Select Committee on European Union Twentieth Report

CHAPTER 4: OPTIONS FOR CHANGE

53.  The adoption of any of the measures in this chapter would require unanimous approval from the 27 Member States. The majority of our witnesses agree that some change is required, but there is no consensus on the form this change should take. We consider in turn five options that have attracted some support in the evidence we have received and which we consider to be viable proposals for change. These options are:

1. GENERALISED "REVERSE CHARGE" OR SALES TAX

54.  We discussed the reverse charge accounting mechanism in Chapter 2 (see Figure 4). A generalised reverse charge would pass the liability for VAT on all transactions between businesses onto the buyer, rather than the seller. VAT would not change hands, and the buyer would be expected to account for the tax to HMRC, and apply it as a credit against tax on sales made. The final buyer in a chain before the final consumer would become responsible for remitting all the VAT on that item. This would in effect replace VAT with a Sales Tax.

55.  As already noted, the UK has secured a derogation to operate a reverse charge accounting mechanism in the mobile telephone and computer chip industries, and a Community-wide reverse charge operates for investment gold. A proposal whereby countries could choose to adopt a reverse charge mechanism on all products was put forward by the German Government, but it has not met with any support from the Commission and it does not appear that it will be pursued during the last weeks of the German Presidency.[34]

56.  If, as we expect, MTIC fraud mutates or migrates to other Member States, it is likely that there will be further requests for derogations to apply a reverse charge to more products in other Member States. The European Commission would not be opposed to these if they were targeted and proportional (Q 135-137). Cross-border trade is likely to continue to grow as the Union expands and the internet facilitates international purchasing. Unless and until all high value/low weight goods, and service industries, are subject to a reverse charge fraud will continue to move into new sectors. A series of limited reverse charges would inevitably merge in time to a generalised reverse charge or Sales Tax.

57.  The change from Value Added Tax to an "end user" or Sales Tax system would come at a considerable cost to both revenue authorities and individual businesses. It is also possible to raise more tax under a VAT system than under a Sales Tax. In a Sales Tax system, the whole of the revenue is collected from the final link in the commercial chain, when the retailer sells to the final consumer; this is commonly disproportionately made up of small businesses for whom tax collection is a considerable burden.[35] Furthermore, studies have shown that a Sales Tax is efficient at relatively low rates but is increasingly difficult to administer as rates rise.[36] Cross-border trade would become more expensive as firms would now pay the Sales Tax rate of the country of purchase. With increasing use of the internet for the purchase of goods, this would lead to firms being undercut by those based in the Member States with the lowest Sales Tax rates. Unless harmonised this would in turn lead to pressure from market forces for tax rates to be cut, and reduce the revenue raising potential of the tax.[37]

2. DESTINATION SYSTEM

58.  Under this system the exporter charges VAT according to the rate applicable in the country of consumption or "destination".

FIGURE 4

The Destination System[38]

59.  This system would require the exporter to register for VAT in each country to which he supplies goods. The European Commission told us that it is currently investigating this system as an add-on to the "one-stop-shop" proposal, currently under consultation, whereby a trader registers for VAT in his home country in respect of all VAT liabilities throughout the EU (Q 142). The taxpayer would file the VAT return electronically and either pay the VAT due directly to the revenue authorities in the destination country, or make one payment to his national bank, who will allocate it between the appropriate countries. There would be no need for a clearing house in this system.

60.  This proposal would eliminate the opportunity for MTIC fraud. However, witnesses have warned us that there will be high additional compliance costs for business: exporters would need to be conversant with VAT rates (both standard and lower rates) and the rules governing deductible VAT in 27 Member States in order to calculate the correct amount of VAT due (Q 192, 195). Similarly, there would be costs for revenue authorities who would have to provide information in most, if not all, of the official languages to the EU. Furthermore, it relies on the "one-stop-shop" proposal being adapted to cater for business to business transactions, and adopted by Member States, if the costs associated with separate registration in other countries are to be avoided.

61.  For most companies, the compliance costs of a Destination System would be unacceptable and would act as a barrier to intra-Community trade, thus fundamentally frustrating the Single Market.

3.1 ORIGIN SYSTEM

62.  The fundamental principles behind the introduction of VAT across the European Community, in respect of intra-community trade, included the eventual abandonment of the taxation of products in the country of destination in favour of taxation of products in the country of origin (the exporting country). This was accordingly proposed by the European Commission when addressing the removal of tax barriers in attaining the Single Market in 1993, but rejected by the Member States.

FIGURE 5

The Origin System[39]

63.  Under this scheme, VAT would be charged at the rate of the exporting country and the purchaser would be able to request a refund of the tax paid from the revenue authority in its own country. This would mirror the position of a business selling to another business in the same Member State and would be logically consistent with the creation of the Single Market. However because of the wide disparity in VAT rates throughout the Community, it was recognised that there would need to be a transfer of the VAT collected by the supplying country to the purchasing country so as to restore the importing country's VAT revenues. This in turn requires the creation of a clearing house to facilitate transfers of VAT between revenue authorities.

64.  The key attribute of the Origin System is its simplicity for traders: purchasers simply pay the appropriate VAT rate for the territory from which they are buying the product. The vendor only needs to know the appropriate tax rates in its own country. Charging VAT on intra-Community trades would eliminate the possibility of Missing Trader fraud as no participant in a trading chain would receive goods VAT free. However, VAT is designed to be a consumption tax and so this system is contrary to its underlying concept, i.e. that products should be taxed at the point of consumption.

65.  A problem arises when the purchaser requests the refund of the tax paid from the revenue authority in its own country. Because the tax has been remitted in the origin country, the purchaser's revenue authority is paying out money it will not receive unless and until it gets a refund from the revenue authority in the exporting country. This system of transfers between revenue authorities would be facilitated by the creation of a clearing house. The Commission's original proposal for a clearing house suggested that the flows through it might be determined by broad macro-economic data, rather than relating information to actual trades. However, modern technology means that HM Treasury can envisage the latter option (Q 348) and it is reasonable to assume that this could be linked to a EU-wide real-time trade logging system should one be introduced.

66.  Member States, however, continue to oppose the Origin System, as they did in 1992. HMRC have told us that some businesses support this approach but that zero-rating of transactions facilitates trade and is of great benefit to business and consumers (p 64, Q 258). HM Treasury expressed concerns that there could be difficulties for Member States in ensuring that they received the tax they were due through the clearing house, and noted that around £40 billion of VAT is associated with goods traded between the United Kingdom and the other Member States (Q 348). They believed there would be "considerable risks" associated with the system (Q 349).

67.  The combination of an Origin System with a clearing house has considerable merit. The clearing house would be logistically feasible and greater sums are reliably and securely handled by the various clearing houses and payment systems operating in European financial markets. The interwoven nature of the European economy means that all countries would have an interest in ensuring that cross-border transactions are accurately recorded and verified, because all countries export to some degree. The risk inherent in having to trust other Member States' revenue authorities, and the associated costs, should be lower than the risk posed by MTIC fraud and the associated losses.

68.  We do not accept that the Origin System would automatically lead to a harmonisation of VAT rates in the Community although we accept that there is likely to be an adjustment in levels of cross-border trade as some purchasers switched to alternative suppliers in lower tax territories. The majority of VAT rates in Member States are already within a small range except for those products which are currently zero-rated in selected Member States, where a large difference between applicable VAT rates would become apparent. The problem this creates would be circumvented by introducing a "Flat Rate" Origin System.

3.2 FLAT RATE ORIGIN SYSTEM

69.  Instead of the supplier charging VAT at the rate of the supplying country, the lowest rate of VAT allowed by the Principal Directive, currently 15%, would be charged.[40] The purchaser would request a refund of VAT paid from revenue authorities in his country on his normal VAT return, who in turn would request a refund from the revenue authorities of the supplying country. The purchaser would need to account for the difference between the higher VAT rate in the country of destination and 15% by way of a reverse charge to ensure that VAT at the full rate of the importing country is paid by businesses who cannot recover their VAT in full.[41] A clearing house would still be necessary but this proposal would meet the principal objection to the original Origin system in that it would avoid large transfers between the revenue authorities to account for differences in VAT rates. The transfer would need only to reflect the net position of trade flows between member states.

70.  The Flat Rate Origin System removes several of the disadvantages of the standard Origin System. As VAT is charged at a single rate, the clearing house would only need to reflect the balance of trade between member states, and not different VAT rates. This would reduce the cost and complexity of the clearing system. Businesses would face no higher compliance costs than at present: vendors would change from charging a flat rate of 0% to a flat rate of 15% (or whatever flat rate level is set out by the Council of Ministers). Furthermore, there should be no political pressure to harmonise VAT rates, or remove derogations for zero-rated products.

71.  There is still an opportunity for Missing Trader Fraud to be perpetrated under this system. However, by minimising the disparity of tax rates between imported goods and those traded within a Member State, the profitability of the fraud and thus its inherent attraction to criminal gangs would be significantly reduced.

3.3 ORIGIN SYSTEM OR FLAT RATE ORIGIN SYSTEM WITHOUT CLEARING HOUSE

72.  This proposal would operate an Origin System or Flat Rate Origin System as described above but without the transfer of VAT revenues between member states through the clearing house. The VAT charged by the exporter would be collected and retained in the country of the supplier; the VAT would in turn be refunded to the purchaser in the country of destination. Net exporting countries would benefit from increased revenue flows at the expense of net importing countries, although this imbalance would be reduced if a Flat Rate Origin System were in place, because the rate of VAT refunded would never be more than the rate of VAT in the importing country. Furthermore, this system retains the "fractionated" nature of VAT, whereby its collection is split between the member states in which value is added.

73.  Without a Clearing House, VAT would change in nature from a pure consumption tax, but the cost associated with the clearing house and the risk associated with relying on other Member States to collect and remit tax revenue would be removed. There would be winners and losers from the change and HM Treasury did not appear to favour it (QQ 351-354). VAT would become payable on goods imported from another Member State even when those goods are normally zero-rated in the domestic market, increasing the cost of some goods in some markets. Countries running a trade deficit with EU partners would lose revenue; those with a trade surplus would receive more.[42]

74.  In their evidence, HM Treasury gave three criteria for any new taxation system: that the right tax ends up in the right place; that the potential for fraud and non-compliance is minimised; and that business is not unreasonably burdened (Q 348). HM Treasury believe an origin system without a clearing house would fail on the first criterion. We believe however that this proposal merits further serious study.

A need for change?

75.  Harmonisation of VAT rates would remove the opportunity of MTIC fraud. The UK is not alone in opposing this harmonisation. There appear to be three options for tackling MTIC Fraud: do nothing and accept it; take steps to make the existing system more robust and sophisticated; or accept that MTIC fraud is inherent in the system and accordingly reform the system. Doing nothing is not an option. A continued ratcheting up of the complexity and compliance requirements related to the existing system will impose increasing costs on legitimate business. A solution to MTIC Fraud will benefit every Member State: countries need to recognise this and agree to act together. It is now time for the Government and other Member States to look more sympathetically at a radical change to the VAT system. The flat rate origin system proposal, either with or without a clearing house, merits further serious study of the potential impact on businesses, levels of trade, and Member State revenues.

76.  We invite the Government, when responding to this Report, to assess the relative merits of all the options for reform which it describes.

---

34   Austria supports the proposal. Other Member States and the UK are opposed to it (QQ 248-251). Back

35   The Government also noted that that the advantage of having the remittance of the VAT liability spread amongst numerous traders in the supply chain would be lost (Q 366). Back

36   Value added Tax: International Practice and Problems Alan Tait IMF 1988 Back

37   High Sales Tax rates encourage evasion techniques such as using or creating a business to buy goods tax-free when they are intended for personal use rather than resale. It would be likely that there would be more off-book "cash" transactions, which is already a common fraud in other sectors (Q 41). Back

38   Adapted from Combating Vat Fraud in the EU: The Way Forward, International VAT Association, March 2007 Back

39   Adapted from Combating Vat Fraud in the EU: The Way Forward, International VAT Association, March 2007 Back

40   Only two member states, Cyprus and Luxembourg, currently apply this rate; however many Member States have derogations which allow them to zero rate some classes of products. Back

41   Partly exempt businesses which cannot recover all of their VAT would be the only purchasers affected by this measure, although as a control mechanism, all businesses would be required to make entries on their VAT returns. Back

42   The United Kingdom's deficit for trade in goods with the EU in 2006 was £37.6 billion. If all traded goods were subject to VAT at the full rate (a generous assumption) this would have led to a potential loss of revenue of £6.6 billion for the UK. However, if a flat rate if 15% is applied to all imports and exports, this loss of revenue would be £5.6 billion: this is of the same magnitude as estimates of losses to MTIC fraud. There would also be considerable savings in administrative and compliance costs, and the system would be simpler for business. Back