Shareholder value: Strategies to minimise VAT on outsourced activities

Historically, outsourcing has been used by businesses in every industry to reduce costs in peripheral activities. However, over the last five years the financial services industry, on a global scale, has made a significant move from a traditional host environment to the strategic outsourcing of core activities. In particular, outsourcing of back office activities and information technology services has ceased to be a commodity and is moving to a partnership or co-sourcing environment in which the outsource provider and the business work together to plan and provide shared resources and skills. This often allows the business to implement changes, enabling quantum leaps in business delivery and capacity. While successful outsourcing arrangements benefit the business, the industry sector and, as a consequence, national economies, there can often be a significant barrier to achieving successful implementation - value added tax (VAT).

To a greater or lesser degree, VAT is a real cost to businesses in the financial services industry. The pure outsourcing of an activity to a third party provider immediately raises the prospect of additional VAT being incurred by that business. The additional VAT is often created by the movement of employees from the outsourcing business to the outsource provider. As employees of the business, no VAT is generated. However, in the hands of the third party provider, the cost of these ex-employees becomes a service subject to VAT. In many areas, the cost of labour is frequently the major component of such an outsourced service. The incremental price of charging VAT on the cost of ex-employees often makes a pure outsourcing proposition uneconomic. The following example demonstrates the disincentive effect of VAT in a situation in which the outsourcing goal is a 10% cost reduction achieved by outsourcing back office activities:

At the beginning of an outsourcing arrangement, the provider is assuming the full cost of the transferred employees. Over the duration of the agreement, typically five to 10 years, the outsource provider will introduce its own methodologies and disciplines and reduce headcount employed in providing the outsourced function. Although the above example is simplistic, it does illustrate that, if VAT was charged at the full £94.72 (giving a total cost of £111.29), no deal would ever be achieved.

The Australian government recognized the disincentive effect of indirect taxation on such outsourcing arrangements when it introduced the Goods and Services Tax (GST) in July 2000. Under the GST, when a financial institution outsources any of its functions, it is automatically entitled to reclaim 75% of the GST charged by the service provider. The remaining 25% is then recovered on the basis of the GST liability of the financial services supplied by the bank or insurance company. Australia is competing with other financial services centres in the Asia Pacific region and this enlightened approach creates an environment in which banks and insurance companies can flourish and maximize their business opportunities without incurring significant, irrecoverable GST costs.

For banks and insurance companies operating in the world's largest economy, the US, no irrecoverable VAT costs exist because the US is the only OECD country not to operate a VAT system. US businesses in the financial services industry have been outsourcing significant parts of their core activities for several years - in fact, many US banks and insurance companies are now negotiating their second generation of outsourcing arrangements.

However, as US banks and insurance businesses have expanded to compete with organizations from around the world, their exposure to VAT has increased. Unlike Australia, the remaining 100 or so countries that do operate a VAT system employ a purist approach to the tax and seek to add VAT to all outsourced services provided by third party suppliers, with no relief or recognition of the adverse impact of the tax on the financial services industry. This governmental indifference has led, particularly in the recent past, to a proliferation of ideas and the adoption of a broader approach to certain aspects of VAT liability. The UK financial services industry has been the prime beneficiary in this respect.

Fundamentally, this pioneering work has taken two routes. The first route involves the formation of a common structure between the outsourcing business and the provider, and the second route uses, where possible, the exemption from VAT offered by certain intermediary services.

STRUCTURING

Many countries operating a VAT system allow companies under common control to establish a single entity for VAT registration purposes - typically referred to as a VAT group. National VAT legislation differs in its definition of what is meant by 'control' because this is often drawn from direct tax or company law legislation. One of the principal advantages of such an arrangement is that all transactions between companies within the same VAT group are ignored for VAT purposes.

To a bank or insurance company considering outsourcing its core activities, experience has shown that it gains the most from outsourcing when it couples information technology with complementary management strategies and organization structures. Many businesses want to achieve these benefits by embodying the outsourcing agreement within a joint venture company established between themselves and the outsource provider. This arrangement allows the outsourcing business to maintain an ongoing and influential participation in the joint venture company while gaining all the commercial benefits outlined above. It also permits the outsourcing business's employees and infrastructure to be transferred to the joint venture with little disruption. In the current market in which 'ownership' of the customer relationship is vital to a business, no bank or insurance business is willing simply to relinquish the operation of its accounting system, customer management and relationship databases, network and data centre operations to a third party. The term 'co-sourcing' has been coined to describe this type of close, interdependent relationship.

The structure to be implemented by the outsourcing business and provider also may need to take into account other commercial necessities such as which business wants (or needs) to consolidate the activities of the joint venture company for statutory accounting purposes. For example, if the outsourcing business wants to demonstrate to the financial markets that it has reduced its overall headcount, there is no point in it consolidating the activities of the joint venture company within its statutory accounts. However, if the market analysts gauge the performance of the outsource provider by reference to its top-line growth, the provider will want to include the activities of the joint venture within its statutory accounts.

These competing commercial requirements regarding consolidation can create issues when seeking to include a joint venture company both within the outsourcing business's VAT group and the activities of the joint venture within the provider's statutory accounts. In the UK, these competing requirements have led HM Customs and Excise (the national VAT authority) to issue a business brief branding such arrangements as "contrived structures". The result is that some outsourcing arrangements have failed. Other countries within the EU, such as Finland, Germany, and the Netherlands place less importance on the accounting treatment when permitting companies to be included within VAT/tax groupings. In practice, the accounting consolidation point is, to all intents and purposes, irrelevant because the underlying arrangements remain the same whether or not the provider consolidates the activities of the joint venture.

Another structuring arrangement used in the UK is a limited partnership. Because the Limited Partnership Act (1905) makes the general partner in an English limited partnership responsible for all the activities of the partnership, it is possible to create a limited partnership with a subsidiary of the outsourcing business as the general partner and a subsidiary of the outsourcing business as the limited partner. If the general partner is, or becomes, a member of the outsourcing business's VAT group, all of the activities of the limited partnership will be included in the outsourcing business's VAT group. This arrangement is often employed by venture capital funds to remove VAT on the manager's fees. Similar arrangements also can apply in Scotland and by the use of the new limited liability partnership.

Despite the global nature of the financial services industry, the data complexes managing and supporting these functions are often centralized in one or two locations. To avoid VAT charges, businesses will want to arrange an outsourcing contract so that services are passed between branches of the same organization located in different countries. Usually, countries operating a VAT system apply a self-charge mechanism (typically referred to as a reverse charge) to the import of intellectual services (including data preparation and consultancy). However, many countries (such as Germany, the Netherlands, and the UK), do not recognize the import of a service between branches of the same legal entity.

If administrative, clerical, or secretarial functions are outsourced, it is possible to reduce the VAT cost or to avoid a VAT charge completely. These services are, within the EU model of VAT, subject to VAT where the provider has established its business. If such functions can be delivered cross-border from a provider established in a country that either does not have a VAT system (such as the Channel Islands) or a country that has a lower rate of VAT on such services, the adverse effect of VAT can be reduced or completely eliminated.

Finally, one of the simplest planning ideas (but most difficult to achieve) is to give the personnel providing the outsourced services dual contract status. The business and the service provider jointly employ the relevant staff. The effect of this legal position is that both companies are the employers and, therefore, the employee makes no supply of services to his or her employer. The difficulty with this arrangement is not VAT; rather, it is managing the employment law situation to ensure that the individual's rights are protected, his or her employment benefits are maintained, and the rules regarding cessation of employment are clearly understood by the individual and both employers.

Exempt intermediary services

VAT represents a cost to the financial services industry because, to a greater or lesser extent, the activities undertaken by a bank or insurance business are exempt from VAT. Consequently, VAT incurred on costs and expenses that relate to these exempt activities is irrecoverable. However, in most VAT jurisdictions in which financial transactions are treated as exempt, the VAT legislation is relatively broadly drawn to include ancillary activities.

Article 13B of the Sixth VAT Directive exempts the following:

1. insurance and reinsurance transactions, including related services performed by insurance brokers and insurance agents; ... and

4. the following transactions:

   • the granting and the negotiation of credit and the management of credit by the person granting it;

   • the negotiation of or any dealings in credit guarantees or any other security for money and the management of credit guarantees by the person who is granting the credit;

   • transactions, including negotiation, concerning deposit and current accounts, payments, transfers, debts, cheques and other negotiable instruments, but excluding debt collection and factoring;

   • transactions, including negotiation, concerning currency, bank notes and coins used as legal tender, with the exception of collectors' items; 'collectors' items' shall be taken to mean gold, silver or other metal coins or bank notes which are not normally used as legal tender or coins of numismatic interest;

   • transactions, including negotiation, excluding management and safe-keeping, in shares, interests in companies or associations, debentures and other securities, excluding:

     - documents establishing title to goods,

     - the rights or securities referred to in article 5(3);

   • management of special investment funds as defined by member states.

Many of the above functions can be outsourced, particularly when they involve the use of information technology or, for example, the use of telephone call centres. However, a fundamental reconsideration of the service being provided is necessary. Historically, many outsource providers have looked at the way a service is being supplied rather than what service is actually enjoyed by the bank or insurance company. This has led many EU tax authorities to limit the VAT exemption to financial institutions. Therefore, a significant VAT disincentive was embedded in any such outsourcing proposal.

Many businesses, advisers, and commentators have sought to challenge this restrictive view applied by the various national VAT authorities. While court decisions have somewhat eroded this policy, it was not until the European Court of Justice (ECJ) ruled in Sparekassernes Datacenter (SDC) v Skatteministeriet that the VAT authorities had to broaden their treatment of exempt transactions. This case involved the supply by SDC to member banks of data services comprising the electronic execution of transfers, the provision of advice on and trade in securities, and the management of deposits, purchase contracts, and loans - ie services falling within article 13B(d)(3)(5) of the Sixth VAT Directive. The Danish tax authorities argued that, because SDC was not itself a financial institution, the supply by SDC to the bank was subject to VAT at the standard rate. The ECJ held that "[t]he identity of the persons and the type of legal person effecting the transactions were ... irrelevant in determining the exempt transactions." The ECJ also went on to explain that "[t]he specific manner in which the service was performed - electronically, automatically or manually - [also] did not affect the application of the exemption." The court concluded that "[t]o be characterized as exempt under article 13B(d)(3) and (5) the services ... had, viewed broadly, to form a distinct whole, fulfilling the specific, essential functions of a service described in those provisions."

The view taken by the ECJ was followed in the recent UK case of Customs and Excise Commissioners v FDR Ltd. In FDR, the Appeal Court decided two issues: whether FDR's services of acting as a clearing house (including effecting settlement) on deposit and current accounts, payments, transfers, debts, cheques and other negotiable instruments for various banks by electronic means was exempt under article 13B(d)(3); and whether the services provided in respect of credit card transactions were a single supply of credit card processing or book-keeping. The court dismissed the appeal by the Commissioners of Customs and Excise against the decision of the VAT Tribunal and concluded that, if services are integral parts of the principal supply (for example, the operation of a deposit or current account) or necessary for its performance, the outsourced services should benefit from the exemption.

The French Administrative Supreme Court in its Sogefonds decision and a German lower court have taken a similar view to the ECJ. However, there remains reluctance on the part of many tax administrations to accept the principle that, when determining the liability of an exempt transaction, the nature of the supply, and not the type of business providing the service, is paramount. For example, the German Ministry of Finance assumes that the responsibility of an outsourced data centre is limited to technical aspects and that data centres operating on the same basis as SDC are not parties to payment transactions - the only parties so connected are the bank and its customers. This view disregards the actual contractual position and ignores a primary element of the ECJ's decision in SDC.

It is also appropriate to consider here the implications of any national banking or insurance regulatory provisions. While, for example, the UK and Swiss governments have always adopted a pragmatic approach to a bank outsourcing its core activities, the German Federal Banking Supervisory Office (BAKred) has adopted a different approach. When the BAKred issued its first policy statement regarding outsourcing by German banks in 1998, it stated that core activities could not be outsourced. BAKred issued a revised document in March 2002 that accepted the principle of outsourcing but required banks to give BAKred advance notice of any intention to outsource and stressed that management of the outsourced functions remained the responsibility of the bank and that any outsourced activities must not be capable of committing a bank to a new banking relationship or to a change in banking risks. Furthermore, if the activities require a banking licence, the service provider cannot operate under the bank's licence - it must itself hold a banking licence.

The Czech Republic and Poland illustrate two non-EU countries that extend the VAT exemption to non-regulated businesses. In the Czech Republic, the Ministry of Finance is likely to follow ECJ decisions even though it is not yet a member of the EU. Indications are that the Czech legislation would permit exemptions to extend to payments and settlement arrangements and the issuance of payment instructions. However, outsourced services going beyond this are likely to require either a banking or insurance licence, as appropriate. The Polish VAT legislation is quite restrictive, with the Polish tax authorities determining the VAT liability of a supply of goods or services by reference to a classification issued by the Statistical Office. This can be harsh because the Statistical Office may seek to identify each element of a service separately rather than as a mixed transaction benefiting from the exemption. The regulatory environment in Poland is well-established and only permits regulated businesses to conduct specified activities. However, the legislation does envisage a situation in which outsourced services can be encompassed by the bank's or insurance company's licence.

CONCLUSION

As demonstrated above, there are a variety of ways that outsourcing deals can be structured or contracted to eliminate, or at least mitigate, irrecoverable costs of VAT. Thorough preparation before the introduction of such arrangements is an absolute necessity. All relevant contracts must support the structure or arrangements that are being implemented and the actual supply of services must follow the contractual position. Failure to make such an investment may leave the arrangements open to attack by the relevant tax authorities.

For further information please contact:

Dennis Knowles (UK)

Tel: +44 20 7303 4536

email: dwknowles@deloitte.co.uk