Delegates at the 4th Asia Tax Forum, in Hanoi, Vietnam asked for further research in two main areas – indirect taxation of the financial sector, and use of tax expenditures as an instrument of tax policy in the region. Several government delegations mentioned challenges that they faced in balancing the needs of maintaining a competitive and enabling environment for the financial sector against the need to tax the sector more efficiently. This is especially important in a region that has to implement a much more broadly based indirect tax system, mainly relying on a VAT, to make up the revenue shortfall caused by the drop in trade taxes.
It was felt that there would be significant benefits for both the private and public sectors to study the indirect taxation of financial services firms and their transactions and services. Policy makers and administrators would be able to examine how comparable transactions were handled in other countries, and evaluate the most appropriate treatment to adopt to meet their own objectives. It was acknowledged that in this complex global financial environment it is desirable to have clear definitions and a high degree of certainty to help tax authorities administer and businesses comply with tax rules. Similarly, because the global financial sector is so interlinked, there likely would be significant economic efficiencies and attendant economic benefits if countries in the region were to adopt consistent approaches, principles and practices in their indirect tax regimes.
Issues arising from inconsistent and differential treatment
In many countries exemption of financial supplies from VAT or an equivalent tax is justified on the basis that it is often difficult to isolate and tax the value added by the financial intermediary. Tax “exemption” however, raises its own set of problems, as the financial services provider is unable to recover some or all of its input VAT cost. This unrecovered VAT becomes embedded in the cost of financial supplies and results in “tax cascading”. Tax cascading is where output VAT is charged by domestic businesses on unrecovered VAT embedded in an exempt financial service acquired by that business as part of its business inputs. This phenomenon inflates the cost of domestic products and services and erodes a country’s competitive advantage. Ultimately, it is the end consumers who are not VAT registered – most notably individual consumers and non-resident businesses – who bear the inflationary cost of this tax cascading.
Gross revenue taxes applied to financial products have a similar effect. Some countries use special excises or gross revenue taxes, e.g. the service tax in India, the gross business receipts tax in Chinese Taipei, the gross receipts tax in the Philippines, the specific business tax in Thailand and the education tax in Korea, to raise tax revenue from the financial sector. These levies and charges are generally based on gross profits, which theoretically have the advantage of administrative simplicity. However, in the same way “VAT cascading” reduces a country’s competitive advantage, these revenue taxes result in financial services having an embedded cost which cascades throughout an economy leading to economic distortions. Indeed, where the burden of these gross revenue taxes are calculated on a periodic (usually monthly) basis without allowing losses to be offset between periods or products, the embedded tax costs can often be amplified resulting in higher inflationary pressure for all goods and services provided within a domestic economy.
Other distortions arise where there is a disparity in the tax treatment of the same transaction or service provided by different types of financial services providers, e.g., bank vs. non-bank financial firms or private vs. government sponsored institutions. These tax differences can distort prices and reduce efficiency in this important sector. As a general principle, an effective tax structure should establish a level playing field among local and foreign businesses and private and public enterprises. This, in turn, will promote productivity as firms compete based on their economic efficiency rather than an institutionalized tax advantage.
It was therefore felt that policymakers and taxpayers would benefit from a thorough review of the various indirect tax models as they are applied in the financial services context and extract best methods and practices from this learning. This should help governments meet their objectives for revenue and competitive efficiency in the most effective way.
Research programme and process
A research programme was agreed by the government and private sector partners; the purpose of the research would be to
- Perform a comparative scan of the rules related to indirect taxation of the financial sector in selected AP jurisdictions
- Identify some minimum normative standards for indirect tax reform in the financial sector.
- Deliver recommendations for tax policy in this area, with some index for measurement of outcomes, which is relevant to countries in the region and recognizes their needs to balance revenue raising with an enabling environment for a strong and vibrant financial sector.
It was felt that participation by the member governments would be vital in this research project, and to that end, a joint working group comprising both private and public sector participants was formed. In developing the research program, it was decided to include a preparatory workshop of the working group to frame the issues, determine the research process, set out further inputs needed for the work and set expectations for the final paper. This took place on 29 January 2008, in Hong Kong; on the government side, Dr. Kavita Rao, Senior Fellow, National Institute of Public Finance and Policy, Government of India, Ms. Buntharika Promphan, Office of Fiscal Policy, Ministry of Finance, Thailand and Mr. Dinh Nam Thang, Deputy Director, Ministry of Finance, Thailand, attended; the other two government members of the working group, China and Malaysia, could not attend but continued to work with the group. On the private sector side, Mr. Jeff VanderWolk, Merrill Lynch (Asia Pacific) Limited, Ms. Greta Chang, JP Morgan and Mr. Hal Davis, Citi Group took part, while Mr John Foster of Citi Group participated by telephone from Australia. They were joined by the ITIC team comprising Prof. Lee Burns, Hafiz Choudhury, Dr. Milwida Guevara, Prof. Joosung Jun and Dan Witt.
The research authors, Prof. Jun and Prof. Burns, presented the outlines of their research at the workshop, including the design issues of VAT on the financial sector, and a comparative review of alternatives, as well as the more applied issues in application of VAT, including review of the intermediation role of financial institutions, challenges in identifying margins, allocation rules, etc. Public sector participants stated their concerns and policy needs, including a need to cover a wider range of taxes than just VAT, as well as the issues that they would like to see addressed in the final paper. Private sector participants raised the practical problems/challenges they faced, and some possible solutions. The workshop ended with a clear set of recommendations concerning the problems/challenges to be addressed in the paper.
It was agreed that the study would be delivered via two distinct papers:
- A macroeconomic analysis by Prof. Joosung Jun, that covers the policy design issues, various alternatives available, a review of the exemption policy in the EU VAT regime and other alternatives, in particular the approaches taken by South Africa and New Zealand.
- A more applied analysis, by Prof. Lee Burns, covering the legislation and other regulations needed in establishing a more efficient regime, including options for countries which apply a broader regime which may or may not include a destination based VAT system for indirect taxation.
The results of the research would then be discussed at the ATF meeting in Delhi, during which public sector participants would add their comments. These further comments would later be dealt with in the study, after appropriate edits, in the form of a review of the issues faced by policy makers in practical application of such policy choices.
The expected outputs of the study were
- Discussion of challenges faced by countries in application of indirect tax, mainly VAT, to the financial sector.
- Make an inventory of problems faced in consistent implementation of VAT and other taxes that result in indirect taxation of financial institution
- Consider model of financial transactions to move towards standard definitions – more likely loose definitions and guidelines – of financial transactions.
- Review of the existing VAT and other legislation on the financial sector, and identify best features.
- Build a basic matrix of the range of indirect taxes currently applied to financial sector supplies and the tax base.
- Consider existing solutions within current spectrum, from NZ zero rating of B2B to current South Africa rules.
- Present, to the extent of the research data available,:
- A series of alternative options that may be used in determining VAT policy.
- Some standards and metrics for use by tax administration policy makers
- If possible, an index of definitions – where private and public sector may both participate and identify specific transactions as falling into a specific category.
Conclusion and next steps
The final papers from Prof. Jun and Prof. Burns were presented at the 5th Annual Meeting of ATF, in New Delhi on May 11-13 2008. These are published below and include comments received during the conference. Policy options are considered in their wider economic impact – competitiveness, growth in capital markets, and inward investment by multinationals – all connected with a strong and vibrant financial sector.
In principle, the authors agree that the Singapore approach to B2B zero rating is preferred on the grounds of simplicity and consequent lower compliance costs, although there may need to be limitations on the application of zero rating to supplies between financial institutions to prevent B2C supplies being effectively zero rated. This approach is also considered to have a base-broadening effect as well as reducing many of the distortions associated with the exemption method. It is considered that apportionment rules that are simple and easy to comply with also have to be designed, in order to apportion input tax credits as B2C supplies will still be treated as exempt supplies.
The research also shows that there is no consistency in the way that countries in the region approach the taxation of financial services under the VAT or similar tax. It was considered in New Delhi that that the next logical step in the research was to consider national practice in the light of the policy options outlined in the research to date. It is expected that such further research could examine current national practice and compare this against a model of results achievable from adoption of the approach suggested.
Accordingly the next steps in the research project are to combine the conclusions from the papers below into a proposed model for taxation of financial supplies in the AP region. National governments would then use this model to compare against their current practice. It is thought that such specific country practices research could include the Philippines, India, Singapore, Thailand, Malaysia, Australia, New Zealand, and China.
The research will cover:
- Taxes/levies that are in substance indirect levies applicable to the financial sector
- Base: e.g. Margins and fees distinctions, gross tax base, etc.
- Scope of financial services are defined as banks, leasing companies, securities trading/brokerage, asset
- management companies, while Islamic finance, insurance companies and pension funds are excluded at this point.
- Exemptions for specific service in financial sector.
These country analyses, combined with an introductory chapter showing how the model was constructed, and a later section on administrative and compliance issues, could then be published as a monograph on indirect taxation of financial supplies in the Asia Pacific region. Additional sections presenting some common definitions, best practice in dealing with the specific transactions covered and areas where governments can cooperate in indirect tax administration to ensure consistent treatment could also be included.