislation" lists a series of supplies which

may be deemed to be financial supplies.

In the Canadian GST22 regime, the term financial supply is defined in terms of financial

instrument. The Canadian legislation simply by description has enlisted as what is

included in the financial supplies and what is not. The Canadian provision regarding

financial supplies are long and complex but comparatively brief and simple than those of

the Australian provision of financial supplies.

The New Zealand GST regime deals with financial supplies as exempt suppliesv'. The

financial supplies are defined'? separately as a list of transactions or activities. The

wording of the description is broad with no intention of limiting the scope of financial

supplies to only supplier, in fact, the intermediaries and arrangers are also included in the

financial supply.

In view of the above discussion on the treatment of the definition of financial supplies in

some other GSTN AT jurisdictions it is evident that the Australian definition of financial

supplies is subject to preconditions. Something is a financial supply if it is the provision,

19 Value Added Tax (VAT) Act 1994.20 Schedule 9 of the VAT Act 1994.21Article l3(B) of the EC's Sixth Directive.22 Section 123 of the Canadian Excise Tax Act RSC 1985 ( the Excise Tax Act)23 Section 14 of the Goods and Services Act of 1985 (NZ)24 Section 3 of the goods and Services Act of 1985 (NZ).

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disposal or acquisition by a financial supply provider of an interest in or under certain

itemized dealings and concepts. The legislations of other GST jurisdictions adopt a

simpler approach of simply enumerating certain types of supplies to be treated as

financial supplies. This approach of listing of certain supplies is more popularly know as

the "shopping list" approach of defining the financial supplies. The Australian structure

is complex and raises the questions as to why the drafters of the legislation preferred this

approach. Ironically, by examining it seems that the said structure caused some problems

rather than benefits. Firstly, the preconditions for there being a financial supply cause

ambiguity. Secondly, the problem with the preconditions is that these require that a

supplier must be financial supply provider. In order to adapt this concept to cover and

acquirer of interest for example an acquirer of shares the definition of financial supply

provider has been extended to include a person acquiring an interest. This leads to the

conceptual absurdity of an acquirer being deemed to be a provider. Which is against the

conventional concept of acquisition being the concept of receipt and provision the

concept of divestment. All of these complexity and intricacy have been avoided in the

overseas legislations by simply following the shopping list approach.

In view of the above discussion, it can be safely said that the Australian provisions

regarding financial supplies have been unnecessarily complicated as result these

provisions had to be complemented with examples ". Ironically the complexity makes no

significant contributions to the equity, clarity and efficiency of the GST administration of

financial supplies.

4.2 The services of arrangers and Non-financial Services/": One of the differences

of treatment of financial supplies between Australian and overseas GST is that in the

25 Schedule 7 and 8 of the Australian GST Act.26 Regulation 40-5.12 and schedule 8 of the Australian GST Act.

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former the services of parties that arrange financial services are taxable supplies.

Therefore the supply of services of intermediaries of financial services is taxable in

Australia. However, in overseas jurisdictions, the services of intermediaries who arrange

financial services for the supplier and acquirer are exempted. The effect of making the

services of arrangers of financial services taxable is that it creates distortion in the tax

structure by creating an incentive to in-source such services. As a result of this bias

towards in-sourcing, the small enterprises who are facilitators of financial services are

adversely effected because their services become taxable, however, if the same services

are not outsourced and rather obtained in-house by employing staff for such services then

such services are input taxed i.e., exempt from GST. The tax policy which treats services

of arrangers and facilitators of financial services differently on the basis whether the

same are outsourced or in-sourced an unfair results in a bias against small enterprise.

Furthermore, the reduced input tax credit scheme is a direct consequence of taxing

services of arranger of financial services to mitigate the side effects of such a

distortionary tax policy. Ironically, the reduced input tax credit further exacerbates the

distortion in the tax policy instead of balancing out the adverse effects of differentiating

between suppliers and facilitators of financials services because, the 75 percent of the full

credit scheme is itself a rough approximation to redress the bias in favour of in-sourcing.

In the UK, there is no equivalent concept of reduced input tax credit scheme. In fact, the

suppliers and facilitators of financial supplies are treated the same as exempt supplies.

This very obviously means that the UK GST legislation has opted for simplicity rather

than perceived efficiency. Although, there have been no studies to quantify the revenue

lost by not taxing the services of facilitators of financial services but the simplicity in the

tax structure is more likely to save GST administration cost and makes it more tax payer

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friendly with no incentive for in sourcing such services. In the EU, the intermediaries of

financial services are included in the exempt financial services. In Canada also the

definition of financial services is broad and the services of intermediaries of financial

services are more likely to be included in the input taxed supplies in Canada. In New

Zealand, the services provided by the intermediaries of financial services as defined in

the New Zealand legislation'" are also GST exempt and therefore there is no issue of

differentiation between suppliers and facilitators of financials services.

S. Key Issues Regarding Exemption Of Financial Supplies From GST:

Although, it is desirous to maintain a broad based GST and avoid exemptions of supplies

as much as possible. However, in most of the GST regimes, the financial services are

exempted for GST purposes. The GST regime's pragmatic choice to exempt the financial

supplies is at the cost of efficiency loss in the GST structure. Treating financial supplies

in this way however, creates a number of problems including creation of tax cascade in

the economy resulting in over taxation of business sector. Another fall out of exempting

the financial supplies is the bias in favour of in-sourcing financial intermediary services

rather than out-sourcing to minimize the impact of GST. This causes an anomaly that in-

sourced financial intermediary services are exempted whereas financial supplies of such

out-sourced services are treated as taxable supplies. Exempting financial supplies also

seem to increase the compliance cost due to need for apportionment of input taxed

financial supplies and other taxable supplies. These key issues are elaborated below;

5.1 Tax Cascade: Taxing an already taxed supply is called tax cascade. In other

words, it is a tax on tax. When financial services are exempted and the GST paid on

goods and services for making the supply cannot be recovered, the non-creditable GST

27 Section 3 of the New Zealand's GST Act.11


will then form part of the cost of production. To compensate for the non-credited inputs

in making the supply, the financial intermediary either raises the price of the service or

absorbs the cost. When the higher cost due to non-availability of input tax credits is

passed on to business, in turn, the business also either increases the price of their products

or absorbs the additional burden of unrecoverable GST. The consequence of cascading is

that either, the final consumer pays the additional tax cost or the non-creditable GST is

absorbed in the profits of the business by reducing the profit margin earned from the final

consumer. This distortion in the tax structure over burdens the economic activity. The

following illustration explains how the tax cascade arises.

Financial Business B FinalBusiness A Intermediary (No input tax Customer- (No input tax Credit as GST is (No input tax-. f---. 1-+Credit) not charged) Credit)

In the-transaction between Business A and the Financial Intermediary, the GST cannot be

recovered because no input tax credit is admissible; the GST is included in the cost of the

financial service supplied by the Financial Intermediary to Business B. This higher cost

may then be passed through to the products sold by Business B to its customers.

5.2 Self Supply Bias: The bias for a financial services provider to provide all key

services in-house may arise if the provider is unable to recover the GST paid on goods

and services purchased. This preference is purely based on the tax anomaly where the

financial intermediary services from external sources are taxable whereas the same

provided in house are exempted. There is popular trend and all sectors of the economy

are turning towards outsourcing to improve competitiveness and efficiency. Financial

institutions are particularly able to benefit from outsourcing of specialist services given

their substantial reliance on data-processing services, and administrative services such as

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IGST & Financial Services

Icheque and payment-processing services. However, although the GST is neutral for

taxable sectors, for financial institutions the economic benefits of outsourcing specialist

services is counterbalanced by the additional tax cost resulting from their inability to

claim input tax credits. For example, where a bank performs IT services in-house, it

cannot recover the GST paid on computer software and equipment. However, its own

labour costs do not bear GST. In contrast, when it out-sources to an IT service provider,

the entire charge bears tax. The net effect is that the GST burden borne by the financial

institution for the IT service is significantly increased by outsourcing'".

5.3 Complexity: The exemption of financial services is a source of significant

complexity and administration cost for tax authorities and financial institutions alike. A

boundary between exempted and taxable supplies makes it necessary for tax payers that

make a combination of supplies to apportion purchases between two activities when

claiming input tax credits. This imposes compliance costs and it can be difficult to

achieve accurately. In practice, apportionment is the most difficult issue facing

intermediaries when complying with GST. This has been compounded by uncertainties in

the application of grouping rules. There are two broad categories of compliance

problems. Firstly. there is inevitably much controversy over the borderline between

exempt and taxable services provided by financial institutions. Secondly, financial

institutions are required to apportion their inputs between taxable (input-creditable) and

exempt (non-creditable) activities. This is typically the area of most controversy between

tax authorities and financial institutions.

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28 Brian Wurts And Frankie Fenton, Indirect Taxes On Financial Services.

1-GST & Financial Services

6. Response To Problems Caused By Exemption of Financial Supplies And

Alternative Approaches: The most distortionary aspect of exempting the financial

supplies is that it causes cascading of GST on business. The other major issue is the in-

sourcing bias for financial intermediary services. The problems presented by exempting

financial services have led to a number of alternative taxing mechanisms for this sector.

Some of these offer promise for reducing the negative consequences of the exemption,

while others are fraught with difficulty for both the financial sector and those charged

with administering the tax. So what are the alternatives of treatment of financial supplies?

As for self supply bias other GST regimes have addressed this issue in a number of

different ways for example in Singapore'" Financial Intermediaries claim input tax credit

on a prescribed recovery percentage, provided that the supplies related to Business to

Business supplies. Similarly in Australia the Financial Intermediaries supplies are

allowed a notional 75 percent input tax credit reduction.

6.1 The Reduced Input Tax Credit Scheme (RITC)30: The reduced input credit

regime is unique to Australia and has no comparables in overseas legislation": The RITe

aims at discouraging the in-sourcing of services by financial supply providers. In other

words, the exemption of financial supplies means that generally any taxable supply made

to a financial supply provider will give rise to a net GST burden that is there will be tax

on the supply but no corresponding input tax credit on the acquisition. This burden may

give financial supply providers with an incentive to in-source certain services rather than

outsourcing them. This is undesired because it leads to distortions. This bias for in-

sourcing, as against outsourcing of services, is unfair for small businesses. Other

29 The Application of Goods and Services Tax on Financial Services-consultation Document, August 1999,commonwealth of Australia.30 Division 70-Financial supplies (Reduced Credit Acquisition) of the GST Act.31 Singapore also has somewhat similar system of reduced input tax credit.

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I·GST & Financial Services

IGSTN AT countries do not have reduced in put credit schemes so why does Australia

have one? The reason is that in Australia, most of the arranging and facilitation services

are taxable supplies, when compared to overseas GST regimes like the UK and EU

Iwhere such arranging and facilitation services are exempt. The RITe scheme is an

attempt to offset the bias created against small businesses. Some of the critics of RITe

claim that the same effect could be achieved by exempting arranging and facilitating "'L {~v",' {'·ft"". ii -,,. I -[ ,.'-'L

services and doing away with RITe system as is done in overseas jurisdictions. The other I/~~>-r it-I'.t aU.view is that RITe is more efficient and precisely maintains the balances out any incentive t j~u;lj.LtJfj

AY./t<-'" ",./I~ .'... "I

':/ V t.•Ivi?-for in-sourcing as against outsourcing of arranging and facilitation services for financial

I

Isupplies. The two views are in fact the case of whether to adopt efficiency or simplicity

in the tax system when both cannot be simultaneously achieved.

The RITe scheme can be illustrated by the following example. In the absence of the RITe

Ischeme, a bank which hires the services of the Valuer for the valuation of the loan and

pay GST on the taxable supply. The bank may not benefit from the input tax credit as the

supplies made by the bank will be input taxed supplies. The GST charged by the Valuer

Iwill be claimed back by the bank. This will increase the costs to the bank. Given that

employment services are not taxable. It would be cheaper for the bank to employ Valuer

in the bank than hire valuation services in order to avoid GST on outsourced services.

IWhat the RITe does is that it allows the bank to claim 75 % of the GST paid to the

Valuer so that the bank doesn't not have a strong incentive to bring the valuation service

in-house. The RITe scheme is aimed at eliminating any disadvantage to the small

Ifinancial service providers as result of GST.32

-",Li I J. /"I;!.<.

t,

32 R Stitt ,CST and Financial Services Tax Specialist VOL 4 No 5, June 2001,

decision between in-sourcing and out sourcing of an arranging or facilitating service of

-'J ~ "''; Lthe financial supplies. Such an inaccurate estimate may be distortionary. .,.j'? Ie <-- .f. -aiu. N (

! .GST & Financial Services

However, there are some difficult issues with the reduced credit scheme ". Firstly, the

need for differentiation of financial services into arranging services as against supplying

of services and making the arranging of services as taxable results in many disputes and .If 'i (i:LU:/rar >'-7 1

litigation which exacerbates the complexity of RITe. Secondly, the process of

apportionment of entitlement of input tax credits is further complicated by the fact that

instead of two in other countries in Australia there are three levels of entitlement of input

tax credits that is full input tax credit, no input tax credit and partial input tax credit. This

makes the calculation of entitlement more complex. Thirdly, the entitlement of 75 percent

of the input tax credit is merely an estimate of the credit required to neutralize the

6.2 Cash-flow method: The main cause of the problem in applying GST to financial

services is that the charge for the services is typically not an explicit price, but rather an

implicit charge reflected in the margins of the financial institution. Applying GST on

such margins is not compatible with a credit-invoice VAT, which requires the GST to be

applied on specific transactions, in order to permit registered purchasers of the services to

claim input credits. The cash flow method attempts to bridge the gap between the need of

calculating the tax based on the gross margins of financial institutions and the need to

directly assign GST to specific purchasers. Essentially, the cash-flow method measures

33 P Edmundson, CST and financial supplies: A comparative analysis of legislative structure, Taxpoint,200l.

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the difference between the value of in-flows i.e., taxable sales and out-flows i.e., taxable

purchases relating to financial transactions. This is undertaken not only for financial

institutions but also for non-financial registered businesses. By measuring the margin

(positive or negative) for financial transactions for all registered businesses, the cash flow

method provides a mechanism by which tax can be assessed on financial institutions, and

input credits can be assigned to business purchasers. Household consumers of financial

services cannot claim a credit for their portion of the tax on financial services. Financial

institutions are permitted to claim input tax credits for the GST they pay on their

purchases of non-financial goods and service because the GST is applied to financial

services in this fashion.

Under the most advanced version of the cash flow method non-financial entities would

be absolved of the need to track their financial positions for GST purposes. Rather, under

this approach, virtually all of the burden of accounting for the tax positions of each

registered customer would be assumed by the financial institution.

6.21 The Truncated Cash Flow Method With Tax Calculation Account": This model

developed by Satya Podder and Morley English predominately addresses the taxation of

financial services in the context of deposit-taking intermediation. However, it can also be

applied to securities transactions, derivative transactions and life insurance. The general

rules of credit invoice method of calculating GST could be easily applied by measuring

and allocating the margin for financial intermediation. This cash flow method of taxing

financial services is called the "truncated cash flow method with tax calculation account"

specifically includes both households and businesses within the scope of the base.

Broadly, under the cash flow method, cash inflows from financial transactions are treated

3-1 Satya Podder and Morley English, Taxation of Financial Services Under Value Added Tax: Applying thecase Flow Approach, National Tax Journal Vol. SO No 1(March 1997)

17


as taxable sales, and cash outflows are treated as taxable purchases. In the case of simple

deposit-taking intermediation, the cash flow method measures and taxes the implicit fee

for financial margins and allocates the margin between borrowers and lenders. Despite

its promising features, the cash flow method makes a number of assumptions as to the

rate of interest (pure interest) on which to index the intermediation fee charged for the

services supplied to lenders and borrowers. Although these assumptions reduce the extent

of the compliance burden faced by businesses, the use of an indexing rate to allocate

financial margins between lenders and borrowers raises concerns about accuracy. It is

concluded that this method also does not resolve the problems of input taxing the

financial services. Notwithstanding its academic appeal, it seems clear that this approach

has severe practical shortcomings. In particular, the financial sector, which would have to

comply with the system, has been virtually unanimous in their concern that this method

would be completely unworkable from a practical perspective. .:::1-

6.3 Zero-Rating Business-to-Business Supplies of Financial Services: Another

alternative treatment of financial supplies is to zero-rate the business to business (B2B)

supplies. The aim of zero-rating the financial supplies is to address the concerns about

exempting the financial services resulting in overtaxing of the financial supplies thereby

creating tax cascades and increasing prices of some goods and services. The following

illustration shows how the zero-rating works.

Business A Financial Business B FinalIntermediary (No input tax credit as Consumer(Input tax Credit) GST is charged at the (No input taxr---. -. zero percent) ~ Credit)

Being Zero rated the supply by the Financial Intermediary to Business B is a taxable

supply and the Financial Intermediary will be able to claim an input tax credit on its18

! ..4~ - -,~.~.~

- "'/ \r ,0:., I ~.,

.'1p.

1 ,i,A jMiscellaneous Provisions) Act 2003 amended the Goods & Services Tax Act 1985 (the .~I~J,V-)'if ~ [\";/,. _-,La ;"'\

I cu:··~ ( J~.~) ~/A' '.i ~£-;),l 'tf.,v11 .u :« t-;.-Y/ !Jur- :J .',

. /,1 f-ji,/' I,N~ it.

/II/"V .• tr.c./;.,iJ)..(.. "J

.£-..4 ,

, .)J-{;~v.)-'


purchases from Business A, used to make that supply. In this way, the supply of

financial services by a registered person to another registered person who has a

predominant activity of making taxable supplies of goods and services will be zero-rated.

However, zero-rating will not apply when the recipient is not registered for GST, nor if

the recipient has more than an incidental activity of making exempt supplies. As shown

in the above figure, zero-rating B2B supplies of financial services, achieves parity with

other (non financial) supplies.

Recently, in New Zealand, the Taxation (GST, Trans-Tasman Imputation and

GST Act) to allow supplies of financial services by a GST-registered person to another

GST -registered person to be zero-rated". The changes integrate the supply of financial

services more fully into the GST system by taxing such supplies at the rate of 0% and

allowing financial services providers to deduct input tax in respect of those supplies. This

is in contrast to the exempt treatment of financial services, whereby GST is not charged

and financial services providers cannot deduct input tax for GST paid on goods and

services used in supplying financial services. From 1 January 2005 the zero-rating rules

allow providers to elect to zero-rate supplies of financial services to customers who are

registered for GST if the level of taxable supplies made by the customer in a given 12-

month period (including the taxable period in which the supply is made) is equal to or

exceeds 75 percent of their total supplies for the period, or they may not meet the 75

percent threshold but are part of a group that does meet the threshold in a given 12-month

period (including the taxable period in which the supply is made) . For example, the

3S GST guidelines for working with the new zero-rating rules forfinancial services Prepared by the PolicyAdvice Division of the Inland Revenue Department, ISBN 0-478-27120-4 Published October 2004, P 0Box 2198, Wellington.

19

countries may also follow the precedent as the scheme prima facie is workable and r, l:J J&''-,',1 Il-t..)-) "t

~ j.,r'~/ " is-~if-o'/1v~J. J V. .i

. i 1-

Reverse Charging: The latest approach proposed by the Howell H. Zee of the tz. -~r(,~lJ""r

/ I. '('{I /l~tti I ":t'l}!,.~",yvfvf .f'r: i.. ,tv

Rt: )pA .- ,) I /)1Iv-C"~ .

,tN 1

A - "kt(,.,L,)t1'-'1..1 r ' .

oJ I. /~,, ~

I i . j,~"".1.':'.-"£') "

'f "1(ii/,j.-v

l ....P j,]I ~')

(liJ.ft.;.J -~

,t-fitvl /1'-p(. i JJ. #-"..i..tt

.-7 .,';/1ti.J,;~1 cr~il

j" , - I ~i• r "i,d-tc"-r..4 ," .., .,,. IV.

((..£..)/t.l') ',.

A~l,l lJ /L,

''Ntt~i :registered as V AT payers. Hence, they cannot serve as V AT collection agents for the . ';4f.v· ,

.·1\' it)( ( : j, / '\ 1.1 ~

/1. -i .~ (~dt1..1,~ I.

36 Howell H, Zee A New Appr:J(l,ch to Taxing Financial Intermediation Services Under a Yalue-Added Tax, J J ...," . L...i I~ _I"IMF Working Paper Fiscal Affairs Department, July 2004, .,' i',": L •

20 " l,l-I " ;.t(,o., I.t ~ (, t.

~',. . t:';'~,.'". 1",-l'L


treasury or finance function of a group of companies who receives financial services.

However, supplies of financial services cannot be zero-rated if they are supplied to

businesses whose activity of making exempt supplies of financial services and other non-

financial exempt supplies is more that 25 percent of their total supplies, or they are

supplied to unregistered persons (or final consumers). Although, it is premature to

comment on New Zealand's experience zero rating financial supplies but if New

Zealand's experience with the zero rating of financial supplies is successful then other

resolves most of the contentious issues arising from exemption of financial supplies.

6.4

International Monetary Fund is called the Reverse charging approach. If the value of a

bank's intermediation services can be measured by the difference between its loan and

deposit interest, then it would be natural to regard loans as the bank's output and deposits

as its input, on both of which a V AT could certainly be imposed: the V AT on the loan

and deposit interest would then be the bank's output tax and input tax, respectively, and

the excess of the former over the latter would be remitted to the government by the bank

as the V AT on its intermediation services, Taxing the loan and deposit interest in this

way is clearly feasible on a transaction-by transaction basis (i.e., the V AT is assessed at

each instance of an interest payment) and is thus fully compatible with an invoice-credit

V AT36. While seemingly straightforward, the above V AT treatment of the bank generates

two crucial problems. The first is administrative; the bulk of bank deposits is derived

from multitudes of individual final consumers who are administratively infeasible to be


government like VAT-registered businesses. However, a procedure already exists. The

procedure in question is known as reverse charging. A reverse charge refers to the

collection of the VAT by a VAT-registered taxpayer on both the input and output side of

its business, and is most commonly used by countries to apply the VAT to imported

services. As foreign services providers cannot be relied upon to collect the VAT for the

domestic government, the responsibility for collecting the tax is shifted, through the

reverse charge, from the foreign suppliers to the resident service importers. When applied

to the present context, reverse charging would basically shift the collection of the VAT

on deposit interest from depositors to banks. In effect, a bank would issue a VAT invoice

to itself for the tax paid on its purchased input (deposits) and claim the same as a credit

against its output tax (collected on loan interest from its borrowers)

The second problem of extending an invoice-credit VAT to deposit and loan interest is

that the final consumer bears a VAT burden that exceeds the VAT on the financial

intermediation services that are embedded in the loan. It results in the over-taxation of

final consumers as bank borrowers. This problem poses a fundamental conceptual

difficulty with the straightforward application of reverse-charging; it would clearly need

to be overcome before one can seriously consider integrating the financial sector into the

VAT's invoice-credit mechanism. Howell Zee had proposed a modified reverse charging

mechanism called franking mechanism. The mechanism that is embodied in the modified

reverse-charging approach to transfer the reverse charge on depositors to borrowers is a

franking mechanism similar to the one used by corporations to frank dividends under an

imputation system. In short, the mechanism ensures that, when borrowers are granted

VAT credits, the credits are derived from deposits that have in fact been reverse-charged.

Moreover, since such credits to borrowers are to be granted on a transaction-by-

l 21


transaction basis, the available credits would have to be calculated after each deposit and

loan in a franking account.

The modified reverse-charging approach proposed above is a simple and effective way to----.r-...-tax financial intermediation services under an invoice-credit GST. It is capable of

overcoming at once all of the problems (over-taxation of registered businesses, under-

taxation of final consumers, and administrative difficulties in apportioning creditable

input tax) associated with the exemption approach.

7. Conclusion:

Integrating the financial sector into the invoice-credit mechanism of the GST is the

remaining major outstanding issue in GSTN AT design. A workable method of taxing

financial services has eluded tax authorities since the inception of value added tax

regimes. Financial services have been generally exempted under various GST systems

due to the inability to identify the appropriate tax base, which is hidden in the financial

margin. As a consequence of failure to devise a workable method, the tax administrations

for the sake of convenience have mostly opted to exempt financial supplies. The

exemption system for financial services, which has prevailed as the standard method of

treating financial services under GST, is a second best solution to an unavoidable

problem. However, exempting financial services has some distortionary effects on tax

base and business activities. Tax cascading, self supply bias and issues of apportionment

are commonly associated with exemption of financial supplies. Tax authorities should

carefully review their options with respect to granting at least partial relief from tax for

outsourcing, both to encourage improvements in competitiveness by financial

institutions, and to avoid obtaining a windfall revenue increase at the expense of

businesses seeking to be more cost-efficient. In this respect, it is high time for the GST

22


exemption mechanism to be adjusted in order not to unfairly penalize financial

institutions attempting to obtain cost savings. In this regard, the innovative approaches

taken in Australia (the Reduced Input Tax Credit scheme) and in Singapore, which

effectively represent a compromise between exempting and zero-rating financial services,

stand out from other GST jurisdictions to be considered carefully.

Tax experts have developed alternative methods to tax the financial supply by zero-rating

the financial supplies, taxing the Cash flow and Reverse charging. Although, these new

methods address some of the drawbacks of the current method of exempting financial

supplies but these methods themselves are fraught with their own set of problems.

Nevertheless, it is clear that innovative thinking such as Zero-rating method or Reverse

Charging schemes for treating financial supplies is needed to respond to the changing

environment.

********************************

Bibliography:

1. A. Greenbaum, The Canadian GST treatment of Financial Services- What lessons

are therefor Australia? Australian Taxation Studies Program, The University of

New South Wales, 2000.

2. Australia, 1999, A New Tax System (Goods and Services Tax) Act 1999

(Canberra).

3. Brian Wurts And Frankie Fenton,Indirect Taxes On Financial Services, Price

waterhouse coopers, Toronto, available at www.internationaltaxreview.com.

4. Carl Bakkar and Phil Chronic an, Financial Services and the GST_ A discussion

paper, Victoria University Press for the Institute of Policy studies, Victoria

University of Wellington, 1985.

5. Council of the EU, 1977) Sixth Directive on the Harmonization of the Laws of the

Member States Relating to Turnover Taxes-Common System of Value-Added

Tax: Uniform Basis of Assessment, 77/388/EEC (Brussels).

23


6. Ebrill, Liam et al. (2001). The Modern VAT, Washington DC: International

Monetary Fund.

7. Grubert, Harry and James Mackie (2000). "Must Financial Services Be Taxed

Under a Consumption Tax?" National Tax Journal, 53(1), 23-40.

8. GST guidelines for working with the new zero-rating rules for financial services

Prepared by the Policy Advice Division of the Inland Revenue Department, ISBN

0-478-27120-4 Published October 2004, POBox 2198, Wellington.

9. Huizinga, Harry, 2002, "A European VAT on Financial Service?" Economy

Policy, Vol. 17, pp. 499-534.

10. Howell H. Zee A New Approach to Taxing Financial Intermediation Services

Under a Value-Added Tax, IMF Working Paper Fiscal Affairs Department, July

2004.

11. Hoffman, Lorey Arthur, Satya Poddar, and John Whalley, 1987, "Taxation of

Banking Services Under a Consumption Type, Destination Basis VAT," National

Tax Journal, Vol. 40, pp. 547-54.

12. Indirect Tax Treatment of Financial Services And Instruments, Report of the

OECD, October 1998.

13. J. Mintz, The Thorny Problem Of Implementing New Consumption Taxes,

National Tax Journal Vol 49 no. 3 (September 1996) pp. 461-74.

14. Kelly Edmiston and William F. Fox A Fresh Look At The Vat.

15. Michael Cullen, GST & Financial Services, A Government Discussion Document.

Policy Advice Division, Inland Reevnue Department, Wellington. October 2002.

16. P Edmundson, GST and Financial Supplies: A Comparative Analysis of

legislative Structure, 2001.

17. Satya Podder and Morley English, Taxation of Financial Services Under Value

Added Tax: Applying the case Flow Approach, National Tax Journal Vol. 50 No

1( March 1997)

18. William Jack (2000) The treatment of financial services under a broad-based

consumption tax National Tax Journal, 53(4), p841 .

24

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