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Value Added Tax: EU proposals for reform and the implications of Brexit Contents

2VAT: flexibility to reduce rates

Committee’s assessment

Politically important

Committee’s decision

(a) Not cleared from scrutiny; further information requested; drawn to the attention of the Business, Energy & Industrial Strategy and Treasury Committees; (b) Cleared from scrutiny

Document details

(a) Proposal for a Council Directive amending Directive 2006/112/EC as regards rates of value added tax; (b) Proposal for a Council Directive amending Directive 2006/112/EC on the common system of value added tax, with regard to the obligation to respect a minimum standard rate

Legal base

Article 113 TFEU; special legislative procedure; unanimity

Department

Treasury

Document Numbers

(a) (39448), 5335/18 + ADDs 1–3, COM(18) 20; (b) (39391), 15904/17, COM(17) 783

Summary and Committee’s conclusions

2.1All EU Member States have to impose Value Added Tax as a condition of their Union membership. The EU’s current VAT system, which in essence dates back to the advent of the Single Market in 1992, is built around a “transitional” system for cross-border VAT—still in effect a quarter of a century later—based on the ‘destination’ principle, where VAT on cross-border sales of goods and services is paid in the Member States of consumption. However, until 2011, the formal objective was to change this to a system based on the ‘origin’ principle—under which VAT is paid in the Member State of the supplier.

2.2While the ‘origin’ principle would allow the EU as a whole to more closely resemble a true single market (because VAT would be paid by, and refunded to, suppliers in the same way for both intra-EU and domestic transactions), it raised intractable political problems. In particular, it would incentivise individual countries to lower their VAT rates to attract additional custom for their businesses—risking distortion of competition—and shift tax revenue to those Member States where suppliers are based (see paragraphs 2.25 to 2.27 in “Background” below).

2.3One of the proposed solutions to this was a gradual harmonisation of VAT rates.27 The 1992 VAT Directive therefore required all EU countries to apply a standard rate of 15 per cent to all goods and services, but with two categories of derogations: a ‘positive list’ of goods and services (in Annex III to the Directive) to which any Member State could apply a reduced rate higher than 5 per cent, and a series of country-specific derogations that reflected the level of VAT charged in those Member States in January 1991.28 This is why the VAT Directive allows the UK, for example, to continue applying zero-rates to food and drink, even though other Member States have to apply at least the reduced rate to those categories under the same legislation.

2.4In 2011, after nearly twenty years of failed efforts to further harmonise VAT rates and abolish these country-specific exemptions, the European Commission and the Member States concluded that the objective of an ‘origin’ principle-based VAT system should be abandoned, and the transitional ‘destination’-based approach instead become the “definitive” system.29 Among other things, this removed the need for the current restrictions on—and any further harmonisation of—Member States’ domestic VAT rates, as a system under the ‘destination’ principle does not carry the same risk of competitive lowering of rates (see paragraph 2.25).

2.5In January 2018, as part of a wider package of reforms to make the ‘destination’-based system permanent, the European Commission tabled a proposal to overhaul the restrictions EU law places on VAT rates. In particular, it would effectively reverse the current approach (where the standard rate must be applied unless a derogation, general or country-specific, is permitted): under the Commission proposal, Member States would be free to apply reduced or even zero-rates of VAT to any good or service, except for those specifically listed (to which the standard rate would have to be applied).30

2.6The Commission has also tabled a proposal to maintain the statutory minimum of 15 per cent for the standard rate of VAT, which technically expired at the end of 2017. This proposal is uncontroversial as no Member State has expressed an interest in lowering its standard rate below that threshold.

2.7The Financial Secretary to the Treasury (Mel Stride) submitted an Explanatory Memorandum on the VAT rates proposal on 8 February 2018.31 The Government supports the Commission’s intention to substantially increase the flexibility for Member States to reduce VAT rates for more categories of goods and services. The Minister notes in particular that the proposed changes would mean Member States would have the ability to apply a zero-rate of VAT to women’s sanitary products, a flexibility which has long been sought by the UK Government.32

2.8However, given that the Commission proposal explicitly notes that the new VAT rates system would not take effect until 2022 at the earliest, it is striking that the Minister does not indicate the proposal would not have a direct impact on the UK. Indeed, the Explanatory Memorandum indicates the Government has begun a ‘mapping exercise’ to identify how the proposal could impact on the UK’s current reduced and zero-rate exemptions.33 That indicates that either the Government believes the post-Brexit transitional arrangement (during which the UK will have to continue applying VAT law) may last well into 2022, or that it is considering seeking continued participation in the EU’s common VAT area afterwards to minimise new trade friction arising from VAT being charged as an import tax on goods flowing between the UK and the EU after Brexit (or, potentially, both).34

2.9We note the proposed amendments to the VAT Directive would provide the UK with the flexibility the Government has sought to vary rates for specific goods and services, such as women’s sanitary products. However, it is unclear whether the Government would have preferred the alternative considered by the Commission (namely, to maintain a ‘negative list’ of specific goods and services to which reduced rates of VAT can be applied, but to add all the country-specific derogations that currently exist—such as the UK’s zero-rates on food—for all Member States to use).

2.10The negotiations on this VAT rates proposal will take place in parallel to the other changes proposed by the Commission to the VAT Directive and its supplementary legislation, including on the taxation of cross-border transactions, a special scheme for small businesses, and administrative cooperation between the EU’s tax authorities. As these all need to be agreed before the new system can take effect, and tax matters are subject to the veto of any EU country, the negotiations are likely to be protracted.

2.11For the UK, the implications of the proposal are inextricably linked to its post-Brexit relationship with the EU’s common VAT area after Brexit. If the UK, as a ‘third country’ like Norway, is completely outside of that area when the ‘definitive’ VAT system takes effect, the Government would in any event have full flexibility to vary value added tax rates beyond the constraints imposed by EU law present or future. We note in this respect that it is the European Commission’s intention that the new VAT system—including the updated rules in rate-setting—will not take effect before 2022, well after the “two year period” of transition during which the UK would remain in the common VAT area after Brexit.

2.12It is notable, therefore, that the Financial Secretary’s Explanatory Memorandum refers to a “mapping exercise” that compares the UK’s current zero-rates and other derogations to those that would be allowed under the Commission proposal.

2.13In our view, the Minister’s Memorandum implies the Government is operating, even if only provisionally, under the assumption that the UK might still be in the common VAT area when the new rules take effect. This ‘mapping exercise’ only makes sense if there is a belief in Government that the new VAT rates legislation could apply to the UK, either as a legal obligation or as part of a voluntary approach by the Government to keep UK VAT law broadly in line with the VAT Directive to minimise post-Brexit barriers to trade. If it did not, there would be no risk to any of the current zero-rates or other exemptions, as the Government could decide to maintain, modify or repeal them these irrespective of the restrictions imposed by EU law.

2.14The lack of clarity is part of a pattern. We have repeatedly asked the Government to provide details of its proposals on the UK’s post-Brexit relationship with the EU on Value Added Tax, in the context of:

2.15To date, we have not received a satisfactory response to these questions. As recently as 19 February, the Financial Secretary told us that he could provide no details about the VAT implications of Brexit for UK businesses because the “arrangements in this regard” will “depend on the outcome of the negotiations”, without specifying what the Government’s objectives are other than a vague ambition to the most “free and frictionless trade as possible”.35 However, he has not ruled out continued UK alignment with EU VAT law (which the European Parliament also supports).36

2.16We also note that the Government, while having rejected the notion that Northern Ireland could remain in a Customs Union and ‘shared regulatory area’ with the EU, has not commented specifically on the latter’s suggestion that Northern Ireland could remain bound by EU VAT and excise law to avoid the need for either side to collect import taxes on the border with Ireland.

2.17In light of these repeated refusals to confirm whether the Government wants to stay in, remain aligned with, or fully exit the single EU VAT area after Brexit, we are left with no option but to conclude that the Treasury is considering seeking some form of continued participation in the EU’s VAT system to minimise new frictions in trade with the remaining Member States. In the absence of clear and detailed proposals, however, we cannot be sure to what extent it would require full compliance with the VAT Directive and related legislation (including restrictions on rates), or the possible jurisdiction of the European Court of Justice (considering that VAT is one of the most heavily litigated areas of EU law).

2.18Consequently, we retain the VAT rates proposal under scrutiny and ask the Minister to clarify the following points:

2.19Given the potential implications of this new EU legislation for businesses, consumers and the Exchequer, we draw the VAT rates proposal to the attention of the Business, Energy & Industrial Strategy and Treasury Committees. We are content to clear the proposed Directive to retain the minimum standard rate at 15 per cent from scrutiny, given the UK’s standard rate is well above this at 20 per cent.

Full details of the documents

(a) Proposal for a Council Directive amending Directive 2006/112/EC as regards rates of value added tax: (39448), 5335/18 + ADDs 1–3, COM(18) 20; (b) Proposal for a Council Directive amending Directive 2006/112/EC on the common system of value added tax, with regard to the obligation to respect a minimum standard rate: (39391), 15904/17, COM(17) 783.

Background

2.20In 1967 the then-six Member States of the European Economic Community (EEC) agreed to replace their national turnover taxes by Value Added Tax (VAT), with the aim of operating a VAT system for cross-border purchases of goods and services in the same way as it would within a single country. This first VAT Directive allowed Member State Governments to set a standard rate at any level they liked, and introduce reduced or increased rates without maximum or minimum limits or restrictions on the types of goods and services to which they could be applied.37

2.21For intra-Community sales of goods, VAT operated as an import tax, paid by the importer to their national customs authorities (i.e. the Member State of the customer) at the border before the goods were released for their use. Similarly, for cross-border supplies of services, the tax was due “where the services provided, the right transferred or granted, or the object hired, is used or enjoyed”, which typically meant in the Member State of consumption (given the limited nature of provision of services at a distance at that time).38

2.22For goods, it was the intention—stated as far back as 1967—to achieve a “common market […] whose characteristics are similar to those of a domestic market”, requiring the eventual abolition of the system of taxation on importation, by having VAT accrue to the Member State of the supplier.39 For cross-border supplies of services, where the question of border controls does not arise, the view was always that taxation of services should take place in the Member State of consumption.40

2.23In 1992, as part of the introduction of the Single Market, the EU Member States agreed to abolish customs inspections on trade in goods between EU countries. While facilitating the free movement of goods, it also meant VAT on cross-border sales of goods could no longer be collected as an import tax by customs authorities. The EU now faced a choice: with the option of collecting VAT for cross-border transactions by customs authorities gone, a new system would have to be created allowing VAT to be collected on cross-border supplies, either in the Member State of the customer (‘destination’) or supplier (‘origin’).

2.24The decision to apply either the ‘origin’ or ‘destination’ principle for VAT on cross-border transactions has significant implications for the extent to which Member States can retain flexibility in setting their national VAT rates (which must be the same for domestic and cross-border transactions).

2.25Despite the political difficulties inherent in the ‘origin’ principle, both the Member States and the European Commission for a long time favoured this system. If implemented, it would be simpler to administer than the ‘destination’ principle, as the supplier could account for their VAT liabilities on both domestic and intra-Community transactions to their national tax authority. This was seen as a boost for the free movement of goods and services within the Single Market.43

2.26However, despite their theoretical preference for the ‘origin’ principle, when faced with the need for a choice between the two approaches as a result of the abolition of customs controls by the end of 1992, the Member States could not agree on a system to make the this system work in practice. They did not want to relinquish their existing flexibility to vary VAT rates,44 and nor could they agree on a redistributive system to compensate for the substantial amounts of VAT revenue that would shift from the Member States of consumption to the Member States with a larger concentration of suppliers.

2.27As a result, in anticipation of a future “definitive” VAT system based on the ‘origin principle, in 1992 a “transitional” system for goods was adopted that allowed for customs controls on goods to be abolished while VAT would still be collected by the Member State of destination, accounted for by the customer rather than the supplier. To encourage this transition to a “definitive” system, there was pressure for gradual harmonisation of VAT rates that would reduce the scope for VAT-based “tax subsidies”:

“Rate convergence amongst Member States would be encouraged by setting minimum levels for VAT rates and limiting the application of reduced rates. It was hoped that over a period of a few years, Member States would be able to achieve the convergence in rate levels needed to allow the introduction of the planned origin-based definitive system.”45

2.28The 1992 “transitional” system did not apply to services, since they are obviously not subject to customs controls. Under the second VAT Directive, the tax was usually paid “where the supplier is located”, which in practice usually meant in the Member State of consumption. However, technological change and the drive towards mutual recognition of services providers under new Single Market legislation increasingly allowed services to be provided at a distance from the 1980s onwards. This shifted the associated VAT revenue to the Member State of the supplier. In response, a series of amendments to the VAT Directive were adopted to address this problem over the years and many explicitly required services to be taxed where the customer is located.46

Current rules on VAT rates

2.29In anticipation of the future introduction of the ‘origin’ principle for goods, in October 1992 the Council agreed on rules limiting the discretion of individual Member States to set VAT rates they had had until that point.47 The new VAT Directive required all EU countries to apply a standard VAT rate of a minimum of 15 per cent,48 and mandatorily exempt certain services from VAT, including insurance and banking services (without a right for businesses engaged in these services to claim a refund for the VAT they paid as input for those services).49

2.30However, the new VAT Directive allowed individual countries to apply a lower rate of VAT—and in some cases no VAT at all—on sales of certain goods or services that would otherwise be subject to the standard rate. These derogations, which still form the basis for the VAT system in force across the EU today, come in two forms.

2.31Firstly, there is an option for all Member States to apply one or two reduced rates, which cannot be lower than 5 per cent, to certain specified goods and services (which are listed in Annex III to the VAT Directive). These include for example most food and drink, pharmaceuticals and medical equipment and broadcasting services. Member States can also apply a reduced rate to only part of a category. Overall, these rules allow Member States to apply a reduced rate, or no VAT at all, to around 65 per cent of household consumption expenditure.

2.32Secondly, specific Member States—primarily those who were already members of the European Community when the internal market was created in 1992—are also allowed, by way of “standstill” derogation, to continue to apply any lower rates, including zero-rates, already in effect before the entry into force of the “transitional”, for goods and services not included in Annex III. The types of derogations in this category, which vary by Member State, are:

2.33The UK and other Member States in 1992 were thus able to “grandfather” their existing lower VAT rates for specific goods and services into the VAT Directive, which they mostly maintain to the present day. Sweden, Austria and Finland were granted similar derogations when they joined the EU in 1995.54 However, like the other Member States, the UK cannot create new zero-rated or reduced rate categories unless explicitly permitted by the VAT Directive, or by unanimous decision of all Member States.

2.34The result of this messy political compromise on exemptions from the general rules of the VAT Directive is a patchwork of different tax treatments of similar products and services across Member States, and a significant degree of flexibility for some—but not all—EU countries to apply reduced rates of VAT. However, the objective of these country-specific derogations from the VAT Directive was to allow for national laws to be gradually adapted to harmonised EU-wide VAT rates in anticipation of the introduction of the “origin” principle.55 Derogations of unlimited duration would therefore expire only when the EU’s “definitive” VAT system takes effect.

Use of reduced rates in practice

2.35In practice, the use of reduced or zero-rates varies very widely between Member States, reflecting national policy priorities,56 but only a few Member States make significant use of the flexibility to apply reduced rates for specific goods and services granted to them by the existing VAT Directive.

2.36The Commission has estimated the “rate gap”, the difference between each EU country’s maximum VAT collection if there was perfect compliance using the reduced rates and exemptions it applies, compared to VAT revenues under perfect compliance if the standard rate was charged uniformly on all goods and services.57 The UK’s “rate gap” is 3.3 per cent, lower than the 5.3 per cent EU average, indicating that it does not make use of the flexibility granted by the VAT Directive to the same extent as other EU countries.

2.37However, this only takes into account the transactions where it applies VAT. It does not include zero-rated supplies, which are the most substantial derogation in terms of tax revenue because of the greater rate of tax subsidisation of the goods and services covered, and because some zero-rates are applied to very broad categories of good. The UK has a relatively large untaxed base because it can apply zero-rate exemptions to twenty different types of goods and services (including food, drink and children’s clothes). In 2000, the latest year for which the Commission was able to cite figures, highest share of zero-rates was in the UK, accounting for about 20 per cent of its theoretical VAT base, followed by Ireland at slightly over 10 per cent.58

2.38Despite the “rate gap”, many Member States are not satisfied that the current legislation offers sufficient flexibility with respect to goods and services to which reduced rates cannot currently be applied. The European Commission receives frequent demands for changes to the Directive,59 usually linked to the fact that goods or services to which a Member State would like to apply a reduced rate are not listed amongst those eligible under Annex III and therefore must be taxed at the standard rate.60 The Commission has also initiated numerous infringement proceedings against Member States for “unlawfully broad” application of reduced rates, which can generate controversy where the good or service in question affects “primary needs, social or cultural objectives” (such as the UK campaign for reduced rates on women’s sanitary products).

Reforming the EU VAT system

2.39Between 1992 and 2006, the European Commission made several efforts to rationalise the VAT Directive by introducing a maximum standard rate;61 approximating and subsequently harmonising VAT rates;62 and, following a comprehensive review, a proposal to abolish the Member State-specific derogations that applied to goods and services not listed in Annex III (i.e. including the UK’s zero-rates).63 However, the Member States could not agree on any of these proposals, and they were subsequently abandoned (although they have on occasion agreed to extend the list of services to which a reduced rate can apply).64 As a result, the requirements and derogations of the 1992 VAT Directive have been maintained mostly unchanged in the current VAT Directive, which was agreed in 2006.65

2.40In parallel to these developments, as we have set out in more detail elsewhere in this Report, the Commission’s efforts to introduce a VAT system for intra-EU supplies taxed in the Member State of the supplier had also yielded no results. In 2011, it concluded that a definitive system for VAT on cross-border sales based on the ‘origin’ principle was “politically unachievable”.66 The Commission therefore said would begin preparing the necessary legislation to permanently base the system on the ‘destination’ principle instead (which would in essence largely reflect the existing situation, as the “transitional” system for intra-EU supplies is already based on accounting for VAT in the Member State of consumption).67

2.41The decision to abandon the transition to the ‘origin’ principle effectively halted any further attempts to harmonise VAT rates and abolish the existing country-specific derogations, as variable rates are not considered a risk to competition within the Single Market under the ‘destination’ principle (see paragraphs 2.25 to 2.27).68

2.42In its 2016 VAT Action Plan, the Commission set out the concrete steps it proposed to take to replace the current transitional arrangements for the taxation of trade between Member States by definitive arrangements based on the principle of taxation in the Member State of destination.69 This would include legislative changes to give individual Member States more flexibility in setting VAT rates, including maintaining all existing reduced rates and derogations and potentially making them available to all Member States. EU Finance Ministers took note of the Commission’s VAT Action Plan in May that year. They welcomed the intention to increase flexibility for Member States to apply reduced and zero rates, but stressed that a “sufficient level of harmonisation” of VAT rates “remains required […] to avoid distortion of competition, rise in business costs and negative impact on the functioning of the single market”.70

2.43On 4 October 2017 the Commission adopted the first proposal introducing the definitive system for the taxation of trade between Member States, and outlined successive steps and sub-steps for introducing this system, including on VAT rates. In January 2018 this was followed by supplementary proposals on VAT rates, an amendment to the special “SME scheme”, and administrative cooperation between tax authorities to tackle VAT fraud.

The Commission proposal on VAT rates

2.44The European Commission published its proposal to amend the restrictions placed by EU law on Member States in varying their rates of VAT for different goods and services in January 2018. The aim is to address two identified shortcomings of the current approach:

2.45When considering how to give legal effect to these two complementary aims, the Commission outlined two options:

2.46It considered the effects of both options in a number of areas, including the extent to which it would provide Member States with flexibility and treat them equally while preserving tax revenues; limit the potential for tax distortion; and minimise complexity for businesses (and therefore the scope for litigation).

2.47The Commission concluded that the second option—allowing for full flexibility to apply reduced rates except were specifically precluded by the Directive—was preferable because:73

Details of the Commission proposal

2.48Following the publication of its proposal on the full shift to the “destination principle” for cross-border business-to-business transactions within the EU in October 2017, the Commission in January 2018 issued further proposals on giving individual EU countries more flexibility to vary their VAT rates and to put existing exemptions on a permanent footing (but extended to all Member States).

2.49The details of the Commission proposal are as follows:

2.50Although EU Finance Ministers declined to indicate their preference between the options in their Council conclusion on VAT in May 2016, at technical level Member States have “preferred the more conservative option” (i.e. maintaining the ‘positive list’ and extending country-specific derogations to all Member States) as national Governments saw the need “for the VAT system to maintain a sufficient level of harmonisation”.82

2.51While the Commission proposal is being discussed in the Council, the Commission has said that it will continue to conduct regular reviews of Annex III—the goods and services to which the reduced rate can currently be applied—in consultation with the Member States in its VAT Committee, to make sure “its wording is clear and not obsolete, and its contents are in line with technological developments and social and political needs”. The Commission would then table a legislative proposal to adapt the Annex as and when needed until the new system took effect.

The Government’s view

2.52The Financial Secretary to the Treasury (Mel Stride) submitted an Explanatory Memorandum on the VAT rates proposal on 8 February 2018.83

2.53The Minister expressed the Government’s support for the Commission’s intention to substantially increase the scope of goods and services eligible for reduced rates, and indeed the flexibility for Member States to apply a zero-rate to such supplies, to “suit their domestic circumstances and needs”. The Minister noted in particular that the proposed changes would mean Member States would have the ability to apply a zero-rate of VAT to women’s sanitary products, a flexibility which has long been sought by the UK Government.84

2.54In relation to the revenue safeguard proposal, the Minister notes that the UK’s weighted average of VAT on taxable transactions rose well above the envisaged 12 per cent floor when the Government increased the standard rate of VAT to 20 per cent in 2011. As such, he added, “the proposed level does not cause immediate concerns in relation to the UK’s current use of standard, reduced and zero rates”.

2.55While it is not clear whether the Government would have preferred the Commission to select the “more conservative” option of retaining and extending the ‘positive list’ to which reduced rates can be applied, the Minister does express a note of caution with respect to the proposed replacement of the current country-specific—including the UK’s ability to zero-rate a wide range of goods and services—with a general right to apply reduced rates except for transactions listed on the new ‘negative list’. The Minister notes that there is some uncertainty as to whether none of the goods or services currently subject to a reduced or zero-rate in the UK are excluded from proposed ‘negative list’. If any of the current derogations were included in the new Annex IIIa, the standard rate of 15 per cent would have to be applied.

2.56It is curious that, in this context, the Minister does not refer to the implications of the UK’s exit from the EU for its domestic VAT regime in any substantive way. In principle, the UK will cease to be bound by the Directive, and any constraints it places on setting of VAT rates, when EU law ceases to apply. In practice, this is expected to be at the end of the post-Brexit transitional period the Government is currently negotiating with the EU. The other Member States have set an indicative end date of 31 December 2020 and the Government wants to negotiate a longer (but “strictly limited”) period of “around two years” from March 2019.

2.57Given that the Commission proposal explicitly notes that the new VAT rates system would not take effect until 2022 at the earliest, it is striking that the Minister does not indicate the proposal would not have a direct impact on the UK. Indeed, the Explanatory Memorandum actively indicates that Government believes the UK may be covered by the EU’s VAT rules well into the next decade:

“The Government has (…) begun a mapping exercise in order to identify how the categories [compulsorily subject to the standard rate] and the intended classification of products by activity codes, align with the UK’s existing zero and reduced VAT rates.

As a proposal intended to grant Member States greater flexibility in the setting of their domestic VAT rates, it is important that full consideration is given to aspects of the proposed changes which may result in the inadvertent loss of Member State autonomy in this respect. It is unlikely that Member States will be willing to agree to any changes that force them to remove or amend their existing reduced and zero rates.”

2.58This ‘mapping exercise’ only makes sense if there is a belief in Government that the new VAT rates legislation could apply to the UK. If it did not, there would be no risk to any of the current zero-rates or other exemptions, as the Government could decide to maintain, modify or repeal them these irrespective of the restrictions imposed by EU law. That indicates that either the Government believes the transition may last well into 2022, or that it is considering seeking continued participation in the EU’s common VAT area afterwards to minimise new trade friction arising from VAT being charged as an import tax on goods flowing between the UK and the EU after Brexit (or, potentially, both).

2.59However, the former of these possible explanations for the Treasury’s apparent presumption that the VAT rates proposal may apply in the UK (namely that the transitional arrangement might still be in effect by 2022) contrasts with the position the Government has taken on other EU proposals which are expected to take effect after December 2020. For example, with respect to the next Multiannual Financial Framework—the EU’s next long-term budget—the Chief Secretary to the Treasury told us it was “not relevant to the UK”. Similarly, the DEFRA informed the Committee that the next Common Agricultural Policy—also due to take effect in 2021—“will not apply to the UK”.

2.60Therefore, it appears the Government is considering continued participation in the EU common VAT area indefinitely, most likely requiring adherence to the VAT Directive and supplementary legislation. We have explored the Brexit implications of this proposal, and for the UK’s VAT regime more generally, in the “Summary and conclusions” section above.

Previous Committee Reports

None.

27 The ‘origin’ principle also required a centralised redistribution mechanism to ensure flows of VAT revenue from Member States of production to Member States of consumption. EU countries could not agree on the workings on such a mechanism either.

28 There are also a number of services which are mandatorily exempt from VAT, but without the right to deduct input VAT, such as financial and insurance services..

29 See Commission document COM(2011) 851.

30 According to the Commission, this approach—and its draft for the ‘negative list’—would allow all Member States to maintain their current reduced or zero-rates, except for three Member States having to “abolish a reduced rate for wine” and for one further country which would have to abolish “a reduced rate for short-term hire of means of transport”. The Commission also considered a second option, which would maintain the ‘positive list’ (i.e. goods and services to which a reduced rate could be applied), while also incorporating all the country-specific exemptions as general derogations into the VAT Directive, available for any Member State to use.

31 Explanatory Memorandum submitted by HM Treasury (8 February 2018).

32 At present, only Ireland can zero-rate women’s sanitary products, as it already applied this rate on 1 January 1991 and this was consequently ‘grandfathered’ into the post-1992 VAT Directive.

33 For example, if one of the UK’s current derogations was—inadvertently—caught by the new ‘negative list’ where the standard rate must apply.

34 See our Report of 6 December 2017 and the chapter of this Report on the “definitive” VAT system for more information on the Brexit-implications for VAT and trade with the EU.

35 http://europeanmemoranda.cabinetoffice.gov.uk/files/2018/02/DOC200218–200220181608392.pdf.

36 See motion for a resolution B8–0135/2018 (7 March 2018). The European Parliament “recalls that the UK’s current position and red lines would lead to customs checks and verification which would affect global supply chains and manufacturing processes, even if tariff barriers can be avoided; underlines the importance of a high level of alignment between the Single EU VAT Area and the UK; believes that taxation matters should be included in any further agreement between the UK and the EU to ensure a maximum level of cooperation between the EU and the UK and its dependent territories in the field of corporate taxation.”

37 Second Council Directive 67/228/EEC of 11 April 1967 on the harmonisation of legislation of Member States concerning turnover taxes—Structure and procedures for application of the common system of value added tax.

38 See Commission document COM(2003) 822.

39 See recital 1 to the first VAT Directive.

40 See Commission document COM(2003) 822.

41 In a cross-border VAT system based on the ‘origin’ principle, suppliers apply to intra-EU sales the VAT rate applicable in the country where they are located. This implies an immediate and significant tax advantage for all sales to non-taxable customers (e.g. final consumers or VAT-exempt organisations such as hospitals) located in a higher-rate jurisdiction, who pay VAT in full. Moreover, taxable customers (i.e. businesses) could obtain a cash flow advantage by purchasing supplies from lower rate jurisdictions (but they will not face lower overall costs, as they will have to charge full VAT when they make sales at their domestic rate). As a result, the European Commission says, any significant rate differences under this system would “fatally undermine” the orderly functioning of the Single Market, which relies on the elimination of tax subsidies having a direct impact on cross-border sales.

42 The evaluation of the VAT system carried out in 2011 found that the application of the destination principle to the tax regime for business-to-business (B2B) trade in goods—and since 1 January 2010 for most services—achieved neutrality towards production decisions, and identified some (limited) potential distortions in the areas where the destination principle is not implemented.

43 This followed a policy orientation established already in 1967. See Commission documents COM(87) 321 and COM(92) 5.

44 In 1993, the standard VAT rate already ranged from a low of 15 per cent in Luxembourg to a high of 25 per cent in Denmark. See “VAT rates applied in the Member States of the European Union: situation as at 1st January 2017“, p. 18 (accessed 15 February 2018). The UK’s standard rate was 10 percent in 1973 and now stands at 20 per cent.

45 To pave the way for the internal market, the Commission proposed to harmonise rates, with a standard rate of minimum 14% and maximum 20% and a reduced rate of minimum 4% and maximum 9% applied to a short list of goods and services (foodstuffs, excluding alcoholic beverages; energy products for heating and lighting; water supplies; pharmaceutical products; books, newspapers and periodicals; passenger transport). It also proposed to abolish all existing derogations.

46 Since 2008, for business-to-business cross-border services, taxation has taken place where the customer is situated, and no longer at the place where the service provider is established. For business-to-consumer services, the place of taxation mostly remained where the supplier is established, as was already the case; however, in certain circumstances (e.g. restaurant services and electronic services like music downloads), taxation of business-to-consumer services would be at the place of consumption in order to prevent distortions of competition between member states operating different VAT rates.

47 Directive 92/77/EEC.

48 Council Directive 92/77/EEC of 19 October 1992 supplementing the common system of value added tax and amending Directive 77/388/EEC (approximation of VAT rates).

49 Article 135 of Directive 2006/112/EC. However, individual Member States can allow businesses which perform exempt services from opting into paying VAT, so that they can claim a refund for input VAT.

50 The UK has the largest amount of zero-rated goods and services. See below.

51 Exemption from VAT.

52 The super-reduced rate is applied in Ireland, Spain, France, Italy and Luxembourg. See Commission document SWD(2018) 7, p. 85.

53 The parking rate is applied by Belgium, Ireland, Luxembourg, Austria and Portugal. The Commission has said these are “mostly targeted VAT subsidies and often concern B2B supplies”.

54 Countries which acceded to the EU in 2004 were mostly only granted three-year temporary derogations, not open-ended ones as available to ‘older’ Member States. These expired in 2010, after having been prolonged once.

55 Judgment of 12 June 2008, C-462/05, Commission v Portugal, EU:C:2008:337.

56 This is because, although reduced VAT taxation can help poorer households and can change consumption behaviour in ways perceived to be desirable, from a budgetary viewpoint it is usually an expensive means of doing so, mainly owing to the fact that reduced rates cannot be targeted to specific groups of consumers.

57 https://ec.europa.eu/taxation_customs/sites/taxation/files/2016–09_vat-gap-report_final.pdf, p. 53.

58 Data by Mathis (2004), “VAT indicators: working paper no 2/2004“. The Commission added: “While the share of the zero rate in the UK and Ireland should have remained roughly constant, possibly with some erosion due to the lower elasticity to income of many of the goods covered by such rate.” The UK applies a zero rate to approximately 20 per cent of all supplies, which is equivalent to 35 per cent of supplies to final consumers who consume 60 per cent of all the supplies for which VAT cannot be deducted.

59 See SWD(2018) 7, p. 17. This includes a request by the UK for the inclusion of women’s sanitary products in the list of goods to which a reduced rate of VAT can be applied.

60 The exhaustive nature of the list of goods and services to which the reduced rates can be applied can, in certain cases, force Member States to breach the fiscal neutrality principle (i.e. that similar goods or services must be subject to the same VAT rate). For example, under Dutch law sunscreen with UVA and UVB filters and toothpaste containing fluoride are pharmaceuticals according to the Dutch Health law, and have to be treated similar to other pharmaceuticals (which are taxed at the reduced rate in the Netherlands). However, Annex III to the VAT Directive does not allow granting a reduced rate to sunscreen and toothpaste. The Dutch Government could therefore either breach the Directive by introducing a reduced rate not permitted, or by increasing VAT on other pharmaceuticals.

61 See Commission document COM(95) 731.

62 See Commission document COM(96) 328, “A common system of VAT“ (22 July 1996).

63 Proposal for a Council Directive amending Directive 77/388/EEC as regards reduced rates of value added tax (COM(2003) 397 final).

64 See for example Council Directive 2009/47/EC.

65 Directive 2006/112/EC, as amended.

66 See Commission document COM(2011) 851.

67 The general use of the ‘destination’ principle for goods notwithstanding, VAT is still levied in the Member State of the supplier for some cross-border transactions within the EU. This is notably the case when non-resident consumers make purchases in another EU country (so that they do not have to declare VAT when they return home); business-to-consumer (B2C) distance sales of goods such as online shopping, where the supplier can apply the origin principle until a value threshold of supplies to a specific EU country in a given year is exceeded; and the special schemes for farmers, travel agents and taxable dealers. With respect to B2C distance sales, the application of the origin principle will be substantially restricted due to [recent changes to EU VAT law], under which the threshold will be significantly reduced, meaning that the destination principle will apply in most cases except for micro-businesses.

68 COM(2011) 851. Its conclusions on the destination system were endorsed by the Council conclusions of 15 May 2012.

69 See Commission document COM(2016) 148.

70 Council conclusions on the VAT action plan and on VAT fraud (25 May 2016).

71 The Member States have made clear to the Commission that they would not accept a proposal to abolish the existing derogations (see SWD(2018) 7, p. 26). In any event, the Commission’s own study found the different national VAT treatments have not had a distortive effect for competition in the Single Market under the ‘destination’ principle that will be made permanent.

72 According to the Commission, if instead of the zero rate a reduced rate of 10 per cent were applied to taxable supplies in the UK, its weighted average rate would increase from approximately 15 to 17 per cent. This, in turn, would increase the Exchequer’s VAT revenue would increase by around 14 per cent, equivalent to approximately £18 billion a year.

73 Commission Impact Assessment SWD(2018) 7, p. 58–59.

74 CPA is the ‘statistical classification of products by activity‘.

75 The maintenance of the 15 per cent minimum standard rate of VAT is contained in a separate legislative proposal which the Commission hopes will be adopted expeditiously, as the current requirement expired on 31 December 2017. However, the Commission notes that this is primarily for reasons of legal certainty, as “all Member States levy standard rates that are well above the 15% threshold, and it seems highly unlikely that in the foreseeable future any Member State would wish to cut the standard rate below 15%”.

76 The draft “standard rates” list is available in the Annex to Commission document COM(2018) 20.

77 Sales of financial services, including insurance, are mandatorily exempt from value added tax under the Directive. However, they are not zero-rated. This means that financial services providers cannot get a refund of their input VAT (i.e. the VAT they pay on the services and goods they buy to provide financial services). The European Commission tabled a proposal in 2007 to address the resulting legal uncertainty and administrative burden on businesses, but it was withdrawn in 2016 after negotiations stalled in the Council. Recently, the Bulgarian Presidency of the Council has been facilitating renewed high-level discussions on this matter, but no legislative proposal is currently foreseen by the Commission.

78 The Commission notes that, under its draft list of standard rate goods and services, some existing derogations would have to be abolished: in three Member States this relates to a reduced rate for wine, and in one Member State to a reduced rate for short-term hire of means of transport.

79 The ‘final consumer’ is the person who acquires goods or services for personal use, as opposed to an economic activity, and thus bears the tax.

80 The Commission notes that the new rules on VAT rating would “not exclude the use to goods or services that are used as intermediate input if those are goods or services typically sold to final consumers”.

81 The weighted average VAT rate in a Member State would take into account all VAT rates in force. Each VAT rate would be weighted with the share of the value of the transactions to which that rate applies as a percentage of the total of taxable transactions.

82 Council conclusions of 25 May 2016.

83 Explanatory Memorandum submitted by HM Treasury (8 February 2018).

84 At present, only Ireland can zero-rate women’s sanitary products, as it already applied this rate on 1 January 1991 and this was consequently ‘grandfathered’ into the post-1992 VAT Directive.



3 April 2018