Ring-fencing retail banks
One of the key measures being pursued in many jurisdictions is the separation of retail banking from investment and wholesale banking activities. In the UK, the Financial Services (Banking Reform) Bill is designed to implement the recommendations of the Independent Commission on Banking (ICB) to this effect.1
The separation and ring-fencing of retail banking activities carries a number of implications from a VAT perspective. By way of background, banks typically operate as a VAT group. Supplies between UK VAT group members are disregarded for VAT purposes with no VAT being chargeable thereon. Further, as confirmed in the FCE Bank case,2 supplies between head office and overseas branches also do not constitute supplies for VAT purposes. In the UK, VAT grouping extends to allowing an overseas entity with an establishment in the UK to be a member of a UK VAT group.
Given that financial services entities are generally not in a position to recover all the input VAT they incur, VAT grouping (and branch structures) represent avenues for reducing the amount of input VAT within a corporate group. Clearly, removal of a member from a VAT group or the transfer of activities for an existing member to a separate company outside the VAT group could impose significant additional VAT costs on services provided between corporate group members. It may also result in the need to consider transfer pricing on intra-group transactions that previously did not exist. In its most recent consultation on the draft legislation for introducing ring fencing in the UK, the only reference to VAT is in para 57 of the explanatory notes where it states that the impact of removing ring-fenced banks from their VAT groups would have to be considered. In this regard, the UK government recognizes that its proposals may imply major additional operational costs, suggesting a figure of up to British Pound (£) 105 million per bank per year.
Although, it may in principle appear perverse to manufacture additional tax cost as a side-effect of measures to improve financial stability, this is nonetheless a potential fallout of the ICB proposal. Where banks continue to share functions and capabilities (e.g. IT) in a post separation environment, there will be considerable challenges in structuring to mitigate the VAT consequences. Maximizing available VAT exemptions and maximizing input VAT recovery through the use of appropriate partial exemption methodologies, in addition to optimized VAT group structures, will be necessary. In addition, consideration of appropriate transfer pricing policies and methodologies will be required.
Elsewhere in this issue we consider how the European Alternative Investment Fund Managers Directive (AIFMD) is creating a radically new environment for the investment management sector.3 The introduction of AIFMD brings with it significant potential VAT implications which need to be reflected upon. The first issue relates to the VAT liability of services provided to Alternative Investment Funds (“AIFs”) and, whether similar to traditional fund vehicles (e.g. UICTs funds), those supplies would fall to be VAT exempt. This particular point has not yet been bottomed out with no specific guidance coming from HMRC in relation to the VAT liability of the types of funds caught by AIFMD. Secondly, AIFMD provides Alternative Investment Fund Managers (“AIFM’s”) with a “marketing passport” for EU AIFs, in addition to a “management passport” providing a legal basis for AIFM’s to manage fund vehicles cross-border. The introduction of these passporting functionalities will increase the amount of cross-border activity – this will create opportunities to structure in VAT-efficient ways, for example by taking advantage of VAT group arrangements in relevant Member States or by taking advantage of the Member States’ non-harmonized practical approach regarding the scope of the VAT exemptions. It may additionally provide Corporate Tax benefits through the use of branches and any exemptions on taxing non-domestic income. Transfer Pricing will however be necessary when determining how to value either intragroup transactions, or the attribution of profits to branches.
Once again, issues of VAT and of corporate structure are closely intertwined in the development of appropriate responses to regulatory change.
VAT group benefit under threat?
Where the regulatory environment is developing in a number of directions at once, from a pure VAT perspective, one of the key uncertainties currently is over the future of the VAT group provisions themselves as they apply to the treatment of branches.
As we have noted, the present interpretation of VAT law in the EU allows that transactions between parts of the same corporate entity – for example between head office and branch – carry no liability to tax. However, a current referral by Sweden to the EU Court of Justice (CJEU) questions whether this is valid where the branch receiving a charge passed on from its headquarters outside the EU is itself within a VAT group. Specifically, the CJEU has been asked:
“Do supplies of externally purchased services from a company’s main establishment in a third country to its branch in a Member State, with an allocation of costs for the purchase to the branch, constitute taxable transactions if the branch belongs to a VAT group in the Member State?”4
The Court has yet to give an opinion. However, the analysis previously advanced by the Commission was that there was a taxable transaction in these circumstances. Consequently, if the CJEU sustain the Commission’s view it would imply that VAT would become chargeable on such supplies. The Commission argues that a VAT group is a legal fiction in which all members lose any individual identity and, crucially, any possibility of remaining part of any other legal entity. They state:
“by joining a VAT group, the taxable person becomes part of a new taxable person, the VAT group and, consequently, dissolves itself for VAT purposes from its fixed establishment located abroad.”5
If the CJEU concludes that the supply in the Swedish case is indeed liable to VAT, the implications could be profound for financial services and other VAT exempt companies. The impact could be especially severe in the UK, with its large financial sector and extensive VAT group provisions with their extra-territorial reach. Transfer Pricing would continue to be applied in the same way, irrespective of whether VAT grouping continues or not. However, its impact will clearly have a significant indirect tax impact if grouping provisions disappear.
Interestingly, the recent CJEU decision in Credit Lyonnais could be viewed as providing a signal to how the European judiciaries currently view VAT group member status for VAT purposes. In that case a head-office and branch were effectively viewed as separate persons for VAT purposes for the purpose of determining recovery of input tax in different jurisdictions.
OECD VAT/GST guidelines
The OECD has become concerned in recent years that the development of VAT and other forms of goods and services tax (GST) regimes has increased the potential for double taxation and unintended non-taxation. In 2006, the organization began to develop guidance for governments on applying VAT to cross-border trade.6 In February 2013 it published for comment a draft consolidated version of these guidelines, which build on two core principles:7
- the neutrality principle, whereby VAT is a tax on final consumption that should be neutral for business
- the destination principle, whereby internationally traded services and intangibles should be taxed in their jurisdiction of consumption.
If generally adopted, the destination principle could have major implications for the taxability of services acquired by a headquarter and supplied onward to multiple branches.
Currently, where there is a single supply deliverable to a number of branches under a global contract, the entirety of the service is taxed according to the location of the branch most closely connected to the supply and the onward branch-to-branch allocations are not subject to VAT. The OECD guidelines would mean that internationally traded services would be taxed according to the rules of the jurisdiction of the place of consumption. When a supply is made to a legal entity that has establishments in more than one jurisdiction, the OECD proposes a two-step method (the ‘recharge method’) to allocate taxing rights to the jurisdictions where the customer establishments using the service are located.
The effect for multinational financial institutions with branches in the EU and other jurisdictions with EU Model and VAT systems would be to bring relevant services within the scope of VAT, with potentially substantial costs. This could represent significant additional VAT cost for financial services entities if not considered properly. Companies will have to review the structure, location and direction of services provided, with potentially profound consequences for operating models. Transfer Pricing will again have an impact on how the attribution of this expense is made to the branches and therefore will in part determine the VAT cost.
Financial institutions face a raft of new regulatory requirements which will drive widespread changes to corporate structures and operating models. Many of the necessary responses will have the collateral transfer pricing and VAT consequences even if these are not immediately apparent. Companies will need to ensure that their evolving strategies take account of the tax consequences to minimize any unanticipated tax costs.
- Independent Commission on Banking, Final Report, September 2011
- Services rendered by a head office to a branch in another Member State are not taxable services for VAT, even if the cost of such services is allocated to the branch, Advocate General opinion, Case C-210/04, September 2005
- Developing business models and structures: the new tax and transfer pricing environment
- The Skandia America Corporation USA case, C-7/13
- The OECD International VAT/GST Guidelines, 2006
- OECD International VAT/GST Guidelines, Draft Consolidated Version, Invitation For Comments, February 2013
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