Consumption Taxation of Supplies of Financial Services in the Asia Pacific Region



The primary broad-based indirect tax is the Value Added Tax (“VAT”). The authors of the Modern VAT observed that “there has been surprisingly – shockingly – little serious research effort devoted to the VAT”. It is fair to say, though, that this is not the case with the application of the VAT to supplies of financial services. There is an extensive literature on this aspect of the VAT as academics and policy makers have researched into methods of incorporating financial services into the ordinary operation of the VAT. However, as Professor Edgar has observed, this research has been largely theoretical rather than empirical. While, as an outcome of this research, several methods have been developed for including financial services within the ordinary operation of the VAT, none have been implemented and it remains the norm to treat the supply of financial services as an exempt supply.

While many Asia Pacific countries have a VAT, there is no consistent treatment of supplies of financial services in the region. A number of countries follow the norm of exempt supply treatment, although differences emerge relating to, inter alia, the definition of financial services, the apportionment of input tax credits, the zero rating of exports, and reverse charging on acquisitions of foreign services by suppliers of financial services. There are some countries in the region that treat supplies of financial services to registered persons (referred to as “B2B supplies”) as zero-rated supplies and still other countries in which supplies of financial services are outside the scope of the VAT, being subject to a separate gross receipts tax or net margin tax. The lack of consistency in the taxation of financial services in the region leads to significant distortions in the marketplace, increased administrative costs involved in enforcing the differential treatment of supplies of financial services, and increased compliance costs for suppliers of financial services with operations in a number of countries in the region.

The purpose of this paper is to survey the approaches in the Asia Pacific region to the taxation of the consumption of financial services and to provide some recommendations for best practice for the region.

It is theoretically possible to impose a consumption tax on private individuals. The tax base would be measured as comprehensive income adjusted by the change in net savings. For a short period in the 1950s, two countries in the region, India and the then Ceylon, imposed a simple expenditure tax on private individuals. However, the imposition of the tax lasted for only a couple of years due to administrative problems and low revenue collection.

Because of the administrative and compliance difficulties in imposing a consumption tax on private individuals, the norm is to tax consumption indirectly through taxing producers on the goods and services that they produce for consumption. While there are several options for taxing producers, the norm is to tax through the VAT. The theory underlying the VAT is that the value of private consumption is the sum of the value added by each producer in the production and distribution of goods and services for ultimate consumption. A producer adds value by processing or handling its purchased inputs with its own labour force and capital equipment (such as plant and machinery). The producer’s outputs are then supplied to other producers (as inputs for their productive activities) or to consumers.

Value added is measured on a transaction basis by reference to outputs less inputs. VAT is paid on inputs acquired (referred to as “input tax”) and VAT is charged on outputs supplied (referred to as “output tax”). The net VAT payable by a producer is calculated on a periodic basis (such as monthly) as the difference between output tax on supplies, and input tax on acquisitions, made during the relevant period. The difference between output tax and input tax represents the VAT on the value added by a producer on goods or services produced. This basis of taxation is referred to as the credit-invoice method, which attaches a VAT liability to transactions.


The proper subject matter of the VAT is consumption. While, in theory, savings is deferred consumption, the return on savings (such as dividends or interest) should not be subject to VAT because it would create a bias against savings. It would mean that savings is more heavily taxed than consumption as both the return of savings and the use of that return for consumption is taxed.

While savings should not be taxed, the services relating to savings (i.e., “financial services”) should be taxed under the VAT in the same way as any other services are taxed. Professor Edgar identifies three broad categories of financial services. First, there are services facilitating the “inter-temporal shifting of consumption through borrowing and saving transactions”. A saving transaction facilitates deferred consumption and a loan transaction facilitates present consumption. Secondly, there are brokerage services facilitating transactions in commodities, currencies, or debt or equities. Thirdly, there are insurance services that facilitate the protection against “bad” consumption through the pooling of risk.

The common feature of each of these classes of services is that the fee for the service may be embedded in a margin (referred to as a “margin-based fee”) rather than being charged explicitly. This may be illustrated by the case of financial intermediation services. The loan of money by a lender to a borrower is a savings transaction. The lender, in making the loan, is saving for future consumption, and the borrower, in accepting the loan, is consuming now out of (expected) future savings. The real interest rate would be set in a direct transaction between the lender and borrower. This is the return in savings for the lender and the cost of current consumption for the borrower.

The difficulty for lenders and borrowers is finding each other. This is the role of a financial institution, which provides intermediation services to lenders (i.e., those that have funds to lend who need to find borrowers) and borrowers (i.e., those who want to borrow funds who need to find lenders). Essentially, the intermediation service involves bringing borrowers and lenders together through deposit taking and lending. However, unlike with most agency services/intermediation services, the financial institution may not charge an explicit fee for the services provided. Instead, the fee may be embedded in the interest rate spread (i.e., the interest rate paid to depositors with the financial institution and the interest rate charged to lenders from the institution). This means that neither interest rate is the “real” interest rate. The interest paid by borrowers is higher than the real interest rate and the interest paid to depositors is lower than the real interest rate.

There are two complications with taxing financial services under a credit-invoice VAT. First, it is difficult to identify the part of the interest rate spread that represents the collective fee charged for the intermediation services provided. Secondly, even if the collective fee for the intermediation services could be isolated, the services are being provided to two customers of the financial institution – depositors and borrowers – and, therefore, the fee must be allocated between those services.


The norm under the VAT is to treat the supply of financial services as an exempt supply. This means that the supplier of the services does not charge output tax on the supply, but cannot claim credits for input tax paid on acquisitions to make the supply. This treatment avoids having to measure the value of the supply, but results in both over- and under-taxation of supplies of financial services.

There is over-taxation in a B2B supply. While no VAT is charged on the supply, the uncredited VAT on the supplier’s inputs would form part of the supplier’s costs that would be taken into account in determining the interest rate spread. Thus, the supplier’s input tax is passed onto its customer but not in a form that the customer can claim an input tax credit for it. In turn, the embedded input tax cost forms part of the customer’s cost in working out its pricing. This results in a cascading of tax (ie., tax imposed on tax) when the customer charges output tax on its supplies. This is a consequence of the breaking of the input tax/output tax chain by the exempt supply. This is distortionary because it increases the cost of the supply of financial services relative to the supply of other goods or services. There are a number of consequences. First, a supplier of financial services is likely to also make taxable supplies. This means that input tax that is not directly allocated to either a taxable or exempt supply must be apportioned between such supplies. This is often complex and involves greater compliance costs when compared to other producers who make only taxable supplies. Secondly, a foreign supplier of financial services may have a competitive advantage over domestic suppliers of such services, particularly if the supply is a zero-rated export from the foreign country. Thirdly, there is a bias in favour of self-supply rather than acquisition for external providers to reduce the level of unrecoverable input tax credits. However, this can put smaller suppliers of financial services at a competitive disadvantage as a smaller supplier may not have capacity to bring services in-house.

There is under-taxation of supplies of financial services to consumers (I.e., B2C supplies”). This is because the value added by suppliers of financial services in B2C supplies is not taxed. In effect, exempt supply treatment means that the supplier of financial services is treated the same as an end user.


A. Zero Rating of Supplies of Financial Services
A zero-rated supply is a taxable supply charged to tax at a zero rate. As with exempt supply treatment, zero-rating avoids having to measure the value of the supply. As the supply is taxable, the supplier can claim credits for input tax paid on acquisitions to make the supply. As the supply is zero-rated, the input tax paid by the supplier is effectively refunded. This means that there is no embedded VAT cost in the price charged to the customer by the supplier of financial services. Nevertheless, in the case of a B2B supply, the cost of the financial services will be included in the customer’s costs in working out the price of the supplies that it makes. Consequently, the value added by financial services is effectively taxed to the customer of the supplier of the services in the output tax charged by the customer on its supplies. This eliminates B2B over-taxation.

Zero-rating of B2C supplies of financial services will result in such supplies not being subject to any VAT. The VAT on inputs will be refunded to the supplier of the services and, as the customer is the end user of the services, there is no output tax charged by the customer.

No country in the Asia Pacific region zero rates all supplies of financial services. However, in 2006, the Government of the Hong Kong Special Administrative Region released a Consultation Document on tax reform that canvassed the introduction of a GST. In the Document, it was proposed that the supply of financial services would be zero rated so as to place Hong Kong’s financial institutions “in a more competitive position over their international counterparts”. There was significant opposition to the proposed GST and the Government announced in June 2007 that the GST would not form part of any proposed reforms.

B. Zero Rating of B2B Supplies of Financial Services and Exempt Supply Treatment of B2C Supplies

New Zealand and Singapore directly or indirectly zero rate B2B supplies of financial services and treat B2C supplies as exempt supplies.

New Zealand formally zero rates B2B supplies of financial services and provides for exempt supply treatment of B2C supplies. While Singapore formally provides for exempt supply treatment of supplies of financial services, full input tax credits are allowed for B2B supplies. The effect, therefore, is the same as zero rating such supplies.

The New Zealand rules are more complex than those in Singapore. New Zealand’s concern with zero rating B2B supplies is that it may result in a complete relieving of GST if the recipient of the supply in turn makes significant levels of exempt supplies. Indeed, retail transactions by financial institutions could be completely free of GST through the use of a two-tier corporate structure. To avoid this outcome, for zero rating to apply, the New Zealand rules require that the value of taxable supplies (other than zero rated financial supplies) made by the recipient of the supply must be at least equal to 75% of the value of all supplies made by the person in a 12-month period that includes the taxable period in which the financial supply was made or in any other period acceptable to the Commissioner. In other words, the recipient of the supply must be predominantly making taxable supplies.

In computing the 75% threshold, zero-rated supplies of financial services do not count as taxable supplies. This means, for example, that zero rating does not apply to supplies between two financial institutions. However, to limit tax cascading, the first supplier can claim an input tax credit to the extent that the second supplier makes supplies to registered persons that satisfy the 75% threshold.

Zero rating of B2B supplies is not limited to supplies made by financial institutions, rather it can apply to any supplier of financial services. In particular, it applies if the financial services are supplied to a member of a group if the value of the group’s total taxable supplies (other than zero-rated financial supplies) is at least 75% of the group’s total supplies. This is a look through rule that applies if the recipient of the supply is not registered but is a member of a group where some or all the members of the group are registered, or the recipient is registered but provides financial supplies to members of the group.

The New Zealand zero-rating rule is information intensive. A supplier of financial services needs to know the ratio of taxable to total supplies of all its B2B customers. In determining whether the 75% threshold is satisfied, a supplier of financial services can use actual information supplied by the recipient of the supply or agree with the Commissioner a method for making the determination. The Commissioner has stated that the Australia and New Zealand Standard Industry Classification can be used for this purpose. Because of the information intensive nature of B2B zero rating, it applies only if the supplier elects for it to apply. An election applies until a notice of cancellation is lodged with the Commissioner.

Singapore treats a B2B supply of financial services by a bank, merchant bank or finance company as an exempt supply but with an approximate of full input tax credits. This is achieved by requiring that these types of financial institutions use an “input tax recovery ratio” for the purposes of determining recoverable input tax rather than the general input tax recovery rule that otherwise applies in circumstances where both taxable and exempt supplies are made.

The input tax recovery ratio is not legislated. Rather, the Singapore Goods and Services Tax Act provides for the making of regulations that provide for treating exempt supplies as taxable supplies in the context of determining recoverable input tax. Regulation 30 of the Goods and Services Tax (General) Regulations then provides that the Comptroller may direct the use of a method of determining recoverable input tax other than the general input tax recovery rule, and may direct the use of a method which treats B2B exempt supplies as taxable supplies. The input tax recovery ratio for banks, merchant banks and finance companies appears to be an example of such a method.

The Inland Revenue Authority of Singapore uses current statistics submitted to the banking regulator, the Monetary Authority of Singapore, to determine, on an annual basis, a separate input tax recovery ratio for each category of banking licence (i.e. full banks, restricted or wholesale banks, offshore banks, merchant banks) and finance companies. An input tax recovery ratio may also be provided to certain categories of special purpose vehicle established by such financial institutions, such as those used for asset securitisation transactions.

The formula used to determine the input tax recovery ratio in respect of each category of banking licence and for finance companies for each annual period is, in essence:

B2B and offshore loans x 100 total loans

In determining the volume of B2B loans, loans to residents (other than loans to individuals and professionals and housing loans), are assumed to be divided evenly between loans to GST registered customers (i.e. B2B) and non-GST registered customers. Accordingly, the input tax recovery ratio is only a soft approximation of B2B supplies, being determined on an aggregate basis for each relevant category of financial institution, solely by reference to lending activities and with the assumption that a significant portion of domestic lending is divided evenly between B2B and retail consumers.

Once determined, the input tax recovery ratio (being a percentage number) is given to, and applied by, each financial institution in the relevant category to total input tax (excluding in respect of disallowed expenses ) to obtain the amount to be claimed as input tax. Accordingly, the input tax recovery ratio is used as a means to achieve an approximate of full input tax recovery in respect of B2B supplies. This is effectively the same as zero rating B2B supplies.

By relying on information already provided to the banking regulator in order to approximate B2B supplies, as well as not actually zero-rating financial supplies and limiting the availability of the input tax recovery ratio to certain categories of financial institution, the Singapore method avoids the compliance costs associated with the information intensive New Zealand method. The Singapore method also avoids the New Zealand concern that retail transactions by financial institutions could be completely free of GST through the use of a two-tier corporate structure. The trade-off is a lack of precision in targeting B2B supplies and the potential for market distortion since not all makers of financial supplies are entitled to use the input tax recovery ratio.

C. Profit-based Measures of Value Added
While it is difficult to measure the value added by supplies of financial services under a transaction-based system, it is possible to do so under a periodic profits based system. This could be measured on either an addition or subtraction basis.

Under the addition method, the value added by a supplier of financial services is the sum of profits (measured on a cash flow basis) and wages. This may be reduced to the following formula –

((Net Profit + depreciation) – new capital investment) + wages

Wages are added back because employees are not registered for VAT. Instead, the value added by employees is captured in the value added by their employers in relation to supplies made.

Israel imposes a simplified version of an addition tax on financial institutions referred to as the “wage-and-profit” tax. The tax is imposed “on the activity in Israel of a financial institution, at a percentage of wages paid and profit earned by it”. By taxing only activity in Israel, exports are excluded from the base. Profits are not adjusted by adding back depreciation and subtracting new capital investment. Thus, the base includes the return on investment and, thus, the value added under the Israeli tax is measured by income and not consumption principles. This may be justified on the basis that the VAT base measured on income or consumption principles would not differ much because depreciable assets are likely to only be a small proportion of a financial institution’s total assets.

The profit component of the tax base under the Israeli system is taxable income (before set off of past year losses) rather than accounting profit. Certain items of interest income exempt from income tax are added back in calculating profit for the wage-and-profit tax. Thus, the simplified base under the Israeli wage-and-profit tax is –

wages + taxable income.

If a financial institution incurs a taxable loss for a tax year, the amount of the loss is deducted from wages in calculating the tax base.

The Israeli approach has compliance and administration advantages. First, the base of the tax relies on amounts calculated for other purposes: payroll and taxable income (with some adjustments). Thus, financial institutions are not required to make any new calculation for the purposes of the tax.

Secondly, the Israeli tax is collected separately on wages and profits. The tax on wages is collected monthly with pay-as-you-earn remittances to the tax administration. The tax on profits is collected in ten monthly advances from February – November which corresponds to the advance collection of income tax. Thus, the base of the tax allows for collection to correspond with existing income tax collection points

Alternatively, a profits-based calculation could be done on a subtractive basis. This was proposed for the Philippines in 2000. The VAT was introduced in the Philippines in 1988. However, the VAT did not apply to supplies of financial services, rather financial institutions were subject to a separate gross receipts tax (see below). It was proposed, though, that the VAT would apply to supplies of financial services by 1998, although this was deferred on several occasions. In the late 1990s, the Philippines Government began working on a proposal that would subject financial institutions to tax on a value added basis. A profit-based methodology, referred to as the Better Alternative Tax (“BAT”) was designed to replace the gross receipt tax. The calculation was computed on a subtractive basis starting with gross income and subtracting expenditures other than wages. The BAT was not implemented as it lacked the support of the financial sector. In particular, the calculation was seen as being too similar to the income tax calculation.

While profit-based methodologies overcome the under-taxation of B2C supplies, there is still over-taxation of B2B supplies. In particular, the Philippines BAT did not provide for the allocation of the BAT paid by financial institutions to the institution’s business customers. While it may be possible to develop allocation rules, these would necessarily be complex particularly given the timing differences between the profit-based tax and the ordinary VAT.

D. Ad Hoc Taxes

Some countries in the Asia Pacific region impose a separate tax on financial institutions. Such a tax is an entity rather than transaction tax.

1. Philippines

The Philippines imposes “percentage tax” on the gross receipts of banks and other financial institutions, including interest receipts. “Percentage tax” is more commonly known as “gross receipts tax” or “GRT”. The rate of GRT is 5%, other than in respect of interest on medium and long term securities and dividend income in which case the following rates apply: interest on medium term securities (2 years < term ? 4 years), 3%; interest on long term securities (4 years 7 years) and dividends, 0%.

The jurisdictional limits of GRT specified in the National Internal Revenue Code differ between banks and non-bank financial intermediaries on the one hand, and finance companies and other financial intermediaries not performing quasi-banking functions on the other. Banks and non-bank financial intermediaries are subject to GRT on gross receipts derived from within the Philippines. Finance companies and other financial intermediaries not performing quasi-banking functions doing business in the Philippines are subject to GRT on gross receipts.

The term “gross receipts” is not defined in the Code but rather in the regulations to mean compensation for all financial and non-financial services, or combination thereof, performed by financial institutions within the Philippines. Thus, GRT does not apply in respect of services performed outside the Philippines by any financial institution, irrespective of type. The definition of gross receipts also contains an inclusive list. The following items of compensation are among those listed: financial intermediation service fees; net trading gains; gain on sale or redemption of investments; net gain on sale of properties acquired through foreclosure; and all other recepts of gross income specified in section 32(A) of the Code. “Interest” (without further qualification) is specified in Section 32(A) of the Code. The regulations further expressly provide that any amount withheld as taxes is to be included in gross receipts.

Whether GRT should be imposed on gross interest or whether deduction should be allowed for items such as interest paid on deposits and amounts withheld as tax, has been the subject of a number of significant cases. From 1952 to 1996, the decision in National City Bank v Collector of Internal Revenue prevailed such that gross receipts included the full amount of interest received without any allowance for deductions. In 1996, it was held in Asian Bank Corporation v Commissioner of Internal Revenue that the withholding tax on a bank’s passive interest income should not be included in gross receipts. This decision was based on Revenue Regulation R.R. No.12-80 which states that GRT on financial institutions shall be based on all items of income actually received.

The decision in Asian Bank was reversed in Commissioner of Internal Revenue v Asian Bank Corporation in which it was held that gross interest earned, without allowance for any deductions, should be included in gross receipts. More recently, the Supreme Court held in China Banking Corporation v Court of Appeals that the withholding tax portion of interest income should be included in gross receipts for the purposes of calculating the GRT.

2. China
China imposes “business tax” on enterprises and individuals engaged in the provision of such services within China as specified in the Provisional Regulations of the People’s Republic of China on Business Tax 1993. “Finance and insurance” are specified in the Regulations as subject to business tax at the rate of 5%.

The amount of business tax payable is determined by multiplying “turnover” by the tax rate. Turnover is the total consideration and all other charges received from the buyer for the provision of the services. Only limited expenses can be deducted in determining turnover. For re-lending businesses, turnover is the balance of interest on lending less the interest on borrowing. For businesses buying and selling foreign currencies, marketable securities and futures, turnover is the balance of the selling prices less the buying prices.

3. Thailand
Thailand imposes “specific business tax” or “SBT” on banking, financial and similar businesses resident in Thailand. SBT is imposed at the rate of 3% only in respect of specific types of gross receipts of the relevant businesses, namely:

• interest;
• discounts;
• fees;
• service charges or profits before deduction of any expenses from the purchase or sale of negotiable instruments or documents of indebtedness; and
• gross profits before deduction of any expenses from the exchange or sale of currencies, issuance of negotiable instruments or documents of indebtedness, or remittance of currencies to a foreign country.

Operators residing outside Thailand may be liable to SBT if they carry on business through a place of business, an agent, a representative, or an employee residing in Thailand.

From 1 January 2008, the SBT rate of 3% is reduced to 0.01% for certain B2B and other transactions, including (but not limited to) interest on loans between financial institutions, gross profit from the resale of securities between financial institutions, interest or discount obtained from debt instruments, gross profit from the purchase or sale of debt instruments, interest from borrowing or lending of securities and gross profit from the exchange of currency.

The reduction in the SBT rate is intended to address concerns relating to the impact SBT on certain financial products and to develop Thai financial markets. However, although the reduction in the SBT rate for certain transactions will clearly reduce the financial burden of SBT on those particular transactions , it will likely increase the compliance burden and market-related distortions created by the tax. Also, the administrative costs in applying and collecting SBT of 0.01% would likely outweigh the revenue generated by the impost. In this respect it is unclear why the SBT rate was not reduced to zero.

4. Korea
Korea imposes “education tax” on taxpayers engaged in banking businesses in Korea. Education tax is imposed at the rate of 0.5% on gross receipts received in Korea of interest, dividends, commissions, guarantee fees, profits from the transfer of securities, insurance premiums, profits from foreign exchange transactions, rent, profits from the transfer of fixed assets and other operating or non-operating revenue.

5. Evaluation of Ad Hoc Taxes

The base for an ad hoc tax does not, in any real sense, approximate the value added by financial institutions. They are, therefore, a poor proxy for the imposition of VAT on supplies of financial services. In fact, there often results in complete over-taxation of financial services because there is cascading of B2B supplies and, as the tax is imposed on the pure interest cost, there is over-taxation of B2C supplies. Indeed, an ad hoc tax may exceed the financial institution’s value added if the institution is actively trading in large volumes at low margins. Ad hoc taxes on supplies of financial services are not recommended. Their main purpose is revenue raising, but they can have significant distortionary effects. Ultimately, they may increase the cost of funds for local borrowers who may then look to overseas lenders for a lower cost of funds.

As stated above, the international norm is to treat a supply of financial services as an exempt supply under a subtractive credit-invoice VAT. The discussion below focuses on the design of the rules providing for exempt supply treatment.

A. Scope of the exemption

The concept of “financial services” defines the scope of the exemption. In theory, the scope of the exemption should be determined by reference to the reason for the exemption, namely the difficulty in identifying and allocating margin-based fees charged for financial services. Thus, it could be argued that the exemption should apply only to financial services with margin-based fees. However, most countries do not make a distinction between services provided for margin-based fees and services provided for explicit fees because of their potential substitutability. The concern being that, if supplies for explicit fees are taxable but supplies for margin-based fees are not, suppliers will simply substitute margin-based fees for explicit fees (at least in relation to B2C transactions). However, there is little empirical evidence to indicate the level of substitutability. As Professor Edgar observes –

“Both regulatory and market factors may limit the ability to engage in such tax-driven substitution. Perhaps most importantly, deregulation and disintermediation have exerted significant pressure to unbundled financial services and price them separately on a fee or commission basis. These forces may mean that there is more limited ability to substitute between margin-based and fee-based pricing than has been assumed.”

Three observations may be made on this issue. First, the level of substitutability is an empirical issue on which more research needs to be done. Secondly, whatever may be the position in developed countries, in developing countries, with fewer competitors and greater regulation, the substitutability of margin-based and explicit fees may be higher. Thirdly, if explicit fees are taxed and margin-based fees are not, there may be an increase in administrative and compliance costs associated with the apportionment of input tax credits. From a compliance or administrative perspective, it is simpler to treat all supplies of a particular type the same rather than as a taxable supply if an explicit fee is charged and as an exempt supply if a margin-based fee is charged.

South Africa is an example of a country that does distinguish between margin-based and explicit fees. Under the South African VAT law, the definition of “financial services” excludes any services for which an explicit fee has been charged. Thus, the definition is confined to services provided in return for margin-based fees.

The definition of financial services tends to be transaction-based rather than entity-based. In other words, exempt supply treatment is not confined to services provided by financial institutions and finance companies; rather a supply by any registered person can be a financial supply. For example, the supply of credit by a trader may be a supply of financial services, although normally this would form part of the supply of goods under an incidental supplies rule. Alternatively, it may not affect creditability based on de minimus rules.

B. Types of Financial Supplies
Professor Edgar divides financial services into three categories: core financial intermediation functions, administrative and cash management services, and agency and advisory services. The main examples of core financial intermediation services include dealings in money, shares, debts or derivative financial instruments, and the provision of credit. Generally, the supply of these services is a supply of financial services regardless of whether an implicit or explicit fee is charged.

Examples of administrative and cash management services include: account-keeping, data processing, debt collection, clearing and settlement services, accounting and record keeping, custodial services, and trust and estate administration. Generally, if these services are related to a core service, they are treated as a financial service. For example, the keeping of a current account relates to the core service of dealing in money (in this case, the taking of deposits). The fee for keeping the account could be explicit or it could be embedded in the margin for the core service. The treatment of these related services as financial services even if an explicit fee is charged is justified on the basis that to do otherwise may affect the pricing of the core service.

This treatment is not necessarily uniform. For example, custodial services (such as the provision of a safety deposit box) may be excluded from the definition of financial services on the basis that an explicit fee is invariably charged and there is less ability to include the price in a margin-based fee. As exempt supply treatment is usually confined to administrative and cash management services that are incidental to core financial intermediation services, the supply of such services by a person other than a financial institution is not an exempt supply. In this situation, there is no opportunity for the supplier to include the fee in a margin-based price. However, this creates an incentive for financial institutions to self-supply these services rather than acquire them from an independent service provider. This is discussed further below.

The third category is agency and advisory services. Agency services (such as arranging for a loan) are generally treated as exempt on the basis that the underlying core service (financial intermediation) is also exempt. Again, this is because the fee for the service may be either implicit in the margin for the core service or explicit. Also, again, if these services are provided by a third party, they are usually not exempt as there is little opportunity for margin-based pricing.

Advisory services (such as financial planning) are usually taxable as the fee for these services is not easily recovered through margin-based pricing.

As the definition of financial services is usually transaction-based rather than entity-based, an issue arises as to whether out-sourced services that could be in-sourced by the financial institution are also financial services. This issue arose in the Databank case in New Zealand. Databank was a company established by the banks long before GST was introduced to provide financial clearing services to the banks. Databank argued that it services included the payment and collection of cheques and, therefore, it was providing financial services. The lower courts found in Databank’s favour, but the Privy Council, by majority, decided that Databank was not supplying financial services. It was held that the cheques that Databank was clearing did not order or authorise Databank to pay or collect money; rather the cheque authorises the bank to pay or collect money. Databank was described as “a moneyless machine transmitting instructions and recording the payment and collection of cheques by banks”. The outsourcing of services by financial institutions is discussed further below.

It is also observed that the definition of financial services is usually set out in the VAT law in some detail. However, when a new financial product is developed, there is often an issue as to whether it comes within the definition. The definition needs to be flexible so that the meaning of financial services can evolve as the financial products themselves evolve.

C. Apportionment of input tax credits
As explained above, the exemption is not entity-based but is transaction-based and, therefore, a supplier of financial services is likely to make both taxable and exempt supplies. Input tax credits are allowed only for input tax paid in respect of acquisitions to make taxable supplies. Generally, no credit is allowed for input tax paid for acquisitions to make exempt supplies. Sometimes de minimis rules apply. For example, if the value of exempt supplies is less than 10% of the value of all supplies, there may be full allowance of input tax credits. Similarly, if the value of exempt supplies is more than 90% of the value of all supplies, there may be no input tax credits allowed. In other cases, apportionment is required. There are three issues with the allocation of input tax credits: first, the determination of the basis of apportionment; secondly, the treatment of a change in use; and thirdly, the treatment of self-supplies.

1. Basis of Apportionment
The major issue for suppliers of financial services is the apportionment of credits for input tax payable on acquisitions that relate to the making of both taxable and exempt supplies. It is important to have a clear and simple rule for the apportionment of input tax credits, particularly as VAT is a self-assessing tax. An example is a rule based on the ratio of the value of taxable supplies to total supplies.

The Australian GST legislation does not include any legislative rules on the allocation of input tax credits and, therefore, it will depend on all the facts and circumstances. Australian case law on the issue of apportionment generally requires that apportionment is grounded in fact, and to be fair and reasonable having regard to all the facts and circumstances. The Commissioner has ruled that the apportionment of input tax credits must be in accordance with these principles. The ruling sets out direct and indirect methods of allocating input tax credits. Direct estimation methods apportion mixed costs to specific outputs in accordance with an internal cost allocation system (such as transaction, product line, function or activity, cost or profit centre, or business division). Indirect estimation methods apportion on the basis of factors or characteristics that are not directly referable to the use of the acquisition. Apportionment may be based on revenues (input tax revenues as a percentage of total revenues) or non-revenue methods (such as number of transactions, floor space, profit or hours). The Commissioner prefers the use of direct methods, but acknowledges that there will be cases when indirect methods have to be used. This approach can lead to widely different outcomes depending on the method applied.

The Singapore Goods and Services Tax (General) Regulations are more prescriptive on the allocation of input tax credits in the case where both taxable and exempt supplies are made. As a general rule, suppliers of both exempt and taxable supplies must claim input tax that is directly attributable to the making of taxable supplies; not claim input tax that is directly attributable to the making of exempt supplies; and apportion and claim only that portion of residual input tax (i.e. input tax that is neither directly attributable to the making of taxable or exempt supplies) that is calculated using the following formula:

Total Allowable Residual Input Tax = Residual Input Tax x Value of Taxable Supplies Value of Total Supplies

However, the general rule is disregarded if one of the additional methods of allocating input tax applies. These additional methods include a de minimis rule, the input tax recovery ratio (discussed supra in V.B.), and the “Regulation 33 exempt supplies” method.

Under Regulation 33 of the Singapore Goods and Services Tax (General) Regulations, input tax incurred by a supplier (other than a Regulation 34 business) in respect of Regulation 33 exempt supplies is fully recoverable, provided a de minimis test is satisfied. Regulation 33 exempt supplies are specific financial supplies, namely, the deposit of money, the exchange of currency, the first issue of a debt security, the first issue of an equity security and the provision of any loan, advance or credit to an employee. For accounting periods beginning on or after 1 April 2008, the assignment of trade receivables, the issue of units under any unit trust, prescribed hedging activities and the purchase of bonds are also Regulation 33 exempt supplies.

Regulation 34 businesses (i.e. those which are not permitted to use the Regulation 33 exempt supplies method of input tax recovery) include banks, insurance companies and other similar financial institutions. In respect of accounting periods beginning on or after 1 April 2008, a number of businesses are removed from the list in Regulation 34. These include investment securities advisers and dealers, commodity and non-commodity futures advisers and brokers, money brokers, and REITS that make at least 51% taxable supplies. Accordingly, these suppliers of financial services will now be entitled to use the Regulation 33 exempt supplies method of input tax recovery.

2. Change in Use
Generally, apportionment is done in the tax period in which the input tax credit is claimed. Essentially, apportionment is based on a reasonable expectation of the intended use of the input. What happens if the actual use differs significantly from the intended use? If the input is finished or intermediate goods, or raw materials acquired to make taxable supplies, rules are included to claw back the input tax credit where the use changes so that the inputs are used to make exempt supplies or for private purposes.

Apart from possible application of anti-avoidance provisions, there are usually no similar rules for input tax credits allowed in respect of capital equipment or commercial buildings where the use changes. However, Australia does have change of use rules for capital inputs. These rules require an annual review of the use of the capital input. The review period depends on the value of the input. For inputs with a value of less than $A50,000, there is only one review at the end of twelve months. For inputs with a value between $A50,000 and $A500,000, there is a review at end of each year for five years. For inputs with a value of $A500,000 or more, there is a review at the end of each year for ten years. The rules do not apply to an input with a value of $A1,000 or less. It is observed that these rules are complex and, particularly with the low threshold for application, increase the compliance costs for those making both taxable and exempt supplies.

3. Treatment of Self Supplies
A consequence of treating financial supplies as exempt supplies is that it encourages financial institutions to self-provide services rather than acquiring them from outside suppliers thereby limiting the amount of non-creditable input tax incurred. However, smaller financial institutions are at a competitive disadvantage as they do not have the capacity to self-supply services, rather they are forced to out-source incurring non-creditable input tax. The Australian GST deals with the bias through the reduced input tax credit scheme. Under the scheme, suppliers of financial services are allowed a reduced input tax credit for common inputs into making financial supplies.

The cost of out-sourcing is the VAT on the value added by the out-source supplier, i.e., profit plus wages. Thus, with in-sourcing, assuming no profit, there is a saving of the VAT on profit and wages. The rate of the reduced input tax credit is intended to reflect the percentage of VAT that would have been incurred on the wages and profits if out-sourced. The rate is 75%.

The reduced input tax credit scheme does not apply to all inputs acquired by a financial institution. Rather, it applies only to inputs of services that can be easily in-sourced. This creates another layer of apportionment (and therefore complexity) for financial institutions. First, they have to apportion input tax between taxable and exempt supplies. As regards inputs to make exempt supplies, there may be an apportionment between those inputs not allowed as a credit and those allowed as a reduced credit.

D. Zero-rating Exports of Financial Services

VAT is imposed on the destination principle, which means that supplies are taxed in the place of consumption. Under the destination principle, VAT is imposed on domestic supplies and imports, with supplies of exports zero rated. The zero rating of exports ensures that there is no double taxation as the country of import (being the country of consumption) will tax the imported goods or services. Consequently, while a domestic supply of financial services might be an exempt supply, an export of such services should be zero rated. As explained above, there is no requirement to value a supply that is zero rated.

If an export of financial services is not zero rated, there is likely to be double taxation if the export is a B2B transaction. As stated above, exempt supply treatment means that the exporter of the financial service will have paid VAT on its inputs to make the export. The financial service is likely to be taxed again in the country of destination on one of two bases. The import of the service may be explicitly taxed under a reverse charge rule, which requires the recipient of the service in the country of import, being a registered person, to charge itself VAT on the service. This treatment is usually applicable to an import of services by a registered person who uses the services to make exempt supplies. More commonly, the import of the service will be taxed indirectly because the cost of the service will be captured in the pricing of the recipient on which output tax is charged.

Consequently, if the input tax embedded in an export of financial services is not relieved, it affects the ability of the supplier of the services to compete in international financial markets. It is usually provided that an export of financial services is treated the same as any other export of services, i.e., as a zero-rated supply. However, this is not always the case. In Korea, while an export of services is zero rated, this does not apply to an export of services that, if supplied domestically would be an exempt supply. The export, like the domestic supply, is treated as an exempt supply. The supplier may, by Presidential Decree, elect not to be exempt from VAT on domestic supplies. An election must remain in place for, at least, three years. However, competitive pressures are such that the election is made only rarely if at all.

If an export of financial services is zero rated, the effectiveness of zero rating depends on the rules for determining whether services have been exported. Ideally, services should be treated as exported if the service is used in a foreign country. This is broadly consistent with the place of supply rules that apply in determining whether a supply is a domestic supply. However, some countries require the provider of the service to be physically outside the country when providing the service. This is a stricter rule that may result in supplies of financial service used in a foreign country still being treated as a domestic supply subject to exempt supply treatment. It is observed that this is not an issue specific to supplies of financial services but applicable to services generally.

E. Reverse Charge on Services acquired by Suppliers of Financial Services from Foreign Service Providers
Exempt supply treatment also creates an incentive for suppliers of financial services to acquire services in relation to making those supplies from foreign suppliers, particularly when the export of those services is zero-rated. The services may be acquired from a separate supplier or from another part of the same enterprise (such as head office). As output tax is not charged on exempt supplies, the value added by the services would not be included in the VAT base. This puts local suppliers of the same services at a competitive disadvantage as compared to foreign suppliers. To prevent this bias, a reverse charge rule usually applies under which the recipient of the supply charges itself VAT on the receipt of the foreign services. This applies to both externally and internally acquired services. As the recipient is making exempt supplies, no input tax credit is allowed for the self-charged VAT.

The following conditions usually need to be satisfied for a reverse charge rule to apply –

(1) There is a supply of services by a person to a registered person. Thus, the recipient of the supply must be a registered person.

(2) The supply is not a taxable supply because the supply is not made in the jurisdiction. This depends on the operation of the place of supply rules.

(3) If the supply had been made in the jurisdiction, it would have been a taxable supply. Thus, for example, if a person imports financial services, which are exempt supplies, the reverse charge rule will have no application.

(4) The registered person acquiring the supply will apply the supply to make exempt supplies.

If these conditions are satisfied, the supply to the registered person is treated as a taxable supply made by that person at the same time and for the same consideration as the actual supply. The registered person receiving the supply must account for the VAT payable on the supply in the VAT period in which the actual supply occurred.

The reverse charge rule does not usually apply if the registered person receiving the supply would be entitled to a full input tax credit as the VAT payable and the resulting input tax credit would cancel each other.

F. Conclusions

There is no consistent treatment of supplies of financial services in the Asia Pacific region. The methodologies used range from the norm of exempt supply treatment to zero-rating B2B supplies to highly distortionary ad hoc taxes. It means that those financial institutions operating in the region face greater compliance burdens than other producers in respect of which the VAT operates in the normal way.

Determining the optimal VAT treatment of supplies of financial services involves balancing the principles of neutrality and simplicity, the revenue needs of Government, and the need to minimise compliance and administrative costs. As explained above, the norm of exempt supply treatment results in both over- and under-taxation of such supplies. There is over-taxation of B2B supplies because of the cascading of tax and under-taxation of B2C supplies because the value added at the retail level is not taxed. In theory, both the over- and under-taxation could be removed through a combination of zero-rating B2B supplies and the use of a profit-based methodology to tax value added in B2C supplies. However, this would be distortionary, complex and involve greater compliance and administrative costs than for other producers who have to comply with one form of the tax only.

While zero rating all supplies of financial services as was proposed for Hong Kong would be simple and would minimise costs, it too is distortionary as it treats one sector of the economy more favourably than other sectors and means that no revenue is collected in relation to B2C supplies. Zero rating of B2B supplies is a good compromise as it would eliminate the over-taxation in B2B supplies, which is arguably the greater distortion caused by exempt supply treatment. While the under-taxation of B2C supplies would remain, this is likely to be less distortionary because there are few services for which financial services could substitute. The Singapore approach to B2B zero rating is preferred on the grounds of simplicity and consequent lower compliance costs, although there may need to be limitations on the application of zero rating to supplies between financial institutions to prevent B2C supplies being effectively zero rated.

Zero-rating B2B supplies does not eliminate the need to apportion input tax credits as B2C supplies will still be treated as exempt supplies. It is important that apportionment rules are simple and easy to comply with. Again, Singapore’s fixed input tax recovery rule is preferable.

For neutrality reasons, zero rating must apply to exports of financial services with export status based on where the benefit of the service is used. Similarly, neutrality requires that reverse charging applies to the import of services to make exempt supplies of financial services.