Future of VAT: Continued evolution and increasing significance
The world will see VAT further increase in importance as a revenue raiser for countries and there will be ongoing change to its scope and mode of operation. Lachlan Wolfers makes predictions for the coming years.
In Five years of rapid VAT evolution: How have predictions held up? we cast an eye back over the changes, foreseen and unforeseen, of recent times. Here, we are looking at the coming years and setting out bold predictions for changes in VAT as it increases its dominance as a national revenue raiser and continues to morph in response to a changing economic environment.
Specifically, we predict that:
Consumption taxes will be the dominant form of taxation around the world;
VAT (or equivalent) will be applied to financial services as the default model;
VAT refunds will largely end (except for a few small categories); and
VAT returns (as we know them) will die.
Undoubtedly, China is at the forefront of many of these trends, though they affect a wide range of jurisdictions. These predictions are paralleled by a series of related predictions for VAT and technology in another accompanying article, VAT and technology: The first fully automated tax?
Consumption taxes and world domination
Over the course of the past 30+ years, the weighted average corporate tax rate by GDP among 208 separate tax jurisdictions has virtually halved from 46.6% in 1980, down to 26.5% in 2018 (as published by the Tax Foundation, Corporate Tax Rates around the World, November 27 2018). Although, it must be acknowledged that the OECD average corporate tax revenue has remained relatively stable as a percentage of total tax revenue throughout (being 8.8% of total tax revenue in 1965 and 9% in 2016).
More staggeringly, is the adoption of VAT by countries, which has increased virtually sevenfold in a period of just over 40 years (from 25 countries in 1977 to around 168 countries in 2019).
Consumption-based taxes, which include VAT, goods and services taxes (GST), sales taxes, excise taxes, and other forms of taxes on goods and services, account for 33% of total taxation across the OECD (according to the OECD's 2018 Consumption Tax Trends, p42, the OECD un-weighted average). They are now only marginally behind taxes on income, profits and capital gains (essentially, personal income tax and corporate income tax combined, which is at 34%) in terms of total revenue collected.
These statistics tell us that consumption taxes are clearly an important source of revenue and that, with the introduction of VAT systems, they are taking on an ever-greater share of that consumption tax revenue. However, the role of consumption taxes as the dominant form of taxation is yet to come to fruition. This will happen over the coming years.
The modern problem with corporate taxation is in the battle for determining 'where' the value is created, which generates the profit of the business, and therefore 'who' has the right to tax that profit. By contrast, in indirect taxes, there is near unanimity in the view that tax should be collected in the place where consumption occurs. The challenge in indirect taxes is how best to collect it.
Corporate taxation, in its current form, is ill-equipped to deal with a situation in which a highly digitalised business can be physically located in country A, but sell products or services on a global basis, without people or significant capital outside their home base. The work being carried out by the OECD as part of its BEPS project (Addressing the Tax Challenges of the Digitalisation of the Economy) to achieve consensus around a new paradigm for taxing the digitalisation of the economy is worthy, and may well be successful in the short-to-medium term. Ultimately however, one wonders if the outcome of this process will be that corporate taxation becomes less of a priority for certain countries, especially where they are at least able to collect a minimum tax liability under pillar two of the OECD's proposals. We explore this more in BEPS 2.0: What will it mean for China?.
This is not to suggest that governments will give up on corporate taxes. As the past few years of tax transparency has shown, the 'fair' imposition of corporate taxes has become not just a legal imperative, but a moral imperative too. An imperative that is increasingly being demanded of highly digitalised businesses.
Faced with such a highly politicised taxation environment affecting highly digitalised businesses; the likelihood of any new measures triggering a boon for transfer pricing professionals; the need to introduce considerable simplifications to ensure the measures are workable in practice; and extensive arbitration measures – governments will likely follow the path of least resistance and diversify their risks and costs by relying on a range of different forms of consumption taxes, noting that consumption taxes (as compared with indirect taxes) are not always, by their nature, borne by end-consumers.
This is not to ignore the other big elephant in the room, which is that the base for corporate taxation is profits, and with many of the large digital economy participants in the world being unprofitable (at least, as yet), this may be 'much ado about nothing'.
Putting all this together, surely legislation which imposes taxes based on turnover from sales, collected in the markets in which these businesses sell, brings with it a far greater alignment between the motives and interests of businesses and those of the countries in which sales are taking place. In short, if, as French politician Jean-Baptiste Colbert colourfully noted, "[t]he art of taxation consists in so plucking the goose as to procure the largest quantity of feathers with the least possible amount of hissing", then surely consumption taxes represent the better goose for plucking.
It is these facts which have spurred the introduction of digital services taxes, or their equivalents, in places like France. There are also similar proposals in the UK and elsewhere. These facts have also spurred the introduction of a foreign e-services tax in Taiwan (China), as well as India's equalisation levy and significant economic presence concepts (to name a few).
To be clear, the proposition that consumption taxes will be the dominant form of taxation is not intended to traverse the legal debate as to the nature of digital services taxes as either a direct or indirect form of taxation. For this, it is worth looking at the EU's proposal for a Council Directive on the common system of a digital services tax (COM(2018)148, March 21 2018) and the request for a preliminary ruling to the ECJ in case C-75/18 involving Hungary's telecommunications tax, and the Advocate-General's opinion in this case issued on June 13 2019. Rather, it is intended to apply the concept of consumption taxes both broadly and practically. These are situations in which the tax is collected by an intermediary but intended economically to be borne by the end consumer (which describes indirect taxes); and where the tax is either calculated or determined by reference to the place in which consumption occurs (for example, gross business receipts taxes).
A further rationale for the view that consumption-based taxation will be the dominant form of taxation around the world is the environment. Be they carbon taxes, environmental levies, the myriad of taxes, fees and charges relating to air travel, traffic congestion charges or even 'shopping bag taxes' – all of these are forms of environmentally-oriented consumption-based taxes.
Recent proposals in France and the Netherlands to potentially end the zero rating of international air travel in a bid to tax CO2 emissions, further highlight encroachments on the previously sacrosanct concept that international air travel should not attract VAT.
In short, consumption taxes are not far behind corporate and personal taxes (combined) in being the dominant form of tax revenue collected amongst OECD countries. The trend sees consumption taxes increasing and corporate and personal taxes (combined) falling. It, therefore, does not take much imagination to envisage a day when consumption taxes overtake.
VAT on financial services: The new default
This is a topic that has added impetus with the advent of the latest European Commission review (announced in April 2019) into the exemption from VAT for the financial services industry. There is a perceived greater urgency to act in this space. Put simply, the view that financial services broadly should be exempt from a VAT is unsustainable in the long-term, for two main reasons.
First, the policy rationale for exempting most financial services from VAT arguably no longer exists. Historically, one of the main reasons for the exemption was the inability to measure the value added on a transaction-by-transaction basis, for example on forex transactions. However, with the growth of fee-based services relative to margin-based services, this measurement problem is no longer as prevalent. Similarly, some countries have demonstrated the ability to devise simplifications to tax margin-based loan services (China, Argentina and Israel); to tax the value added in general insurance (New Zealand, China, Singapore, Australia and South Africa); and even life insurance (India, though excluding the savings component).
Second, the nature of financial services is fundamentally changing. No longer is it possible to draw a clear line between the products or services of traditional banks, insurers and asset managers and contend that they need to be exempted from VAT for their services; while component or outsourced providers, especially many 'new economy' participants in peer-to-peer (P2P) lending, fintech, payment processors, and even digital currency providers, may be taxed.
Let's take a very simple example. It is commonplace for consumers to be charged a fee for withdrawing money from an ATM, for instance when using a card from a different bank. In Australia, such fees are exempt from GST in accordance with Regulation 40-5.09(4A) of the GST regulations and this is confirmed in GST Ruling 2014/2. However, what is the inherent policy problem which limits the ability to apply GST to these transactions? How does this really differ from a situation in which a customer uses their credit card and a surcharge is imposed, for which GST will apply (if the underlying supply is taxable – see GST Ruling 2014/2)? Likewise, how does this differ from a situation in which the fee is imposed by a third-party payment processor, which is similarly taxed for GST purposes in Australia?
From a broader policy perspective, is this an example where the GST treatment differs because of 'who' is making the supply, rather than by reference to 'what' is being supplied? To be clear, it is not suggested that the analysis of the current legislation is incorrect, rather that the policy does not produce economic equivalence between substantially similar transactions.
Interestingly, when Facebook launched its new cryptocurrency Libra in June 2019, it symbolised the growing encroachment of digital economy participants into the financial services sector, and signalled the death knell for the ability to ringfence exempt financial services from a VAT. This trend is even more obvious in countries such as China, where companies including Alipay and Tencent dominate the digital payments market.
There are three major exceptions where the taxation of financial services under a VAT is unlikely to be fully realised. The first is in certain personal loan products, such as home loans, where for political expediency, governments may well choose to continue with exemptions from VAT. The second is in the trading of derivatives and other financial instruments, where the imposition of VAT would operate more like a wealth or capital gains tax (such as in China). Derivatives or financial instruments are also arguably not really 'consumed' in any traditional sense. The third and final exception is in jurisdictions which apply substitutes for VAT in certain areas of financial services; for example, the EU's insurance premium taxes, Korea's education tax, and Thailand's specific business tax.
The challenges in maintaining financial services' exemption from VAT are all too obvious when one considers recent international case law and legislative developments. Take for example the treatment of payment processing services. The question of whether exemption applies or not differs significantly from jurisdiction to jurisdiction, and can even vary depending on whether the service fee is collected from the end-consumer, or through the merchant. For example, the UK has historically adopted a wide application of financial services VAT exemptions, including for payment services, as opposed to other EU countries which have adopted a narrower interpretation of VAT exemptions. Where payment services are provided to merchants, VAT exemptions have a highly distortive effect and create VAT leakage in the supply chain. Many payment service providers and processors therefore seek to apply VAT on their services, allowing them to claim input tax credits.
The other notable example is in the classification of cryptocurrency. For example:
In European Union Case C-264/14 (Hedqvist), the European Court of Justice held that bitcoin is a currency and therefore exempt from VAT when used to pay for goods or services;
In Australia, as of July 1 2017, the supply of cryptocurrency is not subject to GST but through a legislative amendment that creates a new category of digital currency, which is neither money nor currency; and
In Canada, recent legislative proposals have been introduced to define cryptocurrencies at 'virtual payment instruments', which are not money but which are nonetheless exempt from GST as a 'financial instrument'.
While these examples highlight the growing trend to exempt a cryptocurrency from VAT when it is effectively used as a medium of exchange, operations surrounding the use of cryptocurrencies, such as mining, may still be subject to VAT.
This highlights the difficulties in ringfencing financial services from VAT. As both the Australian and Canadian examples show, if ringfencing is to occur, then the concept of 'financial services' needs to be regularly updated. In the EU, the problem is even more acute given that the EU Directive dates back to 1977, and even the proposals back in 2011 to update the rules would already be outdated. Put simply, regularly updating a concept which, from both a commercial and regulatory perspective, is increasingly blurred, is exceptionally difficult.
For all of these reasons, we predict that VAT will be applied to financial services as the default method, though a limited range of exemptions will still need to apply.
VAT refund disappearing act
The proposition that VAT refunds will end is one of the most controversial. In particular, the idea that VAT, which is a tax not intended to be imposed economically on business, would cease to be refundable in circumstances where inputs exceed outputs in a given period, is near heresy. It directly contradicts the OECD's guidelines. Furthermore, critics of this proposition may point to the potentially detrimental impact on exporters and start-up businesses.
However, let's consider the evidence on the state of VAT refunds, some of which is based on the KPMG International VAT/GST Refunds Survey 2014 carried out on the efficiency VAT/GST refunds in 65 countries, and on more recent developments since that time:
1) Securing VAT refunds is a commonly deployed device used by fraudsters, and therefore scrutiny is required so as not to leave tax authorities exposed. They require tax authorities to deploy significant resources to combat such fraud, often with the impact of delaying refunds for legitimate businesses;
2) Tax authorities are increasingly taking an inordinate amount of time to process refunds – for instance, some EU countries are known to scrutinise and delay VAT refunds, especially for non-resident companies and even for those with taxable activities in the country of refund;
3) Tax authorities are increasingly imposing tax audits as a precondition for the payment of a refund (for example, in Indonesia);
4) Refunds of VAT are often being offset against other tax obligations before being paid (for example, in Australia);
5) We are seeing a growing trend of countries only allowing VAT refunds to foreign businesses if the principle of reciprocity is followed with respect to businesses from that first country operating overseas. For example, many EU countries do not allow VAT refund claims for businesses located outside the EU unless there is a reciprocity agreement or similar arrangement with that country for VAT recovery. Indeed, in a global context, refunds to non-resident non-VAT registered businesses is becoming the exception rather than the rule;
6) Anecdotally, the availability of tourist VAT refund schemes seem to be diminishing, either through the imposition of higher de minimis amounts, or through administrative burdens which practically discourage their use (for example, long queues, offices not being open, enhanced paperwork requirements etc.).
Due to the factors above, businesses are also increasingly becoming reluctant to claim VAT refunds for certain expenses on a cost-benefit basis.
One wonders if this trend of diminishing, discouraging and disentitling otherwise legitimate refund claims will lead to a situation in which they largely end. We say 'largely' end because we would expect them to continue for exporters and for other suppliers making zero-rated suppliers habitually. The abolition of VAT refunds for these specific situations would be counterproductive for those countries, either in terms of harming their international competitiveness or in effectively undermining the policy of zero-rating certain supplies. Indeed, a number of countries are expanding the scope of exported services concessions (exemptions or zero-rating), such as Russia, Indonesia, Cambodia and China. This has the corresponding effect of limiting the need for refunds by foreign businesses receiving those services. Furthermore, sales of goods to large exporters (in countries like France and Italy) and of certain services to exporters (Costa Rica) also operate so as to minimise the need for refunds by those exporters.
The shift away from VAT refunds is interrelated with our view that the future will see the use of blockchain technology and mechanisms to collect VAT through the payment system (for example, in the UK). This will result in VAT systems more closely resembling retail sales taxes. (We have gone into this in further detail in VAT and technology: The first fully automated tax?)
A further example where we see the risk of refunds being denied is in situations where a business' VAT payable is overstated, either by reason of overstated output tax or more commonly, by understating input tax credits in that tax period. This can arise because of a myriad of innocent commercial reasons, including not processing accounts payable invoices on a timely basis, or because purchase invoice amounts were missed off initially. The ability to later identify understated input tax credits and seek a refund of them, is potentially at risk. Australia is an example of a country which has taken considerable steps to impose limitations on such refunds, including by reference to time periods and by measures which are designed to ensure the end-consumer benefits if such a refund is paid out.
If VAT refunds end, they will likely be replaced by a system allowing the carry forward of VAT credit balances, much like the carry forward of losses in a corporate tax context.
Death of the VAT return (as we know it)
This proposition is not dissimilar to one made by KPMG back in 2014 (have a look at Five years of rapid VAT evolution: How have predictions held up? and the prediction that there will be no more periodic returns). The only difference is that this is starting to become a reality, for example in India, with the introduction of an electronic invoicing system which will be used for the pre-filling of GST returns, proposed from January 1 2020; and in Brazil, with perhaps the most advanced e-invoicing system in the world, requiring a digital stamp from the tax authority and real-time reporting of transactions.
The death of the VAT return is an inevitable consequence of several factors. First, electronic invoicing through government regulated invoicing systems, which means that the government already has the sales data to enable pre-filling of returns. Second, the need to carry out data matching or verification of purchase invoices through such government regulated invoicing systems (see VAT and technology: The first fully automated tax? for more). And third, the need for real-time reporting of transaction level data (for example in Spain and Hungary) such that the government is provided with ERP data on a regular or real-time basis.
Similarly, European countries including Portugal, Poland, Austria, Norway are increasingly adopting a standard audit file for tax (SAF-T) and similar requirements, that ask taxpayers to provide transactional data in a pre-defined auditable format to tax authorities, either periodically or on the tax authority's request. Poland is planning to replace the VAT return entirely with the SAF-T filing from 2020.
It is highly likely, in our view, that over the next five years, VAT returns will be pre-filled for taxpayers. The objective then turns into one of carrying out a reconciliation exercise to check the accuracy of the returns and make any adjustments required.
While pre-filling may be the direction of travel in the short-to-medium term, in the longer-term the actual filing of VAT returns may be rendered completely redundant. We explore this further in VAT and technology: The first fully automated tax? Because the data that forms the basis of VAT returns will be fed automatically from business' own enterprise resource planning (ERP) systems, simplifications will render the compliance process largely untouched by subjective judgment and B2B transactions will no longer be taxable and creditable, given VAT systems will closely resemble retail sales taxes. Furthermore, in accordance with the proposition we make in VAT and technology: The first fully automated tax?, in many countries the data will in fact be held directly through government regulated invoicing systems.
In conclusion, VAT returns will die a natural death, and it will likely occur in two stages – first, through pre-filling, and second, through a combination of enhanced data transmission tools and the removal of much of the subjective judgment which currently takes place in VAT compliance.
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Lachlan Wolfers is the national leader of indirect taxes for KPMG in China, and since 2019 he has also been the global head of indirect taxes for KPMG.
Before joining KPMG China, Lachlan was the leader of KPMG Australia's indirect taxes practice and the leader of KPMG Australia's tax controversy practice.
Lachlan led KPMG's efforts in relation to the VAT reform pilot programme in China. During the course of this work, he provided advice to the Ministry of Finance (MOF), the State Taxation Administration (STA) and other government agencies in relation to several key aspects of the VAT reforms, including the application of VAT to financial services, insurance, real estate and business transfers, as well as other reforms relating to the introduction of advance rulings in China.
Lachlan was formerly a director of the Tax Institute, which is the most prestigious tax professional association in Australia. In this role, he was frequently invited to consult with the Australian Taxation Office and Commonwealth Treasury on tax issues, as well as consulting with government officials from both China and the US about indirect tax reform.
Before joining KPMG, Lachlan was a partner in a major law firm. He has extensive experience in a broad range of taxation and legal matters. He has appeared before the High Court of Australia, the Federal Court of Australia and the Administrative Appeals Tribunal, including in the first substantive GST case in Australia.
Lachlan is a noted speaker on VAT issues and has presented numerous seminars for various professional associations, industry groups and clients on the VAT reforms in China.