The tax treatment of the financial services sector is
complex, not only because it is a complicated
sector, but also because it is conceptually
difficult. Despite these difficulties, it is
important that authorities consider these issues
closely, due to the economic importance of the
sector and because it is an important source of tax
revenue.
The financial services sector, which includes
banks, insurance companies, securities companies,
investment companies and pension funds, is clearly
important in the Caribbean. In 2000/2001 there were
around 1,000 offshore banks, 1,200 insurance
companies, and 5,000 mutual funds located in the
Region.
The contribution to revenue by offshore
financial centers’ (which includes the financial
services sector) is important, with annual fees from
this sector raising an average for ECCU countries of
3.4 percent of central government revenues (in the
2000 year) with much higher shares in the British
Virgin Islands (54.6 percent) and the Cayman Islands
(14.6 percent). The sector is also likely to be a
significant contributor to corporate tax
revenues—for example, it is estimated that in the
2000 year around 40 percent of Barbados corporate
tax revenue was from the offshore financial sector.
Like any tax policy design, it is important that
the tax policies for the financial services sector
satisfy the principles of equity, simplicity and
efficiency. Of particular concern with the financial
sector is to ensure that the tax system does not
create distortions in the sector (for example,
between different types of financial institutions or
different types of financial products). Governments
can also be prone to give this sector special
treatment creating distortions between the financial
sector and other sectors due to incentives towards
the inefficient allocation of resources. At the same
time, care needs to be taken with the opportunities
for tax arbitrage to which this sector is especially
susceptible.
There are many tax issues which affect the
financial services sector including: the taxation of
financial instruments; withholding taxes on interest
and dividends; tax regimes to promote offshore
financial centers; taxation of foreign exchange
transactions; taxation of cross-border leasing; the
application of double tax treaties to financial
services; and, the treatment of financial services
under the value added tax (VAT). It is not possible
to cover all these issues in this paper.
The focus
of this paper is on five broad tax policy issues:
(1) the treatment of financial services under the
VAT;
(2) the income measurement issues facing
financial institutions;
(3) financial transaction
taxes;
(4) regional harmonization of the taxation of
the financial services sector; and,
(5) the
implications of a flat tax for the financial
services sector. These issues were chosen because
they seem to be areas of particular importance to
the Caribbean at this time. The purpose of this
paper is to briefly discuss the key issues relating
to these five areas and the options for resolving
those issues, including the international
experience.
The rest of this paper is organized as follows:
Section I discusses the VAT on financial services;
Section II considers some tax issues relevant for
financial institutions; Section III looks at
financial transaction taxes; Section IV consider the
regional tax harmonization for financial services;
Section V discusses flat taxes; and Section VI
concludes.
I. VAT ON FINANCIAL SERVICES
The importance of
VAT in the Region is clear, with at least six
countries in the region in the process of
introducing a VAT. The taxation of financial
services is a problem that all countries with a VAT
have to face. Revenue and equity considerations
suggest that financial services should be subject to
VAT just like other goods and services. However, the
administrative problem for financial services is
that it is difficult to measure the financial
services to be taxed.
Financial institutions provide a range of
services including: fee-based services such as
advisory services, safe-keeping, fees on ATM
transactions and portfolio management services;
intermediation between borrower and lender; and
insurance services. Clearly the value of fee-based
services are usually able to be measured.
The
problem arises with the main service—intermediation
between depositors and borrowers—because the price
charged for these services is often implicit rather
than explicit. To illustrate, assume a bank offers a
deposit rate of 5 percent and lends at 12 percent.
The value of the services is given by the margin of
7 percent. However, it is not clear how much of this
margin relates to services given to the borrower and
services given to the deposit holder.
Therefore, for
financial services it is difficult to apply the
standard invoice-credit method—under which firms pay
tax based on the difference between the tax paid on
their sales and the tax paid on their inputs.
Most countries deal with this issue by simply not
applying VAT on financial services. The experience
in the Caribbean is the same with most countries
exempting financial services. However, such an
approach deprives governments of much needed tax
revenue.
At the same time, exempting this sector
from VAT when most other sectors are being taxed
creates distortions, because the consumption of
financial services by households is under taxed,
compared to consumption of other goods which are
subject to VAT. Also, consumption by businesses is
overtaxed, since there is cascading when taxable
businesses purchase tax-exempt services.
Cascading
is where further tax is paid on an already taxed
good or service with no credit for taxes paid
previously. For example, a financial institution
will pay tax on many of its business inputs such as
computers and office supplies. As the financial
institution is outside the VAT system, they will not
be entitled to an input tax credit for the VAT paid
on those supplies. Instead, they will pass the cost
of this on to businesses who will include that in
the final price to consumers on which VAT will be
charged. Hence VAT on the inputs are effectively
taxed twice.
Of course, cascading, distortions and
tax base erosion can arise with any exemption under
the VAT, that is why countries are encouraged to
keep VAT exemptions to a minimum, and especially be
careful not to expand exemptions after the
introduction of a VAT.
A. Options for VAT on financial services
As a
result of the problems outlined above, a number of
countries have decided to impose VAT on at least
part of the sector’s activities. Some of these
options are set out below.
Basic exemption approach Many countries impose
VAT on fee-based financial services, since they can
easily be included in an invoice-credit system. The
European Union (among others) follow this approach,
known as the “basic exemption” approach, since it
exempts basic activities (intermediation) while
taxing ancillary services, such as advisory
services, safe-keeping, fees on ATM transactions and
portfolio management services. Exported financial
services are usually zero-rated.
The advantage of this approach is that it brings
into the tax net some financial services, thereby
increasing revenues and reducing cascading. The
administrative problem with this approach is that it
requires banks to apportion their inputs, which
means identifying the portion that is used in the
provision of fee-based services, so that banks can
claim the associated VAT input credits. This
apportionment is difficult in practice and can lead
to disputes between taxpayers and the tax
authorities.
This is evident in the European Union
which has recently announced a review of the Sixth
VAT Directive which governs the treatment of
financial services and insurances. The review is
considering (amongst other issues) the level of
deductible input VAT, the definition of exempt
services, and ways to reduce the administrative
costs for businesses.
Exemption with input credits approach Singapore
has tried to overcome the problems with the basic
exemption, in particular cascading, by allowing
financial institutions to claim VAT input credits
under the “fixed input tax recovery method.” Under
that method, the financial institution is entitled
to a VAT input credit based on a fixed percentage of
total input taxes. The fixed percentage is based on
industry norms and the type of financial
institution.
Australia also seeks to provide partial input tax
credits for exempt services provided by financial
institutions. Providers of financial services may
recover a specific 75 percent of the input tax paid
on purchasers used in providing the services.
The advantages of the methods used in Singapore
and Australia is that they overcome some of the
cascading, though not all, and they remove some of
the administrative complexity in apportioning input
credits between taxable and exempt services.
Zero-rating business to business approach New
Zealand has recently adopted an approach where a
financial institution can recover input tax credits
on financial supplies provided to VAT-registered
businesses (effectively, zero-rating). A condition
of accessing the credit is that the value of the
taxable supplies of the VAT-registered business is
at least 75 percent of sales over a 12 month period.
The zero-rating approach is conceptually similar to
the fixed input tax recovery method adopted in
Singapore except the financial institutions are
required to ascertain the VAT status of their
customers, rather than apply an industry norm. This
approach partly deals with the cascading problem.
However, the sales threshold and the fact that the
financial institution needs to know the status of
the VAT-registered business, including whether it
satisfies the sales threshold, appears to make this
system administratively complex.
Taxing gross interest approach Argentina levies
VAT on the gross interest charged on loans. Since
banks can easily levy this charge on a transaction
by transaction basis, businesses can claim their VAT
payments on financial services as input tax credits.
However, cascading remains a problem as the bank
cannot claim an input tax credit for VAT paid on
their business inputs.
A further problem is that
consumers who finance their purchases with debt must
pay VAT on both the cash price of their purchases,
as well as on the loans to finance it. This would
not be a problem, if the gross interest charged
represented the price of the financial service
provided, because consumers would be paying two
separate taxes—that is, on the goods and on the
financial services. But gross interest considerably
overstates the value of the financial service
provided, overtaxing the consumers—but benefiting
government revenues. As a partial compensation, VAT
on gross interest is levied at a lower rate (10.5
percent which is half the normal 21 percent rate).
Addition method
Under this method, which has been
adopted by Israel, taxes are levied on the sum of
the firms’ wages and profits, as an approximation of
value added. This is a relatively simple approach as
banks can easily calculate their wages and profits
and do not need to value their services on a
transaction-by-transaction basis. The problem with
this approach is that it does not address the
cascading problem as it does not fit well with the
invoice-credit method of VAT used elsewhere in the
economy. This is because the tax is not imposed on a
transaction-by-transaction basis.
Cash-flow approach
An alternative approach, which
has not yet been tried in practice, is the cash flow
approach. Under this approach, VAT would be imposed
on all cash inflows (which includes loan repayments,
deposits, and interest receipts) and a tax credit
granted on its total cash outflows (which includes
lending, deposit withdrawals, and interest
payments). The net outcome of this approach is a tax
on the interest margin, and hence, value added by
the financial institution. The tax would be levied
on a transaction-by-transaction approach and would
therefore be compatible with the invoice-credit
method.
However, there are limitations with this
approach. Because the loan principal is taxed, a
borrower could suffer cash-flow problems because of
the upfront burden of the tax (similarly, a
depositor could have a cash-flow benefit).
Furthermore, all taxpayers rendering financial
services and VAT-registered businesses would be
required to calculate the tax on their cash flows
which could be a significant administrative burden.
Finally, the cash flow method would pose some
difficult transitional issues in dealing with
deposits and loans outstanding at the time of
introduction of the system.
B. VAT and Insurance
The VAT treatment of
insurance depends on whether it is life insurance or
non-life insurance. This difference is important
because while all types of insurance include
explicit fee-based financial services, a significant
part of life insurance premiums represent savings of
the insured and should not be taxed under a VAT. It
is for this reason that most countries exempt life
insurance under the VAT irrespective of the
treatment of other financial services.
Most countries treat non-life insurance like
other financial services. Therefore, it is exempt in
the European Union, and taxable in Israel under the
addition method. However, in New Zealand, Australia
and Singapore tax is paid on non-life insurance
premiums. Therefore, any business paying non-life
insurance premiums is entitled to an input tax
credit. Any insurance claims paid by an insurance
company are grossed-up for VAT so that the insurance
company can claim input tax credits for the VAT
component in the claims paid. Therefore, VAT is
imposed on the difference between the payment of
premiums to the insurer and the payment of claims to
the policy holder. The advantage of this approach is
that it overcomes the cascading problem. However,
the grossing-up approach is complex.
C. Summary
There is no perfect solution to the
problem of taxing financial services under the VAT.
Different countries have applied different systems,
depending on their need for revenue, and their
concerns about distortions and administrative
complexity. Despite the difficulties in taxing
financial services under the VAT, there are benefits
for Caribbean countries in taxing the sector in
terms of removing distortions and raising much
needed revenue. In designing a tax policy response
to this issue, policymakers need to balance the need
to ensure the tax provisions do not unduly interfere
with commercial practices but at the same time make
sure that the tax base is not eroded.
II. TAXATION OF FINANCIAL INSTITUTIONS
Two of the
most common financial institutions in the Caribbean
are banks and insurance companies. While banks and
insurance companies are generally taxed in a similar
way to other corporations, there are certain
problems which arise in measuring their taxable
income. This paper discusses three of these
problems:
(1) the taxation of financial instruments;
(2) deductions for uncertain financial commitments
which are bad debts in the case of banks; and,
(3)
deductions for future insurance claims in the case
of insurance companies.
Taxation of Financial Instruments
Banks may be
involved with derivatives and other financial
instruments in a number of capacities: providing
them to clients; as members of stock or futures
exchanges; as players in the interbank market; for
hedging, speculative or offsetting risk on their own
account; and as intermediaries. The issue for banks
is how to treat these instruments for tax purposes.
A lack of clarity in the tax treatment of these
instruments may open up unintended tax planning
opportunities for financial institutions.
The most accurate assessment of taxable profit on
these instruments is to assess them on a mark to
market basis—that is, the gain or loss for the
period is the difference between the cost (or
opening value) of the asset and its market value at
the end of the tax period. Such an approach is
usually consistent with the accounting standards
with which international banks would be familiar. An
exception may be for instruments held by a bank for
hedging its own risk. It is usual for the two sides
of the hedge to be taxed on the same basis, so that
mark to market may not be appropriate if the other
side of the hedge is not taxed on that basis.
Bad debts of banks
The issue of bad debts—that
is, debts which are unlikely to be recovered, either
in full or in part—is of particular importance to
banks. The broad principles for the tax treatment
are that tax relief is given—sometimes with
limitations and restrictions—for specific provisions
for bad debts (that is, a provision relating to a
specific debt or debts where an actual problem has
been identified). Tax relief is less generally
given—and usually subject to limitations—for general
provisions (that is, a provision which does not
relate to any specific debt but is a provision
against a possible problem in the future).
The actual practice in countries varies with
three broad approaches to providing relief.
Charge off approach
The charge-off method, which
is used in the United States, recognizes an expense
for bad debts only as debts become worthless—that
is, the creditors have exhausted all legal means of
recovery and written off the debts as finally
irrevocable. Under this method, if an amount
previously charged-off as uncollectible is later
recovered or the loan again becomes performing the
amount previously written off is restored to income.
The criticism of this approach is that it is too
restrictive, unduly delays the deduction, and
inhibits the banks from adopting prudent levels of
provisioning.
Commercial accounts approach
Countries with
well-developed and well-observed accounting rules
often base their treatment of bad debts on
commercial accounting practices. Some allow both
general and specific provisioning, sometimes subject
to an overall ceiling. For example, Singapore allows
banks to make a general provision without reference
to specific debts, up to a maximum of 3 percent of
qualifying loans and investments. The argument for
this method is that it more accurately reflects the
reduction in a bank’s assets compared to the
charge-off method. However, it is open to potential
abuse as too much discretion can be left to the
banks.
Regulatory approach
The regulatory approach seeks
to overcome some of the concerns of the commercial
accounts approach by relating the tax relief to the
minimum provisions required (according to objective
criteria) by the central bank or other regulatory
authority. While some countries provide relief for
the loss provision required by the regulatory
authorities, others only allow a portion (e.g.,
80-90 percent) of the loss provision on the basis
that the regulatory authorities may overstate the
provision as they are concerned with the stability
of the banking system and so take a prudent view.
Insurance claims
An important issue for insurance
companies is the tax treatment of the outstanding
claims reserve—this reserve consists of the loss
reserve, which is an actuarial estimate of losses
reported and but not yet paid out, and the incurred
but not reported reserve (known as the IBNR), which
is an actuarial estimate of losses that have
occurred during the year but have not yet been
reported.
There are two issues with the calculation of
these reserves. Firstly, the reserves are based on
actuarial estimates which means that insurers can
reduce their tax liabilities by increasing the
reserves. Some countries overcome this by adopting
the reserve required for regulatory purposes.
However, such reserves are usually overstated as the
regulator is normally concerned with the stability
of the insurance system rather than the tax system.
Therefore, an option is to allow a portion of the
regulatory reserve (e.g., 80-90 percent).
The second
issue, is that reserves for future payouts should be
discounted so that they are not overstated and
insurers undertaxed. However, regulators do not
usually allow discounting (as this decreases the
reserves) and so most OECD countries do not require
discounting for tax purposes. The exceptions are
Australia, Canada and the United States which do
require discounting.
III. FINANCIAL TRANSACTION TAXES
Some countries
impose taxes on the income of financial institutions
or their transactions. These taxes can include:
stamp duties; turnover taxes; taxes on bank deposits
and withdrawals; insurance premium taxes; tobin
taxes—that is, taxes on foreign currency
transactions. Sometimes these taxes, such as the
turnover tax, are imposed on financial institutions
as a proxy for the VAT on the financial services
sector. It appears that these types of transaction
taxes are imposed in the Caribbean, as they are in
other parts of the world.
The advantages of these types of taxes is that
they can yield significant revenue and often do not
have the technical complexities of other taxes.
However, there is evidence that while these taxes
have been effective in generating revenue in the
short term, there are a number of problems with
these taxes. Firstly, the evidence suggests
financial transaction taxes are distortionary as
they can obstruct price discovery and price
stabilization, increase volatility, reduce market
liquidity, and inhibit the efficient functioning of
capital markets.
Secondly, financial transaction
taxes have contributed to significant financial
disintermediation—that is, financial transactions
by-passing the banking sector. This has led to the
third problem, which is that financial
disintermediation has resulted in an erosion in the
tax base—that is, as financial transactions by-pass
the financial sector those transactions are outside
the scope of the financial transaction tax and it
also leads to a decrease in profits in the financial
sector resulting in a decline in corporate tax
revenues.
It is because of these concerns that the trend in
developed countries is to move away from these taxes
and rely on less distortionary taxes such as a broad
based VAT. Financial taxes can be useful in a time
of fiscal crisis as they are a fairly simple means
for raising revenue in the short term. However, they
should only be introduced for a short period and be
replaced by less distortionary taxes as soon as
possible.
IV. REGIONAL TAX COORDINATION
The Caribbean, like
many other regions, is seeking coordination in a
range of areas, including tax. There is work being
done in the region to develop a single financial
space through the removal of cross-border
restrictions. To aid that, and to avoid arbitrary
distortions due to differences in tax systems, a
move towards harmonization, especially in the
taxation of financial institutions, would be useful.
Otherwise there is a danger of a ‘race to the
bottom’ in the Region—that is, one country’s cut in
the tax rate or reduction in the tax base (e.g., by
an increase in tax incentives) makes others worse
off (due to a loss of revenue, investment and/or
profits) so that other countries respond, resulting
in tax rates which are too low and tax bases too
narrow in the collective interest. A number of
countries in the Caribbean offer generous tax
incentives to the financial services sector.
Other regions have tried to address this issue
with some form of tax coordination. One example is
the European Union Code of Conduct for business
taxation, which is a non-binding code of
coordination whereby members agree to rollback, and
not introduce, measures which unduly affect the
location of investments. The OECD, while not on a
regional basis, has also adopted a similar approach
in the OECD harmful tax practice project. As many
Caribbean countries are aware, the OECD has also
sought the cooperation of non-member countries
through the OECD Global Forum.
Of particular interest in the Caribbean, and more
local, may be the recent work being undertaken on a
code of conduct in Central America. The idea for a
code arose from a concern in the region that, with
the potential increase in exports as a result of the
Central American countries and Dominican Republic
Free Trade Agreement with the United States
(CAFTA-DR), foreign direct investment would increase
in the region and therefore countries would seek to
provide tax incentives to attract that investment.
This could lead to a race to the bottom.
To deal
with these concerns, the Ministers in the region set
up a working group on tax coordination. The
principles for the coordination were to: protect the
tax base and strengthen the tax systems; maintain a
friendly tax environment for investment through
moderate and predictable taxes; avoid tax
discrimination and tax competition; and, respect
national sovereignty.
The working group which is supported by the IMF,
IADB, and Spanish government, is preparing a code of
conduct on tax incentives for investment as well as
a regional model treaty to avoid double taxation of
income and capital. Part of the work on tax
incentives involves setting criteria for tax
incentives—such as, transparency,
non-discrimination, neutrality of a project’s net
present value regarding location in the region, and
no favored administrative treatment of foreign
investment. Countries would be required to classify
incentives according to the criteria and eventually
eliminate those incentives which conflict with the
code.
The work being undertaken in Central America is
still in progress. However, it may provide a model
for tax coordination in the Caribbean in relation to
tax incentives, especially for the financial
services sector.
V. FLAT TAX
The question has been asked whether a
flat tax has any implications for the financial
services sector. The term “flat tax” has been used
very loosely with the flat taxes found in practice
being different in important ways. The classic Hall-Rabushka
(1995) flat tax combines a single rate tax on wages
with a cash-flow tax on business income levied at
the same rate—it is a simple way of implementing a
single rate consumption tax (the normal return to
capital being excluded from tax). This has not been
adopted by any country.
The common feature of the
supposed flat taxes being adopted by a number of
countries is a single positive marginal rate of tax
on labor income (for example, Russia has a single
personal income tax rate of 13 percent). In some
cases, but not all, the corporate income tax rate is
charged at the same rate.
Much of the enthusiasm for the flat tax can be
found in Eastern Europe where countries such as
Russia, Estonia, Slovenia and Slovakia have all
adopted this approach. Of course countries such as
Jamaica have had a flat personal income tax for some
time. Other countries which have recently discussed
the introduction of a flat tax include Germany,
Greece, Mexico and Costa Rica.
The key arguments for the flat tax are that it is
simple and encourages beneficial supply-side
effects, including not least improved compliance.
The latter effects, it should be noted, relate less
to the ‘flatness’ of the schedule but rather to its
low level—much of the flat tax rate rhetoric,
arguably, is about the level of tax rates, not the
number.
Against this, some have equity concerns with
the loss of progressivity in moving to a flat rate
structure. There is also no evidence that the flat
tax reforms have the increase in revenue effects
claimed by some countries. Also, while there may be
some simplification benefits, much of the complexity
of a tax system typically comes from exemptions and
exceptions in the definition of the tax base rather
than simply the tax rate.
As the flat tax essentially applies to personal
income tax it has little effect on the tax treatment
of the financial services sector, other than to the
extent that individuals derive income from the
financial sector (such as interest on deposits) and
that income is also subject to the flat tax. Also,
if there is an alignment of the corporate tax rate
with the personal income tax rate under a flat tax
regime, it will affect all corporate taxpayers
including financial institutions. Although that will
not be the case if the financial institution is
subject to a concessional corporate tax rate.
VI. CONCLUSION
This paper attempts to consider
some of the tax policy issues relating to the
financial services sector which may be of interest
in the region. The range of issues covered
demonstrates that there are many facets to the
taxation of the financial services sector. These
issues are often very complex and there are usually
no easy solutions, which is evident by the diversity
of practices throughout the world. Despite these
difficulties, one of the key objectives for the
Caribbean could be to harmonize as much as possible
the tax treatment of the financial services sector
in the region so as to facilitate the development of
the Caribbean community.
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European Commission, 2006, “Consultation Paper on
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Hall, Robert E., and Alvin Rabushka, 1995, The
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Ivanova, Anna, Michael Keen and Alexander Klemm,
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Kirilenko, Andrei, 2006, “Bank Transaction
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Peter Mullins
Senior Economist
Fiscal Affairs Department
IMF
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