## _wp04119 — Modified Reverse-Charging Approach to Taxing Deposit and Loan Interest

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---

### I. Introduction and motivation
- Over 120 countries with a value-added tax (VAT) today exempt the financial sector to varying degrees.
- Developed countries tend to apply VAT to some explicit-fee financial services; many developing countries exclude the entire financial sector.
- Even taxing fee-based services leaves a significant share of financial sector value-added—especially banking intermediation represented by interest margins—exempt.
- Zee (2004) reports the value-added of the financial sector averages 24.7 percent of GDP in OECD countries (Table 1), with the EU average at 27.8.
- Exemption gives rise to significant economic distortions (cascading, overtaxation of business inputs, undertaxation of final consumers) and motivates exploration of alternative VAT treatments.
- Proposed approach: a “modified reverse-charging” system that:
  - Applies a reverse charge shifting collection of VAT on deposit interest from depositors to banks.
  - Establishes a franking mechanism managed by banks to transfer VAT collected on deposits to borrowers as credits against VAT on their loan interest on a transaction-by-transaction basis.
  - Produces net VAT remitted by a bank equal to the VAT rate on its provision of intermediation services; VAT burden is ultimately borne by final consumers (borrowers or consumers of goods/services embedding intermediation services).
  - Is compatible with an invoice-credit VAT.

### II. Nature of the problem and current alleviating measures
- Invoice-credit VAT basics:
  - Output tax imposed on taxed goods/services supplied by VAT-registered businesses.
  - Input tax credit given for tax paid on inputs used to produce taxed outputs.
  - Net VAT remitted = output tax collected less input tax paid.
  - Final consumer bears the VAT burden; businesses act as collection agents.
- Difficulty with financial intermediation:
  - Many intermediation services are priced implicitly (interest margins), not by explicit invoices, breaking the transaction-level invoice-credit chain.
  - Deposits are supplied by final consumers who are not VAT-registered and cannot claim input credits; this breaks the credit chain.
- Consequences of exemption:
  - Breaks the VAT credit chain, causing cascading and overtaxation of financial intermediation when purchased as business inputs, and undertaxation when consumed by final consumers.
  - Financial institutions still incur compliance costs for fee-based taxed services (identifying creditable input tax).
- Country practices reviewed (selected facts preserved):
  - Australia: fixed 75 percent creditable proportion (Div. 70; Regulation 70–2 and 70–3).
  - Singapore: creditable proportion varies by industry (e.g., 58 percent for finance companies to 98 percent for offshore banks).
  - New Zealand (enacted late 2003): zero-rating business purchases of all financial services with practical restriction that the purchasing VAT-registered business must have taxable supplies at least equal to 75 percent of total supplies.
  - Israel: addition-method VAT for the financial sector (increasing cascading).
  - Cash-flow basis proposals (e.g., Poddar and English (1997); Hoffman et al. (1987)) and the TCA (European Commission (2000)) are administratively complex.

### III. Modified reverse-charging approach — core concept
- Scope: focus on banks’ deposit-taking and lending activities as core intermediation services; principles extend to other intermediation activities.
- Conceptual treatment:
  - Treat loans as bank output and deposits as bank input.
  - Apply VAT to loan interest (output tax) and to deposit interest (input tax).
  - Use reverse charging to have VAT on deposit interest collected by the bank and credited against VAT on loan interest, preserving the invoice-credit chain for businesses borrowing from banks.
- Reverse-charging mechanism:
  - Shifts collection responsibility for VAT on deposit interest from depositors to banks (so VAT-registered taxpayers collect VAT on both input and output sides).
  - Bank effectively invoices itself for tax on purchased inputs (deposits) and claims the credit against output tax (loan interest).
  - Reverse charging is analogous to current practice for imported services.

### IV. Franking mechanism (detailed mechanics and numerical illustration)
- Purpose: transfer reverse charges levied on depositors to borrowers so that VAT credits available to borrowers derive from reverse-charged deposits; avoids overtaxation of final consumers and preserves correct VAT on intermediation margins.
- Franking account maintains three running balances:
  1. Cumulated unlent deposits
  2. Cumulated unclaimed reverse charges on the unlent deposits
  3. Unclaimed reverse charge per unit of unlent deposit
- Balances updated after each deposit (credit entry) and loan (debit entry). Calculations can be computerized; banks need not ascertain depositor or borrower registration status; depositors and borrowers incur no compliance costs.
- Numerical assumptions used in the illustrative example (Table 2 and Table 4):
  - Principal amount = 1,000
  - Deposit rate = 4 percent
  - Loan rate = 9 percent
  - VAT rate = 10 percent
- Selected sequence entries (preserving figures exactly):
  - 1st deposit: Principal = 1,000; Interest rate (Percent) = 4; Reverse charge = 4 → Cumulated unlent deposits = 1,000; Cumulated unclaimed reverse charges = 4; Unclaimed reverse charge per unit = 0.004
  - 2nd deposit: Principal = 3,000; Interest rate = 5; Reverse charge = 15 → Cumulated unlent deposits = 4,000; Cumulated unclaimed reverse charges = 19; Unclaimed reverse charge per unit = 0.00475
  - 3rd transaction: Loan principal = 2,000; Interest rate = 9; Notional VAT = 18; VAT credit from franking account = 9.5 (0.00475 × 2,000); Net VAT paid by borrowers = 8.5
  - 4th deposit: Principal = 2,000; Interest rate = 3; Reverse charge = 6 → Cumulated unlent deposits = 4,000; Cumulated unclaimed reverse charges = 15.5; Unclaimed reverse charge per unit = 0.003875
  - 5th transaction: Loan principal = 1,000; Interest rate = 7; Notional VAT = 7; VAT credit = 3.875; Net VAT paid by borrowers = 3.125 → Cumulated unlent deposits = 3,000; Cumulated unclaimed reverse charges = 11.625; Unclaimed reverse charge per unit = 0.003875
  - 6th transaction: Loan principal = 3,000; Interest rate = 8; Notional VAT = 24; VAT credit = 11.625; Net VAT paid by borrowers = 12.375
- Totals from Table 4 (preserved exactly as shown):
  - Total deposits principal = 6,000
  - Total reverse charge = 25
  - (later columns) Total cumulated unlent deposits = 6,000; Total cumulated unclaimed reverse charges = 49; Total unclaimed reverse charge per unit = 25; Total net VAT paid by borrowers = 24
- Interpretation:
  - Total net VAT paid by borrowers = 24, which equals 10 percent of the intermediation margin: loan interest received (490) minus deposit interest paid (250) = 240; 10 percent of 240 = 24.
  - The franking mechanism yields the theoretically correct result: only value-added intermediation margin is taxed, with reverse charges on deposits transferred as borrower credits.
- Treatment of outstanding balances:
  - Franking account treats outstanding deposits and loans at period-ends as withdrawn/paid and then re-deposited/re-lent at the beginning of the next period at the same interest rates (recognizing that interest margins may change and net VAT liability on existing fixed-interest loans may vary from period to period).

### V. Extensions and flexibility
- Sharing VAT between depositors and borrowers:
  - If depositors are charged an implicit fee of x percent for consumption of intermediation services, deposit rate gross of implicit fee = (4 + x) percent (example uses deposit rate 4 percent).
  - To tax depositors for such services, bank collects as part of its output tax (0.1x) percent in VAT revenue on its deposits (VAT rate assumed 10 percent).
  - Practically: reduce net interest paid to depositors from 4 percent to (4 – 0.1x) percent; increase reverse charge base from 4 percent to (4 + x) percent.
  - Any reverse charge passed to borrowers as credit via the franking account reduces net VAT paid by borrowers by exactly the VAT paid by depositors.
  - Implication: x determines only how the VAT burden is split between depositors and borrowers; it does not affect overall revenue. Banks can set x across account types or over time to reflect differences in services and market conditions.

### VI. Comparison with cash-flow approach
- Cash-flow approach (summary example):
  - Taxes bank on all inflows and provides credit on all outflows. Example with deposit 1,000:
    - Tax when deposit received = 100; tax credit when deposit withdrawn with interest = 104 → combined net tax credit = 4.
    - For loan of same amount: credit of 100 when issued; tax of 109 when repaid with interest → combined net tax = 9.
    - Net effect over deposit and loan = 5 (tax on the interest margin).
- Administrative shortcomings of cash-flow approach:
  - Requires VAT calculations on a cash-flow basis by nonfinancial businesses for transactions with financial institutions—potentially large compliance costs.
  - Includes principal amounts in the tax base (offset later), creating cash-flow burdens and complications when VAT rates change.
  - Proposed remedy (TCA) adds complexity: needs per-customer tracking of deposit and loan inflows/outflows, accrued interest on open balances, and period-end reporting.
- Advantages of the modified reverse-charging approach over cash-flow:
  - Ignores principal amounts, removing the need to compute accrued interest or handle VAT rate changes across loan/deposit lifetimes.
  - Eliminates an entire layer of administrative complexity while delivering conceptually-correct VAT results on intermediation services.

### VII. Policy assessments, properties, and recommendations
- Properties of the modified reverse-charging approach:
  - Corrects limitations of the exemption approach (overtaxation of registered businesses, undertaxation of final consumers, and administrative complications in apportioning creditable input tax).
  - Produces theoretically-correct VAT on intermediation margins: bank net VAT remittance equals VAT on value added by intermediation.
  - Does not require banks to ascertain depositor or borrower VAT registration status.
  - Calculations can be computerized; minimal enforcement and compliance costs for nonfinancial customers.
- Comparative assessment:
  - Superior to existing alleviating measures (fixed creditable proportions, partial zero-rating) because it addresses both overtaxation of business inputs and undertaxation of final consumers.
  - Conceptually preferable and administratively simpler than the cash-flow approach, which is elegant but burdensome.
- Recommendation:
  - The modified reverse-charging approach merits serious consideration by policymakers as a practical and theoretically sound method to integrate the financial sector into the invoice-credit VAT mechanism.

### Key statistics and exact figures preserved from the source
- Number of countries with VAT today that exempt financial sector: more than 120.
- Reported OECD value-added of the financial sector, 2001 (Percent of GDP) — selected entries and averages:
  - Australia 26.2
  - Austria 27.0
  - Belgium 29.3
  - Canada 1/ 25.7
  - Czech Republic 16.7
  - Denmark 23.4
  - Finland 22.9
  - France 30.5
  - Germany 30.8
  - Greece 23.6
  - Hungary 20.5
  - Iceland 2/ 20.2
  - Ireland 3/ 17.9
  - Italy 28.4
  - Japan 23.9
  - Korea 23.8
  - Luxembourg 57.9
  - Mexico 12.1
  - Netherlands 27.6
  - New Zealand 1/ 29.2
  - Norway 19.4
  - Poland 14.2
  - Portugal 21.0
  - Slovak Republic 19.4
  - Spain 22.9
  - Sweden 24.0
  - Switzerland 3/ 29.5
  - Turkey 14.7
  - United Kingdom 29.9
  - United States 3/ 27.7
  - Average 24.7
  - Memorandum item: EU average 27.8
- Numerical assumptions for illustrative examples:
  - Principal amount = 1,000
  - Deposit rate = 4 percent
  - Loan rate = 9 percent
  - VAT rate = 10 percent
- Australia’s stipulated creditable proportion: 75 percent (Div. 70 and Regulation 70–2 and 70–3).
- Singapore creditable proportion examples: ranges from 58 percent (finance companies) to 98 percent (offshore banks).
- New Zealand practical restriction for zero-rating B-to-B transactions: purchasing VAT-registered business must have taxable supplies at least equal to 75 percent of total supplies.

*Source — IMF Working Paper “Modified Reverse-Charging Approach to Taxing Deposit and Loan Interest” (section content as provided).*

### References................................................................................................18

### _wp04119 - References................................................................................................18

### Tables

- 1. Value-Added of the Financial Sector in OECD Countries, 2001................................4
- 2. VAT Treatments of Deposits from and Loans to Residents....................................10
- 3. VAT Treatments of Deposits and Loans Involving Nonresidents.............................12

*Source: _wp04119 - References................................................................................................18*

### 4. Modified Reverse-Charging Approach to Taxing Deposit and Loan Interest...............14

### 4. Modified Reverse-Charging Approach to Taxing Deposit and Loan Interest

### I. Introduction
- Over 120 countries with a value-added tax (VAT) today exempt the financial sector to varying degrees.
- Developed countries tend to apply VAT to some explicit-fee financial services; many developing countries exclude the entire financial sector.
- Even taxing fee-based services leaves a significant share of financial sector value-added—especially banking intermediation represented by interest margins—exempt.
- Zee (2004) reports the value-added of the financial sector averages 24.7 percent of GDP in OECD countries (Table 1), with the EU average at 27.8.
- Exemption of the financial sector can give rise to significant economic distortions and has motivated exploration of alternative VAT treatments.
- The paper proposes a “modified reverse-charging” approach:
  - Apply a reverse charge that shifts collection of VAT on deposit interest from depositors to banks.
  - Establish a franking mechanism managed by banks to transfer VAT so collected to borrowers as credits against VAT on their loan interest on a transaction-by-transaction basis.
  - Outcome: net VAT remitted by a bank equals the VAT rate on its provision of intermediation services; VAT burden is ultimately borne by final consumers (borrowers or consumers of goods/services embedding intermediation services).
  - The approach is compatible with an invoice-credit VAT.

### II. Nature of the Problem and Alleviating Measures in Practice
- Invoice-credit VAT basics:
  - Output tax imposed on taxed goods/services supplied by VAT-registered businesses.
  - Input tax credit given for tax paid on inputs used to produce taxed outputs.
  - Net VAT remitted = output tax collected less input tax paid.
  - Final consumer bears the VAT burden; businesses act as collection agents.
- Difficulty with financial intermediation:
  - Many financial intermediation services are priced implicitly (interest margins), not by explicit invoices, making invoice-credit VAT inapplicable transaction-by-transaction.
  - Measuring value-added of implicit-priced services is feasible via subtraction or addition methods, but those do not support the transaction-based invoice-credit chain.
  - Deposits—the key input—come from final consumers who are not VAT-registered and cannot claim input credits; this breaks the credit chain.
- Consequences of exemption:
  - Exemption breaks the VAT credit chain, causing cascading and overtaxation of financial intermediation when purchased as business inputs, and undertaxation when consumed by final consumers.
  - Financial institutions still bear compliance costs for fee-based taxed services (identifying creditable input tax).
  - International competitiveness pressures have increased interest in alternatives to exemption.
- Country approaches reviewed:
  - Australia and Singapore: allow financial institutions to claim a credit for a stipulated proportion of input VAT even when inputs produce exempt sales.
    - Australia uses a fixed 75 percent creditable proportion (Div. 70; Regulation 70–2 and 70–3).
    - Singapore’s creditable proportion varies by industry (e.g., 58 percent for finance companies to 98 percent for offshore banks).
    - Advantages: administratively simple; no need to separate taxable from exempt sales.
    - Limitations: ad hoc, may only reduce (not eliminate) overtaxation of businesses; may worsen undertaxation of final consumers.
  - New Zealand (enacted late 2003, targeted implementation discussed):
    - Zero-rating business purchases of all financial services (zero-rating of B-to-B transactions).
    - Conceptually superior: preserves credit chain for business transactions and can eliminate overtaxation of business consumption.
    - Administrative cost: requires separating sales to registered businesses and final consumers to apportion creditable input taxes; practical application in New Zealand restricts zero-rating to cases where the purchasing VAT-registered business has taxable supplies at least equal to 75 percent of total supplies.
  - Israel: addition-method VAT for financial sector (separate from invoice-credit VAT), which increases cascading and is not an appropriate fix.
  - Cash-flow basis proposals (e.g., Poddar and English (1997); earlier Hoffman et al. (1987)) have been considered, including by the EU (European Commission (2000)), but are administratively complex.

### III. A New Approach to Taxing Financial Intermediation Services
- Scope: focus on banks’ deposit-taking and lending activities as core intermediation services; principles extend to other intermediation activities though operational details may vary.
- Concept: treat loans as bank output and deposits as bank input. VAT applied to loan interest (output tax) and deposit interest (input tax). Net output minus input remitted by bank equals VAT on intermediation services.
- Two principal problems:
  - Administrative: deposits are supplied by many final consumers who cannot be VAT-registered collection agents.
  - The existing solution: reverse charging.
- Reverse-charging mechanism:
  - Reverse charge shifts collection responsibility for VAT on deposit interest from depositors to banks (VAT-registered taxpayers collect VAT on both input and output sides).
  - Practically, the bank issues a VAT invoice to itself for tax paid on purchased input (deposits) and claims it as a credit against output tax (loan interest).
  - Reverse charging is commonly used for imported services where foreign suppliers cannot collect domestic VAT.
- Illustrative assumptions used in the paper’s numerical example (Table 2):
  - Principal amount = 1,000
  - Deposit rate = 4 percent
  - Loan rate = 9 percent
  - VAT rate = 10 percent
- Effects of reverse-charging (illustrated for four combinations of depositor and borrower being VAT-registered business or final consumer):
  - VAT applied to loan interest and collected by bank as output tax regardless of borrower status.
  - Final consumer borrower who pays loan interest inclusive of VAT has no further tax implications.
  - If borrower is a registered business, VAT on loan interest is creditable like other input VATs.
  - VAT applied to deposit interest as bank input tax is collected by the bank via reverse charge regardless of depositor status and credited against the bank’s output tax under invoice-credit procedures.
  - Result: bank’s deposit-taking and lending activities are fully integrated into the invoice-credit VAT mechanism; credit chain remains intact for businesses borrowing from banks, preventing cascading when financial intermediation services are used as business inputs.

### Key Statistics and Exact Figures Preserved from the Source
- Number of countries with VAT today that exempt financial sector: more than 120.
- Reported OECD value-added of the financial sector, 2001 (Percent of GDP) — selected entries and averages as in Table 1:
  - Australia 26.2
  - Austria 27.0
  - Belgium 29.3
  - Canada 1/ 25.7
  - Czech Republic 16.7
  - Denmark 23.4
  - Finland 22.9
  - France 30.5
  - Germany 30.8
  - Greece 23.6
  - Hungary 20.5
  - Iceland 2/ 20.2
  - Ireland 3/ 17.9
  - Italy 28.4
  - Japan 23.9
  - Korea 23.8
  - Luxembourg 57.9
  - Mexico 12.1
  - Netherlands 27.6
  - New Zealand 1/ 29.2
  - Norway 19.4
  - Poland 14.2
  - Portugal 21.0
  - Slovak Republic 19.4
  - Spain 22.9
  - Sweden 24.0
  - Switzerland 3/ 29.5
  - Turkey 14.7
  - United Kingdom 29.9
  - United States 3/ 27.7
  - Average 24.7
  - Memorandum item: EU average 27.8
- Numerical assumptions for Table 2 example:
  - Principal amount = 1,000
  - Deposit rate = 4 percent
  - Loan rate = 9 percent
  - VAT rate = 10 percent
- Australia’s stipulated creditable proportion: 75 percent (Div. 70 and Regulation 70–2 and 70–3).
- Singapore creditable proportion examples: ranges from 58 percent (finance companies) to 98 percent (offshore banks).
- New Zealand practical restriction for zero-rating B-to-B transactions: purchasing VAT-registered business must have taxable supplies at least equal to 75 percent of total supplies.

*Source: IMF Working Paper — “Modified Reverse-Charging Approach to Taxing Deposit and Loan Interest” (section content as provided).*

### 1.    D = R = Final consumer

### _wp04119 - 1.    D = R = Final consumer

### Reverse-charging approach (basic invoice-credit VAT application)
- Scenario outcomes (illustrative figures as shown in the four permutations):
  - B’s output tax: Collects VAT = 9 from R; issues a VAT invoice to R; pays VAT = 9 to B.
  - B’s input tax: Reverse charges VAT = 4; claims a credit for the VAT reverse charge (where applicable).
  - Tax payment/burden outcomes:
    - For cases labeled 1/ or 3/ (where borrower is final consumer): Remits VAT = 9 to the government; bears the VAT burden on D’s deposit and B’s margin; net revenue to the government is 9.
    - For cases labeled 2/ or 4/ (where borrower is a registered business): Remits VAT = 9 to the government but the registered business may claim a credit; net revenue to the government is nil.
- Key conceptual point:
  - The invoice-credit VAT with straightforward reverse charging leads to overtaxation of final consumers (bank borrowers) relative to the VAT on the financial intermediation services embedded in the loan. Registered businesses can claim credits and therefore do not bear the net VAT burden.

### Reverse-charging and nonresident transactions (Table 3 summary)
- Assumptions used in numerical illustration:
  - Principal amount = 1,000
  - Deposit rate = 4 percent
  - Loan rate = 9 percent
  - VAT rate = 10 percent
- Selected outcomes:
  - D = Nonresident; R = Resident:
    - B’s output tax: Collects VAT = 9 from R; issues VAT invoice to R; pays VAT = 9 to B.
    - B’s input tax: Reverse charges VAT = 4; claims a credit for the reverse charge.
    - Tax payment/burden: If borrower is a final consumer, bears VAT burden on D’s deposit and B’s margin; net revenue to government would be 9 if borrower is a final consumer, but nil if borrower is a registered business.
  - D = Resident; R = Nonresident:
    - B’s output tax: Applies zero rate; pays no VAT to B.
    - B’s input tax: Reverse charges VAT = 4; claims a credit.
    - Tax payment/burden: Net revenue to the government is nil.

### Modified reverse-charging approach (franking mechanism)
- Purpose:
  - Transfer reverse charges levied on depositors to borrowers so that VAT credits available to borrowers derive from reverse-charged deposits, avoiding overtaxation of final consumers and preserving correct VAT on intermediation services.
- Mechanics (franking account):
  - Maintains three running balances:
    1. Cumulated unlent deposits
    2. Cumulated unclaimed reverse charges on the unlent deposits
    3. Unclaimed reverse charge per unit of unlent deposit
  - Balances are updated after each deposit (credit entry) and loan (debit entry).
  - Example parameters: VAT rate = 10 percent.
- Numerical illustration (sequence from Table 4):
  - Deposit and loan sequence entries (selected figures preserved):
    - 1st deposit: Principal = 1,000; Interest rate (Percent) = 4; Reverse charge = 4 → Cumulated unlent deposits = 1,000; Cumulated unclaimed reverse charges = 4; Unclaimed reverse charge per unit = 0.004
    - 2nd deposit: Principal = 3,000; Interest rate = 5; Reverse charge = 15 → Cumulated unlent deposits = 4,000; Cumulated unclaimed reverse charges = 19; Unclaimed reverse charge per unit = 0.00475
    - 3rd transaction: Loan principal = 2,000; Interest rate = 9; Notional VAT = 18; VAT credit from franking account = 9.5 (0.00475 × 2,000); Net VAT paid by borrowers = 8.5
    - 4th deposit: Principal = 2,000; Interest rate = 3; Reverse charge = 6 → Cumulated unlent deposits = 4,000; Cumulated unclaimed reverse charges = 15.5; Unclaimed reverse charge per unit = 0.003875
    - 5th transaction: Loan principal = 1,000; Interest rate = 7; Notional VAT = 7; VAT credit = 3.875; Net VAT paid by borrowers = 3.125 → Cumulated unlent deposits = 3,000; Cumulated unclaimed reverse charges = 11.625; Unclaimed reverse charge per unit = 0.003875
    - 6th transaction: Loan principal = 3,000; Interest rate = 8; Notional VAT = 24; VAT credit = 11.625; Net VAT paid by borrowers = 12.375
  - Totals from Table 4 (preserving exactly as shown):
    - Total deposits principal = 6,000
    - Total reverse charge = 25
    - (later columns) Total cumulated unlent deposits = 6,000; Total cumulated unclaimed reverse charges = 49; Total unclaimed reverse charge per unit = 25; Total net VAT paid by borrowers = 24
- Interpretations and properties:
  - After the sequence, total net VAT paid by borrowers = 24, which equals 10 percent of the intermediation services represented by loan interest received (490) minus deposit interest paid (250) = 240; 10 percent of 240 = 24.
  - The franking mechanism produces the desired theoretically-correct result: only the value-added intermediation margin is taxed, with reverse charges on deposits transferred as borrower credits.
  - The mechanism does not require the bank to ascertain the registration status of depositors or borrowers.
  - Calculations can be computerized; neither depositors nor borrowers would incur compliance costs in the process.
  - The franking account treats outstanding deposits and loans at period-ends as withdrawn/paid and then re-deposited/re-lent at the beginning of the next period at the same interest rates (noting that interest margins may change and net VAT liability on existing fixed-interest loans may vary from period to period).

### Extension: sharing VAT between depositors and borrowers
- Mechanism to allocate some VAT burden to depositors:
  - Suppose depositors are charged an implicit fee of x percent for consumption of intermediation services; deposit rate gross of implicit fee = (4 + x) percent (example uses deposit rate 4 percent).
  - To tax depositors for such services, bank collects as part of its output tax (0.1x) percent in VAT revenue on its deposits (VAT rate assumed 10 percent).
  - Practically, reduce net interest paid to depositors from 4 percent to (4 – 0.1x) percent; increase reverse charge base from 4 percent to (4 + x) percent.
  - Any reverse charge passed to borrowers as credit via the franking account reduces net VAT paid by borrowers by exactly the VAT paid by depositors.
- Implications:
  - x determines only how the VAT burden on intermediation services is split between depositors and borrowers; it does not affect overall revenue.
  - Banks can set x across account types or over time to reflect differences in services and market conditions; banks have no inherent bias favoring depositors or borrowers under this mechanism.

### Comparison with the cash-flow approach
- Cash-flow approach summary:
  - Taxes bank on all inflows and provides credit on all outflows; example with deposit 1,000:
    - Tax when deposit received = 100; tax credit when deposit withdrawn with interest = 104 → combined net tax credit = 4.
    - For loan of same amount: credit of 100 when issued; tax of 109 when repaid with interest → combined net tax = 9.
    - Net effect over deposit and loan = 5, i.e., tax on the interest margin.
- Shortcomings and administrative complexities of cash-flow approach:
  - Requires VAT calculations on a cash-flow basis by nonfinancial businesses for transactions with financial institutions — potential large compliance costs.
  - Includes principal amounts in the tax base (albeit offset later), creating cash-flow burdens for borrowers and complications when VAT rates change.
  - Proposed remedy: tax calculation account (TCA) to track deposit and loan inflows/outflows for each customer, with accrued interest on open balances and reporting at period-ends — adds complexity.
- Advantages of the modified reverse-charging approach over cash-flow:
  - Ignores principal amounts, removing need to compute accrued interest or to handle VAT rate changes across loan/deposit lifetimes.
  - Eliminates an entire layer of administrative complexity present in cash-flow approaches while delivering conceptually-correct VAT results on intermediation services.

### Discussion and concluding remarks
- Main policy assessments:
  - The modified reverse-charging approach:
    - Corrects limitations of the exemption approach (overtaxation of registered businesses, undertaxation of final consumers, administrative complications in apportioning creditable input tax).
    - Is superior to existing alleviating measures because it addresses the problems completely.
    - Is conceptually correct, administratively simple, and entails minimal enforcement and compliance costs.
  - The cash-flow approach:
    - Conceptually elegant but administratively complex and potentially burdensome for banks, borrowers, and nonfinancial business customers.
  - Overall recommendation:
    - The modified reverse-charging approach merits serious consideration by policymakers as a practical and theoretically sound method to integrate the financial sector into the invoice-credit VAT mechanism.

*Italic: Source — _wp04119 - 1.    D = R = Final consumer*

### References

### _wp04119 - References

### References on VAT and financial services
- Alba, Cristian E. Rosso, 1995, “Taxation of Financial Services Under the Value Added Tax: A Survey of Alternatives and an Analysis of the Argentine Approach,” International VAT Monitor, Vol. 6, pp. 335–49.
- Huizinga, Harry, 2002, “A European VAT on Financial Service?” Economy Policy, Vol. 17, pp. 499–534.
- Hoffman, Lorey Arthur, Satya Poddar, and John Whalley, 1987, “Taxation of Banking Services Under a Consumption Type, Destination Basis VAT,” National Tax Journal, Vol. 40, pp. 547–54.
- Jenkins, Glenn P. and Rup Khadka, 1998, “Value-Added Tax Policy and Implementation in Singapore,” International VAT Monitor, Vol. 9, pp. 35–47.
- Poddar, Satya, and Morley English, 1997, “Taxation of Financial Services Under a Value-Added Tax: Applying the Cash-Flow Approach,” National Tax Journal, Vol. 50, pp. 89–111.
- Schatan, Roberto, 2003, “VAT on Banking Services: Mexico’s Experience,” International VAT Monitor, Vol. 14, pp. 287–94.
- Schenk, Alan, and Howell H. Zee, 2004, “Treating Financial Services Under a Value Added Tax: Conceptual Issues and Country Practices,” in Taxing the Financial Sector: Concepts, Issues, and Country Practices, ed. by Howell H. Zee (Washington: International Monetary Fund), pp. 60–74.
- Zee, Howell H., 2004, “World Trends in Tax Policy: An Economic Perspective,” Intertax, Vol. 32, pp. 352–64.

### Jurisdictional legislation, directives, and reports
- Australia, 1999, A New Tax System (Goods and Services Tax) Act 1999 (Canberra).
- Council of the EU, 1977) Sixth Directive on the Harmonization of the Laws of the Member States Relating to Turnover Taxes—Common System of Value-Added Tax: Uniform Basis of Assessment, 77/388/EEC (Brussels).
- European Commission, 2000, The TCA System—A Detailed Description (Brussels).
- New Zealand, 2002, GST and Financial Services (Wellington).

*Source: _wp04119 - References.*

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