Part III: Applying Goods and Services Tax to financial sector is challenging

IMF has recommended a Financial Activities Tax to be levied on the sum of profits and remuneration of financial institutions

The third part of a 6-part series on GST

One of the most significant features of GST would be the taxation of financial services. No country in the world has been able to design a model for inclusion of financial services within the VAT/GST framework. India, if successful, will chart a new course, which could well become a model for the rest of the world to emulate.

Historically, activities of the financial intermediaries have been exempted from VAT, the prime reason being the non-explicit nature of the charge for the services provided by the intermediaries and the consequent difficulty in determining the tax base. For example, the consideration by a bank for intermediation between borrowers and depositors is the interest margin or the spread between interests received on the loans and paid on the deposits. This margin, while known in aggregate, cannot be readily computed for individual loans and deposits.

While the exemption avoids the need to measure the tax base for financial transactions, it gives rise to distortions in the financial markets. For instance, the denial of credit to the exempt financial institutions for the VAT charged on their inputs creates disincentives for them to outsource their business process operations. Where they render services to business clients, the blockage of input tax credits results in tax cascading, adversely affecting their competitive position in the international markets.

Given the rapid expansion of the financial services sector and the progressive nature of the tax on financial services, particularly in the case of developing countries, the modern approach favours taxation of financial services, with exemption limited to instances where there is no practical method of applying the tax.

India applies service tax on almost all financial services, with the exception of gains from trading in securities and interest margins. The GST task force of the Thirteenth Finance Commission has recommended that GST be extended to all financial services using the so-called “cash flow method” or other variants.

It is interesting to note that the International Monetary Fund (IMF), in its interim report for the G-20 nations on a fair and substantial contribution by the financial sector, has recommended a Financial Activities Tax (FAT) to be levied on the sum of profits and remuneration of financial institutions. Given that the FAT base is similar to that of GST, countries like India may well choose to respond to the IMF proposal by applying GST to financial services, rather than enacting FAT as a separate levy.

Certain technical issues would need to be addressed in extending the base of the service tax to all financial services under GST. For example, consideration could be given to bringing interest margin within the tax net on an aggregate basis, as opposed to each transaction separately. To avoid tax cascading from taxation of business transactions, the aggregate margin could be bifurcated into B2B and B2C components, and the tax applied to the B2C margin only.

In the case of insurance, currently the service tax is applicable to gross premiums, excluding the savings element. However, the proper base for GST would be the net underwriting income of the insurer, i.e., premiums as reduced by claims, as is the case in New Zealand, Australia and Singapore. These models could be readily adapted for the Indian GST.

The author is partner, Ernst & Young. Views expressed are personal.