Since 1 January 2021, financial services (FS) and insurance firms can benefit from VAT savings when providing certain financial or insurance services to EU clients.
Traditionally, FS businesses have only been able to recover input VAT on costs used for providing specified supplies of certain financial or insurance services provided to non-EU customers.
However, from 1 January 2021, the VAT recovery also extends to businesses providing:
- Certain financial or insurance services to the EU (including most intermediary services); and
- Financial or insurance services directly linked to export of goods to the EU.
The definition of taxable supplies within existing partial exemption special methods (PESM) will automatically cover the extension in specified supplies. However, businesses should still monitor and review whether their current methods remain appropriate.
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Whilst welcome news, as always the underlying detail behind these new rules is far from simple - the definition of ‘certain’ services is key (as some are excluded), and businesses will need to review the treatment of costs relating to the transitional period.
HMRC initially took the position that if costs were incurred pre 1 January 2021, businesses could not reallocate and recover VAT on costs relating to the extended definition of specified supplies. However, there has now been a shift in HMRC’s policy which increases the scope to reallocate and recover VAT previously denied.
HMRC has now confirmed that where costs were incurred before 1 January 2021 (Pre Brexit costs) in relation to such services made to EU customers on or after 1 January 2021 (Post Brexit supplies), then where a business’s partial exemption year ends after 11pm 31 December 2020, such input tax could also be recoverable.
This means as part of a business’ annual adjustment, depending on circumstances, it may be able to recover some or all of the VAT on these costs. There is no change to the rules for domestic supplies, as such input tax would continue to be irrecoverable to the extent it is used for providing financial and insurance related services to UK businesses.
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What this means
These rules have been welcomed, as businesses that continue to provide certain financial or insurance related services to EU counterparties are now able to unlock VAT recovery that was traditionally an absolute cost. Of course, following regulatory uncertainty on the passporting rules, many business will have restructured business operations and ceased to provide services to EU customers. However, even where this is the case, the level of supplies made by the UK business which previously inhibited VAT recovery will be removed, which in most cases should result in an increase on VAT recovery on overheads.
Regardless of any Brexit restructuring, businesses should now review carefully the VAT treatment of related historic and ongoing costs following these rules changes. There may well be occasions where businesses have made financial or insurance related supplies to EU customers before 1 January 2021 but are incurring costs in relation to these supplies on or after this date. In this instance careful consideration will be needed in order to classify the correct VAT treatment.
Of course, any significant increase in VAT recovery may well trigger a routine VAT inspection. Therefore, it is more important than ever that businesses are happy that their ‘house is in order’ before the VAT man comes calling.
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Partial Exemption Review
Although the definition of taxable supplies within existing PESMs will automatically cover the extension in specified supplies to add supplies to the EU, it would be prudent and timely for many businesses to review their current partial exemption methods to determine both the likely impact of the change and also whether the existing method remains appropriate or should be updated.
Businesses will need to check their year-end as the VAT recovery for Pre Brexit costs incurred for Post Brexit supplies is dependent on their VAT year ending after 11pm on 31 December 2020. As such, if a business’ year-ends before this time and/or over the last 4 years the business has incurred Pre Brexit costs which were intended for use for Post Brexit supplies, according to HMRC, such VAT is not recoverable. Such businesses may be out of pocket and should seek advice.
Further, there is an added sting in the tail for businesses on PESMs which use a provisional recovery rate based on prior year’s figures, and adjusted at annual adjustment – these businesses may have to wait until the following year’s annual adjustment to unlock the VAT savings (e.g. businesses on a 31 March 2022 year end would use YE 31 March 2021’s recovery rate as provisional, and would need to wait to make an annual adjustment for YE 31 March 2022 to recover any additional VAT resulting from the change in rules). Such businesses may wish to consider whether to write to HMRC to change their PESM to unlock any savings in advance of the annual adjustment.
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Alongside these Brexit-driven changes, it is worth noting that HM Treasury has recently conducted a call for evidence on the VAT grouping rules in the UK. Further changes (for example on the question of establishment only or full entity VAT grouping following the Skandia case) are likely in the medium term.
We are also seeing challenges from HMRC on the interpretation of an establishment for VAT purposes, and any business that has a branch in a UK VAT group (particularly those which were set up many years ago) should look to review its position. Test cases on these points will be addressed in the Courts, and further developments are eagerly awaited.
Any further changes arising in respect of the VAT grouping rules and/or the issue of what constitutes an establishment is likely to have a material impact on the FS sector, so businesses should closely monitor for any further updates.
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Businesses should now take the opportunity to review and assess their situation from a VAT perspective, including:
- Has the business traditionally been recovering VAT in line with the old rules?
- Can the business identify what supplies will benefit from VAT recovery under the new rules?
- Does the business incur any direct costs which could benefit from full VAT recovery?
- What impact will the new rules have on the VAT recovery for overheads? Does the current partial exemption method produce a fair and reasonable result – or is there an opportunity to consider alternative methods which may produce a more fair and reasonable recovery? How will you implement the rules for supplies that straddle 1 January 2021 in your quarterly VAT return workings and your annual adjustment?
- Does the business have appropriate processes and controls in place to implement the new rules? Are these processes/controls in line with the digital linking requirements of Making Tax Digital which take effect from April 2021
- How will be the business be affected if HMRC introduces further changes to VAT Grouping and rules on establishment?
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For help and advice on this or any other VAT issue, please get in touch with your usual BDO contact or Stephen Kehoe, Aditi Hyett, Vicki Weston or Syeed Reza.