OPTIONS IN TAX POLICY AND ADMINISTRATION FOR THE FINANCIAL SERVICES SECTOR

 
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.

REFERENCES

European Commission, 2006, “Consultation Paper on modernizing Value Added Tax obligations for financial services and insurances,” Belgium.

Hall, Robert E., and Alvin Rabushka, 1995, The Flat Tax, 2nd edition (Stanford: Hoover Institution Press).

Ivanova, Anna, Michael Keen and Alexander Klemm, 2005, “The Russian Flat Tax Reform,” IMF Working Paper WP/05/16 (Washington DC: International Monetary Fund).

Kirilenko, Andrei, 2006, “Bank Transaction Taxes,” IMF Research Bulletin, June.pp.1,4-5.

Poddar, Satya, and Morley English, 1997, “Taxation of Financial Services under a Value-added Tax: Applying the Cash-flow Approach,” National Tax Journal, Vol. 50, No. 1, March, pp. 89-111.

Suss, Esther C., Oral H. Williams and Chandima Mendis, 2002, “Caribbean Offshore Financial Centers: Past, Present, and Possibilities for the Future,” IMF Working Paper WP/02/88 (Washington DC: International Monetary Fund).

Zee, Howell H. (ed.), 2004, Taxing the Financial Sector, (Washington DC: International Monetary Fund).

Peter Mullins
Senior Economist
Fiscal Affairs Department
IMF
 
2011 Caribbean Community (CARICOM) Secretariat. All Rights Reserved. P.O. Box 10827, Georgetown, GUYANA.
Tel: (592) 222 0001-75 Fax: (592) 222 0171 | E-mail your comments and suggestions to: registry@caricom.org | SiteMap