As more businesses globalize their operations and seek to reduce costs by offshoring, cross-border intracompany transactions are increasing.
This article was first published in the Ernst & Young Indirect Tax Briefing, Issue 5, August 2012
In the European Union (EU), these transactions can give rise to VAT charges, and for most businesses in the financial services sector, some or all of this VAT is irrecoverable.
This article discusses the practical issues that arise in identifying cross-border supplies of services, determining the correct VAT liability and potential opportunities to mitigate the VAT cost.
Identifying cross-border services
On a practical level, as a first step, consideration should be given to the procedures and controls in place to ensure that cross-border intracompany services are identified for EU VAT reporting purposes.
Identifying these types of charges and dealing with them correctly for VAT purposes can prove particularly difficult where payments are settled through intercompany accounts without issuing invoices or where services between group companies are “netted off” for accounting purposes.
VAT should be applied to cross-border services rendered between group companies. However, consideration should be given to the nature of the service (taxable or exempt) and to the corporate structure involved.
The charge to VAT
Not all cross-border intracompany charges are subject to VAT. In order to determine the VAT treatment of intracompany supplies of services, it is necessary to establish both:
- The place of supply for VAT purposes
- The VAT liability of the supply
Following the introduction of the EU VAT package place-of-supply changes, effective 1 January 2010, the default rule for a cross-border supply of services between businesses is that the place of supply is where the recipient of a service “belongs.” Therefore, the requirement to account for VAT rests with the recipient of the service under the “reverse charge” procedure.
The recipient of the service must then determine whether the service it has received is taxable or not. If the recipient cannot recover VAT paid in full (as is common for financial services companies), the addition of reverse-charged VAT increases the cost of the service.
However, VAT may not, in fact, apply to the intracompany charge, for example, because the service is supplied to a different part of the same legal entity (albeit in a different country) or because an exemption applies.
Cross-border supplies within the same legal entity
The European Court Judgment in the FCE Bank case established that there cannot be a supply of services within the same legal entity (e.g., from a head office to a branch or between branches). Thus, VAT should not be accounted for on services rendered between such establishments.
However, there is uncertainty whether the principles set out in the FCE Bank case still apply when one of the establishments is a member of a VAT group. On 2 July 2009, the European Commission released a Communication setting out its view on the proper application of VAT grouping in the EU member states. In the Commission’s opinion:
“The exclusion of fixed establishments situated abroad of a taxable person in the member state which has introduced the VAT grouping scheme may at first glance seem inconsistent with the FCE Bank ruling. However, this ruling makes no reference whatsoever to the situation of a VAT group. Furthermore, it should be noted that, by joining a VAT group, the taxable person becomes part of a new taxable person, the VAT group and, consequently, dissolves itself for VAT purposes from its fixed establishment located abroad."
"This means that if a taxable person joins a VAT group, any services it subsequently supplies to its fixed establishment abroad would be considered as supplies made between two separate taxable persons. That the fixed establishment situated abroad is excluded from being eligible for a VAT group in that member state is therefore not at variance with the FCE Bank ruling.”
The United Kingdom (UK) and Ireland and several other member states do not treat a VAT group as a separate taxable person. Although the European Commission launched infringement proceedings on various aspects of VAT grouping against eight countries in 2009, it is interesting to note that the proceedings do not challenge this aspect.
VAT exemptions for financial services and insurance
As we mentioned earlier, care should be taken to establish the exact nature of the intracompany supplies. This is important because if a service is exempt, there is no requirement to self-account for reverse-charge VAT.
Certain financial services are exempt from VAT under Directive 2006/112/EC Art 135(1) (b)-(g). This includes the issue, transfer or receipt of, or any dealing in money or securities, and the making of credit or management of credit by the person granting it.
Article 135(1) (a) of the Directive provides exemption from VAT for insurance and reinsurance transactions and related services performed by insurance brokers and insurance agents.
The cost-sharing exemption
The cost-sharing exemption allows businesses and organizations that make VAT exempt and/or non-business supplies to work together to meet their common ends but without incurring VAT as an extra cost.
Article 132 1 (f), Council Directive 2006/112/EC (the VAT Directive) exempts from VAT services provided by independent groups of persons to their members where all of the following hold:
- Members carry on VAT-exempt or non-business activities
- The services they receive are directly necessary for the activities
- The groups claim exact reimbursement for the joint expense
- The exemption doesn’t cause distortion of competition
Once implemented, a cost-sharing group (CSG) is able to provide services without creating a cross-border VAT charge within the EU.
A number of conditions must be fulfilled for the exemption to apply. They include the following:
Services provided by independent groups of persons to their members
The group has to be an independent entity. There is no requirement to form a specific type of entity for this purpose. However, a European Economic Interest Group (EEIG) is often used for these purposes.
Where members carry on VAT-exempt or non-business activities
The members of the group should carry on VAT-exempt or non-business activities. This requirement is met by businesses operating in the financial sector, although some member states set a limit by way of a pro rata (e.g., UK legislation specifies 5% or more exempt or non-business activities must be carried on and even extend this to all members of the group, including those in other member states where there is no such limit).
The services they receive are directly necessary for the exempt and non-business activities
The services received in the group should be “directly necessary” for exempt activities. As a proposed simplification measure in the UK, where a member of a CSG has wholly exempt and/or non-business activities or negligible levels of taxable activity, all the supplies it receives from a CSG are regarded as “directly necessary” for those exempt and/or non-business activities.
In the UK, for the purposes of this test, a negligible level of taxable activity is deemed to be less than 15%. Where a member of a CSG has exempt and/or non-business activities that form 85% or more of its total activities, all the supplies it receives from its CSG are regarded as being “directly necessary.”
The groups claim exact reimbursement for the joint expenses
The group can claim only exact reimbursement from members of their share of the costs, i.e., there should be no mark up. This requirement may, of course, have an impact on the transfer pricing analysis of the recharges.
However, this issue can be addressed by the use of a cost-sharing entity, such as an EEIG, since costs may be incurred by the EEIG, including a transfer pricing mark up, but then be shared within the group at cost.
The exemption does not cause distortions of competition
The application of the exemption must not cause a distortion of competition. This requirement permits member states to impose restrictions, such as excluding certain services from the exemption or allowing the exemption only for certain sectors.
Germany now faces infringement proceedings, due to its narrow application of the exemption, and it will no doubt argue that it has restricted the application of the provision to avoid “distortions of competition.”
Not all EU member states have introduced the cost-sharing exemption in Article 132 1 (f) of Directive 2006/112/EC. Following a consultation process, this exemption will shortly be added to the UK VAT law.
Given the importance of the financial services sector in the UK, this is an important development and it will potentially allow a number of financial services companies to avoid additional irrecoverable VAT on intracompany charges.
Article 132 1 (f) of the VAT Directive is mandatory. Therefore, businesses in those member states where the exemption has not been implemented may seek to rely on the principle of “direct effect” (i.e., that the article applies without being expressly implemented into national legislation).
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