Nevertheless, despite VAT exemption being the default "rule", VAT may already apply to some degree to many regulated financial services providers, for example if its services fall outside the scope of exemption, or the EU member state in which it operates has introduced an option to tax and the operator exercises that option. Some member states have introduced this option, for example France1, and this note considers some of the key practical issues raised by the optional regime now in place.
This is a quite standard question with what appears to be an obvious answer: as a service provider subject to VAT, an operator could be entitled to recover the input VAT on all its investment costs, as well as on its overhead costs. This would likely entail a huge cost saving.
On the other hand, the "option to tax" would not be detrimental for customers if a large part of the clientele were made up of businesses who are themselves subject to VAT. These customers will be able to deduct the VAT invoiced on the services supplied to them by financial service providers.
That said, if another part of the clientele does not deduct input VAT, for example individuals and non-taxable legal persons (public authorities, holding companies, etc.) and exempt or non-business undertakings (small non-taxable businesses, providers of medical services, non-making profit organisations, charities, educational services, etc.), the exercise of the option may entail a critical commercial issue.
The operator will have to balance the profit resulting from the recovery of the input VAT on the cost price of the service and the correlative increase of the sales price for such services, resulting from the application of VAT in addition to the VAT exclusive or net price. In this case, the operator will likely have to find a way to share this additional profit with its customers.
Opting for the payment of VAT therefore requires an optimal estimation of both the gains in terms of costs and the losses in turnover according to the possibility of increasing the selling prices or not. This exercise is even more essential as the notion of turnover in the banking sector constitutes in itself a very specific problem (i.e., is direct taxation applicable on gross flows or on net banking income?).
The framework provided by the VAT Directive
It is relevant to mention that the VAT Directive includes "may" provisions. Those provisions refer to the articles of the VAT Directive that state that individual EU member states have the possibility, but not the obligation, to implement certain provisions into its domestic VAT legislation. Among those provisions, there is an "option to tax" regulated financial services. Some EU member states have already implemented it (e.g., France and Germany) whereas others have not yet moved in that direction (e.g., Luxembourg and Spain).
The option to tax regulated financial services is granted by Article 137, 1 (a) of the VAT Directive. Paragraph 2 of the same article clarifies that the EU member states decide the terms for governing the application of the option.
For the sake of clarity, not all regulated financial services are exempt in the first place, but are subject to the standard rate; only those listed by Article 135, 1 of the VAT Directive benefit from the exemption. The Court of Justice of the European Union (CJEU) has stated that exemptions constitute exceptions to the general principle that VAT is to be levied on all services supplied for consideration by a taxable person, and so must be construed and applied narrowly.
France as an illustration
The scope of the VAT exemption applicable to regulated financial services in France is similar to the scope of Article 135 of the VAT Directive. However, based on the aforementioned Article 137, 1(a) of the VAT Directive, France introduced the possibility to opt in for VAT. The historical regime (reformed in 2022) was structured around an option to tax, (a) granted to businesses running a financial activity as a main business, (b) applicable to all financial services, (c) excluding a specific list of transactions and (d) with no possibility to withdraw the option during a certain period.
Under this regime, businesses supplying financial services on an occasional basis were not entitled to opt in for VAT. However, some financial revenues such as interest, capital gains on bonds and shares, and foreign exchange profit were in any case VAT exempt, even when the operator had opted in for VAT.
As of 2022, France has amended its regime and permits businesses to opt in for VAT on an operation-by-operation basis. This provides more flexibility to operators. Nevertheless, the list of transactions subject to VAT remains unchanged. Therefore, if the operator may opt in depending on the potential customer's possibility to recover the input VAT, part of the services will remain, in any case, exempt from VAT and not considered as zero-rated when charged to EU recipients.
It is worth noting that opting in for VAT on cross-border financial services does not lead to effectively applying output VAT (i.e., the place of supply of the service is located outside France and thus remains supplied outside France), but it enables the service provider to recover the associated input VAT.
Opting in for VAT: practical consequences
As previously mentioned, an option per supply and per customer offers more flexibility in terms of pricing and reduces the impact VAT may have on B2C customers, other VAT exempt financial services providers or investors such as funds and holding companies. On the other hand, opting in for VAT enables the neutralization of VAT on costs incurred by the regulated financial services provider and could also have an impact on the final pricing of a financial service. So the answer to the question on whether to opt in or not is not necessarily straightforward, notably in EU member states such as France, where VAT exemption is linked to other tax regimes. In France, VAT-exempt financial services providers are subject to a specific tax assessed on its payroll costs.
The downside of a mixed regime with transactions subject to VAT and and VAT-exempted transactions is the potential complexity of handling different VAT regimes per operation and per customer. One could pose the question: Are the accounting systems of the participants in financial transactions properly designed to track each potential scenario? The issue may affect not only the service provider who has to issue a valid invoice in due time and remit the VAT to the authorities. It also affects the service recipient that will have to determine, depending on its own VAT status, whether the applicable VAT is recoverable or not.
In this regard, in France and Luxembourg, the issuance of a valid VAT invoice is not mandatory for VAT-exempted regulated financial services. Therefore, opting in for VAT means a modification of the invoicing process in those EU member states where the option is exercised. Anticipating this kind of practical aspect is key when the decision to apply VAT is made in an industry not generally familiar with the issuance of VAT invoices. Otherwise, the customer will lose its right to deduct input VAT, so the commercial impact will be adverse at the level of the service provider.
Opting in for VAT: pending questions
Opting in for VAT in one EU member state may result in a different set of questions that are not entirely resolved at an EU level. In this regard, the jurisprudence of the CJEU is very limited, where it exists at all. The following items are some examples of potential difficulties, either theoretical or practical, concerning an optional regime.
To the extent that the VAT Directive provides that EU member states have the freedom to determine the conditions under which the option can be defined, it means that the scope of the option is not harmonized and, more importantly, that an EU member state can introduce discrimination between operations and operators. However, the said freedom is limited by the general principles of EU law, which restricts the EU member state's prerogative. In this regard, it should not be possible to introduce options solely limited to the residents of an EU member state.
Another difficulty is defining the scope of the option. The wording used by EU member states to describe when VAT applies or not may be different from the wording used to describe the scope of the VAT exemption itself. For example, both the VAT Directive and the French legislation exempt from VAT operations, including negotiation, concerning operations on shares and bonds, but the domestic legislation allows the option for VAT on negotiation but excludes "commissions received on the issuance and placement of bonds and shares" from the scope of the VAT option. For the CJEU, "negotiation" means intermediation, but, one could wonder, how is "placement" or "issuance" exactly defined? This leads to another unforeseen/undesired consequence about the possibility of the CJEU to effectively limit/restrict/harmonize the scope of the option, which, in principle, remains in the hands of the EU member states. In a harmonized VAT world, operators may expect to have, at the very least, a limited list of definitions and concepts applicable to both the exemption and the option.
Some further problems/concerns may arise concerning the situation where a foreign head office has a branch in a member state that deals with different customers. Does the option of the local branch apply to the regulated financial services provided directly by the foreign head office to local customers without the involvement of its local branch? Is the foreign head office entitled to opt in for VAT locally without affecting its local branch? France currently considers the two establishments of the same legal entity as different taxable persons in this regard. The same question arises when the local branch is member of a VAT group. How will the local option for VAT interact with the presence of a local VAT group and what is the impact when some of the members of the VAT group have a non-EU head office or establishment?
Another unsolved issue is the possibility to consider regulated financial services subject to VAT upon option as a sector, as referred to in Article 173 of the VAT directive. As a reminder, two sectors are considered as two different businesses for the calculation of the recoverable VAT. As an example, France has a more restrictive approach than the UK in this regard. Taxable financial services are not a separate activity but form with VAT exempt services a joint and standalone business for which VAT is deductible using the pro rata of recovery for most of the expenses allocated to that business.
A final question that is relevant is whether it would be possible for an EU member state to apply the option for VAT on a complex service that includes a component eligible for the option and another component ineligible? This scenario seems to be contradictory with CJEU case law. Indeed, according to the CJEU jurisprudence, as notably summarized in the Frenetikexito – Unipessoal Lda (Case C-581/19) of 4 March 2021, there is only one VAT regime applicable to a unique transaction made of a main element and ancillary ones. Nevertheless as an example, France implemented this approach in the past. This is not the case anymore.
So, as we can see, a first conclusion only focused on the deductible VAT savings may be rapidly counterbalanced by many other issues to be solved before making the final decision. These issues are the downside of a flexible regime. However, flexibility is likely the best approach in a continuous innovative and evolving market, provided that definitions used by the EU member states for both the scope of the exemption and the option are clear and harmonized. Our hope is that the EU member states will "opt in" for this approach.
1 Austria, Belgium, Bulgaria, Croatia, Estonia, France, Germany, Lithuania and Poland have currently implemented the "option to tax" for financial services, but not in a uniform manner.
