GST and Financial Services

Research Paper
GST & Financial Services

Irian ur Rehman Khan The University of Sydney, Faculty of Law, Sydney Law School
June 2005
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 services have been briefly .. f(~"f~
examined and alternate proposals discussed. 1. Introduction:
on taxing financial
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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
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. 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
,"
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 outsource 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
In Australian GST legislation, the term input tax is used instead of exempt. 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 providing these 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.
I
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 2.1
7 .
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
Regulation 40-5.09 Regulation 40-5.10, Often a financial supply may partially have a taxable component which is difficult to separate from the primary input taxed supply. In such a situation, such a partial supply, which is incidental and directly connected with the main financial supply. Such a supply does not have a separate consideration and therefore deemed to be a financial supply for all practical purposes. An example of financial supply could be the provision of advice by the lender or borrower in connection with the loan arrangement. Such an advice shall be an incidental financial supply. 7 Regulation 40-5.12 of the GST Act 8 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.
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 facilitator

15
between a financial supply provider and a financial supply
Therefore, third party who is arranging the financial su:pl: ~.e;. t~e :~~a~~ial
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supply facilitator'" is not entitled to the benefits of iJ\pht tax supplies. Supplies made by financial supply facilitator are taxable supplies. This is unique to Australian legislation as 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 merely listing certain types of supply. Contrary to the simple shopping list 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
15
Supplies connected with Australia are defined in s 9-25 (5) of the GST Act. Financial supply provider is explained in Regulation 40-5.06 of the GST Act Financial supply facilitator is explained in Regulation 40-5.07 of the GST Act. Regulation 40-5.12 of the GST Act. 4
16
,17
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 zerorated, 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. They do not assert that it is inappropriate to tax financial services because they do not directly enter the utility function, but rather that it may be inappropriate to tax financial services. They explicitly hold open the possibility that the optimal rate at which to tax financial services may be at a positive rate, albeit somewhat lower than the standard rate
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
regimes'
response
to
financial
ill OEeD
services.
Table 1. Value-Added
of the Financial Sector
Countries, 2001
(Percent of GDP)
Australia Austria Belgium
Canada 1/
Czech Republic Denmark Finland France German').' Greece Hungary Iceland 'u Ireland 3/ Italy Japan Korea Lu .. xernbourg Mexico Netherlands New Zealand 1i Norwav Poland Portugal Slovak Republic Spain Sweden Switzerland 3/ Turkey United Kingdom United States 3/ Average Memorandum item: EU average ... Source: l2()04).
26.2 27.0 293 25.7 16.7 23.4 22.9 30.5 30.8 23.6 20.5
20.2
17.9
28.4
23.9 23.8 57.9 12.1 27.6 29.2 19.4 14.2

21.0
19.4 22.9 24.0 29.5 14.7

29.9
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- I. /
24.7
z-,
27.8
4.1
The Definition of financial Supplies:
Australian
definition
of financial
supplies
does not enumerate
the supplies which are financial and supplies fulfilling
supplies rather the GST legislation are deemed to be financial
sets out preconditions supplies.
that criteria
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,
20
Value Added Tax (VAT) Act 1994. 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).
19
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 26
Schedule 7 and 8 of the Australian GST Act. Regulation 40-5.12 and schedule 8 of the Australian GST Act.
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
10
.GST & Financial Services
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 insourced 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.
Business A
-.
Financial Intermediary
(No input tax Credit)
Business B
f---.
(No input tax Credit as GST is not charged)
Final Customer
1-+
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 12
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cheque
and payment-processing
services.
However,
although
the GST is neutral
for
taxable sectors, for financial services is counterbalanced
institutions
the economic
benefits of outsourcing
specialist to it
by the additional
tax cost resulting
from their inability IT services in-house,
claim input tax credits. cannot recover
For example,
where a bank performs software
the GST paid on computer
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
5.3
increased by outsourcing'". services is a source of significant alike. A
Complexity:
The
exemption
of financial
complexity
and administration
cost for tax authorities
and financial
institutions
boundary between exempted make a combination claiming achieve
and taxable supplies makes it necessary to apportion purchases between
for tax payers that two activities when to
of supplies
input tax credits. accurately.
This imposes
compliance
costs and it can be difficult difficult issue
In practice,
apportionment
is the most
facing in
intermediaries the application problems. exempt
when complying of grouping there
with GST. This has been compounded rules. There much are two broad controversy
by uncertainties
categories
of compliance between financial and
Firstly.
is inevitably provided
over the borderline Secondly,
and taxable
services
by financial
institutions.
institutions
are required
to apportion
their inputs between taxable (input-creditable)
exempt (non-creditable) tax authorities
activities. This is typically the area of most controversy
between
and financial institutions.
28
Brian Wurts And Frankie Fenton, Indirect Taxes On Financial Services.
13
1GST & 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 insourcing 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 allowed a notional 75 percent input tax credit reduction. 6.1 The Reduced Input Tax Credit Scheme (RITC)30: The reduced input credit supplies are
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 insourcing, as against outsourcing of services, is unfair for small businesses. Other
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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. 14
I
I I I I I I I I I
GSTN 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 where 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 services and doing away with RITe system as is done in overseas jurisdictions. The other
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view is that RITe is more efficient and precisely maintains the balances out any incentive for in-sourcing as against outsourcing of arranging and facilitation services for financial supplies. 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 scheme, 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 will 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. What 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 financial service providers as result of GST.32
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32
R Stitt ,CST and Financial Services Tax Specialist VOL 4 No 5, June 2001,
15
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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 /rar >''i-7 (i:1 .If litigation which exacerbates the complexity of RITe. Secondly, the process of
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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 decision between in-sourcing and out sourcing of an arranging or facilitating service of the financial supplies. Such an inaccurate estimate may be distortionary.
-'JIe ~ -ai u. "'';

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.f.
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.
16
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 the case 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. 6.3 Zero-Rating Business-to-Business
.:::1-
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 Intermediary
Business B
r---.
(Input tax Credit)
-.
(No input tax credit as GST is charged at the zero percent)
Final Consumer
~
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 its 18
4~ - -,~.~.~
r
! ..
,0:., I
"'/ \ ~.,
p.
.'1
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
1
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[
j
(
Miscellaneous Provisions) Act 2003 amended the Goods & Services Tax Act 1985 (the
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~/A GST Act) to allow supplies of financial services by a GST-registered person to another ~.~) ~-;),l ' ' '.i tf.,v 11 . u : t-;.-Y/ ! GST -registered person to be zero-rated". The changes integrate the supply of financial J ur- :J .', 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 12month 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
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GST guidelines for working with the new zero-rating rules forfinancial services Prepared by the Policy Advice Division of the Inland Revenue Department, ISBN 0-478-27120-4 Published October 2004, P 0 Box 2198, Wellington.
19
treasury However, businesses financial supplied comment Zealand's countries
or finance supplies
function
of a group of companies services cannot
who receives
financial
services. to
of financial
be zero-rated
if they are supplied
whose activity of making exempt supplies of financial exempt supplies is more that 25 percent persons
services and other nonor they are to
of their total supplies, Although, financial supplies prima
to unregistered on New experience
(or final consumers). zero rating
it is premature supplies
Zealand's
experience
but if New then other and
with the zero rating of financial the precedent
is successful
may also follow
as the scheme
facie is workable
resolves most of the contentious
issues arising from exemption proposed
of financial supplies.
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Reverse Charging:
Monetary
The latest approach
by the Howell H. Zee of the approach. If the value of a its loan and
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intermediation
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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: and deposit interest would then be the bank's the V AT on the loan and
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output tax and input tax, respectively,
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the excess of the former over the latter would be remitted to the government as the V AT on its intermediation services,
by the bank
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Taxing the loan and deposit interest in this transaction basis (i.e., the V AT is assessed at with an invoice-credit
(liJ.ft.;.J -~
way is clearly feasible on a transaction-by each instance of an interest payment)
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and is thus fully compatible
ti.J,;~ cr~il 1
j" , r
V AT36. While seemingly two crucial problems. from multitudes registered
straightforward,
the above V AT treatment of the bank generates
-r.. 4
The first is administrative; final consumers the bulk of bank deposits is derived to be of individual who are administratively infeasible
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as V AT payers. Hence, they cannot serve as V AT collection agents for the
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36
Howell H, Zee A New Appr:J(l,ch to Taxing Financial Intermediation IMF Working Paper Fiscal Affairs Department, July 2004,
Services
Under a Yalue-Added Tax,
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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-
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, undertaxation 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
9.
2198, Wellington.
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. 15.
Kelly Edmiston and William F. Fox A Fresh Look At The Vat. 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 .
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