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The source of VAT problem

The financial services sector is moving into a new era of VAT pain and this time it is technical.

The new source of pain is a matter of opinion on technical law and has the makings of a tax lawyers&#39 field day. It relates to outsourcing of services – a real life issue for many businesses – and the possible tax cost of doing so because of VAT exemption.

Defining VAT exemption

VAT exemption means that.the financial services sector may not recover all the VAT that it pays on goods and services which it buys in but it does not have to charge VAT on all its services.

The new era arises because of the uncertain definition of which financial services activities are exempt from VAT. As businesses outsource their activities, can the external provider claim VAT exemption or must it charge VAT? If it has to charge, then outsourcing carries a VAT cost for the financial services sector.

The starting point is European law, which provides that certain “transactions” are VAT-exempt. Broadly, those transactions are defined in transient terms, for example, granting credit.

The source of the uncertainty is that the different translations of European law use different terms so the European Court of Justice cannot give a clear statement of principle.

However, to put the question into practical terms, for example, if an outsourced service, that is, credit-checking, is one step in the process of “granting credit”, does it qualify for VAT exemption?

A recent judgment might have put an end to the debate. It held that, even if the outsourced service is “essential” to completing the transaction, it does not warrant the conclusion that it is VAT-exempt.

That might reasonably be read as meaning that no outsourced service could qualify – what better basis to qualify for exemption could there be than being essential to tjhe relevant transaction? And if that does not qualify, what else could?

However, that is not the end of the debate. The court in that case went on to find that an outsourced service qualified for VAT exemption because, when looked at bro-adly, the service satisfied the precise requirements of the law. So, the pain comes partly from using a broad approach while assessing narrow tests. It amounts to using a hammer to knock in a screw.

In an earlier case, it was decided that being an essential element of the supply was one criterion for VAT exemption. So, dealing with contradictory decisions is another source of the current pain.

That earlier decision held that the other preconditions for VAT exemption were, briefly, that the outsourced service must change the legal rel-ations between, say, the bank and its customer (in the case of a transfer, which was the situation of that specific case but might not always apply to other categories of exemption) and be distinct in character and specific to the overall exempt service provided by, say, the bank.

For completeness, the court in that earlier decision also held that it did not matter what sort of business provided the outsourced service or whether it had any contact with the customer or how the service was performed.

Without going into a detailed analysis, these two decisions clearly take different approaches. That is enough to make this a difficult area of law.

Defining supply

Then there is the question of whether what is being supplied is one supply or two and if it is one supply made of more than one part, which part should determine the nature of the supply, that is, whether it is VAT-exempt or not.

For example, the service outsourced might be to transfer money and provide information. Transfers of money are exempt. Information services are not. But if the information is linked to the transfer and subordinate to it and the two are invoiced together, then the total service could be VAT-exempt.

Take a pragmatic approach

In the light of this confusion, what can financial services businesses do when considering outsourcing?

They could join the myriad angels dancing on the head of this VAT law pin. Analysing all the facts and judgments of the cases would be fascinating but not of great practical use as the decisions depend so much on the particular facts of the case. Or they can take a more practical approach and the key is knowledge sharing.

The first step is to take a commercial approach to interpreting the law. This requires a combination of the facts and the law. These often rest with different individuals and the exchange can take time and patience. The viewpoint can also affect the outcome so it is best not to jump to conclusions.

It can pay to look at the issue in the widest context. Rejigging the original proposal could produce a significant saving and the courts have not yet taken away all rights to save tax in this way.

The second step is to document the supply properly. This means not only the service agreements but also things as prosaic as the layout of the invoice. The best laid plans of mice, men and VAT planners often go awry for such seemingly small details, especially if the VAT man is watching.

The third step is to present that persuasively to Customs.

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