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Article

Irish Tax Review January 2008

VAT RATE SIMPLIFICATION :
IS THE END OF LOW RATES UPON US?


Once upon a time there was the Treaty of Rome. Its goal was the removal of economic barriers between the member countries and the attainment of a single common market. Ideally the single market is supposed to function as if the various national markets were regions of a large European market. It follows that there should be no obstacles to trade in goods and services across the borders of the Member States. This is the relatively straightforward rationale for harmonisation of taxes, including indirect taxes. 

Since 1967, as part of this process, the Council of Ministers has issued a series of Directives in relation to VAT, the first two of which resulted in the implementation of VAT by all Member States. The EU receives a portion of all VAT collected by Member States and further harmonisation was required to provide the EU with a basis for its own income. This took the form of the original Sixth Directive on the Harmonisation of the Laws of the Member States relating to Turnover Taxes – Common System of Value Added Tax: Uniform Basis of Assessment, 1977. It became generally known as the Sixth Directive. A recast Sixth Directive took effect on 1 January 2007.

The Sixth Directive did not require harmonisation of VAT rates and did not eliminate fiscal borders. In order to achieve this, the Council of Ministers agreed in 1991 that a transitional system of VAT would exist until 1997, when it would be replaced with a definitive VAT system. 

However the target date has come and gone and Member States are still clinging tightly to the transitional regime. Attempts by the Commission to encourage them towards a definitive system have not worked so far. Hence the transitional regime has become anything but transitional. 

In 2006, the Commission engaged a firm of consultants, Copenhagen Economics, to produce a study on the impact of reduced VAT rates in terms of job creation, economic growth and the proper functioning of the internal market. The study was completed on 21 June 2007 and concluded that there is a strong argument for having uniform VAT rates in the European Union. According to the report, a uniform rate would maintain a high degree of economic efficiency, minimise otherwise substantial compliance costs and promote the smooth functioning of the internal market. However the report also considered that there is a valid argument in favour of selective cuts in VAT rates, primarily in locally supplied services and parts of the hospitality sector. It concluded that each case should be considered on its own merits and alternative non-VAT instruments should also be seriously appraised as preferable to reduced VAT rates. The devil, it said, was in the detail. Indeed. 

In July 2007, the Commission launched a political debate on rate simplification, in particular with regard to the reduced VAT rates, with the aim of designing new common rules to apply after 2010. 

Against this backdrop, and based on the – admittedly optimistic – expectation that significant changes can be expected in EU VAT rates after 2010, now may be an appropriate time to examine from an Irish perspective the reduced VAT rates and VAT exemptions provided for in the Sixth Directive. 

Where do Rates Come From?

The recast Sixth Directive provides in Articles 93 to 130 and Annex III and IV a legal framework for the application of VAT rates in Member States. 

The Commission claims that the basic rules are simple: 

Standard rates

Article 96 of the Sixth Directive says that “Member States shall apply a standard rate of VAT, which shall be fixed by each Member State as a percentage of the taxable amount and which shall be the same for the supply of goods and for the supply of services”. 

Article 97 states that “from 1 January 2006 to 31 December 2010, the standard rate may not be less than 15%”. There is also political agreement that the standard rate will not exceed 25% and it does not in any Member State. 

Ireland’s standard rate is 21%. This applies to all goods and services other than those liable at any other rate or exempted under the First Schedule. Clearly we are a long way from offending the 15% standard-rate floor provided for in Article 96, even though this too is up for consideration as we approach its 2010 expiry date. 

Reduced rates

Annex III or not Annex III?

Article 98 allows Member States to apply either one or two rates reduced rates to the goods and services set out in Annex III. Clearly they are not obliged to do so. 

Under Article 99, the reduced rate applicable to Annex III activities may not be less than 5%. 

The combination of Articles 98, 99 and Annex III allow Ireland to apply the 13.5% rate of VAT to for example the provision of hotel accommodation. Because of the 5% “floor” however, these legislative provisions do not allow for our 0% or 4.8% rates though such provisions are found in other parts of the Directive. 

Under Article 110 for example, Member States which at 1 January 1991 applied the reduced of VAT lower than the minimum laid down in Article 99 (i.e. lower than 5%) could continue to do so provided that the reduced rates were in accordance with Community law and were adopted for clearly defined social reasons and for the benefit of the final consumer. This type of reduced rate is often referred to as a “super-reduced” rate. Article 110 thus provides a basis for applying the 0% VAT rate to the items listed in Annex III (1), i.e. “foodstuffs (including beverages but excluding alcoholic beverages) for human and animal consumption; live animals, seeds, plants and ingredients normally intended for use in the preparation of foodstuffs; products normally used to supplement foodstuffs or as substitute for foodstuffs”. 

One might wonder about the basis in the Directive for the 4.8% VAT rate which under Section 11(1)(f) of the VAT Act we apply in Ireland to supplies of live horses and greyhounds and to the hire of horses. In fact the Commission commenced infringement proceedings on 18 October 2007 against Ireland and a number of other EU Member States in relation to the application of the super-reduced rate in such cases

Ireland’s 4.8% VAT rate is not to be confused with our flat-rate compensation percentage (the “flat-rate addition”) for unregistered farmers. This is provided for in Section 12A of the VAT Act and derived from Articles 295 to 305 of the Sixth Directive. Our “flat-rate addition” increased from 4.8% to 5.2% under Section 84 of the 2007 Finance Act, with effect from 1 January 2007. The 4.8% applicable to supplies of livestock, live greyhounds and the hire of horses remains unchanged at 4.8%. 

Annex III also lists, among the items mentioned above, the following groups: 

• Water.
• Pharmaceutical products.
• Book/newspapers. 
• Certain cultural and entertainment activities such as admission to the cinema, circuses etc. 
• Certain social housing and street cleaning. 
• Hotel accommodation.
• Transport of passengers and their accompanying baggage. 
• Undertaking and cremation services. 

Anyone wondering about the last two bullet points and VAT exemption (as opposed to zero rating) should find answers in the section on “Exemptions” further on in the article.

As a final point in relation to Annex III, Article 118 states that Member States which at 1 January 1991 were applying a reduced rate to the supply of goods or services which are not specified in Annex III may continue to apply a reduced rate provided that it is not less than 12%. These reduced rates are often referred to as “parking rates” because the rate is effectively “parked“ “until the adoption of definitive arrangements”. In Ireland, our parking rate is 13.5% and it applies to supplies of energy for heating and light (the ESB bill), movable property, the supply of movable property, services relating to the care of the human body etc. 

It is apparent from this much that the supplies to which Ireland subjects the 13.5% VAT rate rely on different Sixth Directive provisions. As a distinction, only those rates derived from Article 118 are regarded as being subject to a “parking” rate. This distinction may or may not become significant if there is to be an involved debate in relation to the removal of non-standard VAT rates. 

Annex IV

Article 106 allows Member States to apply the reduced VAT rate provided for in Article 98 to certain 
labour-intensive services by way of Council Decision 200/185/EC. Under Article 99, the reduced VAT rate could not 
be less than 5%. 

Appendix IV of the Directive specifies the sectors involved as:

• Small services of repair (bicycles, shoes and leather goods, clothing and household linen)
• Renovation and repairing of private dwellings (excluding materials)
• Window cleaning and cleaning in private households
• Domestic care services (home help, care of the young, elderly, sick or disabled)
• Hairdressing.

This provision was introduced in 1999 on an experimental basis. It was extended in 2006 to the end of 2010. Although Ireland applies the 13.5% rate to such services (which are listed in the Sixth Schedule of the VAT Act), it is not considered that we are participating in the Annex IV “experiment” on the grounds that we had already been applying a reduced VAT rate in these areas for many years. They are not specifically listed in Annex III and the reduced rate used in this country is greater than 5%, so strictly speaking it would appear that Ireland’s use of the 13.5% in such sectors is based on Article 118 of the Directive. 

Derogations

Derogations in this context are authorisations given to Member States to use special measures derogating from the provisions of the Directive. In my view, many of the concessions “built in” to the Articles referred to above should be regarded as derogations to the extent that they are specifically intended to be temporary measures. Despite the amount of “wriggle room” it seems there was not enough latitude to accommodate all Member States and all circumstances. 

Section 395 allows Member States to introduce new derogating national provisions after the Directive came into force in their jurisdiction, subject to certain conditions. 

Article 394 on the other hand allowed Member States to retain certain special measures which they were applying at 1 January 1977 to simplify the procedure for collection of VAT or to prevent certain forms of tax evasion or avoidance. Presumably this was only going to be necessary in cases where the existing national provisions were not already covered in Articles 110, 118 etc as already outlined. 

While derogations can of course apply in areas other than VAT rates, most of Ireland’s derogations currently in force are in fact concerned directly or indirectly with VAT rates. We rely on Article 394 derogations in the following areas:

• Sea fishermen would normally be taxable persons under Article 9 of the Directive. The flat-rate addition 
schemes provided for in Articles 295 to 305 of the Directive apply to fishermen but not sea fishermen. Ordinarily therefore sea fishermen would be obliged to register and account for VAT if the sales of fish exceeded the goods registration threshold, which is currently €70,000. However, under the derogation, sea fishermen are allowed to remain unregistered in respect of their sales of “dead fish” to VAT-registered persons in Ireland and overseas. 

• Ireland includes the provision of food products via a vending machine or in a catering establishment in 
Section 5 of the VAT Act i.e. we regard food supplied by this means as the supply of a service and not the provision of goods. Ireland applies 0% VAT to most basic food stuffs as goods and it was necessary to make the “services” distinction to protect the government’s VAT “take” from the vending machine/catering sector. This is one instance where a derogation effectively applies a higher VAT rate. The position is complicated in that the Directive itself does not require Ireland to apply 0% VAT to basic foodstuffs. Rather Ireland is permitted to apply the 0% rate under Section 110 of the Directive, as outlined above. 

• Under Article 14 of the Directive, a supply of goods is defined as “the transfer of the right to dispose of 
tangible property as owner”. The renting of property would constitute a supply of services since there is no transfer of the right to dispose of the property as owner. Ireland’s derogation from Article 14 means that the granting of a lease for a term of 10 years or more is treated as a supply of goods. This has various implications, most particularly that no VAT is payable in relation to the rent because the VAT is chargeable upfront on the capitalised value of the lease. In any event, changes in this area as a result of the ending of derogations will be superseded in this country by the proposed new VAT and property legislation which we expect to be contained in the 2008 Finance Act. 

• Section 11(4A) of the VAT Act relates to the preparation of zero-rated food and drink for sale when the food and drink is provided by the customer, i.e. the person to whom the catering service will ultimately be supplied. This would apply for example in relation to a wedding reception where the bride and groom supplied the caterers with the zero-rated food and drink, which the caterer was to use for the purpose of catering for the event. Under Section 11(4A), the caterer is required to charge VAT at 13.5% on the entire contract, including the food and drink. 

• Article 302 of the Directive provides that “if a flat-rate farmer is entitled to flat-rate compensation, he 
shall not be entitled to deduction of VAT in respect of activities covered by this flat-rate scheme. Under Value Added Tax (Refund of Tax) (No. 25) Order, 1993 (Statutory Instrument No. 266, 1993), Ireland, by derogation, allows flat-rate farmers to obtain a further form of deduction for VAT on expenditure incurred on the construction, extension etc of any farm building or in relation to land drainage or reclamation.

Exemptions

Article 371 allows Ireland to exempt certain transactions listed in Annex X, Part B of the Directive, including cremations, undertaking and the transport of passengers and their baggage, on the basis that we were exempting them at 1 January 1978. As indicated above, under Article 98 and Annex III, one would have expected that a reduced rate might apply to these transactions. Under Article 110, one might have conceded that this reduced rate could be as low as 0%. However Article 371 allows exemption for such services, at least until the definitive VAT system is adopted. 

Articles 131 to 165 are the main exemption provisions in the Directive. They provide for the exemption from VAT of certain goods and services which are seen to be of special interest for reasons which might be considered to be for general/societal benefit (eg education, medical services, child care, cultural services etc). Other areas such as banking and insurance are also exempted but for other reasons. 

Exempted goods and services supplied by these sectors are in practice not free of VAT because the suppliers pay VAT but are not entitled to VAT refunds. In this respect there is “hidden” VAT and this VAT treatment is less beneficial than for zero-rated products. 

Article 166 provides that “the Commission shall, where appropriate, as soon as possible, present to the Council proposals concerning common arrangements for applying VAT to the transactions” referred to in Articles 131 to 165. 

From this phrase we should perhaps understand that the “normal” exemptions which we have come to know, if not love, must also be regarded as transitional. For example the exemption generally applicable up to now in relation to financial services and insurance has recently been considered by the EU Commission with a view to “modernising and simplifying the complex VAT rules for financial and insurance services and securing a level playing field in the pan-EU market for thee services as far as VAT is concerned”. On 28 November 2007, the Commission adopted a proposal for a Council Directive in this area. It remains to be seen how this may translate into changes in the VAT regime in these sectors. 

Harmonisation – The Crock of Gold?

The Irish VAT rate is extremely non-uniform by comparison with certain other Member States. Denmark has just one rate. And it’s 25%. 

There appears to be no doubt that multiple rates increase administrative costs. Both Revenue and traders incur difficulties in relation to categorisation of goods and services. Traders selling goods and services in more than one category who wish to be compliant have to bear the costs of categorising their sales and accounting by category. Traders who are less scrupulous about compliance have an incentive to defraud by mis-categorising. Zero-rating of items of domestic consumption greatly increases the number of traders eligible for refunds. 

The most common putative justification for non uniformity is a socio-economic one i.e. that it is required by vertical equity – goods forming a higher percentage of the budgets of the less well off should be more lightly taxed. In general, the progression of rates does seem to apply to goods and services of decreasing levels of necessity, but some of the fine distinctions indicate a certain outmoded view of society and are in some cases bizarre to the point of being comical. 

Take biscuits for example. A plain biscuit is subject to VAT at 13.5%, but the rate applicable to chocolate biscuits is 21%. At some distant point in Ireland’s past, it seems that some hair-shirted policy boffin felt that the plain people of Ireland would require a certain quantity of plain biscuits (possibly for nourishment – in the case of a return of famine - and to keep them quiet) whereas they should not in decency aspire to .. chocolate biscuits.

Condoms are also – somewhat controversially - standard rated and it is apparently too late to change this using a new derogation because according to Article 395 of the Directive “measures intended to simplify the procedure for collecting VAT may not, except to a negligible extent, affect the overall amount of the tax revenue of the Member State collected at the stage of final consumption”. 

And finally, what sinister approach to “vertical equity” has a burger and chips subject to VAT at 13.5%, while a (relatively) healthy smoothie will cost the consumer VAT at 21%? And this in the face of alleged concern about national obesity levels? 

Maybe we could consider addressing some of these VAT rate anomalies in the context of the proposed political debate on rate simplification. 

Changes arising from rate harmonisation would not of themselves necessarily mean that the standard rate would apply across the board. What it could mean is that a broader swathe of goods and services would be subject to the standard rate. Logically, the consumer could see certain prices increase accordingly as the new uniform rate applied. However this should result in an increased VAT take overall, which should allow for a reduction in the standard rate, giving a consumer price reduction in other areas- such as passenger cars. Many factors would have to be taken into account and a detailed examination would more properly be the stuff of an economics article. 

It is not evident that that an Irish government would find it easy to tackle such sweeping VAT reforms. The mere mention of “VAT on children’s shoes” would be likely to strike dread into the hearts of any politicians who might contemplate such things. Widescale adjustment of the existing VAT rate structure would have to be handled very skillfully to avoid inflation, social unrest and in some cases, genuine hardship.Certainly there would be a need for some sort of compensatory measures for those on low incomes. Indeed the Copenhagen Economics Report recommends that alternative non-VAT instruments should be seriously appraised to replace low VAT rates in certain areas. The Copenhagen Economics report also acknowledged that the value of private consumption would be most affected in countries where the existing VAT rates vary considerably – such as Ireland – whereas in countries where already have an almost uniform rate structure – like Denmark – a change in the rates would have little effect.

Conclusion 

The rates provisions of the Directive give rise to more variations than one might initially imagine. And national authorities have made fulsome use of leeway which has been available up to now in relation to low VAT rates. The result is a labyrinth of disparity and considerably more than a trail of breadcrumbs may be needed to find our way back to the original goals of the Treaty of Rome. 

If the Commission can muster up the political will for genuine debate around rate simplification and uniformity, we could be living in interesting times between now and 2010. If. 

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Reference Material: 

Study on reduced VAT applied to goods and services in the Member States of the European Union – Final Report – 21 
June 2007 – Copenhagen Economics – 6503 DG TAXUD

VAT Rates applied in the Member States of the European Community – Situation at 1st May 2007 – DOC/2137/2007 – EN.

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