Not cleared from scrutiny; further information requested; drawn to the attention of the Business Energy and Industrial Strategy and Treasury Committees
Proposal for a Council Directive amending Directive 2006/112/EC on the common system of value added tax as regards the special scheme for small enterprises
Article 113 TFEU; special legislative procedure; unanimity
(39449), 5334/18 + ADD1–3, COM(18) 21
3.1The European Union forms a Single EU VAT Area, where each Member State is required to levy value added tax on supplies and goods of services. Uniquely, within this area VAT on imports of goods between EU Member States are not collected by customs officers at the border. To enable this system to work, EU VAT law imposes significant ‘behind the border’ administrative burdens on businesses, which are responsible for collecting the tax and paying it to the relevant tax authority. For small businesses in particular, VAT compliance costs can be significant.
3.2To mitigate these costs, the EU VAT Directive contains several provisions designed to ease the burden on small businesses dealing with value added tax, which are collectively known as the “SME scheme”. In particular, individual EU countries can use the “SME exemption”, which allows them to exempt smaller businesses based domestically from charging VAT to their customers if their annual turnover is below a specific threshold, and apply various simplification regimes aimed at small businesses to reduce overall VAT-related administrative burdens.
3.3The current legal framework has resulted in a patchwork of different approaches to simplifying the VAT system for small businesses between EU Member States, and is seen as a barrier to trade and growth.
3.4To address these issues, the European Commission presented a legislative proposal in January 2018 to amend the SME-specific provisions of the VAT Directive (as part of a wider process of reform of the Single EU VAT Area). The main elements of its proposal, which we have set out in more detail in paragraph 3.32 to 3.42 below, are to:
3.5The Commission wants these changes to take effect alongside the wider reforms of the EU’s VAT system in summer 2022. However, that timetable will depend on the progress made by the EU’s national governments on the proposals: under the Treaties, each Member State has a veto over new European tax legislation.
3.6The Financial Secretary to the Treasury (Mel Stride) submitted an Explanatory Memorandum on the proposal for a revised VAT scheme for small businesses in February 2018. In it, he welcomed the Commission’s aim of “[reducing] the burden placed on SMEs by the administration of VAT and that lessens any VAT threshold-related distortions”, including the extension of the SME exemption to small businesses from other EU countries.
3.7However, the Minister also identified a number of areas of concern or which require further clarification, in particular with respect to the interaction between the Government’s own work on reform of the UK VAT threshold—on which the Treasury launched a consultation in March 2018—and the Commission proposals for a new maximum VAT exemption threshold and the transitional relief mechanism where the threshold is exceeded. With respect to the implications of Brexit for the UK’s VAT regime and its participation in the single EU VAT area, the Financial Secretary’s Explanatory Memorandum is silent.
3.8The Committee currently has under scrutiny a number of important VAT-related legislative proposals tabled by the European Commission since autumn 2017. We have taken note of the proposal to simplify the VAT obligations for small businesses, and to remove VAT-related barriers to cross-border trade within the European Union. Compared to the other elements of the VAT reform package, the changes are less drastic but could nonetheless have a major impact on individual small firms.
3.9Although the proposals are driven by the need to make it easier for small businesses to trade across borders within the EU without being hampered by different national VAT systems, they would necessarily also have a domestic impact. In the UK, should EU VAT law apply despite Brexit (see below), the most significant changes resulting from the proposed changes to the SME scheme would be:
3.10As the Minister has rightly noted, these proposals cut across the Government’s own work on the UK’s VAT threshold following a review by the Office for Tax Simplification in 2017. However, any changes to the VAT Directive would, of course, only have a direct impact on the UK were it still subject to EU VAT law when they take effect. If it were not, the Government would be free to vary the VAT threshold; to apply the SME exemption to UK businesses only; and to structure invoicing and reporting requirements as it sees fit. Conversely, of course, UK businesses would not be able to use the SME exemption when selling to consumers in the EU-27.
3.11More generally, as we have stated repeatedly, the UK’s exit from the Single EU VAT Area would mean that exports of goods from the UK to the EU and vice versa would be subject to physical custom controls to ensure the correct amount of VAT is paid (in contrast to the current situation, where there are no such controls and movements of goods are monitored via the EU’s VAT Information Exchange System). This will make UK suppliers less attractive to EU customers (and vice versa), while also presenting cash flow issues for businesses which can currently pay VAT on cross-border purchases after they have already taken possession of their imports.
3.12However, whether or not the UK will still be bound by EU VAT law when the European Commission’s VAT reform proposals are due to take effect in 2022 remains unclear. Consequently, we also do not know whether the Commission’s SME proposal will in fact restrain the Government’s room for manoeuvre if it wanted to amend the VAT threshold, or other aspects of UK VAT law.
3.13We note in this respect that the Minister’s Explanatory Memorandum on the proposal assumes the new EU legislation on VAT obligations for SMEs may apply in the UK, as demonstrated by the fact that the Government is concerned the Commission proposals could “interact” with its own review of the UK VAT threshold. The same implicit acceptance that the Treasury may have to continue to apply the VAT Directive, including the slew of amendments proposed in recent months by the Commission, is also present in the Minister’s Memoranda on the other proposals we consider elsewhere in this Report.
3.14In our view, there are three possible reasons why this might be the case.
3.15The Government has not made clear which of these reasons lies behind its assumption that reforms to the EU’s VAT system may apply in the UK from 2022 onwards. It should urgently clarify its intentions in this area, considering the significant implications for UK businesses of an exit from the Single EU VAT Area (in terms of increased domestic flexibility, at the expense of easier access to the EU market).
3.16Moreover, if the UK were to remain subject to the substance of EU VAT law beyond 2021, this raises serious concerns about the Government’s loss of veto over tax-related EU proposals on 29 March 2019. There is clearly a possibility that some or all of the Commission’s wider VAT reform package could be formally endorsed by the Council after March 2019, when the UK would be unable to block them, while the Government could nevertheless be under an obligation to implement them.
3.17Given the substantial impact these proposals could have in the UK, and in view of the considerably uncertainty about the future of the relationship between European and British VAT law, we retain the document under scrutiny. We also draw it to the attention of the Business, Energy & Industrial Strategy and Treasury Committees.
3.18The EU Value Added Tax Directive (Directive 2006/112/EC) requires all Member States to collect value added tax (VAT) on supplies of goods and services. As a consumption tax, its costs are borne ultimately by the final consumer, but—as an indirect tax—the revenues are collected by businesses that make those supplies.
3.19Under the EU VAT system, businesses supplying goods or services collect the VAT paid by the consumer, while being able to deduct from the VAT they have collected the amount of tax they have paid to other suppliers on purchases for their business activities. The difference between VAT collected from consumers (output VAT) and VAT paid to other suppliers (input VAT) is the VAT due to the tax authorities. The resulting “fractionated” system spreads payment of the tax throughout supply chains, in some ways making it self-policing as a business has an interest in ensuring their customer pays VAT because they have had to do the same when purchasing their own supplies.
3.20As a result of businesses having to collect VAT, the EU law places them under a number of administrative obligations which aim at ensuring a correct functioning of the system. These obligations can be summarised as follows:
Registration with the VAT authority of the Member State where VAT must be paid (typically where the customer is based)100
Issuing invoices to customers showing VAT paid
Keeping accounts in sufficient detail for VAT to be applied and its application checked by the tax authorities
Preparing and submitting periodical VAT returns and recapitulative statements
Periodic payment of VAT to the appropriate tax authority
Source: European Commission
3.21The compliance burden of meeting these obligations generates a significant cost for businesses. VAT obligations are particularly burdensome for small businesses, given that they have more limited resources than large businesses. This leads to small businesses bearing proportionally higher VAT compliance costs than larger businesses relative to their size. In recognition of this higher burden, and the barrier it can pose to the development of successful new businesses, the VAT Directive contains several provisions designed to ease the burden on SMEs dealing with VAT.
3.22The SME scheme allow Member States to:
3.23In addition, there are SME-specific derogations and exemptions available that are not, in a legal sense, part of the “SME scheme” under the VAT Directive but based on other provisions of the same Directive. These can affect the obligations for businesses in different ways in different Member States, for example as relates to rules on invoicing, accounting or reporting of VAT.
3.24The current legal framework has created a patchwork of different approaches to simplifying the VAT system for small businesses, which varies considerably from one Member State to another. This, in itself, poses a barrier to cross-border trade within the Single Market: as VAT on business-to-consumer sales must normally be accounted for by the supplier in the country of the customer, businesses have to be familiar with potentially multiple different national VAT systems. Overall, the European Commission says:
“the fact that all of these measures are scattered throughout the VAT Directive increases the complexity of the current rules. Moreover, they are conceived as measures independent from each other rather than as a full simplification regime for small enterprises, which affects the overall effectiveness of the SME scheme.”
3.25The current SME scheme in the VAT Directive has, in the Commission’s view, created two main problems that need to be addressed.
3.26Firstly, the SME exemption only benefits domestic and not intra-EU trade. This is because small businesses can benefit from the SME exemption from collecting VAT (see above) only in the Member State where they are established. As such, given that under EU law VAT must normally be paid in the country of the customer, any businesses seeking to supply to another EU country would have to pay VAT there, under the locally-applicable rules.
3.27Overall, this puts small businesses (which are unlikely to have the necessary resources to comply with two or more sets of VAT rules) seeking to expand across the EU at a competitive disadvantage in two ways:
3.28The potential burden of having to comply with VAT rules in another EU country when wanting to sell goods or services there is potentially significant, because of the complexity and diversity of legislation on VAT obligations across the EU. As a result, the Commission says, “discourages SMEs from exploiting the opportunities offered by the Single Market by increasing the costs of border-crossing trade flows relative to domestic sales”.
3.29In 2015, the EU introduced a simplified registration and payment system MOSS (Mini One Stop Shop) to address these problems for small businesses supplying electronic services to final consumers (B2C). The MOSS allows a business to make their VAT payments on a cross-border sale to their domestic tax authority at the rate of the Member State of the customer, after which the revenue is remitted to the latter’s tax authority. Under recently-agreed reforms, the MOSS systems is due to be expanded to all cross-border business-to-consumer sales in the EU from January 2021. However, these represent only a small fraction of intra-EU transactions that attract VAT, as the vast majority concerns business-to-business sales.
3.30Secondly, at domestic level, the SME exemption creates the “threshold effect”, incentivising small businesses to limit their growth to avoid crossing the turnover threshold and becoming subject to the full obligations of the VAT Directive. This effect has been most pronounced in the UK, because of its high threshold. In November 2017, the Office for Tax Simplification within the Treasury reported:
“The data and anecdotal evidence considered (…) clearly shows that the threshold distorts behaviour by creating a significant cliff-edge, resulting in a bunching effect just below the £85,000 turnover level, rather than the smoother pattern one would otherwise expect. The threshold is therefore presenting a significant disincentive to maximising the potential growth of some businesses and, considering the numbers involved, this is likely to adversely impact economic growth.
This problem appears more acute in the UK than in other EU countries because of the high level of the UK registration threshold. Indeed, the OTS has often been told that some businesses take steps to reduce the level of their business activity to avoid crossing the threshold.”
3.31The European Commission published a VAT Action Plan in 2016. Among a raft of other reforms, including changes to the taxation of cross-border sales, the restrictions on VAT rates and administrative cooperation between tax authorities, the Commission also announced that it would prepare a “comprehensive simplification package for SMEs that will seek to create an environment that is conducive to their growth and favourable to cross-border trade” to address the issues described above.
3.32In January 2018 the Commission tabled the amendment to the VAT Directive on obligations for small businesses as it had announced in its Action Plan two years earlier. The main elements of its proposal are to:
3.33We have described these aspects of the proposed new SME scheme individually below.
3.34The Commission proposal would make substantial changes to the existing limitations on the SME exemption (i.e. the turnover threshold below which a company does not have to charge output VAT or account for input VAT). Currently, the 26 Member States which use the SME exemption fall into two categories:
3.35Under the Commission proposal, these country-specific restrictions and thresholds would be abolished. Instead, Member States would be allowed to vary their own national VAT threshold at will, up to a new common upper limit of €85,000 (£75,415). The proposal also allows for varying the threshold for VAT registration for different business sectors based on “objective criteria”. The flexibility for the pre-1977 Member States to continually adjust their domestic threshold to maintain its real value will be removed (although none except Ireland and the UK operate thresholds near or in excess of the proposed maximum in any event).
3.36The Commission has proposed to tackle the phenomenon of SMEs restricting their activities to remain under their domestic VAT threshold. Under the new scheme, small businesses would be allowed to continue to benefit from the SME exemption in a given Member State even if their turnover exceeded the relevant national threshold by 50 per cent or less during a single calendar year. For example, in a Member State where the threshold is €40,000, a business would not be required to register in the first calendar year in which they exceed the threshold, providing in that calendar year their turnover remains at or below €60,000. In any subsequent year, if the turnover exceeds the domestic threshold (by any amount), the company would no longer be able to benefit from the VAT exemption.
3.37In parallel, the Commission proposes to abolish existing graduated relief schemes for VAT (operated in Spain, the Netherlands, and Finland), under which the amount of VAT to be collected by a business is reduced depending on its turnover, with the relief gradually decreasing with the increase of turnover. The Commission believes these schemes can be eliminated because they were found to be “a source of complexity and contributes little to reducing the compliance burden of small enterprises”. The abolition of graduated relief itself will have no impact in the UK as it does not currently apply such a scheme.
3.38The proposal would amend article 283 of the VAT Directive, requiring Member States to apply the SME exemption from VAT registration not only to their domestic businesses, but also to “non-established enterprises” (i.e. small businesses based in another EU country). To benefit from the SME exemption when selling into another EU Member State, the business in question must have a turnover below the relevant domestic threshold in that country.
3.39In addition, an SME seeking to avail itself of the VAT exemption in another EU country would have to have a turnover across the entire European Union not exceeding €100,000 (£88,723). This “Union turnover” restriction is aimed at preventing larger companies from benefiting from the SME exemption in numerous Member States (i.e. if their turnover in each Member State were below the applicable SME exemption threshold, but its collective turnover plainly put it beyond the category of a ‘small business’). The domestic authorities of the EU country where the SME is established would have to “collect all relevant information on its turnover” and “inform the tax authorities of the other Member States concerned in which the small enterprise carries out its supplies”.
3.40Lastly, the Commission proposal would rationalise the structure of the VAT Directive by incorporating various simplified obligations (registration, invoicing, keeping of accounts and VAT returns) for exempt enterprises explicitly into the exemption scheme, rather than having them “scattered” throughout the legislation.
3.41As part of this process, the Commission also wants to create a new set of simplified obligations for small enterprises that do not benefit from the SME exemption (for example, those eligible for exemption but opting for taxation on the basis of the general rules to allow them to deduct input VAT, or those with turnover above the exemption threshold that applies in their market). To target these simplification measures, the Commission proposes to create a new definition for ‘small enterprises’, namely those with a turnover lower than €2 million (£1.8 million).
3.42For business in this category (including those covered by the SME exemption, insofar that does not negate the need for other VAT-related administrative requirements in their Member State), each EU country would also have to implement a set of simplified VAT obligations for small enterprises, including:
3.43The Financial Secretary to the Treasury (Mel Stride) submitted an Explanatory Memorandum on the proposal for a revised VAT scheme for small businesses in February 2018. In it, he welcomed the proposals that “reduce the burden placed on SMEs by the administration of VAT and that lessens any VAT threshold-related distortions”. The Minister also explains the proposal does not breach the subsidiarity principle, because “consistency of treatment [of small businesses] is more likely to be achieved through action at EU level”.
3.44With respect to the extension of the SME exemption from accounting for VAT to all EU businesses, to facilitate cross-border trade, the Minister says:
“The Government understands that the proposal to allow non-established businesses also to benefit from the UK’s SME exemption should reduce the burden of VAT on small businesses. The Government sees the logic in the Commission’s suggestion that in a destination based EU VAT system a national SME exemption should apply to non-established businesses as well.”
3.45However, the Minister also identified a number of areas of concern or which require further clarification, namely:
3.46Overall, the Minister concludes that, whilst the Government
recognises the merits “of simplifying the VAT obligations of small businesses, more work is needed to review the benefits of such changes”. With respect to the implications of Brexit for the UK’s VAT regime and its participation in the single VAT area, the Financial Secretary’s Explanatory Memorandum is entirely silent.
85 Outside of the EU (including for imports of goods from third countries into the EU), VAT is an import tax collected (or checked and deferred) at the border following customs controls.
86 Directive 2006/112/EC, as amended.
87 See Chapter 1 of Chapter XII of Directive 2006/112/EC.
88 Consequently, small companies which do not charge VAT can also not deduct their input VAT. They are effectively treated as a final consumer.
89 See SME exemption threshold varies by EU country (see “Background” below). In the UK it is £85,000, the highest of any Member State.
90 Intra-EU business-to-business supplies are generally zero-rated given the abolition of customs controls, after which the business customer accounts for the VAT due to their domestic tax authority under the reverse charge mechanism. See our Report of 6 December 2017 on the Single EU VAT Area for more information, and how the Commission has proposed changing this system.
91 This so-called ‘threshold effect’ is particularly pronounced in the UK, because it operates a VAT threshold at a much higher level than any other Member State.
92 The European Commission set out the scale of its proposed reforms in its . In addition to the SME-specific amendments, it also includes separate legislative proposals on the way in which VAT is accounted for on business-to-business transactions between Member States; the flexibility of individual EU countries to vary their VAT rates; and the level of administrative cooperation between the EU’s national tax authorities to tackle VAT fraud and evasion. We have discussed these other proposals separately in the other chapters of this Report.
93 €1 = £0.88415 or £1 = €1.13103 as at 28 February.
94 In most cases under EU VAT law, value added tax must be paid in the Member State of consumption. However, for cross-border business-to-business supplies of goods and services within the EU, the VAT must be accounted for by the customer and not the supplier (for reasons explained in our ). Therefore, the extension of the SME exception would primarily benefit small businesses seeking to sell goods or services to consumers in other Member States.
95 submitted by HM Treasury (8 February 2018).
96 See .
97 See . Supplies of services to businesses are subject to different rules (as they must typically account for the VAT themselves, rather than the non-EU supplier).
98 The UK’s formal exit date could be different if the Government requested an extension of the Article 50 period, or if the Withdrawal Agreement specifies a different date.
99 For example, both the Isle of Man and Monaco are within the Single EU VAT Area despite not being part of the EU. However, in both cases this is because of their close association with an EU Member State.
100 As we have discussed elsewhere in this Report, the payment of VAT on cross-border transactions within the EU can, under certain circumstances, be made to the tax authority of the country where the supplier is based (e.g. for distance sales of goods to consumers below a value threshold). In addition, the EU has a “Mini One Stop Shop” system for providers of certain electronic services to consumers which allows them to account for VAT to their national tax authority, which then remits it to the tax authority of the consumer’s Member State.
101 See Chapter 1 of Chapter XII of .
102 Under flat rate schemes, the business does not have to precisely calculate the difference between their input and output VAT and make up the difference to their tax authority. Instead, they can apply a fixed flat-rate percentage to their gross turnover to arrive at the VAT due.
103 Under graduated relief, the amount of VAT to be collected by a small business increases gradually as the business turnover increases beyond certain thresholds.
104 Cash accounting schemes aim to improve the cash-flow of small businesses by allowing them account for the VAT charged (output VAT) only when they have received payment from their customers (rather than at the point at which a supply is actually made, even if payment is not yet received), and deduct the VAT paid (input VAT) only once the purchases have been paid for. For example, under the UK’s cash accounting scheme, small businesses can pay VAT on their sales when they are paid by their customers, and reclaim VAT on your purchases when you have paid your supplier.
105 Under the VAT Directive, the UK (and certain other Member States) can only increase this threshold to maintain its value in real terms as it was in 1977.
106 See European Commission, ““ (accessed 9 March 2018). Ireland is the only other Member State to have a VAT registration threshold above €50,000 (the UK’s, converted to euros, currently amounts to €95,000). The Netherlands and Spain are the only Member States not to use the SME exemption.
107 , p. 16.
108 For example, there are thresholds on the distance sale of goods to another EU country below which a business can pay VAT domestically and above which the VAT must be paid in the country of the customer. These thresholds can vary by Member State and can require a small business to register for VAT in another country.
109 Under MOSS, the business still has to comply with certain rules of the Member State of consumption (for example related to invoicing), but it does not have to register for VAT purposes in that country.
110 See our .
111 As part of the ‘definitive’ system of VAT, the European Commission has suggested expanding the MOSS to all intra-EU sales, although this is likely to be controversial as it shifts responsibility for VAT collection to a large degree to ‘supplier’ Member States like Germany. See our .
112 Office for Tax Simplification, ““ (November 2017).
113 We have covered the other three elements of the VAT reform package in other chapters in this Report.
114 Spain and the Netherlands do not operate the SME exemption.
115 I.e. Germany, France, Italy, Belgium, Luxembourg, the Netherlands, the UK, Denmark and Ireland.
116 The graduated relief scheme are in effect a variation of the SME exemption, in the sense that they also relieve small enterprises of the burden of collecting tax, although this is done gradually by means of multiple thresholds. Like the SME exemption, the graduated relief is available only to domestic businesses, and the thresholds under which the exemption applies are determined in relation to the annual turnover of the business.
117 Non-EU businesses that sell into the EU would not be able to make use of the SME exemption as they are outside the single VAT area.
118 See article 290 of the VAT Directive. Businesses could opt for this if they want to be able to deduct input VAT on their supplies.
119 The SME exemption in itself only allows an SME not to charge VAT on their sales (and, as a result, to deduct input VAT). It does not necessarily mean no VAT administrative requirements apply to them. For example, in some Member States SMEs which use the VAT exemption must still register for VAT purposes or issue VAT invoices.
120 At present, article 252 of the VAT Directive makes it optional for Member States to allow annual VAT returns for any business. The Commission proposal would make it compulsory to offer this option to small businesses.
121 The Annual Accounting Scheme in the UK is open to businesses with a turnover below £1.35 million. See also .
122 submitted by HM Treasury (8 February 2018).
123 See .
124 See footnote 102 for more information on so-called “cash accounting schemes” to reduce VAT-related administrative burdens on SMEs.’
3 April 2018