Suppliers of financial services to non-EU customers may face limitation on VAT recovery

HMRC have issued draft changes to the Specified Supplies Order, which enables suppliers of VAT exempt financial services to recover VAT to the extent that their customers belong outside the EU. In its present form, the Specified Supplies Order provides a significant benefit to many banks and other financial institutions.

HMRC's proposal is that suppliers of financial intermediation will only have the right to VAT recovery where both the intermediary's customer and the recipient of the underlying financial service are non-EU. For these purposes, "financial service" effectively includes the issue and secondary sale of most types of financial instrument, including shares and bonds.  

This measure is intended to counteract "offshore loop" arrangements which are used most widely by providers of retail financial services (and, in particular, insurance services) to the UK market. However, the changes are broadly drafted and, in their present form, would impact on a range of business as usual activities conducted by a range of financial institutions. For example:

1. A bank or corporate financier providing intermediary services to a non-EU company, in relation to an IPO, would not be entitled to recover VAT if shares in the company are purchased by EU buyers.
2. A bank or corporate financier providing intermediary services to a non-EU bond issuer would not be entitled to input VAT recovery if the bond purchasers were in the EU. 
3. A bank or corporate financier providing intermediary services to a non-EU parent company in relation to the disposal of a subsidiary, would not gain the right to input VAT recovery if the subsidiary was sold to an EU buyer.
4. A bank providing intermediary services to a non-EU lender would not be entitled to VAT recovery if the borrower was located in the EU.  
5. Providers of fund distribution services to a non-EU investment manager would not be entitled to VAT recovery if investors into the fund were located in the EU. 

Aside from the significant financial implications, the measure proposed by HMRC would require the intermediary to identify the location of the end buyer of the financial instrument and this could be extremely difficult where a chain of intermediaries are involved. It is also unclear whether HMRC would accept an apportionment of the intermediary's input VAT where the underlying financial instruments are issued or transferred to both EU and non-EU recipients. 

The draft legislation is the subject of an ongoing consultation between HMRC and industry representatives and it is hoped that some of the apparently unintended consequences will be dealt with through refinement of the draft provisions. Financial institutions that would be affected by the change should follow, and consider becoming involved in, the consultation and should assess its impact in terms of the cost of irrecoverable VAT as well as compliance obligations.