TAXATION OF FINANCIAL SERVICES UNDER A VALUE-ADDED … · SATYA PODDAR * & MORLEY ENGLISH * Abstract - Financial services have generally been exempt under value-added tax (VAT) systems

TAXATION OF FINANCIAL SERVICES UNDER A VAT

89

TAXATION OFFINANCIAL SERVICESUNDER A VALUE-ADDEDTAX: APPLYING THECASH-FLOW APPROACHSATYA PODDAR * & MORLEYENGLISH *

Abstract - Financial services havegenerally been exempt under value-added tax (VAT ) systems due to theinability to identify the appropriate taxbase, which is hidden in the financialmargin. A cash-flow VAT approachrepresents one means of defining thistax base in a way that is compatible withcredit-invoice VATs. This paper describesthe use of a cash-flow VAT for a bankingdeposit/loan operation and indicates thepractical difficulties blocking use of thefull cash-flow method. It then describesa variant of the cash-flow system,referred to as the “Truncated Cash-FlowMethod with Tax Calculation Account,”which is designed to overcome thesedifficulties.

One of the most difficult areas in theoperation of value-added tax (VAT)systems has been the treatment offinancial services. A workable method oftaxing such services has eluded taxauthorities for decades. As a conse-

quence, almost all the countriesemploying a VAT have opted to exemptfinancial services rendered to residentsof their countries. Although theexemption approach has been widelyadopted, there have been significantproblems in its operation. The resultingtax cascading creates numerouseconomic distortions and adverselyaffects the competitive position ofdomestic institutions in internationalmarkets, while the definitions andallocations needed to operate thesystem have proven to be very complex.

This paper presents an approach toapplying a VAT to financial services thatis designed to operationalize the cash-flow method. The cash-flow methodhas been considered a conceptuallysound method of applying a VAT tofinancial services with some attractiveattributes in the context of credit-invoiceVAT systems. However, the method hasalso been seen to exhibit severalfundamental difficulties, which havekept it from being used except in a fewlimited situations. The approachsuggested here is designed to overcomethese fundamental difficulties, while*Ernst & Young, Toronto, Ontario, Canada M5K 1J7.

NATIONAL TAX JOURNAL VOL. L NO. 1

90

retaining the positive aspects of thecash-flow approach. The solutionidentified appears promising. However,it requires considerable elaboration andtesting to ensure that it is indeedpractical. This paper outlines theapproach as a basis for comments andfurther research.1

The paper concentrates on the keyconceptual issues involved in the designof the cash-flow approach beingdeveloped. It does not attempt to assessthe administration or compliance coststhat the system would impose, nor doesit cover all of the critical design issuesthat would arise.2 Considerable furtherwork, some of which is underway, willbe required to consider all such issues.

BACKGROUND

The cash-flow method has receivedconsiderable attention in the literature,both as an alternative form of a VATand as a replacement for the corporateincome tax. The classic treatment of thisform of tax is found in Meade (1978), inwhich the approach is largely discussedfrom the perspective of serving as asubstitute for the corporate incometax.3 However, the approach discussedin this paper is a cash-flow VAT appli-cable to financial services, which isdesigned to function as a component ofa broad-based VAT system applying toboth financial services and nonfinancialgoods and services.

This paper sets out the nature offinancial services in a deposit and loanbanking transaction, provides examplesof how a cash-flow system functions totax such services appropriately, indicateswhy a cash-flow tax is considered tohave particular merit as a means ofextending a VAT to financial services,and discusses the problems in the cash-

flow approach which heretofore haveblocked its adoption in a general VATsystem. It deals with the basic deposit/loan activities at a conceptual level.However, the intention would be forother financial services also to betaxable under the system proposed, ifthey are not already part of the regularcredit-invoice system (as financialservices rendered for a fee or commis-sion). Other financial service activitiesinclude life and property and casualtyinsurance; purchase, sale, and issuanceof financial securities; brokerage andother agency services; advisory, manage-ment, and data processing services; andspecialized financial products such asbullion and derivatives.

Financial Services in BankingTransactions

Financial intermediaries create value bycontrolling the cost for carrying outtransactions in financial markets andhelping reduce the costs of transactionsin real goods and services.4 Financialintermediaries are able to charge fortheir services in two ways:

(1) explicit fees and commissions and(2) implicit charges in the form of

margin.

Examples of explicit fees and commis-sions include safe-deposit box rentalcharges, fees for certain trustee services,commissions charged by brokers onacquisitions and dispositions of securi-ties, and charges for issuance oftraveler’s checks. In principle, there is noconceptual difficulty involved in theapplication of a VAT to these explicitcharges. In fact, many of the countriesthat have VATs do apply them to at leastcertain services for which specific fees orcommissions are the typical method for


91

2

2

charging for the services. Safe-depositbox rental charges, debt collectioncharges, and fees for advisory servicesare taxed in all countries with a VAT.

However, the situation is quite differentin the cases in which the charge for thevalue-added takes the form of animplicit charge included in the marginon the exchange of funds associatedwith a financial transaction. Figure 1indicates the basic nature of bankingintermediation involving a deposit andloan transaction. Depositors may behouseholds, businesses, or otherentities, as may the lenders. In theexample, the value of banking services isshown as the spread between theinterest received by savers ($70) andthat paid by borrowers ($150). The valueadded (before deduction of purchasedinputs) in the transaction is $80.5

Analysis of this type of transactionindicates that the financial flowsinvolved are of the four types listedbelow. The appropriate treatment of

each component under a generalconsumption tax such as a VAT isprovided in brackets.

(1) The initial deposit creates a rightto a future cash withdrawal andthe future cash repaymentscontingent on this right. (Thismerely represents transfer of fundsand should not be taxable.)

(2) Pure interest payments. (This is acompensation for deferral ofconsumption from one period tothe next and should not be taxableunder a consumption tax. Theseinterest payments are income tothe recipient and should only betaxed as consumption if and whenconsumed.)

(3) Pure risk premiums representingthe amounts charged to borrowersto cover the risk of default. Theyare equal to the expected value ofdefaults, excluding any profitelement or administrative cost ofthe financial institution. (The purerisk component should not betaxable, as it is only a redistribu-

FIGURE 1. Banking

1

1 Households Business Other

InterestReceived

Loans 1,000

Deposits 1,000

Households Business Other

InterestPaid

Value ofBankingServices

150

(70)

80


92

3

tion of funds that is a form ofwealth transfer among theparticipants in the underlyingtransactions.)

(4) The compensation to the financialinstitution for the costs involved inaccepting deposits and makingloans, including the profit earnedon behalf of shareholders. (Theamount remaining after nettingout capital costs is the value-addedthrough financial intermediation ofthe financial institution and theappropriate tax base for a generalconsumption tax.)

While only the final component (net ofcapital costs) represents value-added,which should be subject to tax, it istypical for the exchanges of funds andthe margins between such exchanges tocommingle several of the types offinancial flows. In many commonsituations, it is impossible to identify thevalue of financial intermediationassociated with specific transactionswith the certainty required in a taxsystem, especially since there may oftenbe cross-subsidization of transactions. Itis this inability to identify and isolate thefinancial intermediation margin onparticular transactions that is thefundamental difficulty in applying acredit-invoice system of VAT to financialservices in which the charge for theservice is in the form of margin. Even incases in which the gross margin can beidentified, it is not possible to separate itinto the value of services provided to thedepositor and the value of servicesprovided to the borrower, which isnecessary if input tax credits are to beproperly allocated to business customers.

Taxation of Financial Services with aCash-Flow VAT

This section describes how a cash-flowsystem would operate to tax correctly

the value of financial services providedby financial institutions, while allowingbusiness customers (registrants for theVAT) to obtain input tax credits provid-ing a recovery of VAT charged on thefinancial services they utilize.6

The essence of the cash-flow method isthat it treats cash flows from financialtransactions in the same manner as suchflows from nonfinancial transactions.Cash inflows from financial transactionsare treated as taxable sales (e.g., a bankwould remit tax on a deposit), and cashoutflows are treated as purchases oftaxable inputs (e.g., a bank could claiman input tax credit on a deposit with-drawal). An exception to this relates toshare transactions in a company’s ownequity. An issue of equity is not consid-ered to give rise to a taxable inflow offunds, and dividend payments do notgive rise to input tax credits.7 To zerorate financial services rendered to non-residents, transactions with nonresidentsare ignored for purposes of the cash-flow tax—inflows and outflows areneither taxable nor creditable. There isno change to the tax treatment ofnonfinancial transactions by financialinstitutions, assuming that these arealready taxable under the normal credit-invoice rules. However, all input taxcredits related to commercial activity arenow claimable, not just those related tononfinancial supplies. Illustrativeexamples can be used to demonstratethat the results are the same as theywould be if the financial institution wereable to identify the value-added in eachtransaction, charge tax on it, andprovide the appropriate invoice to allowbusiness customers to claim input taxcredits.

Illustrative examples are provided forthree cases, all involving a bankingtransaction consisting of the receipt of adeposit, a loan, and a repayment of the


93

loan and the withdrawal of thedeposit with the payment of interest inboth cases. It is possible to providesimilar illustrative examples for othertypes of transactions and differentcategories of customers with the basicresults continuing to hold.8 The threecases, which are set out in summaryform in the indicated figures, are asfollows:

(A) consumer depositor, consumerborrower (Figure 3),

(B) consumer depositor, businessborrower (Figure 4), and

(C) resident consumer depositor, non-resident borrower (Figure 5).

It is useful to use a common set ofassumptions about interest rates, thevalue of services, and the rate of theVAT to facilitate comparisons ofdifferent cases. These are detailed inFigure 2. A basic assumption in theexamples is that the government canearn a rate of return on its cash bal-ances that is equal to the pure rate of

interest. This would be equivalent tothe rate that the government wouldpay on its short-term debts. In theexamples, this government rate ofinterest is 12 percent. With sevenpercent being paid on deposits, theconsumer is considered to be receivingfive percent in intermediation servicesassociated with the deposit. The valueof intermediation services provided tothe borrower by the bank is threepercent, the difference between theinterest rate on the loan and the risk-free government rate. The interest ratesshown are tax inclusive. The rate of theVAT is ten percent.

Figure 3 sets out the case in which boththe depositor and the borrower areindividuals not engaged in commercialactivities. In this case, the VAT should becollected on the value of the financialservice to both the depositor and theborrower, as both represent personalconsumption. The example indicatesthat the cash-flow method doessuccessfully tax this margin.

FIGURE 2. Common Assumptions For Illustrative Examples

Deposit Interest

Loan Interest

Pure Rate of Interest= Interest earned by government

Value of Services to Depositor

Value of Services to Borrower

Total Value of Financial Services

VAT Rate

7%

15%

12%

5%

3%

8%

10%


94

Under the cash-flow method, the bankwould be subject to a tax of $10 on thecash inflow from the deposit but wouldbe entitled to an input tax credit of $10on the cash outflow associated with theloan. As these two cancel out, therewould be no tax revenue for thegovernment and no tax implications forthe bank. When the transactions areunwound in period 2, the bank wouldagain have offsetting tax liabilities andcredits arising from repayment of theloan (giving rise to a liability as a cashinflow) and the withdrawal of thedeposit (giving rise to a credit as a cashoutflow). However, the tax of $1.50 (tenpercent of $15) associated with the cashinflow would exceed the input tax credit

of $0.70 (ten percent of $7) obtained asa result of the cash outflow as intereston the deposit. The bank would berequired to remit the balance of $0.80to the government as a VAT in respectof the financial intermediation servicesprovided. The tax of $0.80 is tenpercent of the value of banking servicesas required.

Figure 4 provides an example in whichthe depositor is still an individual but theborrower is now a business engaged ina commercial activity. If the cash-flowmethod is to yield the correct result,there should be a net tax levied on theservice provided to the individualdepositor who is a consumer of financial

Period 1

Deposit 100 10Loan –100 –10

Subtotal 100 –100 0

Period 2

Loan Repayment 100 10Loan Interest 15 1.50Deposit Withdrawal –100 –10Deposit Interest –7 –0.70

Total 115 –107 0.80

Total Value of Banking Services = 8VAT = 0.80

No further tax adjustment at the consumer level

FIGURE 3. Illustrative Example

A: Consumer Depositor, Consumer Borrower

BankInflows

BankOutflows

Tax/Credits


95

services, but no net tax applicable tothe services provided to the borrower,because the financial service in this caserepresents a business input.

Figure 4 indicates that the tax remissionsby the bank are the same as those inExample A, namely, $0.80 in period 2.However, the loan and its repayment

now have tax implications for thebusiness borrower. In the first period,the cash inflow from the loan gives riseto a tax liability of $10 (ten percent ofthe cash inflow of $100). In the secondperiod, the loan is repaid with interestand there is a cash outflow of $115,giving rise to an input tax credit of$11.50. The present value of this credit


Tax Payments by Bank

Period 1 0Period 2 0.80

See example A

Tax Payments by business borrower

Period 1

Loan 100 10

Period 2

Loan Repayment –100 –10Loan Interest –15 –1.50

Subtotal –11.50

Govt Revenues

Period 1 Tax 10Interest earned @ 12% 1.20Period 2 Tax (0.8 – 11.5) –10.70Total 0.50

Equals 10% of the value of Banking Services to Consumer Depositor

B: Consumer Depositor, Business Borrower

BorrowersInflows

BusinessBorrowerOutflows

BusinessTax/

Credits


96


is equal to the present value of theborrower’s earlier tax paid at theborrower’s interest rate of 15 percent.The business borrower thus does notexperience any net tax on its use ofbanking services.

The revenue implications of thesetransactions for the government aresummarized at the bottom of the figure.As was noted earlier, the governmentcould invest the $10 tax remitted in thefirst period at the government interestrate of 12 percent. As shown in the

figure, this provides the government with$11.20 in the second period. Meanwhile,in the second period, the governmentprovides a credit of $11.50 to thebusiness borrower, while receiving tax of$0.80 from the bank (as in the firstexample). The second period thus leadsto a cash outflow of $10.70 for thegovernment. When this is netted againstthe $11.20 the government has on hand,the government is left with $0.50 in taxrevenues. This is equal to a ten percenttax on the $5 of financial servicesprovided to the individual depositor.

Tax Payments by Bank

Period 1

Resident Deposit 100 10Nonresident Loan –100 0Subtotal 100 –100 10

Period 2

Nonresident Loan Repayment 100 0Nonresident Loan Interest 14.70Resident Deposit Withdrawal –100 –10Resident Deposit Interest –0.70Subtotal 114.70 –107 –10.70

Govt Revenues

Period 1 Tax 10Interest earned @ 12% 1.20Period 2 Tax –10.70Total 0.50

Equals 10% of the value of Banking Services to Resident Consumer Depositor

C: Resident Consumer Depositor, Nonresident Borrower

BankInflows

BankOutflows

Tax/Credits

–7

0


97

The example thus indicates that thecash-flow method provides for refund-ing of tax to business users of financialservices, while assessing tax on con-sumption of these services by house-holds.

The final illustrative example set out inFigure 5 involves a domestic individualdepositor with a nonresident borrower.The deposit by the resident leads to aVAT of $10 on the cash inflow, and thegovernment earns $1.20 interest onthis, giving it funds available of $11.20in period 2. When the resident indi-vidual withdraws his deposit withinterest ($107 in total), the bank claimsa credit of $10.70. The governmentreceives net VAT revenues of $0.50,which is equal to the VAT rate of tenpercent applied to the financial serviceworth $5 to the individual. The foreignloan has absolutely no tax conse-quences, as the inflows and outflowsassociated with transactions withnonresidents are ignored. As a result ofthis, the bank would be able to providethe loan to the foreign resident at thetax-exclusive interest rate of 14.7percent, placing the bank in a competi-tive position with banks in otherjurisdictions that may not be subject toconsumption taxes with respect tofinancial services.9

Desirable Features of the Cash-Flow TaxApproach for Financial Services

The cash-flow method as outlinedabove exhibits a number of verydesirable characteristics as a method ofextending the VAT to financial services.

Time value of money excluded with no

explicit adjustment

In discussing the nature of value-addedin financial services, it was noted that

financial margins include a payment inrespect of the time value of money,which compensates savers for delayingconsumption. This is an income pay-ment and should not be part of the taxbase for the VAT. A fundamentalattribute of the cash-flow method isthat it excludes the time value of moneywithout explicitly requiring it to beidentified. There is thus no requirementthat margin be disaggregated into itscomponents for the value-added to betaxed. Clearly, this is very attractive froman operational perspective, because it isvery difficult to carry out such a disag-gregation.

Full removal of tax cascading

The cash-flow method allows for the fullremoval of tax cascading on financialservices provided to registered persons.Registrants are able to claim input taxcredits in respect of their cash outflowsto financial institutions, while they aresubject to tax on their inflows. In thecase of nonfinancial enterprises, inputtax credits on outflows will normallyexceed tax on inflows. This excesscompensates them for the tax they willbe paying on their purchases of financialservices. As was indicated by theexamples, the operation of the system issuch that the registrants are placed inidentical positions to the ones theywould be in if the tax were not in place.

Destination basis

The cash-flow system functions on adestination basis and provides for theequivalent of zero rating of servicesprovided to nonresidents. Transactionswith nonresidents do not lead to eitherthe application of tax or the claiming ofcredits. Domestic financial institutionsare not at a disadvantage in the supplyof services to nonresidents. Because thecash-flow method is on a destination


98

basis, it is compatible with this aspect ofthe VAT for a credit-invoice systemapplying to other goods and services.

Fully compatible with the credit-invoice

method

In fact, the cash-flow method is fullycompatible with the credit-invoicesystem nonfinancial services. As well asoperating on the destination basis, itprovides for the claiming of input taxcredits in respect of financial servicesand thus eliminates cascading. Becausevalue-added on financial services istaxed on an equivalent basis to otheractivities, it eliminates the non-neutral-ities which create adverse economiceffects.

It is for these reasons that the cash-flowapproach has often been seen as themost promising mechanism for extend-ing the VAT to financial services.

Difficulties with the Cash-Flow Approach

Despite the attractive features of a cash-flow approach to taxing financialservices, there have been a number offundamental difficulties identified thathave kept this method from beingadopted in practice.10

The first of these relates to the implica-tions of tax rate changes, the mostsignificant of which would be the rateincrease associated with introducing thetax. This is a concern, because for thecash-flow method to function appropri-ately, the credit for the cash outflowshould be at the same rate as the taxapplicable to the tax inflow. A simpleexample demonstrates the issue raised.For example, suppose a VAT wasintroduced in which financial serviceshad previously been exempt. If thesystem simply came into effect, aborrower would receive a credit for the

principal and interest upon repaymentof the loan (equal to $11.50 per $100of principal using the values from theearlier examples), despite never havingpaid tax on the cash inflow. This wouldclearly be quite inappropriate and leadto net debtors being overcompensatedfor the VAT on the financial servicesconsumed.

In theory, one could implement a systemthat required all registered persons topay an additional tax equal to the taxrate increase times the excess offinancial liabilities over financial assetsjust prior to the tax rate change. As aconsequence, value-added earned priorto the change is taxed at the old rateand value-added earned subsequently istaxed at the new rate. While thisapproach is conceptually valid, it wouldbe subject to political objections andwould clearly raise cash flow issues forbusiness.

Second, any time registrants took outloans, they would be required to pay taxon the cash inflow. As a result, theborrowing requirements would increasein order to finance the tax paymentassociated with the loan. While thebusiness would subsequently recoverthis tax at the time the loan was repaid,there would clearly be cash-flowimplications that would be seen asproblematic by nonfinancial businesses.

Finally, the cash-flow method, asoutlined above, would require non-financial businesses to carry out all thecalculations for the tax in order toobtain access to input tax credits for thefinancial services purchased. For small-and medium-sized businesses, thiswould be a considerable complianceburden and would considerably reducethe effective benefit from having accessto the input tax credits. The system asimplied in the earlier description thus


99

can be criticized as unduly complex formany businesses.

CASH-FLOW METHOD WITH TAXCALCULATION ACCOUNT

This section describes refinements to thecash-flow system designed to deal withthe problems identified in the precedingsection, while retaining the generaladvantages of the cash-flow approach.The methods described revolve around amechanism that is referred to as the taxcalculation account (TCA). A secondrefinement involves “truncating” thesystem, by placing the major complianceactivities solely with financial institu-tions.

Cash-Flow Method with the TCA

Two of the main difficulties identifiedwith respect to the basic cash-flowsystem were cash-flow problems relatedto payment of tax at the time ofborrowing and transitional adjustmentsat the startup of the system or at thetime of a tax rate change. In each ofthese cases, the difficulty arises onlywith respect to margin services involvingcash inflows and outflows of a capitalnature. The treatment of fees andcommissions and cash flows of a currentnature related to margin activities donot lead to any problems.

The TCA is a tax suspense accountcreated to obviate the payment of taxby taxpayers and of credits by govern-ment during the period that cashinflows and outflows of a capital natureoccur. Tax that would otherwise bepayable/creditable is instead debited/credited to the TCA and carried forwardto the period during which the capitaltransaction is reversed. The TCAmechanism thus allows deferral of taxon cash inflows and of tax credits oncash outflows. However, these deferrals

are subject to interest charges at thegovernment borrowing rate.

Basic Features of the TCA

The basic features of the cash-flowmethod with a TCA can be brieflysummarized as follows:

(1) tax payments on cash inflowsrelated to a financial instrument(whether an asset or a liability)debited to the TCA;

(2) input tax credits on cash outflowsrelated to a financial instrumentcredited to the TCA;

(3) net balance in the TCA subject toan indexing adjustment at thegovernment borrowing rate (aswill be discussed later, a short-termgovernment borrowing rate is aproxy for the pure rate of interest);and

(4) a balance in the TCA payable (orrefundable, if a negative amount)periodically, after subtracting anotional amount equal to the taxrate times the value of thefinancial instrument at the end ofthe period.

Figures 6 and 7 illustrate the operationof the TCA for a $100 loan and adeposit transaction, respectively,assuming that the interest and tax ratevalues are the same as those used in theearlier illustrations. Under the full cash-flow method, both the bank and thebusiness registrant would have TCAaccounts. It is assumed, in this example,that the deposit and loan occur at theend of period 1 and that there are nocurrent interest amounts in that period.The deposit and loan are both assumedto be repaid at the end of the secondperiod.

In Figure 6, the bank has made the $100loan, leading to a cash outflow and thus


100

FIGURE 6. Cash Flow Method with TCA


Illustration

TCA for loans by a bank

Amount TCA

Loan (100) (10)

TCA Indexing — (1.2)

Interest 15 1.5

Loan Repayment 100 10

Loan Closing Value — —

Net Tax Due — 0.3

Illustration

TCA for deposits with a bank

Amount TCA

Deposit 100 10

TCA Indexing — 1.2

Interest (7) (0.7)

Withdrawal (100) (10)

Deposit

Closing Value — —

Net Tax Due — 0.5


101

a credit balance of $10 in the TCA. Therewill be a negative $1.20 indexingadjustment added at the end of theperiod. The repayment of the loan willlead to a cash inflow of $100 and adebit of $10 in the TCA. The receipt ofloan interest of $15 will result in a debitentry of $1.50. The balance of theseentries is a positive amount of $0.30,which must be paid to the governmentas tax.

In Figure 7, the operation of the TCA forthe $100 deposit is described. The cashinflow of $100 gives rise to a debit of$10 in the TCA. Indexing at 12 percentfor the period results in a further debitentry of $1.20. The withdrawal of $100as a cash outflow gives rise to a credit of$10, while the interest payment resultsin a further credit of $0.70 in the TCA.The balance after all of these entries is adebit balance of $0.50, which is payableto the government as tax.

It can be noted that the total taxpayable by the bank is $0.80 in respectof both transactions, the same amountas that calculated for a completedeposit/loan transaction in the earlierexamples using the basic cash-flowapproach.

The figures can also be used to indicatethe implications of a situation in whichthe interest payments are made in theperiod, but the loan and depositprincipal amounts are not repaid. In thatcase, there is no entry for the loanrepayment or deposit withdrawal in thetwo figures and no associated debit andcredit entries in the TCA. However,because the accounts are still open sincethey contain an asset and a liability,respectively, a calculation of the notionalvalue of the debit/credit that would beassociated with closing the accountneeds to be made, as described in thesummary of the system above. This

ensures that any tax or credits actuallypaid are not related to capital amounts.The notional adjustment as definedearlier is carried out by subtracting anotional amount equal to the tax ratetimes the value of the financial instru-ment at the end of the period. Thiscalculation is, in effect, equivalent tosimply moving the loan repaymententries one line lower in Figure 6, to beshown as a loan closing value, and thedeposit withdrawal entries one linelower in Figure 7, to be shown as thedeposit closing value. The tax and creditcalculated for the two accounts are thenidentical to those previously described,where the accounts are closed by a loanrepayment and a deposit withdrawal.

The TCAs in the books of a businessborrower or a business depositor are themirror images of the TCAs for a loan ora deposit in the books of the bank. Forexample, a business firm with a $100loan from a bank will have an initialdebit entry of $10 (at a tax rate of 10percent) in the TCA, to which indexingof $1.20 will be added at the end of theyear. Payment of interest of $15 on theloan in the year will result in a credit of$1.50. Finally, repayment of the loanwill result in a credit of $10 for the cashoutflow associated with the repayment.The overall balance will be a negativeamount of $0.30, which will be refund-able to the business as an input taxcredit. This is the mirror image of the$0.30 tax calculated by the bank in itsTCA for the loan to the business. Thisexample shows that the net tax payableof the bank TCA becomes the taxcreditable per the business borrowerTCA.11

As can be seen from the examples, theTCA system eliminates any cash-flowproblems by deferring tax paymentsand credits on capital transfers. Forexample, the commercial borrower is no


102

longer required to remit tax because ofthe inflow of funds from the loan inperiod 1. All that happens at the timeof borrowing is that an amount iscredited to the tax calculation account.Despite the fact that the governmentdoes not receive the tax in respect ofinflows of cash related to borrowings, itis at little risk in revenue terms. Theexpectation is that the amounts thatwould otherwise be remitted will bereversed by a tax credit for the capitaloutflows associated with loan repay-ments and interest.12

The TCA balances can be harnessed todeal with tax rate changes. The out-standing TCA balances would be grossedup at the time of a tax rate increase sothat the tax/credit in respect of capitalflows before or after the change is thesame as the tax/credit adjustment inrespect of the reverse flows after thechange. Similarly, a tax rate reductionwould be handled by grossing downTCA balances at the time of the ratechange. As a result, there would be noimmediate cash-flow consequences fromthe rate change for either government orbusinesses, and tax/credits would becorrectly calculated at the new ratessubsequent to the rate change.

The introduction of the system wouldproceed in the same manner. A debit/credit balance would be created in theTCA at the start of the system, equal tothe tax rate times the value of a givenfinancial liability or asset. There wouldbe no cash flow consequences of thisopening adjustment for business at thestartup, and subsequent tax/creditswould then be determined under thegeneral procedures described above.

The characteristics and advantages ofthe system relative to the basic cash-flow system can be briefly summarizedas follows.

(1) It eliminates cash-flow problemsby deferring tax payments andcredits on capital transfers.

(2) Government is at little risk inrespect of tax deferrals, becausetax payments on capital inflows(e.g., borrowings) are expected tobe reversed by tax credits forcapital outflows (e.g., loanrepayments), except in the case ofbankruptcy.

(3) The benefit/loss from deferral oftax or credit is offset by theindexing of outstanding TCAbalances by the governmentborrowing rate.

(4) Transition difficulties are addressedthrough initial debiting/crediting ofthe TCA at the commencement ofthe system and adjustment of theoutstanding balance at the time ofany tax rate change.

Tax Calculation Account: IllustrativeExample of System Implementation

Figure 8 provides an example of thefunctioning of the TCA during imple-mentation of the system. It is assumedthat the system is introduced at the mid-point of a year. If the system is tofunction correctly, only one-half thevalue-added at the bank should be taxedfor either a loan or deposit transaction.Only the case of a loan is shown, but itis easily surmised that similar resultswould occur for a deposit transaction.

At the bank, there were no tax implica-tions when the original loan was made.At the point the system is introduced,the current value of the loan will beascertained, including accrued interest.The bank will create a TCA entry equalto the tax rate times the value offinancial assets as the starting value asof the date of implementation. In orderfor the system to exclude fully value-added prior to implementation of the


103

system, the assets (and liabilities) that areused to calculate the TCA at implemen-tation must include amounts for theaccrued interest on the deposit and loan.

In the example, the negative TCA inrespect of the loan would be $10.72(the tax rate of 10 percent times theprinciple of $100 compounded for one-half of a year at 7.24 percent, which isequivalent to an annual rate of 15percent). The TCA indexing is thenapplied for the remainder of the year atthe indexing rate of 12 percent annually.The value of such indexing compoundedto the redemption point of the loan sixmonths later is $0.63. When the loan isrepaid, the $100 loan repayment createsthe usual $10 credit entry, and theinterest cash flow adds a credit of$1.50. The tax payable is $0.15. This is,

in fact, equal to one-half year of value-added in respect of the loan portion ofthe bank’s financial activities.

A similar example could be presentedfor a rate change. A rate change wouldrequire closing an existing TCA justbefore the rate change and restarting itjust after the rate change. In this case,the opening value of the TCA balance(which is the closing value of the closingTCA balance at the end of the previousperiod) would be grossed up to reflectthe extent of the rate increase.

The Tax Calculation Account: Issues

To ensure that the tax calculationaccount functions correctly, there are anumber of issues that must be ad-dressed. These include the choice of the


Illustration

TCA for loans by a bank

Amount TCA

Loan (100.00) (10.00)

Opening Balance (107.24) (10.72)

TCA Indexing — (0.63)

Interest 15.00 1.50

Loan Repayment 100.00 10.00

Loan Closing Value — —

Net Tax Due — 0.15


104

indexing rate, the treatment of theindexing rate outside the deposit/loaninterest range, the rate changes in theindexing rate, the frequency of indexingadjustments, the asset valuations forsystem implementation or rate changes,and the compliance concerns.

Choice of the indexing rate

The indexing rate in the cash-flowmethod with the TCA plays the criticalrole of dividing the margin betweenborrowers and lenders. It thus deter-mines the size of the input tax creditthat will be available for the registeredusers of financial services. It also servesthe purpose of charging/creditinginterest on the outstanding taxbalances.

As the rate that charges/credits intereston outstanding tax balances, it shouldbe the interest rate that the governmentwould have earned/paid on the tax/credit amounts had there been nodeferral. From the perspective ofdividing the margins, the indexing rateshould be a pure rate of interest thatdoes not include any margin forfinancial intermediation or risk premium.Conceptually, any variation between theshort-term and long-term interest ratesreflects risks (bad debt risks or marketrisk of change in interest rates) or valueof intermediation services.

From both of these perspectives, itappears that a short-term treasury billrate would be a good approximation ofthe cost of short-term money forgovernment and a pure rate of interestthat does not contain any risk orintermediation elements.13

Indexing rate initially outside range of the

deposit and lending rates

In some cases, the indexing rate couldinitially be outside the range of the

deposit and lending rates. For example,the indexing rate could be 12 percent,but a particular institution could have adeposit rate of 14 percent and a lendingrate of 22 percent, where the rates arelocked-in for a period of, say, five years.This pattern could occur because of theterm structure of interest rates and theinstitution-matching deposits and loansfor a given maturity period. For ex-ample, the short-term interest ratescould be in the 12 percent range, butthe five-year interest rates could bemuch higher because of the traditionalupward sloping yield curve. A locked-ininterest rate for a five-year loan impliesadditional market risks for the lenders,but these risks can be eliminated for thebank by matching the maturities for thedeposits and loans. The floating ratescould still be 7 percent for deposits and15 percent for loans as in other ex-amples.

The 10 percent difference between the12 percent indexing rate and the 22percent lending rate could be viewed asconsisting of two components: a 3percent charge for the normal bankingservices and an additional 7 percentcharge for the market risks inherent in afive-year locked-in investment.

By the same token, the negative twopercent difference between the indexingand the deposit rates could be viewedas consisting of a five percent servicecharge by the bank to the depositor,and a reverse seven percent charge bythe depositor to the bank for theadditional market risk the depositor istaking by making a locked-in deposit forfive years.

Conceptually, both the service chargeand the market risk premium are aconsideration for financial services andshould be included in the tax base. Ifthe bank, the depositor, and the


105

borrower were all registrants, then theuse of the 12 percent indexing rate byall three would yield an appropriateoutcome. The depositor would remit taxon two percent, the bank would remittax on eight percent (ten percent servicecharge to the borrower, offset by twopercent net payment to the depositor),and the borrower would get credit withrespect to ten percent service and riskcharge to the bank.

However, if the depositor is not aregistrant, then the bank should not beallowed to claim a deduction for the netservice payment of two percent to thedepositor. In this example, the depositoris a net supplier of services to the bank.The services supplied are protectionagainst the risk of movement in depositinterest rates over the five-year period.The service provided by the unregistereddepositor is to be treated as any othersupply by a small supplier. It is neithersubject to tax nor eligible for a credit.

These are clearly issues on which furtherinput from financial institutions andother financial experts are essential.They need to be reviewed further fromboth conceptual and administrativeperspectives.

Changes in the indexing rate

Short-term interest rates change overtime, and, thus, the indexing rate issubject to fluctuations. Since deposits andloans may have fixed interest rates over aperiod of years, changes in the indexingrate would result in modifications to themargin assigned to the borrowers orlenders. A number of conditions couldoccur, and some of these appear on thesurface to lead to rather unusual results.The possibilities are as follows:

(1) new rate still between the depositand lending rates,

(2) new rate lower than the depositrate, and

(3) new rate higher than the lendingrate.

The first situation involves a change ofthe indexing rate, but the new rate isstill between the deposit and lendingrate. In this case, there would simply bea change in the allocation of the marginbetween the depositor and the bor-rower.

If the rate goes down, the marginallocable to the depositor goes downand that to the borrower goes up. As aresult, the lender would be a able toclaim a larger input tax credit. This resultis equivalent to full accrual of all capitalgains and losses. When the indexinginterest rate goes down, with thedeposit and lending interest ratesremaining fixed, the depositor enjoys acapital gain on the deposit that islocked-in at the old, higher interest rate,and the lender suffers a capital loss. Thecapital gain enjoyed by the depositorcould be viewed as reducing the netpayment to the bank for financialservices. On the other hand, the loss tothe borrower could be viewed as anincrease in the payment to the bank forfinancial services.

Example: Initial lending rate 15 percentand indexing rate 12 percent imply a ser-vice charge of 3 percent to the borrower.If market conditions change and the in-dexing rate falls to ten percent, the lendersuffers a capital loss of two percent foreach year the borrowing rate is locked-in. If the borrower were to pay down theold loan immediately and refinance it atthe rate of 13 percent, the bank wouldcharge a penalty of 2 percent per annumon top of the principal amount of the loanoutstanding. This additional penaltywould be viewed as interest or an addi-tional service charge and would be sub-ject to tax in the hands of the bank. The


106

borrower would receive an input taxcredit in respect of this additional servicecharge and an ongoing credit for theregular service charge of three percent.If the loan is not paid down, then the useof the ten percent indexing rate gives ex-actly the same result, i.e., credit for a to-tal service charge of five percent.

Therefore, the indexing mechanism hasa very desirable property of automati-cally giving recognition to changestaking place in the implicit servicecharge due to market conditions.

Frequency of indexing adjustments

For the system to yield the absolutelycorrect result, the indexing adjustmentneeds to be applied on a compoundbasis to whatever the outstandingbalance is each day over the course ofthe tax period. This provides a measureof the accrual of indexing adjustment ina manner akin to the accrual of interest.This reflects the fact that the indexingadjustment is, in fact, a mechanism forcharging/crediting interest on deferredtax balances.

To achieve the appropriate results, thefrequency with which indexing adjust-ments would need to be calculatedwould vary greatly from asset/liability toasset/liability. For fixed term loans,calculations once a year might besufficient, while for deposit accounts,daily compounding would be appropri-ate (subject to possible de minimusrules). In practice, the legislation couldprobably give institutions considerableflexibility in the choice of the frequencythat they consider appropriate, as longas it is calculated at the same annualcompound rate.

Where interest rates change frequently,a decision has to be made whether theindexing rate would be changed at thesame time or only at fixed periodic

intervals, e.g., only at the beginning of acalendar month. It is largely an adminis-trative and compliance matter, as thereare certain considerations that limit thepotential for tax planning based uponinfrequent indexing adjustments. Fromthe government’s point of view, theindexing adjustment may not implysignificant revenue loss because itmerely serves to divide bank marginsbetween borrowers and depositors,leaving the overall taxable marginunaffected. Of course, the divisionwould have indirect revenue conse-quences if the borrowers were busi-nesses who claimed an input tax creditand the depositors were consumerswho could not claim any credit. In thecase of bearer transactions, an increasein indexing rate would reduce the taxbase for financial assets, but wouldincrease it for liabilities. In reality, giventhat both depositors and borrowerswould include a combination ofbusiness and non-business customers,and given that financial institutionswould have both bearer financial assetsand liabilities, the risk of inappropriatetax planning behavior on the part offinancial institutions from infrequentindexing rate adjustments is likely to besmall as long as interest rate volatility islimited.

Valuation of assets and liabilities at the

commencement of the system or for a

change of tax rate

A valuation of financial assets andliabilities will be needed at the time ofintroduction of the cash-flow VAT forfinancial services and at the time of anyrate change. The valuation at com-mencement is necessary to restrict theapplication of the VAT and the availabil-ity of credits to postcommencementservices. The valuation for rate changesis to ensure that accrued service valuesat the time of the change are subject to


107

tax and credit at the old rate and thatsubsequent services are subject to thenew rate.

The valuation is required for financialassets and liabilities only. Nonfinancialproperties do not require valuation.

Ideally, the adjustments in the TCAshould be based on the fair marketvalue of assets and liabilities at the timeof change. The values must includeaccrued, but unpaid interest. This wouldensure that the tax or a change in itsrate did not have any retroactiveapplication.

In the case of loans, any loans that hadbecome bad or doubtful before thecommencement of the system would bediscounted and valued at their realizablevalue. Otherwise, the system wouldresult in the bank obtaining a tax creditfor bad or doubtful debts that hadoccurred before the commencement ofthe system but that were not written offin the books until after the commence-ment of the system.

Truncated Cash-Flow Method with a TCA

It was noted earlier that the cash-flowtransactions of the financial institutionform a mirror image of the cash-flowtransactions of the business registrantsin respect of deposit and loan transac-tions. This observation can be harnessedto provide one further system proposalthat responds to a fundamentaldifficulty with the cash-flow approach.In this case, it is the complexity thatwould be experienced by smallerbusinesses in carrying out the cash-flowcomputations. The proposal wouldinvolve all the cash-flow calculationsbeing undertaken by the deposit andloan intermediaries, thus truncating thecalculations required under the generalcash-flow approach.

Under the truncated system, for loansand deposits with a financial institution,the TCA calculations could be done bythe financial institution, with a periodicstatement issued by the institution forthe net tax credit claimable by businesscustomers. With the exception of theindexing adjustment, the TCA entrieswould equal the tax rate multiplied bythe entries in the deposit or loanaccount. The resulting statement issuedto the customer by the financialinstitution on the basis of TCA calcula-tions becomes a tax invoice and servesthe same purpose as a tax invoice fornonfinancial goods and services. For atruncated cash-flow approach to applyto all types of financial services, adefinition of financial institutions alongthe lines described in the previoussection would be required to determinewhich taxpayers should have to carryout the TCA calculation and issueinvoices.

Conceptually, based on the abovediscussion, one can consider that thereare three alternatives for a cash-flowapproach when applying a VAT todeposit and loan banking services.These are as follows:

(1) the general cash-flow system inwhich all registrants calculate taxesand credits on a cash-flow basis;

(2) the cash-flow tax with a TCA inwhich all registrants calculate taxand credits using the tax calcula-tion account; and

(3) the truncated cash-flow systemwith a TCA in which financialinstitutions carry out the TCAcalculations and nonfinancialregistrants have access to input taxcredits based on invoices suppliedby financial institutions.

In most respects, the truncated cash-flow system with the TCA gives almost


108

identical results to the full cash-flowapproach. It also provides a response toeach of the fundamental difficulties thathave been considered to exist in respectto the cash-flow approach and, thus,holds out considerable promise as afeasible option. However, further designwork, testing, and analysis are necessarybefore such a system can be imple-mented.

Definition of Financial Institutions

The definition of financial institutionswould obviously be important under thetruncated cash-flow system, becauseonly financial institutions would carryout the cash-flow calculations andwould have the responsibility for issuinginvoices to business customers indicat-ing the amount of tax paid with respectto their financial services. Prior todiscussing the definition of financialinstitutions in the truncated system, it isuseful to note certain considerationsthat would arise in defining taxablepersons under a full cash-flow systemfor financial services.

The full cash-flow method wouldinvolve all persons involved in carryingon a commercial activity applying thecash-flow computations to theirfinancial transactions, unless a specificexception applied.14 Taxable personsthus would include the following:

(1) financial institutions;(2) other businesses acting as financial

intermediaries, e.g., a retail storewith credit card operations; and

(3) other businesses with financialtransactions linked to theirnonfinancial commercial activities,e.g., a manufacturer borrowing orlending funds in the course of itsmanufacturing activities.

Taxable persons would not includeconsumers and individual investors normutual funds and other pooled invest-ment vehicles making portfolio invest-ments on behalf of fund members. Therationale set out for the exclusion ofportfolio investments by individualsapplies in toto to the investmentactivities of persons not engaged in anyother commercial activity, and they thusshould not be taxable persons forpurposes of the cash-flow tax. Themutual fund exemption merely extendsthe personal level treatment to pooledinvestment vehicles.

It would be expected that most enter-prises, other than those acting asfinancial intermediaries, would realize atax saving by being designated a taxableperson. In other words, by beingtaxable, they would be able to receiveinput tax credit in respect of theirfinancial transactions with taxablefinancial institutions. This wouldespecially be the case when they hadthe option to exclude portfolio invest-ments. Enterprises other than financialinstitutions that are engaged in thefinancial intermediation business (e.g.,credit card services provided by largevendors) would be required to beregistered for purposes of the cash-flowtax. This would ensure a uniformtreatment of all enterprises providingsuch services.

Under the truncated version of the tax,only the first two of the three types oftaxable persons identified would beconsidered financial institutions and havea responsibility to do the cash-flowcalculations and issue invoices tocustomers in regard to the tax onservices. Other businesses with financialactivities would not need any specialcash-flow calculations, but would be ableto claim input tax credits in respect of the


109

VAT on financial services on the basisof invoices provided by financial institu-tions.

The definition of financial institutionscould include the following:

(1) banks, credit unions, and trust,loan, and acceptance companies;

(2) credit card companies;(3) Investment dealers;(4) life insurers and property and

casualty insurers; and(5) any other person whose principal

business is lending money,accepting deposits, or purchasingor selling debt securities.

Pension funds, investment funds, andfinancial holding companies, whichprovide financial services primarily totheir affiliates, could be excluded fromthe definition. Their activities tend eitherto be in the nature of portfolio invest-ments (as opposed to intermediationactivities between depositors/savers andborrowers/users of funds), which wouldbe excluded from the tax base were theinvestments to be held directly byindividuals, or of services to otherregistrants, who could claim full credit inany case for the tax charged on financialservices.

Consideration would have to be givento including in the cash-flow base thefinancial transactions of any otherperson who carries on a financialbusiness on a regular and continuousbasis, even if such activities are notthe principal business of the person.An example of this would be creditcard services to customers provided bydepartment stores. The deciding factorin whether to include such activities inthe cash-flow system would be apragmatic one, depending upon theextent of competitive distortions that

are created by ignoring the financialservices of nonfinancial institutions.

Distortions arise only when businessesexcluded from the definition of financialinstitutions provide substantial marginservices to consumers and other non-registered persons. A practical review ofthe extent of such situations would benecessary to determine if, and where,such a supplementary category offinancial business exists. Such businessescould be required to segregate suchoperations and to follow the rulesapplicable to financial institutions. Inthat event, the definition of financialinstitutions becomes redundant. What isneeded then is a definition of financialbusiness, regardless of whether it iscarried out by a financial institution or anonfinancial enterprise.

Other Design Features

Implementation of a cash-flow variantof the VAT for financial services wouldnecessitate dealing with several specifictax design features in order for the taxto function appropriately. The mainexamples of such design features relateto the tax base, exclusions from the taxbase, treatment of bad debts, transac-tions with shareholders/owners,transactions between financial enter-prises and nonfinancial persons,portfolio investments, definition oftaxable persons, secondary markettransactions, transactions with non-residents, place of supply, definition offinancial institutions, and financialservices rendered by nonresidents. Thedesign of the tax would also need to beextended to other types of financialservices such as life and property andcasualty insurance, investment dealerservices, and credit card services. Someof these areas are the subject ofongoing research.


110

While much remains to be done, ourpreliminary examination suggests thatthe cash-flow system can be extendedto most financial services in a satisfac-tory manner. There would undoubtedlybe a need for special rules and compro-mises to deal with specific sectors andtransactions. These features would alsobe an element in the potential overalladministrative and compliance burdenof the system.

Conclusions

This paper has outlined a mechanism forapplying a cash-flow system of a VAT tofinancial services. The principal designinnovation is the development of a taxsuspense account referred to as theTCA. Means of limiting the necessarytax calculations to financial institutionshave also been identified. Theseapproaches deal with the fundamentaldifficulties relating to system startup, taxrate changes, cash flow impacts, andcomplexity, which have generally beenconsidered to stand in the way ofimplementing this approach to applyinga VAT to financial services. The completemechanism proposed is referred to as atruncated cash-flow method with aTCA.

ENDNOTES1 The mechanisms discussed in this paper were

developed during research projects carried out forthe Commission of the European Communities.However, the views expressed are those of theauthors and not of any of the organizationsproviding research support for the project. Theauthors wish to thank Michel Aujean, Director,Indirect Taxation, and members of the VAT andOther Turnover Tax Unit, European Commission,Directorate-Génerale XXI, for their assistance andcomments in this research. David Leslie of Ernst &Young, Toronto, played a critical role in the earlydevelopment of the system. The authors also wishto thank Richard Bird, Glen Cronkwright, JackMintz, and Bill Vandeburgh for their detailedcomments, as well as the numerous otherindividuals who have provided comments on the

approach during its development. Comments fromthe referees provided valuable assistance inimproving the presentation and in identifying issuesfor further consideration.

2 The issues for which further design work arenecessary are identified toward the end of thepaper. One crucial design issue considered in thepaper but that requires further analysis is theselection of a so-called indexing factor. The indexingfactor is the interest rate that is used to allocate thefinancial margin between suppliers of funds andusers of funds under the cash-flow methodapproach proposed.

3 Other studies that discuss the tax with particularemphasis on its applicability to financial servicesinclude Barham, Poddar, and Whalley (1987);Hoffman, Poddar, and Whalley (1987); andHoffman, (1988).

4 A sample of studies that consider various aspects ofthe value-added by financial transactions includesMeade (1978); Barham, Poddar, and Whalley(1987); Hoffman, Poddar, and Whalley (1987);Hoffman (1988); and Henderson (1988).

5 The value-added would be disbursed as paymentsof salary and wages to labor, payments of dividendsto owners, and purchase of other inputs used in thefinancial intermediation activity (for example,computers and rental payments for real property).There might also be a portion used to offset losseson bad debts.

6 The examples provided of the operation of a cash-flow tax reflect material contained in a discussion ofa cash-flow VAT contained in Poddar and English(1994).

7 The appropriate treatment of equity transactions isdiscussed in Meade (1978). Essentially, if equityinvestments were treated in the same manner asother financial transactions, economic rents earnedby shareholders would be sheltered from taxation inaddition to the normal rate of return reflecting thetime value of money.

8 For clarity of exposition, the examples assume thatthe term and value of the deposit equal the termand value of the loan. However, the cash-flowmethod essentially operates on each customer’stransactions independently and provides theappropriate result where, for example, a series orgroup of deposits funds a loan.

9 Current VAT systems provide for zero rating offinancial services that are exported. Whiledetermining the place of supply and allocatingtransactions among exempt and zero-rated activitiesare a significant source of complexity, conceptually,zero rating does eliminate any bias against domesticinstitutions on exported financial services. However,financial services supplied by offshore financialinstitutions into the domestic market do have a taxadvantage over those supplied by domesticinstitutions. Foreign institutions do not pay any taxon inputs, either because of zero rating or the


111

absence of a VAT in the foreign jurisdiction, whilethe domestic institutions do bear (noncreditable) aVAT on their inputs. Extension of a VAT to financialservices thus would eliminate this adverse economiceffect for domestic financial institutions in Europe.

10 New Zealand has applied a cash-flow system toproperty and casualty insurance services. However,the services provided to borrowers from the insurershave not been taxed, and the system is a partial onein that respect.

11 It is useful to observe at this point that it is thismirror image characteristic that is used indeveloping a truncated version of the system. Underthat system, all the calculations would be done bythe financial institutions, which could carry separateTCAs for each customer. This would not onlyidentify the tax payable by the bank in respect ofthe financial services provided to the customer, butwould also provide the means by which the bankcould provide an invoice for taxes paid, which wouldallow a business customer to claim input tax credits.

12 One situation in which there would not be anoffsetting entry would be as a result of bankruptcy.Design of a cash-flow system would requiredevelopment of appropriate rules for the treatmentof bad debts.

13 While the initial view in developing the TCA systemwas that a single interest rate, excluding all risk andintermediation services, should be selected as theindexing rate, with a short-term governmentborrowing rate appearing to approximate such abenchmark, further consideration needs to be givento this issue. Among the specific questions to beaddressed would be the following:(1) Is a single rate more appropriate than a cluster ofrates reflecting different maturities of loans anddeposits? (2) If a single rate is used, what is the bestproxy? (3) Given that no interest rate may provide aperfect proxy, what are the nature and magnitudeof any distortions? Further research is being under-taken on this issue.

14 A major issue exists with respect to the appropriatetreatment of portfolio investments by nonfinancialregistrants. While a strong case can be made forexcluding transactions with respect to portfolioinvestments as a parallel to the treatment ofindividual portfolio investments, this would raiseconcerns where treasury operations are actually arather significant factor in the overall activities of anonfinancial commercial undertaking. Thisimportant issue is not discussed in this paper.

REFERENCES

American Bar Association Section ofTaxation. “1975 ABA Section Tax Report: TheSpecial Committee on the Value-Added Tax.”Reprinted as “Technical Problems in Designing a

Broad-Based Value-Added Tax for the UnitedStates.” Tax Lawyer 28 (1975): 193–209.

American Bar Association Section ofTaxation. “Evaluation of an Additive-MethodValue-Added Tax for Use in the United States.”1977 ABA Section Tax Report: The SpecialCommittee on the Value-Added Tax. Tax Law 30(1977).

American Bar Association Section ofTaxation. “Value Added Tax: A Model Statuteand Commentary.” Report to Committee onValue Added Tax of the American Bar Associ-ation Section of Taxation, Washington, D.C.,1989.

Barham, Vicki, Satya N. Poddar, and JohnWhalley. “The Tax Treatment of Insuranceunder a Consumption Type, Destination BasisVAT.” National Tax Journal 40 No. 2 (June,1987): 171–82.

Canadian Department of Finance. Tax Reform1987: Sales Tax Reform. Ottawa, 1987.

Clarkson Gordon (Ernst & Young). Taxation ofFinancial Institutions, An Analysis of CanadianTax Reform Proposal. Toronto, 1987.

Henderson, Yolanda K. “Financial Intermediar-ies Under Value-Added Taxation.” New EnglandEconomic Review (July–August, 1988): 37–50.

Hoffman, Lorey Arthur. “The Application of aValue-Added Tax to Financial Services.”Canadian Tax Journal 36 No. 5 (September–October, 1988): 1204–24.

Hoffman, Lorey Arthur, Satya N. Poddar, andJohn Whalley. “Taxation of Banking ServicesUnder a Consumption Type, Destination BasisVAT.” National Tax Journal 40 No. 4 (December,1987): 547–54.

Institute for Fiscal Studies. The Structure andReform of Direct Taxation. Report of aCommittee Chaired by Professor J. E. Meade.London: George Allen & Unwin, 1978.

Meade, James, ed. The Stucture and Reform ofDirect Taxation. London: Allen & Unwin, 1978.

Poddar, Satya, and Morley English. “Taxationof Financial Services under a VAT: Issues andOptions.” Presented at the National TaxAssociation Conference on The Taxation ofFinancial Services, Florida, 1994.

Vanesse, Pierre. Sales Tax Reform and theCanadian Financial Services Industry: Exploringthe Options. Financial Services Research ProgramReport for The Conference Board of Canada,Ottawa, March, 1989.

Vanesse, Pierre. Operating as a Tax-ExemptCorporation: Canadian Financial Institutions andthe GST. Financial Services Research ProgramReport for The Conference Board of Canada,Ottawa, November, 1989.

Documents

TAXATION OF FINANCIAL SERVICES UNDER A VALUE-ADDED … · SATYA PODDAR * & MORLEY ENGLISH * Abstract - Financial services have generally been exempt under value-added tax (VAT) systems