The European Commission (EC) has published a landmark study concluding that the EU’s VAT framework for financial services is no longer fit for purpose.
Changes in technology and success of other countries drives change
Perhaps the study’s most striking conclusion is that the original technical rationale for exempting financial services from VAT “no longer remains fully valid.” Advances in technology, digitalisation and international experience mean that at least part of the sector could now be taxed under the normal VAT system.
Many other countries have now successfully introduced VAT on their financial services, including China, Brazil and Australia. This UK financial services VAT review is underway, too.The EU Parliament financial services VAT reforms are also reviewing the same modernisation.
EU uncompetitive VAT banking and insurance regime, penalising outsourcing
The EC study argues that the current EU VAT framework is increasingly inconsistent with the EU’s wider objectives of building a Savings and Investment Union by making cross-border financial services more costly and complex.
The Commission argues this effectively penalises outsourcing, shared service centres and fintech partnerships, encouraging institutions to perform functions internally for tax reasons rather than commercial efficiency.
1. Modernise today’s VAT exemption
The least disruptive option would retain the exemption but update rules that have become increasingly uncertain.
The Commission recommends modernising VAT definitions for areas where Member States currently diverge, including payment services, insurance intermediation, custody services, derivatives, fund management and crypto-asset services. It also proposes simplifying the complex partial exemption calculations that financial institutions use to recover input VAT, potentially through harmonised or fixed deduction methods.
These measures would improve legal certainty and reduce compliance costs without fundamentally changing the VAT treatment of financial services.
2. Reduce hidden VAT on irrevocability
A second package would leave the exemption in place but reduce the amount of irrecoverable VAT borne by financial institutions.
The Commission examines extending VAT grouping, reintroducing broader cost-sharing arrangements and requiring every Member State to offer an option to tax financial services. Where business customers can recover VAT, charging VAT would largely eliminate today’s hidden VAT costs without increasing the overall tax burden for businesses.
The study estimates that approximately €54 billion of VAT incurred annually by the financial sector is hidden input VAT. This distorts commercial decisions by encouraging banks and insurers to perform activities in-house instead of outsourcing to specialist providers such as fintech businesses, payment processors and cloud service providers.
3. Partial or complete removal of the exemption
The most ambitious reforms would fundamentally change how financial services are taxed.
The study concludes that applying VAT to fee-based financial services is now technically feasible and would remove many of today’s economic distortions and legal uncertainties. Products priced through explicit fees can readily be taxed, whilst services remunerated through interest margins, such as lending and deposits, could remain exempt because they continue to present practical valuation challenges.
The report also evaluates replacing the exemption with a Financial Activities Tax (FAT). However, it concludes this would not fully restore VAT neutrality because FAT is not a transaction-based tax and would leave distortions within business-to-business supply chains.
Why hasn’t reform happened before?
The shortcomings of the current VAT exemption have been recognised for decades, yet reform has consistently stalled.
The principal obstacle has always been the difficulty of taxing interest-based financial products, where there is often no explicit taxable consideration. Reform also creates winners and losers. Financial institutions would welcome greater recovery of input VAT, but governments must balance this against changes to VAT revenues, the interaction with existing insurance premium taxes and financial transaction taxes, and the possible impact on the cost of financial services for consumers.
Perhaps the greatest hurdle is political. Any amendment to the EU VAT Directive requires unanimous agreement from all 27 Member States, making fundamental VAT reform exceptionally difficult to achieve.
The publication follows a recent call by the European Parliament’s Economic and Monetary Affairs Committee for reform of the VAT exemption, suggesting the debate over the future taxation of financial services is now gathering momentum.
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