VAT and Derivatives: A Measure of Value
Derivatives are difficult to fit into established legal, accounting and tax categories. Their status for VAT purposes is largely determined by pragmatic considerations of what works in practice, rather than precise consideration of what the legal scheme requires. The VAT treatment operates largely independently of the general accounting and tax analysis.
As regards derivatives contracts, there are at least four possible VAT treatments:
Derivatives are always at one remove from their underlying subject matter. A derivative is a contract to deliver chattels or pay a sum of money calculated by reference to a variable, consisting of the price or rate of some underlying item. The underlying item may be a commodity, a physical such as a share or an index. Hence underlying items include equities, bonds, commodities, electricity supplies, interest rates, exchange rates and stock market and other indices.
The ‘underlying’ means the subject-matter by reference to which amounts payable under the derivative contract are determined. Derivatives both reflect the underlying subject matter (oil, coffee, a currency, an interest rate, a bond price, a dividend on a share) and are assets in their own right (a promise to deliver an item at a future date or pay a sum of money representing its value or a net sum).
The VAT question is whether to focus on the financial aspect or the underlying.
At the dawn of UK VAT,Customs recognised that futures markets posed special problems for the VAT system.The oldest piece of VAT legislation which is still in force is the Value Added Tax (Terminal Markets) Order SI 1973/173. Accordingly, a bold decision was taken to deal with these issues on a pragmatic basis, zero-rating some activities and exempting others. As neither the Second VAT Directive nor the Sixth VAT Directive contained any special rules relating to derivatives, the national rules could plough their own furrow, without overmuch concern about their compatibility with Community law. The one decisive intervention of Community law in this field has been the First National Bank of Chicago case (referred to below). Generally, the VAT treatment of derivatives has been fitted into the framework of financial services, without any consistent underlying basis.
Lenin said that all political problems resolve themselves into the question: who whom? Who does what to whom? The VAT question is, who supplies what to whom? Where a person makes exempt supplies, he is in tax terms treated as not making a supply, because his activity does not generate any recoverable VAT.
In the UK sixteen major banks together incur some £1.3 billion of irrecoverable VAT on expenses. This is because of the wide-reaching exemption of financial services from the requirement to charge VAT, with the consequent inability to recover VAT.To the extent that they cannot recover VAT, banks are not regarded as a taxable person, but as final consumers. As the ECJ explained in Staatssecretaris van Financien v Hong Kong Trade Development Council (Case 89/8) [1982] ECR 1277 at 1286 (para 9):
Under [the common system of VAT] is it clear that tax is no longer deductible when the chain of transactions has come to an end. It is then charged to the final consumer who cannot pass on the amount of the tax unless there is a further transaction in which a price is paid.
The reason why the transaction is treated as one in which ‘no price is paid’, even though banks charge for their services and make profits, is that financial contracts generally involve a payment of money against money. Money is both the price and the subject- matter of the contract. The customer and supplier constantly change masks, so that they fulfil both roles. Both parties make supplies reciprocally to each other. If people had to pay VAT at both ends, VAT would be charged on VAT, with a cascading effect.The way out of this dilemma is to exempt most financial contracts.
In the classic form of contract, a contract is an exchange of promises. One promise is concerned with the subject-matter of the contract; the other promise is concerned with the contractual consideration.
In order to be within the common system of VAT, a transaction has to involve the doing of something, other than simply making a promise to pay a sum of money. The promise to pay money is the counterpart of a potentially taxable supply: it is not a supply as such.
The UK legislation expresses this very clearly, when Value Added Tax Act 1994 (‘VATA’), s 5(2)(b) says: “anything which is not a supply of goods but is done for a consideration … is a supply of services”. Money cannot form both the subject-matter of the contract and the consideration for the contract.
In C & E Comrs v FDR Ltd [2000] STC 672 at 686 [para 35] Laws LJ observes:
It is well recognised that commercial transactions whose essence involves the movement of money are in many cases, for conceptual reasons, ill-suited for the application of the VAT regime, and it seems likely that this is what lies behind the art 13B(d) exemptions.
The ‘conceptual reason’ to which Laws LJ refers is that money is consideration for a supply, but not a supply in itself.The value of a supply is the monetary consideration, the price paid in money by the customer. If payment of money by the customer to the supplier is also a supply, the business customer is going to have to charge VAT to his supplier, in respect of the service which the customer in turn performs by paying the supplier’s bill. However, to pay money is not to make a supply. Otherwise the VAT system would become a perpetuum mobile, driven by an endless ping-pong, and tax would snowball indefinitely.
This insight is ancient and has been expressed in many different ways. St Thomas Aquinas wrote that money was mensura nec mensuratum, “a measure of value, but not something whose value is itself measured”. Savigny wrote that money “embraces the value itself which is measured by it, and thus it represents the value of all other forms of wealth”.
The ECJ has commented on the difficulty of applying VAT to financial services. The Advocate General Colomer observed in Sparekassernes Datacenter (SDC) v Skatteministeriet (Case C-2/95) [1997] STC 932 at 940 [para 42]:
The Community legislature has granted the exemptions at issue to a series of “transactions” frequently encountered in legal dealings, since otherwise tax would have fallen upon both normal commercial activity effected by means of the commercial instruments mentioned (cheques, negotiable instruments, current accounts and so on) and upon transfer of shares, interests in companies, debentures and other securities.
The Advocate General seems to be saying that the reasons for the exemption are purely pragmatic, i.e. the number and frequency of such transactions. In CSC Financial Services Ltd v C & E Comrs (Case C-235/00) [2002] STC 57 the same Advocate General returned to the theme, saying at 63 (para 24):
I find that the exemption can have no rationale other than that of liberating from the tax regime transactions which, in view of their frequency … and habitual nature, are a central component of the financial systems and, therefore, of the economic activities of the member states.The aim pursued is to avoid a burden on certain services which would be liable to hamper the functioning of the market.
In view of these difficulties, conceptual and pragmatic, no practical method of applying VAT to financial services has ever been devised.
These difficulties are encountered in heightened form with regard to financial instruments and derivatives.The reason is partly historical.When the Sixth Directive was enacted in 1977, derivatives in their modern form scarcely existed outside commodity and foreign exchange markets. Moreover, the notion of a ‘special method’ of partial exemption was undeveloped. As a result, the VAT treatment of such contracts has evolved on a pragmatic basis, largely outside the Sixth Directive.
The Sixth Directive fudged the issue by providing in art 13B(d) that most financial transactions are exempt from VAT.Article 13B(f) also exempts ‘betting, lotteries and other forms of gambling’.
The Sixth Directive does not distinguish between exempt supplies and non-supplies. In many cases the distinction does not matter: absent special cases, no VAT is recoverable in respect of either.
Tax authorities have tended to distinguish between transactions in which a specific charge is made (exempt supplies) and transactions where remuneration is obtained by means of a margin (no supply because no identifiable consideration).
Commercially, fee-based and margin-based services are alike made in the course of business. The illogicality of this distinction was for VAT purposes was exposed in C & E Comrs v First National Bank of Chicago (Case C- 172/96) [1998] STC 850. This concerned foreign exchange dealings for which no commission was charged, the bank’s return being derived from the spread between the bid and offer prices for the currency in question.The bank was registered for VAT in the UK and operated a transaction based special exemption method, the fraction being the number of transactions with counterparties outside the EU, divided by the total number of transactions. Customs excluded foreign exchange transactions, on the grounds that the exchange of money for money did not constitute a supply.The bank wanted to recover under art 17(3)(c) input tax attributable to foreign currency transactions where the customer was located outside the EU.The Court of Justice held that it made no sense to say that a dealer in foreign currency was working for payment where he charged a commission, but working for free where he set his buy and offer rates so as to achieve a profit from the margin.As the Advocate General said at 859-860 (paras 45-), “the spread resulting from the difference in rates constitutes the payment for the service supplied by the bank … the customer paid a higher price for a foreign currency than he would obtain were he to sell that currency back to the bank immediately”. Where there is a margin it is not possible to value services on a transaction by transaction basis. Nevertheless, the Court held that there was a supply of services by the bank and that the consideration was the net result of foreign exchange transactions over a period. The Court concluded at 870 (para 34):
It must therefore be held that foreign exchange transactions, performed even without commission or direct fees, are supplies of services provided in return for consideration, that is to say supplies of services effect for consideration n…
As regards the quantification of the consideration, the Court said (at 870, para 31):
any technical difficulties which exist in determining the amount of the consideration cannot by themselves justify the conclusion that no consideration exists.
Notwithstanding these ‘technical difficulties’, the result is logical and unsurprising. It can also be extended to other margin services such as dealers in interest rate swaps.
In consequence, the ‘non-supply’ argument has largely disappeared with regard to financial services. FNBC establishes that a global link between the amounts received and the transactions is sufficient to make an activity into a supply.
Where the transaction involves payment, there will be a supply in the form of a financial service where the transaction leads to “a real change in the legal and financial situation” between the parties: Sparekassernes Datacenter (SDC) v Skatteministeriet (Case C-2/95) [1997] STC 932 at 954 (para 53).
Hence payment of interest is usually regarded as consideration for a supply of services, namely, the grant of a loan. The loan itself is regarded as a continuous supply of services, taking place where the lender receives the interest:VATA Sch 9, Group 5, Item Nos. 1 and 2;VAT General Regulations, SI 1995/2518, reg. 90.The transfer of money from the lender to the borrower, and its repayment, are a supply, being the transaction in respect of which interest is payable, but do not constitute consideration for a supply.
Some derivatives can be completed by delivery of the underlying: e.g. an oil forward. Some derivatives can be completed either by delivery of the underlying or by payment of a cash sum, e.g. an oil future. Some derivatives can only be satisfied by a cash payment: e.g. a contract for differences, a weather derivative. Supplies of power are regarded as supplies of goods, and so assimilated to commodity forwards:VATA Sch 4, para 3. Cash is not an underlying, except in so far as banknotes and coin are considered as chattels. Foreign currency has always played an ambiguous role in law, because it can function as a commodity as well as money. Hence a currency forward might be regarded as either a forward sale of a commodity, like a grain forward, or a pure financial transaction. A contract for differences will be a pure money contract.
The underlying subject matter of forwards will vary. In some cases, the underlying will be exempt (e.g. interest rate forwards, share options) or zero-rated (e.g. a grain forward). In other cases it will be taxable (e.g. power supplies). Electricity forward agreements (EFAs) are according to their terms contracts for differences. On the other hand, other contracts between electricity suppliers for the future supply power will be regarded as supplies of goods. Futures will be regarded as contracts for differences. The essential issue is whether such transactions are to be regarded as purely financial transactions, or as something else, namely, a transaction relating to the ‘underlying’. In practice supplies involving both derivative contracts and financial instruments are effectively either exempt or zero-rated.However, there is little conceptual framework for the VAT treatment and such principles as there are applied inconsistently.
The VAT status of such transactions may be determined by the legal analysis of the transaction whether the supply (if any) is regarded as goods or service the nature of the underlying whether the contract is expected to run to delivery whether the transaction takes place on a futures exchange whether the counterparties are members of a futures exchange whether a broker is a principal or agent:
The broad principle is that, if a contract is regarded as being made for the delivery of an underlying, the nature of the VAT treatment depends upon the nature of the underlying deliverable asset or financial instrument. If there is no underlying, if the contract is purely a money contract, then the transaction is exempt or outside the scope.
The difficulty of the underlying subject matter approach is that transactions fall into three groups:
Group (1) contracts are purely financial transactions, i.e. contracts for differences.Group (2) contracts are classified for VAT purposes according to the nature of the underlying. The problem is that a very wide range of contracts fall within (3). Are these contracts to be assimilated to (1) or (2)? In practice, the answer depends upon (a) the likelihood or not that the contract will run to delivery; and (b) the closeness of the relationship between the derivative and the underlying. Most exchange traded contracts will be closed out, by the purchase of an offsetting contract. In the absence of a special statutory treatment, they will be treated as falling under (3). If the derivatives contract is regarded as closely linked to the supply of the underlying, the contract will fall under (1). Otherwise contracts will fall under (3).
There are three types of derivative:
Most derivatives on financial instruments are considered to be exempt under VATA, Sch 9, Group 5, Item No 1, but some fall under Item No 6. interest rate futures and options are treated as supplies of securities for money. Equity options are regarded as securities. A currency future will fall under Item No 1. A bond future will fall under Item No 6.A contract for differences is regarded as ‘security for money’, so falling under Item 1. Item 1 serves as a residual category. A swap is regarded as involving a continuous supply of services, because payments take place at intervals over the life of the contract.
VAT reporting, valuation and timing bases may well be different from that used in the accounts and for direct tax purposes. In the case of loans gross interest will be brought in for VAT purposes, even the margin may be negative. In the case of swaps, for VAT purposes only payments made and received will be taken into account, while for general purposes swaps are likely to be reported on a mark to market basis.
In practice the invaluable British Bankers’ Association Blue Book – largely the work of Paul Tipping of the BBA and Peter Mason of Abbey – sets out the BBA’s agreement with Customs and valuation rules for the different categories of derivatives.For example, the value of a supply under a currency option is the premium; the value of a financial future is the turn or commission charged; for a swap the value is the net amount received by either party on a given payment date.
Many commodity futures and options will be traded on markets covered by the VAT (Terminal Markets) Order, SI 1973/173. This applies to the London Metal Exchange, the London Rubber Market, the London Cocoa Terminal Market, the London Coffee Terminal Market, the London Vegetable Oil Terminal Market, the London Wool Terminal Market, the London Bullion Market, the London Meat Futures Market, the London Soya Bean Meal Futures Market, the Liverpool Barley Futures Market, the International Petroleum Exchange of London, the London Potato Futures Market, the London Platinum and Palladium Market and the London Securities and Derivatives Exchange. While member to member supplies are outside the scope, they are taken into account as transactions, when a transaction-based partial exemption method is being applied. Broadly speaking, transactions between members of these exchanges, whether classified as supplies of goods or supplies of services, are zero-rated.
Transactions in bullion fall under special rules. Cash-settled transactions are not covered by TMO. LIFFE comprises the London Traded Options Market (LTOM). Trading as a member of LIFFE will be an exempt or partly exempt activity, with scope for input tax recovery where the client belongs outside the EU.When a contract is made it is registered with the LCH and margin becomes payable.Margin is outside the scope, because it does not represent consideration for any supply.
Transactions may simply produce a profit or loss. In some cases, a separate service charge or commission may be identified. Commission is paid by a principal to an agent. Commission charge to principals may also be zero-rated as being (a) ancillary to a zero-rated supply, or (b) because the goods notionally supplied are outside the UK, or (c) because the person to whom services are supplied is established outside the EU.
Commission charged by introducing brokers, who introduce business to members of the exchange, are standard-rated if the introducing broker is established in the UK. If he is established outside the UK, the reverse charge procedure should be operated.
Suppplies by members of LIFFE to their clients are on a principal to principal basis and any charge by a member is a dealing turn, rather than commission.
Because of the international nature of derivatives contracts, the place of supply rules play an important part in their VAT treatment.
VAT is only chargeable on supplies within the UK.The place where a service is supplied and so chargeable to tax is normally the place where the supplier has his business establishment: art 9(1). However, there are extensive departures from this rule. In particular, art 9(2)(e) provides that a number of ‘supplied where received’ services are treated as supplied ‘where the customer has established his business’.These include ‘banking, financial and insurance transactions’.Thus a UK bank which makes a loan to a private person in France, supplies that service in the UK. If a UK makes a loan to a taxable person established in France, that transaction takes place in France.
If the overseas supply is one that would have been taxable, had both parties been in the UK, it will be outside the scope, but treated as if it were taxable for the purposes of input tax recovery. If the supply would have been exempt in the UK, but is deemed to take place outside the EU, any related input tax which can also be ‘attributed to taxable supplies’ by virtue of SI 1995/2518, reg 103 and VAT (Input Tax) (Specified Supplies) Order SI 1992/3121, reg 16. If the supply is treated as made in another EU Member State but would have been exempt in the UK, the input tax is not recoverable because the supply is outside the scope but it is not ‘specified’.
Where a taxable supply escapes VAT in one Member State because it is deemed to take place in another, it may be subject to VAT in the other country under the ‘reverse charge’ mechanism.
If ‘supplied where received’ services are performed by a person established outside the UK, for a customer established in the UK, and the service is charged to tax at a positive rate, those services they will be provided in the UK and fall within the scope of UK VAT. In these circumstances, the UK customer is liable to a ‘reverse charge’.The ‘reverse charge’ rule means that the customer rather than the supplier is made liable for the VAT. Where the reverse charge applies, the recipient must bring in the supplies obtained from abroad as if he had first made and then received them. This is achieved by the fiction that the customer has made the supply to himself. Hence the mirror image of the ‘supplied where received’ rule is the ‘reverse charge’ rule.These are two sides of the same coin.The reverse charge rule is contained in art 21(1)(b) of the Sixth Directive. The relevant UK provisions are in Value Added Tax Act 1994 (‘VATA’) s 8, Sch 5 and Sch 9.
So long as the services in question fall within VATA Sch 9 (exempt supplies), they do not enter into the reverse charge mechanism. Hence cross-border derivatives transactions will not produce reverse charge liabilities.
In truth, derivatives cannot all be put in the same VAT basket. The existing tax regime is largely reliant on practice rather than law. This leaves taxpayers some scope for flexibility in integrating their VAT affairs with their overall operations.