Banks provide credit card services to customers by way of issuing a credit card as the issuing bank. They enter into an agreement with the merchant establishment (ME)/service establishment (SE) who sell goods or services to the holder of the credit card.
The ME/SE generates a bill for the cardholder concerned with the help of a machine installed by the bank at the ME/SE premises. Sometimes, if the merchant has his bank account in another bank (other than the issuing bank), the issuing bank does not provide a machine to the ME/SE, which may be provided by another bank (merchants bank), known as the acquiring bank.
In common parlance, banks that participate in acquiring card activities (transactions with customers) are known as acquiring banks, and they provide the ME/SE machines with inbuilt software. The acquiring bank can also act as an issuing bank.
Credit Card Transaction and Flow
Whenever a customer buys any item from an ME/SE using a credit card, the customer receives the item without any immediate payment. The customer produces the card to a merchant, instead of paying in cash. The card is then swiped in the swiping machine installed at the premises of that ME/SE. The moment the establishment swipes the customer’s credit card, the information is transmitted online to the acquiring bank/Issuing bank, which then sends a response to the establishment after verifying the authenticity of the cardholder. The transaction takes place, and a charge slip is generated by the swiping machine. The customer signs the charge slip, and the merchant retains a copy of it.
Thereafter, the ME/SE submits a copy of the charge slip to the acquiring bank. After completion of the transaction, the acquiring bank makes a payment to the ME/SE for all the charge slips submitted by the ME/SE after deducting a merchant service or discount fee at a pre-agreed rate, varying from 2% to 5% of the transaction value, in consideration to the business generated on the credit card at the establishment location and arranging for payment to the merchant on behalf of the customer. The acquiring bank thereafter collects the payment from the cardholder if they are the issuing bank, otherwise it collects it from the card’s issuing bank. The issuing bank makes the payment to the acquiring bank and collects money from the end customer.
The portion of the merchant service or discount fees charged by the acquiring bank by the ME/SE is passed on to the issuing bank through a payments technology company (PTC) (e.g. Visa or Mastercard) as part of the daily settlement process in a pre-agreed ratio as prescribed under their guidelines. A portion of the fees passed on to the issuing bank is referred to as “interchange fees.” It is understood that the interchange fees are not shared directly between the acquiring bank and the issuing bank.
A diagrammatic representation:
At a broad level, the value-added tax (VAT) implications of various legs of the arrangement from a UAE VAT Law perspective are summarized in the table.
VAT on Interchange Fees
Purpose of Interchange Fees
As can be seen from the diagram, the mechanism of charging interchange fees is complex. Interchange fees are intended to cover costs as a guarantee to payment, the technology used for verification and approval of card payments, terminal or contact-less reader, technology to track frauds, systems maintenance, and customer call centers, etc. incurred for providing card services. If interchange fees did not exist, banks would find it difficult to cover the costs and would stop investing in innovation, stop issuing cards altogether or increase the fees paid for their card services.
The interchange fee is consistently monitored and adjusted—sometimes increased and sometimes decreased. This is to ensure that the economics presents a competitive value proposition for all parties. Interchange fees must promote card holding and use, as well as an expansion in the number and types of businesses that accept cards. If the rates are too high, retailers will not accept cards; if the rates are too low, issuing banks will not find it economical to issue cards.
The PTCs generally establish the default interchange fees between the issuing bank and the acquiring bank for fixing the rates. It may be noted that the PTC collects a separate fee, called the “network” or “scheme fee”, from the banks for its services, although this is not considered to be a part of the interchange.
It is understood that in all cases, the interchange fee (which is part of the amount merchant discount fees that the acquiring bank deducts when they make a payment to the retailer) is always paid to the issuing bank by the PTC and there is no money transaction between the issuing bank and the acquiring bank.
VAT—Interchange Fees Received by Issuing Bank in the UAE
Thought 1: A school of thought maybe that the interchange fee represents a money related service between the issuing bank and the PTC and is exempt as financial services in terms of the UAE VAT Law. Considering that the PTC would generally be located outside the UAE, the services may qualify as a zero-rated.
Thought 2: There is no contract between the issuing bank and acquiring bank, but both enter into agreements with the PTC to transfer the purchase price. If the acquiring bank does not receive money, it can demand payment only from the PTC. Therefore, it can be said that the PTC receives guarantee service from the Issuing bank. Thus, one may argue that the interchange fee is a consideration for the guarantee service provided by the Issuing bank to the PTC. Under the UAE VAT Law, consideration need not be paid by the recipient of the service but can be paid by any third party that does not have contractual relationships with the supplier. The acquiring bank has a significant interest in the guarantee promise by the issuing bank. If the issuing bank does not reimburse the purchase price, the acquiring bank can claim it from the PTC. Thus, the interchange fee paid by the acquiring bank constitutes consideration for the guarantee service provided by the issuing bank to the PTC. However, considering that the PTC would generally be located outside the UAE, the guarantee services provided by the issuing bank may qualify as a zero-rated.
Thought 3: One may argue that the issuing bank is not providing any service to the PTC, and the PTC is merely collecting and passing on the interchange fees that it has received from the acquiring bank. Hence, it should be treated as out of the scope of VAT.
Thought 4: A question may arise whether the Issuing bank has provided any service to the acquiring bank, and assuming both the banks are in the UAE, could these services be taxable in the UAE? When a credit card is swiped on a machine in the ME/SE for verification, the issuing bank will verify whether the credit card holder is eligible to use the card before payment and thereafter it would, in turn, communicate to ME/SE to complete the transaction. In this case, both the banks are providing a service to the cardholder and the ME/SE. The issuing bank is only providing a service to the cardholders to confirm their eligibility for credit, which cannot be said to be a service to the ME/SE or to the acquiring bank.
Thought 5: Interchange fees received by the issuing bank are merely a share of the revenue. The VAT on the gross merchant discount fees (which includes the interchange fee) has been discharged by the acquiring bank when it recovered the merchant discount fees for the retailer. The issuing bank has received only a share of the merchant discount fee called the interchange fee, which has already been subject to VAT. In other words, sharing of the merchant discount fees between the acquiring bank and the issuing bank cannot be a service transaction, but as sharing of income between two service providers, and should be outside the scope of VAT. Additionally, as a supply of services assumes that there is a legal relationship between the parties, exchanges that are not based on any reciprocal contractual relationship are outside the scope of VAT.
The interchange fee is the largest part of the merchant discount fees, and it goes to the banks that issue cards to customers. The value of interchange fees could be a substantial source of revenue for issuing banks. Therefore, issuing banks need to be careful in evaluating the agreements, the underlying flow of the transactions, and the manner in which money changes hands between the customer, retailer, acquiring bank, PTC and the issuing bank, before concluding the appropriate VAT treatment of interchange fees.
Furthermore, considering that the financial services are exempt under the UAE VAT Law, it is necessary to be aware of the impact on the input tax recovery and the apportionment calculation.
Deepak Agarwal is an Associate Partner at WTS Dhruva Consultants, United Arab Emirates (the UAE).
The views expressed above are personal.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.