VAT: Cross border changes from 1 January 2016

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Donald Drysdale By Donald Drysdale for ICAS

2 November 2015

Significant VAT changes are imminent for enterprises operating across European and other international borders through branch structures, as Donald Drysdale explains.

A long wait for a fix

It seems eons since the French tax authorities took exception to the way Credit Lyonnais, a French bank with branches in other EU member states and elsewhere, was calculating its deductible proportion of VAT.

The problem started in 1988.  The dispute rumbled on for a quarter of a century, culminating in a judgment from the European Court of Justice (ECJ) in Le Crédit Lyonnais (Case C-388/11) in September 2013.  Member states must comply with the ruling, but it has taken the UK government more than two years to act.  Following an announcement in the March 2015 Budget that the law would be amended from 1 August 2015, changes to the VAT Regulations are now expected to take effect from 1 January 2016 but are still awaited in final form.

Partial exemption

Some services, including financial services, are exempt from VAT.  A UK business providing exempt services to customers within the UK or elsewhere in the EU need not charge VAT, but can’t obtain relief for VAT it pays on related costs. However, exempt financial services to customers outside the EU are specifically treated as taxable for the purposes of input tax deduction, so VAT on related costs may be deducted.

A UK business that makes both taxable and exempt supplies can reclaim VAT on costs relating specifically to its taxable supplies, but not on those relating to its exempt supplies.  To calculate what proportion of any residual VAT on its costs can be relieved, it must use a partial exemption method.

Partial exemption is explained in HMRC’s VAT Notice 706. In some cases businesses use the partial exemption standard method, which calculates the recoverable percentage of residual input tax based on taxable turnover as a proportion of total turnover (both net of VAT).  In other cases businesses may use special methods specifically approved by HMRC.

For these purposes existing UK law allows UK partly exempt businesses with foreign branches to recover VAT on branch overhead costs by reference to supplies made by the branches.  However, the government considers that this may create scope for excessive claims by over-allocating overheads to non-EU branches.

The impact of Credit Lyonnais

In Credit Lyonnais the ECJ concluded that the EU VAT Directive could not be interpreted so as to allow a company to take into account the turnover of its EU or non-EU foreign branches when calculating how much input tax it can deduct in the member state where it has its principal establishment.

Interestingly, the ECJ’s decision did not preclude taking into account the activities of EU or non-EU foreign branches by reference to measures other than turnover, as could arise for example under a partial exemption special method.

The UK rules for partial exemption methods are to be changed.  UK businesses will be unable to take into account any VAT allocated to foreign branches when carrying out their partial exemption calculations, whatever method is used.  HMRC claim that this will simplify the calculation for businesses, whilst hoping that it will also mitigate the risk of some businesses manipulating the amount of VAT they can recover.  There are others who think that the changes might even improve overall VAT recovery for some businesses that operate through foreign branches.

The impact of Skandia

It would be wrong to look at the repercussions of Credit Lyonnais without also considering the judgment delivered by the ECJ in Skandia America Corp. (USA), filial Sverige (Case C-7/13) in September 2014.  This determined that VAT was chargeable, under the reverse charge mechanism, on a management charge from a US parent to its Swedish branch.  The Swedish branch had been included in the Swedish group VAT registration, and the ECJ found that this had the effect that there was a separation between the US parent and its Swedish branch for VAT purposes.

HMRC guidance on Skandia published in February 2015 contrasted the UK VAT grouping rules with those of Sweden, on grounds that if an overseas company with a UK branch joins a UK VAT group, it is not the branch alone but the whole legal entity (the company and its branches) that becomes part of that VAT group.  Thus services provided between UK and overseas establishments of the same body are rarely supplies for UK VAT purposes, as they are usually transactions within the same taxable person.

From 1 January 2016, existing UK VAT law will be interpreted so as to treat an overseas establishment of a UK-established entity as part of a separate taxable person if the overseas establishment is VAT-grouped in a member state that operates ‘establishment only’ grouping provisions similar to those of Sweden.  Such businesses must treat intra-entity services provided to or by such establishments as supplies made to or by another taxable person, and account for VAT accordingly. This will be the case whether or not the UK entity is part of a UK VAT group.  If it is, the same applies to supplies between the overseas establishment and other UK VAT group members in UK.

Lessons to be learnt

Both Credit Lyonnais and Skandia bring far-reaching changes to the VAT ground rules in the UK from 1 January 2016 – the former by imminent secondary legislation, and the latter by revised HMRC interpretation.  Those operating across borders should equally be alert to like-minded changes being made by some other EU member states.

In multinational groups and companies with foreign branches, VAT planning should be revisited to guard against unexpected problems arising.  And within the limits of acceptable tax planning, steps may be appropriate to ensure that all proper tax-saving opportunities are explored.

Article supplied by Taxing Words Ltd.

Topics

  • Tax

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