A no-deal Brexit would be bad news for most businesses, but banks and financial institutions could be in line for significant tax savings.

If the U.K. leaves the European Union without a deal on the terms of its exit, these financial companies would be allowed to recover value-added taxes on overhead costs incurred in providing products and services—the input VAT. They are barred from doing so under EU rules.

Thirty-five of the U.K.'s largest banks surveyed in 2018 by industry group UK Finance estimated they paid 3.7 billion pounds ($4.8 billion) of irrecoverable VAT during the year.

As VAT charges in the EU range from 17 percent to 27 percent, the amounts that banks and financial institutions could recover annually could run into the hundreds of millions of euros, tax advisers said.

Most companies in the U.K. can reclaim the input tax before their products are purchased by customers. This tax is commonly recovered at each point in the supply chain, and the end consumer ultimately pays the tax. But if consumers are exempt from paying VAT on the products or services that financial institutions provide, the companies can’t recover most of the input tax charged.

For example, the cost associated with a U.K. bank making a loan to an EU client can include legal fees for drawing up contracts, the administrative costs of running a branch, and fees to consultants and translators. When the bank pays for these overheads costs, it incurs 20 percent VAT that it isn’t allowed to recover.

“Whatever the costs incurred through running the financial institution, they know they cannot recover their VAT, and they’re passing this 20 percent cost on through their prices,” said Alan Pearce, a VAT partner at Blick Rothenberg.

The U.K. tax authority has indicated that in the event of a no-deal Brexit it would allow U.K. financial firms to recoup this input VAT. The EU VAT directive would also make it possible for EU financial businesses selling products and services into the U.K. to do the same in the event of a no-deal Brexit.

Winners and Losers

“There will be winners and losers, when it comes to the amount of VAT these banks will be able to recover, as some banks will be able to have more VAT refunded because of the mix of cross-border trade they do,” said John Forth, VAT partner at RSM UK Group LLP. Whether this is simply a silver lining will be a function of the amount they can recover and the Brexit costs they must incur, he added.

Banks have been among the businesses most affected by Brexit. In many cases, they have been forced to shift assets to the EU from the U.K. in order to continue to provide services to their EU clients.

EY estimates that financial services firms will shift as much as 1 trillion pounds to the EU as a result of Brexit.

Investment banks like Nomura Holdings Inc., Japan’s largest investment bank, have said that Brexit will force them to move their European base of operations to other EU financial centers, possibly resulting in thousands of job cuts. Nomura CEO Koji Nagai said the bank may also need to make as much as $1 billion worth of cost cuts in order to offset Brexit losses.

The EU in April granted the U.K. an extension to exit the bloc, pushing the date to Oct. 31 from March 29—reducing the immediate danger of a no-deal Brexit. However, a no-deal Brexit remains a distinct possibility as political support for a withdrawal agreement negotiated by Prime Minister Theresa May, currently the only alternative, remains lukewarm.

Zero Rating

“Generally speaking, everything that the financial services business does is exempt from VAT,” Forth said. Under a no-deal Brexit, the VAT treatment would be the same as a “zero rating,” he said.

A zero rating is when the government treats the product or service as if VAT were due but charged at the rate of zero, allowing companies to recoup input VAT.

This would mean that in the event of a no-deal Brexit, the U.K. and EU would allow companies to recover VAT incurred on costs, such as legal advice for contracts that went into the creation of services sold across the border.

“Most of the VAT costs that banks incur that they can’t recover are in things like the cost of managing real estate and legal fees for drawing up contracts. This would allow them to get back costs and increase their margins,” Forth said.

Reclaiming VAT paid on producing the financial services wouldn’t have been considered possible a few years ago because of how much tax it would cost the U.K. tax authorities, said David Jordorson, a senior policy adviser for taxation at the Association of British Insurers, a U.K.-based insurance industry body. The group’s members include Axa SA, Aviva Plc, Bupa, and the insurance arm of BlackRock Inc., the world’s largest asset manager.

The amount of VAT on input costs that companies pay doesn’t “normally appear in audited accounts because they are below-the-line calculations,” Jordorson said. For the insurance sector, it would be billions of pounds, he added.