U.S. banks and insurance companies may face significant, backdated value-added tax bills in the U.K. amid moves to tighten rules that previously permitted exemptions for services within the same company, tax advisers warn.
Currently, banks and financial services firms arrange inter-group services within “VAT groups” to significantly reduce their VAT bill, because such services provided within a VAT group are exempt from the tax.
But changes, set to be published April 1, 2019, with immediate effect, will mean firms can be liable for any tax they avoided while the branch was in the VAT group.
“This revised guidance will come into effect from April 2019 and reflects HMRC’s current ‘crackdown’ on perceived unfair exploitation of the UK’s generous VAT grouping regime by some in the banking sector, according to Jason Collins, head of tax at Pinsent Masons.
The government’s crackdown on overseas members of VAT groups could hit U.S. banks in particular because of their wide use of the practice of routing services from their U.S. operations into the U.K., said one magic circle tax adviser, who asked not to be named because they are currently advising clients in the financial services sector on the issue.
“Based on what I’ve seen, it’s a bigger issue with U.S. banks and they don’t have to be doing anything particularly naughty, with the impact being as much as half a billion pounds across the sector,” the adviser told Bloomberg Tax.
Services such as IT and accounting are often outsourced to subsidiaries in countries like the U.S. and India. These services can then be provided across a company but exempted from VAT, if a U.K. branch of the subsidiary is in a VAT group, provided the branch meets the “fixed establishment” requirement. The requirement means that the branch must have a degree of permanence in terms of U.K.-based human and technical resources.
The tax authority changed the rules after arguing that the overseas-based branches shouldn’t have been within U.K. VAT groups to begin with.
“We’ll end the practice of purchasing services through overseas branches to avoid UK VAT,” the Chancellor of the Exchequer Philip Hammond said in his budget speech Oct. 29.
VAT groups were created in 1973 as an administrative easement to help companies and the government avoid multiple VAT returns. As VAT isn’t charged on services within a VAT group, they have a significant tax advantage for companies particularly in the financial services industry, where VAT is often non-recoverable.
Removing these overseas branches from VAT could mean firms can liable for any VAT they previously considered to be an exemption.
“This is a very live issue in the financial services and insurance sector as they often have overseas branches in their U.K. VAT group, particularly where they are outsourcing back office services,” said Daniel Lyons, head of tax policy at Deloitte UK.
Targeting Financial Services
Despite the government’s efforts to maintain the City of London as Europe’s key financial center following Brexit, the U.K. tax authority—Her Majesty’s Revenue and Customs—has recently been flexing its power to question VAT group membership of financial service firms.
Earlier this year, Barclays revealed in its interim results that HMRC had asked it to pay 184 million pounds ($242 million) in backdated VAT, after it removed several overseas members from the bank’s U.K. VAT group.
Barclays has contested HMRC’s findings. The matter hasn’t yet been escalated to a tax tribunal.
The bank isn’t unique in being put on the spot over its VAT grouping arrangements. In November 2017, the U.K. tax authority sent letters to major insurance companies requesting more information about the overseas members of the VAT groups.
Barclays, HSBC and Royal Bank of Scotland declined to comment for this article.
Clarity, Protecting Revenue
The government promised that the pending guidelines will provide “clarity,” rather than new or amended rules, an important caveat for back-dating taxes, tax advisers said.
Specifically, it will clarify what it considers a company’s “fixed establishment,” an economic substance threshold designed to avoid brass-plating, for overseas members of a VAT group.
The government has also warned it may use its “revenue protection powers” when assessing VAT group arrangements. The government wouldn’t usually use its powers when revenue loss arises because supplies within a company’s entities are exempt from VAT.
“Where we consider that there seems likely to be a revenue loss that goes beyond the accepted result of grouping, we will feel entitled to use our revenue protection,” the tax authority warned.
“Where they suspect there has been abuse and don’t feel they can win on the grounds of fixed establishment they can use the ‘protection of revenue’ rule to expel overseas member from VAT groups and achieve the same result,” said Mustafa Sikandary, associate director at London-based Moore Stephens LLP.
However, a hardening stance could mean that HMRC looks closer at whether the amount of VAT avoided by banks and insurance firms is significant enough to warrant use of these powers, said Deloitte’s Lyons.
“If a U.K. branch has say five employees, but the Indian subsidiary it represents in the VAT group has 150 employees that also provide the majority of the service, there is a question around if this is sufficient to merit its membership of the group beyond its tax advantage, which means HMRC could be allowed to use their powers to protect the revenue it lost as result of the grouping,” he said.