Introduction

The world of banking can cover a broad spectrum of areas that can typically operate under a banking institutions umbrella. Traditionally banking was represented by retail and commercial banking where the main businesses was to provide a sanctuary for individual and commercial savings and at the same time provide loans and finance to individuals and businesses.

However nowadays, many banks also offer Investment Banking and Private Banking services. Listed below are a number of services provided by the different areas of banking. (The list is not exhaustive)

Investment Banking

Investment Banking services are mainly provided to Large Public and Private Companies, Pension Funds, Governments, other Banks and Private Equity etc.

Services Provided:

Mergers and Acquisition Advisory - Advising on strategic transactions such as Acquisitions, Mergers, Joint Ventures, Leveraged Buyouts, Business Restructures
Trading Platforms - That Facilitate the trading of Bonds (debt), Equities, Swaps, Options, Futures,
Debt Financing - Bond issuance, Securitisation (Asset & Mortgage Backed securities), Loans, Liability Management
Equities (stock)Lending - Acting as intermediary for a company that lends shares for a fee and a company that pays a fee to borrow the shares possibly for shorting.
Initial Public Share Offerings - Advising and raising finance for the issue of shares to the general public
Debt Underwriting - Arranging and underwriting the issuance of debt
Share Underwriting - Underwriting shares during Initial public offerings (basically a guarantee to buy a portion of unsold shares)
Risk Management - Providing clients with management solutions to better manage interest rate and foreign exchange risks and exposures
Research - Carrying out general market, micro and macro economic research or specific sector research for clients for a fee
Commodities Trading - Trading in physical commodities such as Oil, GAS, Electricity, Metals and Precious Metals such as Iron, Nickel, Gold, Silver, Palladium
Private Equity - The pooling of funds to use to make acquisitions for investment purposes
Market Data - The provision of real-time electronic data to companies, markets etc, to enable and assist decision making

Wealth Management and Private Banking

Wealth Management and Private Banking is mainly provided to private Individuals and smaller companies. Services Will include:

Portfolio Management - Discretionary and Non Discretionary management of client assets
Private Banking - A package of banking services for affluent individuals with levels of bespoke services for different grades of affluence. E.g. £100K to 500K, £1M to £10M, £10M to £50M etc.
International Banking - A package of banking services offered to Expats etc
Fund Management - The Management of pooled funds in Unit Trusts, OIEC's or through a fund supermarket owned by the bank or externally
Model Portfolios - Bespoke portfolios that are designed specifically to achieve the investment goals of a group of clients
Financial Advisory and Planning - Retirement Planning, Estate Planning, Executor and Estate Administration, Trustee Services, Pensions, Tax Advisory
Financing - Trade, Real Estate, Boats. Yachts, Private Jets
Execution Only - Retail share investing
Credit Cards - Providing credit card services to clients

Corporate Banking

Corporate Banking is mainly provided to larger commercial enterprises where turnover exceeds between £5M - £10M. Some of these services are listed below.

Business Banking - Providing business bank accounts to corporate clients
International and Trade Finance - Providing international import and export financing, letters of credit
Asset Financing - Providing financing solutions for acquiring cars, boats, planes, property
Debt Factoring and Invoice Discounting - Proving working capital solutions by taking over a client's debtors for a fee to provide clients with smother cash flow.
Inventory Finance - Providing finance to intermediary distributors of trucks, Tractors, Construction Equipment, Cars
Cash Management - Finding the best return on client cash balances by moving the funds around to get the best rates
Foreign Exchange - FX Trading
Corporate Credit Cards - Providing corporate credit cards to firms
Business Development loans - Loans to help businesses grow

Retail Banking

Retail Banking is mainly provided to individuals (general public) and small and medium sized businesses. Services include:

Traditional Banking - The provision of bank accounts (current and savings)
Cheque Clearing - The clearing and processing of cheques with other banks
Mortgages - The provision of residential mortgages
Personal Loans - Loans to consumers to buy cars, domestic appliances,
Business Loans - Loans to businesses to fund growth and acquisitions
Debit and Credit Cards - Provision of personal Debit and Credit Cards
Insurances - Travel insurance, Residential Insurance

Banking Income

Most of the income generated by banks will either be:

Fees Received
Interest Received
Commission Received

VAT Liability of Services Supplied by Banks

The VAT liability of banking income will depend on:

Type of Service being provided to clients and customers
The Place of Supply of those Services
The Type of Client (business or non business) services are being provided to
The Specific VAT rules governing the services being supplied
Whether the Service is to a Branch, a VAT Group member or not

The VAT liability will either be:

Standard Rated (20%)
Zero Rated
Exempt
Outside the Scope

Type of Service Being Provided

Financial Services are largely Exempt from VAT under the Financial Services VAT Exemption (VAT Act, Schedule 9, Group 5, 1-9). As such, many services offered by Banks will be Exempt when supplied in the UK.

Services that are not covered under the Finance Exemption will be taxable at the Standard Rate (20%) when supplied in the UK by banks and other financial institutions .

The Place of Supply of Services and the Type of Client

The place of supply of services as mentioned under the place of supply tab, is determined largely by whether the supply is to a customer or client in business or whether the supply is to a non business customer.

Business Customer

Supplies to customers in business (VAT Registration is normally sufficient evidence)
Supplies to customers that have both business and non-business activities such as charities, local authorities and government departments

Non Business Customer

A customer who is not in business
Private individual
Charity, Government Department or other body which has no business activities

Services Supplied to Customers in Business

Supplies to clients in business will be covered under the B2B (Business to Business) General Rule and thus the place of supply will be where the customer or client belongs. (Clients Country of Operation).

Services Supplied to Non Business Customers

Normally supplies to Non business customers under the place of supply rules will be covered under the B2C (Business to Customer) General Rule and thus the place of supply will be where the supplier belongs. However there are special rules in place for particular B2C services (including Financial Services) that treat the place of supply of those services that would normally be taxable in the UK as being supplied where the customer or client belongs.

List of Services Supplied by Banks and their VAT Liability

As mentioned above, banks provide a broad spectrum of services and below is a list of B2B and B2C services both within and covered by the Financial Services VAT Exemption and those that are not covered.

Note: The services listed below that are Exempt when provided to clients in the UK are within the scope of the Finance Exemption and the services that are Standard Rated are not.

Below we have listed the main types of services offered by banks and the VAT liability for each service which depends largely on the type of client B2B or B2C and the service being offered.

Retail "Day to Day Banking

The Traditional service offered by banks to the retail sector (general public) of accepting cash deposits and providing advances and loans, cheque processing and clearing to customers where interest in earned by the banks as income is:

Exempt when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Insurance Services

Many banks will offer insurance products such as home insurance, contents insurance, motor breakdown insurance to its customers. These services will be:

Exempt when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Corporate Finance (Mergers and Acquisitions)

This service is mainly offered by Investment Banks and will involve providing Advisory Services in relation to potential acquisitions or mergers between companies.

These services are:

Standard Rated when provided to B2B and B2C customers in the UK
Outside the scope of VAT (with recovery) when provided to B2B and B2C non UK Customers

Corporate Loans (Including Mortgages)

Corporate Loans can be offered by retail banks to smaller businesses or by banks providing corporate banking services to larger businesses that turnover millions of pounds a year.

The granting and advancing of credit falls within the Financial Services Exemption and is:

Exempt when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Execution Only Share Transactions

Many banks will offer online trading platforms that facilitate execution only trading in securities such as equities whereby members of the public or companies can buy and sell shares.

Execution only trading means the bank will act on the clients instruction to either buy or sell shares (with no advisory or recommendations involved) and the VAT liability is as follows:

Exempt when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Arranging the Issue or Placement of Securities

Banks (Investment) involved in the arrangement or placement of shares, rights issues, coordination of an issue of shares where there are a number of participants, this service will be:

Exempt when supplied to a B2B customer in the UK
Outside the Scope of VAT (with recovery) when provided to a B2B customer

Safe Custody

Some banks offer safe custody services whereby clients can store documents such as share certificates, Gold, Silver, titles etc for a fee.

This Fee is:

Standard Rated (20%) for B2B and B2C when supplied to customers in the UK
Outside the Scope of VAT (with recovery) when provided to a B2B or B2C customer

Global Custody

Global Custody may contain safe custody but will include a package of additional services such as the collection of dividends, interest etc.

Where the service contains additional activities as described above along with safe custody, then the VAT liability will be:

Exempt when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Nominee Services

Nominee Services whereby client shares will be held in the name of the bank on behalf of them.

These services are:

Exempt when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Stock Lending

Stock lending describes a situation where one person, the ‘lender’, transfers to a second person, the ‘borrower’, the legal title, along with all the dividends and rights, to securities. The borrower agrees to return to the lender, at a later date, an equivalent number of the same securities as those received.

Stock lending is :

Exempt when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Share Underwriting

Share underwriting where a bank will receive a commission or fee for guaranteeing to buy unsold shares during an Initial Public Offering (IPO) is :

Exempt when supplied to a B2B customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B customers.

Note: Any shares onward sold by the Bank will also follow the same VAT liability as above.

Tax, Legal, Accountancy

Adhoc services that may be provided by some banks or financial institutions are not covered by the Finance Exemption and are thus:

Standard Rated 20% (taxable) when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Portfolio Management

Portfolio Management services normally offered by the Private Banking or Wealth Management arms of banks for individual clients can be split into discretionary or non discretionary. These services can be offered either internally or via third party Investment Managers.

(Portfolio Management does not fall within the Financial Exemption like the management of funds such as AUT's of OEIC's as the service is not a collective investment where large numbers of clients funds are pooled together and invested)

Discretionary Portfolio Management is where the Manager will make investments on behalf of the client based on their goals and risk appetite
Non Discretionary Portfolio Management is where the client makes their own investment decisions and may take recommendations or advice from the manager but will ultimately decide on the investments the manager should make on their behalf.

Normally the Portfolio Manager (the bank) or the external Portfolio Manager will charge an Annual Management Fee which will be:

Standard Rated 20% (taxable) when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

The Investment manager as part of the contract may apply a transaction charge (commission) for executing trades or buying and selling securities on behalf of the client.

If these charges as part of the contract are a separate supply of dealing charges, then the VAT liability is as follows:

Exempt when supplied to a B2B customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B customers.

If these charges as part of the contract are bundled together as a single fee for Investment Management, then the VAT liability is as follows:

Standard Rated 20% (taxable) when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Model Portfolios

A Model Portfolio Service is a tailor made service designed by an Investment Manager(s) for a group of investors with the same investment aims. Funds are invested in a diverse range of assets and asset classes with the aim of reducing risk for clients. This service has traditionally been treated in the same way as normal portfolio Management by applying VAT on fees charged.

However many portfolio managers are removing VAT from their fees charged to UK clients on the basis of a recent case (Tatton) where HMRC refunded a substantial amount of VAT on fees charged for their model portfolio service on the basis that the funds were pooled similar to collective investments.

Futures Contracts - (Financial)

Financial Futures are standardised derivatives contracts offered by and traded by Investment banks (as Futures Exchange Members) and allow investors to:

Speculate on the price movement of an underlying financial instrument (Stocks, Interest Rates, Currencies, Indexes).
Hedge against the movement of the price of a financial instrument. ( mainly companies that use the future contact as a hedge against to protect their own financial instruments )

Financial Futures can either be cash or non cash settled.

Cash settled means there is no actual delivery of the financial instrument at expiry whereas Non Cash Settled means there is actual delivery of the instrument.

Futures contracts are highly liquid and can be traded on Futures Exchanges prior to the expiration date.

Income generated by banks from Futures contracts (commission earned by banks) is:

Exempt from VAT when sold or traded with counterparties in the UK
Outside the scope with recovery when sold to a non UK counterparty

Financial Forward Contracts

Financial Forwards Contracts (forwards) are similar in nature to Futures Contracts in that they both require the buyer and seller to set the quantity of a financial instrument and the date of delivery or expiry. However the major difference between the two is that whilst the Futures Contract is normally a standardised contract traded on a futures exchange, a Forward is a non standardised private agreement between a buyer and seller OTC.

Note both futures and forward can be traded privately off exchange Over The Counter (OTC).

Income /commissions generated by banks as broker to investors in Forward Contracts is:

Exempt from VAT when sold or traded with counterparties in the UK
Outside the scope with recovery when sold to a non UK purchaser

Financial Options

Options are Financial derivatives that are based on the value of underlying securities such as stocks, bonds, currencies and give the buyer the right to buy (call option) or sell (put option) the underlying asset on a specific date and and specific price. Unlike futures or forwards there is no obligation to actually buy the underlying asset. As such a premium is paid for the right to buy the options.

Most options are equity options and are traded on exchanges and if exercised, settled via centralised clearing houses.

Income generated by banks trading or facilitating the trading of options is:

Exempt from VAT when sold or traded with counterparties in the UK
Outside the scope with recovery when sold to a non UK counterparty

Foreign Exchange Trading (FX) (Spots)

Banks often act as brokers offering FX currency trading (Spots) to clients and charge commission.

The Income generated will be:

Exempt from VAT when sold or traded with counterparties in the UK
Outside the scope with recovery when sold to a non UK counterparty

Research

Banks (investment) often have research departments that compile and sell investment research normally to companies to assist with their investment decisions.

This research is:

Standard Rated 20% (taxable) when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Trading Platforms

Many larger banks may offer trading platforms "dealer systems" to their clients which allows them to buy and trade securities or provides live market data such as share prices or foreign exchange rates.

Systems that purely provide market data services to users are taxable as follows:

Standard Rated 20% (taxable) when supplied to a B2B and B2C customer in the UK
Outside the scope of VAT (with recovery) when provided to Non UK B2B or B2C customers.

Systems that allow users to insert bits and offers for securities and Match the parties anonymously and finalise the deal will be be covered under the Intemediary Exemption and Exempt from VAT.

If the system does not match the parties on an undisclosed anonymous basis then the service will be vatable at the standard rate 20%

Hire Purchase

Banks may offer their customers Hire Purchase which allows them to pay installments over a set period for goods such a motor vehicles or washing machines with the option to make a final payment for the goods at the end of the payment term. Where the goods and finance are provided by the bank, then there will be two supplies one of goods and one of credit.

For the supply of goods, the customer will be charged standard rated VAT at 20% immediately for the supply of the goods and the ongoing supply of credit repayable in installments will be Exempt.

Factoring & Invoice Discounting

Some banks may offer Factoring and or Invoice Discounting to clients.

Factoring is where a factoring company (bank) purchases the outstanding debtor balances from a client for a charge and can either be recourse or non-recourse. Recourse is where the client maintains the responsibility and bears all the risks of debtor non payment. If the debtor goes bankrupt or the bank can't collect the funds from the debtor, then the client will have to buy back the debt from the bank. Non Recourse factoring means that the factoring company bears greater risk if a debtor defaults on its debt. Another feature of factoring is that it means the bank or factor can maintain a credit control facility for the debts and collect the debts directly from the debtors.
Invoice discounting is where the bank provides a loan against the clients outstanding debtor balance for which the client can draw down against. The Debtor will be unaware that the client is using this facility.

There can be many charges levied by the factor (bank) some of which may be Standard Rated 20% and others Exempt. Below is a list of the possible charge types and their VAT liability.

Arrangement and or Activation Fee - Standard Rated 20% VAT if provided to UK Businesses and Zero Rated if provided to Non-UK business
Discount Fee or Charge for Credit - Exempt if provided to UK Businesses and Zero Rated if provided to Non-UK business
Service Charge - Standard Rated 20% VAT if provided to UK Businesses and Zero Rated if provided to Non-UK business
Non Utilisation of Loan Facility Fee - Exempt if provided to UK Businesses and Zero Rated if provided to Non-UK business
Early Termination Fee - Standard Rated 20% VAT if provided to UK Businesses and Zero Rated if provided to Non-UK business
Funds Transfer Charges - Exempt if provided to UK Businesses and Zero Rated if provided to Non-UK business
Legal and other Admin Fees - Standard Rated 20% VAT if provided to UK Businesses and Zero Rated if provided to Non-UK business

Private Equity / Strategic Investments

Banks can also as part of their business use its own funds along with other corporate clients or individuals to invest (or build up stakes) in external businesses with the aim of holding those businesses for investment purposes. I.e. Capital growth. Income generated from those investments can be dividends which are outside the scope of VAT or in the case where the bank is actively managing those investments and charging a fee to the other participant, this will be Standard Rated.

BANK COSTS AND VAT

Banks by their nature are not actively trading in physical goods and as such most of their costs will be professional or resource (staffing) related.

Costs - Plus VAT

For Banks, VAT will typically be incurred on professional service and IT related costs such as

Information Technology
Software and Software Development
Virus and Anti Malware Protection
Hardware such as Computers, Servers, Screens, Keyboards, Mouses
Telecommunications and Equipment
Market Data
Brokerage
Consultancy Services
Legal Services
Electricity
Administration
Furniture and Fittings
Security
Property Rental (opted properties)
Other Asset Purchases for Hire Purchase or Inventory Finance
Office Supplies
Exchange Membership
Licence Fees
Exchange Admin Fees
Exchange Access Fees
Gate way / Terminal Connectivity
Swift Messaging
Advertising
Sponsorship
Research

Costs - No VAT

Banks will have significant Non Vatable Costs due to the large numbers of staff they employ.

Wages and Salaries
Income Tax and National Insurance
Bonuses
Property Rental (non opted)
Pension Contribution
Clearing

Systems and VAT

Banks may have a variety of systems (especially the larger banks) to record Income and cost and the associated output and input VAT respectively. Most of the time the number of different systems will be dictated by the number of acquisitions the banks have made over the years where they inherit different systems from each acquisition.

However many will have core well established market leading systems (Accounts Payable and Accounts Receivable) such as SAP to record and account for VAT on the bulk of their sales and purchases and which can easily be integrated into into Tax Engines to churn out VAT Returns.

From a VAT perspective, the most important and critical aspect for systems in today's digitalized world is their ability to apply the correct VAT code to specific transactions and their flexibility for full end to end automation of the VAT Accounting, Reporting and Recovery process.

Sales and VAT Reporting

Services provided by Banks to their customers (both internal and external) will need to be treated and categorised correctly for VAT to ensure:

The correct amount of Output VAT is included on their VAT Returns and paid to HMRC
The correct amount of VAT is included on sales invoices
Their Partial Exemption VAT Recovery Rates and Actual VAT Recovery is accurate

The best way to ensure the accuracy of above is to:

Have a highly automated billing system with links to the static data system that stores clients name, type and location / country of operation details
Have a digitalised VAT process that auto allocates income to the correct Partial Exemption sectors
Have well trained front office billing staff who understand VAT and the differences created by billing to UK vs Non UK customers
Have robust controls around the review and authorisation of invoices
Have a Team of Tax or VAT specialist to monitor, advise and carry out regular reviews of the VAT billing Process
Have multiple level VAT return reviews and investigate and seek explanations for any quarter on quarter exceptional variances

Costs and VAT Reporting

VAT incurred by banks on costs is often very significant and as such it will be high on management's radar to ensure:

VAT allocation is aligned to cost allocation
VAT recovery from HMRC is optimised
VAT is recovered in accordance with the Partial Exemption Method agreed with HMRC
VAT Recovered is allocated back to the correct business area (Equities, Corporate Finance, Corporate banking, Private Banking etc)

VAT incurred on costs can be split into:

Front Office VAT - VAT that is directly incurred and attributable to specific business areas such as Corporate Banking, Mergers and Acquisitions, Fixed Income Bond Trading, Corporate Loans, Foreign Exchange
Back Office or Infrastructure VAT - General VAT incurred for all business areas such as IT, Consultancy, Electricity, Security, Administration.

Partial Exemption Methods and VAT Allocation

Most banks will be partially exempt in that they provide taxable and exempt services to their clients and as such will have agreed methods with HMRC for allocating and recovering VAT incurred on their costs.

Note: Partially exempt means that not all of the VAT incurred on costs will be recoverable from HMRC, only a portion.

These agreements are known as Partial Exemption Special Methods (PESM) and will be different for each bank. They contain precise details of how VAT will be allocated to the different agreed sectors (Equities, Investment Banking, Retail Banking, Derivatives etc) and also how VAT recovery should be calculated.

So the agreements will stipulate how VAT will be allocated. For example based on the:

Firms internal Cost Allocation Methodology
Business Area Activity
Business Area Front Office Headcount
Others

VAT Recovery

The recovery of VAT in banks will be based on specific formulas as stipulated in the Partial Exemption Special Method. Most will be in the following format:

VAT Pool X Taxable Sales (Standard Rated + Reduced Rate + Zero Rated

/ Total Sales (Taxable + Zero Rated + Exempt) = VAT Recoverable %

Note: The amounts in the above categories can be in the form of sales values, no of transactions, no of sales credits etc and will depend on what is agreed in the PESM

Looking at the above formula, it can be seen that the level of VAT recovery will be dependent on the ratio of taxable sales to total sales.

The more exempt sales a bank has the lower the VAT recovery
The greater the taxable sales a bank has the greater the VAT recovery will be.

VAT Recovery Methods

Due to the complex operational nature of banks and their varied products, most will have agreed Partial Exemption Special Methods (PESM) with HMRC. These agreements prescribe in detail how input VAT will be allocated and the methods to be used in the various areas of the bank to recover VAT.

Standard Method - is simply a values method as shown below but may have special rules depending on the products supplied :

VAT Pool X Value of Taxable Sales / Total Value of Sales = VAT Recoverable %

Partial Exemption Special Methods (PESM) - Can include Values, Transaction Counts, Sales Credits etc as agreed with HMRC for the different business areas or sectors within a bank.

There are a number of typical Partial Exemption Special Methods (agreed method with HMRC for the allocation and recovery of input VAT) in use by Banks namely:

Values Based Method
Transaction Count Method
Sales Credits Method
Mixture of Above

The method used will depend on the complexity of the banking business. A purely Retail or Corporate banking business will be able to use the standard values method which uses revenue values to calculate the VAT recovery rate (RR) to be applied to the pools of input VAT to determine the level of VAT the bank can recover from HMRC.

The Recovery Rate Calculation is:

Values Based Method

(Std Rated + Reduced Rate + Zero Rated)

(Std Rated+ Reduced Rate+ Zero Rate + Exempt ) = RR

Note the method can be used in conjunction with the other methods

Pros

Data usually easy to extract from Accounting System
Easy to review, audit and verify source data
Uncomplicated or time consuming

Cons

Assumes larger Loan book areas use higher input VAT (not always the case so input VAT allocation needs to be accurately based on use)
Not always suitable for more complex operations like Investment Management, Wealth Management and Investment Banking

Transaction Count Method

This method uses transactions instead of values by tallying up each transaction for example each receipt of a fee or commission (less any refunds) in each business area. For example equities, credit, FX, Bonds or Fixed income etc. As this method measures each business transaction, it can be more accurate in terms of calculating the correct VAT recovery rate for more complex business areas.

The Recovery Rate Calculation is:

No of Trans (Std Rated + Reduced Rate + Zero Rated)

No of Trans (SR+ R Rate + Zero Rate + Exempt ) = RR

Pros

More suitable for complex banking operations
Transactions are more reflective of use than values
Likely to produce a more accurate VAT recovery rate than the values method

Cons

Extracting the data and maintaining the reports and systems that support this can be time consuming and tedious.
Annual reviews of data sources and IT sign-offs will be required to ensure accuracy of the transaction count data
Takes much longer to compile and review the data to be able to calculate the annual adjustment

Sales Credit Method

This is a more modern method which uses the internal Sales Team reward and incentive system which is based on the level of sales each team generate. Basically notional sales credits (values) are allocated to each product sales team based on the level of sales generated for each product. It is a values based system albeit not actual sales values. The key here is that the notional values allocated are reflective of the level of sales in each team and credits allocated are reviewed at multiple levels to ensure the rewards to the product teams Credit, Equities, FX, FI are reflective of performance.

The Recovery Rate Calculation is:

Sales Credits Non UK (Zero Rated)

Sales Credits (Non UK (Zero Rated) ) + Exempt (UK)) = RR

Note: This method will mainly be used for calculating the partial exemption recovery calculation for exempt type services such as equities, bonds, derivatives trading etc as the sales credit data can be split into UK / Non UK notional values and thus exempt / zero rated. Using it for banking would be tricky as the sales credits allocated to the UK would be for a mixture of taxable and exempt products and a further split at this level may not be readily available or reliable enough for the PESM calculation.

Pros

Data collection is much easier than the traditional values and transaction count method as it's usually readily available because the data is used internally for annual reward.
Don't have to source data from multiple sources compared to other methods.
Potentially quicker PESM calculation
Values directly linked to activity

Cons

Reliance on non finance area to provide data which can increase bottle neck risks .
Queries have to be referred back to different teams

HMRC VAT Notice 706 (Extract on Special Methods)

6. Special methods

6.1 The definition of a ‘special method’

A special method is any calculation, other than the standard method, that enables you to calculate how much of your input tax you may recover. It must only allow you to recover the input tax on your purchases to the extent that you use these purchases to make taxable rather than exempt supplies now or in the future.

Supplies that are made outside the UK that would be taxable if in the UK and certain exempt supplies to non-UK customers also gives the right to recover input tax, but there are special rules (see section 9).

A special method is unique to your business, and you can develop it to deal with your particular business circumstances. However, you must not use a special method, nor change a special method that you are already using, without our written approval.

With effect from 1 January 2011 you may apply for a special method (known as a ‘combined method’) which combines your business or non-business (other than private use) and

partial exemption calculations. See paragraph 7.1 for more information.

6.2 Get approval for a special method

You cannot change your method without our prior approval. You must continue to use your current method, whether that is the standard method or a special method, until we approve or direct the use of another method or direct termination of its use.

You can get approval for a special method by using one of these options:

the online service
in writing to the VAT Written Enquiries team at BT VAT, HM Revenue and Customs, BX9 1WR, United Kingdom
by email to: PESM@hmrc.gov.uk

From 1 August 2022, you will no longer be able to send a special method request to the PESM@hmrc.gov.uk email address.

Only write to the Written Enquiries team if you are unable to use the online service.

You must explain clearly how your proposed method will work, you should see Appendix 2 in this guide.

When you propose a special method you must include a declaration that the method is fair from its effective date of application, and for the foreseeable future so that from its effective date a fair amount of input tax is recovered. If we subsequently find your declaration to be incorrect we may serve a special method override notice (see section 8 for more information about the special method override notice) to override the method so that from its effective date input tax would be recovered according to the use of purchases in making taxable supplies. A declaration is incorrect if 2 conditions are not met, the:

method does not produce a fair and reasonable attribution of input tax to taxable supplies resulting in an unfair over-recovery of input tax
person signing the declaration knew or ought reasonably to have known this at the time they made the declaration

If you apply to change your existing special method this is an application for a new method and you will also have to provide a declaration.

The declaration can be made using the template at Appendix 1.

All approvals and directions of special methods must be given in writing by HMRC.

If we decide to approve your method, we will set it out in a format which includes standard terms and conditions. A covering letter will be sent to you with the method asking you to check that it accurately reflects your proposal. Unless you raise concerns within 30 days we will assume that you’re content with the approved method.

If we decide not to approve your method we will write to you explaining the reasons why, and where appropriate, invite you to make further or modified proposals. If you make a further or modified proposal you will need to make a new declaration. If there are specific aspects of the method that you need to discuss, you may do so before making a firm proposal, saving the need for an additional declaration.

You will usually be allowed to use the new method from the start of the tax year in which the declaration to the written application (being the approved application) is received.

See section 8 about the special method override notice.

6.3 What a special method can contain

A special method is unique to your business and can contain any calculations or stages that are needed to make sure it is fair and reasonable. All special methods should:

reflect all your business activities
provide for direct attribution of input tax to taxable supplies
provide for direct attribution of input tax to exempt supplies
identify residual input tax
calculate the element of residual input tax that relates to taxable supplies
calculate the element of residual input tax that relates to exempt supplies
allow you to determine the total input tax that you can recover

6.4 Dealing with different parts of your business separately in your special method

If a method calculates a separate recovery rate for each sector it is commonly referred to as a ‘sectorised’ method. Partial exemption sectors might arise naturally from the way your business organises itself, for example, if your business has discrete areas, activities, or even accounting centres, in which you use your input tax differently. This is most likely where your business is large and complex, or where your business consists of a VAT group of separate businesses.

Very often, the best way to get an accurate partial exemption recovery method in the least burdensome way is to base it on your internal cost accounting system used for management reporting purposes. However, there are circumstances where this is inappropriate, for example, where costs are reported on a marginal basis. If you propose a method based on internal cost accounting, you will need to explain the kind of system being operated and what controls are in place to make sure that it’s accurate.

6.5 How to determine the recovery rate for residual input tax

When you use the standard method the percentage recovery rate for residual input tax is calculated using the values of supplies made by your business. When you use a special method you can determine your percentage recovery rate using other allocations and apportionments. You can even use a different type of calculation for each sector if you have a ‘sectorised’ method.

6.6 Examples of allocations and apportionments

Some examples are:

output values
numbers of transactions
staff time or numbers
inputs or input tax
floor area
costs allocations
management accounts

This list is not exhaustive and if you use any of the above you must make sure that the resulting calculation produces a result that is a true reflection of the use to which your input tax is put. The most common apportionment methods are output values and number of transactions, although some of the others can work in some circumstances. However they are more common as allocation methods between business sectors. More information can be found in PE30000 — VAT partial exemption guidance.

6.7 Rounding in special methods

You must calculate the percentage recovery rate produced in your special method to 2 decimal places.

6.8 Changes in your circumstances

If you operate a special method and there’s any change in your business circumstances, or if you’re a VAT group and there’s any change in the group membership that may have a significant impact on the amount of input tax you can claim, it’s important that you tell us immediately.

If your method is no longer suitable for your business, you should propose an alternative method. If you fail to propose a suitable method, we may direct you to use a specified method. In some circumstances a special method override notice (see section 8) may need to be served.

6.9 HMRC imposing a method

We have the power to direct a business to use a particular method or to stop using an existing special method. These powers are only used in circumstances where we are unable to identify a mutually satisfactory method, or where the VAT system is being abused.

Directions are made in writing and apply from the date they’re given, or from a specified future date. If you disagree with the issue of a direction you can ask for either of the following:

a review of our decision
an appeal to be heard by an independent tribunal

There’s more information about what you can do if you disagree with our decision in a HMRC factsheet and customer guidance which can be found at in HMRC1: HM Revenue and Customs decisions — what to do if you disagree.

6.10 Annual adjustments when using special methods

You have to follow a similar procedure to the standard method to calculate the annual adjustment for a special method (see section 12).

6.11 Gaps in special methods

A special method is said to have a ‘gap’ whenever it fails to specify how to deal with an amount of residual input tax. Gaps most commonly arise when business circumstances change after methods have been approved.

Residual input tax falling into a ‘gap’ is to be recovered to the extent that the purchases on which the input tax is incurred are used in making taxable supplies. Where the treatment of input tax on purchases is only partly covered by the method, that is, part of the input tax falls into the ‘gap’, only that part of the input tax not covered by the method comes under these rules.

This does not mean that we think that methods with ‘gaps’ are acceptable but merely sets out how to cope with gaps if they arise in future. Once a gap has arisen, we expect that you will make suitable proposals for a new method that takes account of the gap and any other known faults in your current method.

VAT and Inter- Company Recharges

VAT Group Members - If a bank operates within a VAT Group structure, then most of the Internal inter entity recharges between VAT Group members will be outside the scope of VAT and thus VAT will not feature on any invoicing between the entities.

However problems can arise where non UK entities recharge into the UK where the Non UK entity is not within the UK VAT Group (by way of being a branch of a VAT group member) and thus significant Reverse Charges can become applicable on cost recharges to UK entities for:

Staff
Consultancy
Intangible Assets (Goodwill)
IT Costs

If the Reverse charge VAT has not been budgeted for locally, then businesses can end up having significant irrecoverable VAT costs hitting their P&L where they are not able to fully recover the reverse charge VAT from HMRC.

International Banks and Sourcing

Banks that have global operations will tend to want to ensure that where supplies of IT and other services are purchased:

Services are provided by local suppliers where possible to the entities using the services
Services are billed and delivered to the entities using the services
The contracts state who is purchasing the service, consuming the service, ultimately paying for the service

This can avoid situations where the services are billed to the UK and incur UK Reverse Charge VAT but actual consumption and use of the services occurs in non UK locations. Although full recovery of the VAT is possible, it can often mean lots of administration to achieve.

Recharging of Professional Costs to Clients

As part of providing services to clients, banks will often incur legal and other professional fees which they will then recharge on to their clients. The VAT element of the cost will also often be recharged depending on whether the banks can recover the costs from HMRC.

The recovery of the VAT incurred on these cost by the bank will depend on the services being supplied to the associated client and the location of the client. See below table for illustration.

Vendor Location UK VAT Service Type VAT Recovery By Bank Location of the client

UK UK 20% Taxable (advisory) Full VAT Recovery UK / Non UK

Non UK 20% RC VAT Exempt Irrecoverable VAT UK

Non UK 20% RC VAT Exempt Full VAT Recovery Non UK

Where the bank can achieve full recovery of VAT as in the above examples, it can then bill the clients for the net value of the professional services invoice. Where the VAT is irrecoverable by the bank from HMRC in the above examples, it may then seek to recover this VAT from the clients by billing the client the net value of the invoice plus the VAT incurred or reverse charged ( VAT self accounted for to HMRC).

Risk Management and Controls

One of the main areas of focus in Banks and more specifically Finance and Tax will be around having an adequate and robust control environment to ensure the accuracy of internal and external reporting and to prevent errors. A large part of this will be to create and maintain a strong control environment from the top downwards and ensure this is embedded within the culture of the bank.

In Terms of VAT, the following list of activities and controls will all help to minimise the risk of errors.

Up to date VAT Coding within front office billing systems
Up to date VAT coding within the accounts payable system
Up to date and thorough procedure notes for VAT return preparation
Multiple reviews of all manual VAT related Journals
Multi-level review of all VAT Returns and Annual Adjustments
Automating manual processes to eliminate human error
Elimination of spreadsheet based VAT reporting (MTD VAT Compliant)
Annual or bi-annual E2E Integrity Review of VAT reporting process and systems
Regular multilevel reviews of VAT accounts
Service Level Agreements between VAT Team and Finance / OPS
Regular training of VAT staff supported by decision trees and diagrams
Ensuring regular engagement with Finance to ensure VAT is considered and built into new systems
Regular review of Partial Exemption Methods and Partial Exemption calculations
Adequate New Product and Trade sign-off procedures
Impact Assessments for all changes to systems
Automated VAT Return Production including VAT allocation and input VAT recovery
Error Correction Notifications to HMRC followed up with remedial actions and controls to prevent error repitition
Risk reporting process that highlights impact of errors on P&L and the required action to remediate
Maintaining good relationships and ensuring transparency with HMRC

Key Current VAT Related Issues In Banking

Electronic Invoicing
Making Tax Digital (MTD)
HMRC Review - Establishment and Branches ( Fixed Establishment or Brass Plate)
European Commission - Review of Financial Services & insurance
Model Portfolios - wealth and Investment Managers
Skandia and Danskie Bank (reverse skandia) CJEU rulings
Sub - Participation vs Syndication

The VAT Act 1994 - Schedule 9, Group 5 (Finance VAT Exemptions)

Item number

1. The issue, transfer or receipt of, or any dealing with, money, any security for money or any note or order for the payment of money.

2. The making of any advance or the granting of any credit.

2A. The management of credit by the person granting it.

3. The provision of the facility of instalment credit finance in a hire-purchase, conditional sale or credit sale agreement for which facility a separate charge is made and disclosed to the recipient of the supply of goods.

4. The provision of administrative arrangements and documentation and the transfer of title to the goods in connection with the supply described in item 3 if the total consideration thereof [sic] is specified in the agreement and does not exceed £10.

5. The provision of intermediary services in relation to any transaction comprised in item 1, 2, 3, 4 or 6 (whether or not any such transaction is finally concluded) by a person acting in an intermediary capacity.

5A. The underwriting of an issue within item 1 or any transaction within item 6.

6. The issue, transfer or receipt of, or any dealing with, any security or secondary security being -

(a) shares, stocks, bonds, notes (other than promissory notes), debentures, debenture stock or shares in an oil royalty, or

(b) any document relating to money, in any currency, which has been deposited with the issuer or some other person, being a document which recognises an obligation to pay a stated amount to bearer or to order, with or without interest, and being a document by the delivery of which, with or without endorsement, the right to receive that stated amount, with or without interest, is transferable, or

(c) any bill, note or other obligation of the Treasury or of a Government in any part of the world, being a document by the delivery of which, with or without endorsement, title is transferable, and not being an obligation which is or has been legal tender in any part of the world, or

(d) any letter of allotment or rights, any warrant conferring an option to acquire a security included in this item, any renounceable or scrip certificates, rights coupons, coupons representing dividends or interest on such a security, bond mandates or other documents conferring or containing evidence of title to or rights in respect of such a security, or

(e) units or other documents conferring rights under any trust established for the purpose, or having the effect of providing, for persons having funds available for investment, facilities for the participation by them as beneficiaries under the trust, in any profits or income arising from the acquisition, holding, management or disposal of any property whatsoever.

7. [Omitted by SI 1999/594, article 4]

8. The operation of any current, deposit or savings account.

9. The management of an authorised unit trust scheme or of a trust based scheme.

10. The management of the scheme property of an open-ended investment company.

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6. Special methods

6.1 The definition of a ‘special method’

6.2 Get approval for a special method

6.3 What a special method can contain

6.4 Dealing with different parts of your business separately in your special method

6.5 How to determine the recovery rate for residual input tax

6.6 Examples of allocations and apportionments

6.7 Rounding in special methods

6.8 Changes in your circumstances

6.9 HMRC imposing a method

6.10 Annual adjustments when using special methods

6.11 Gaps in special methods

The VAT Act 1994 - Schedule 9, Group 5 (Finance VAT Exemptions)

Item number

Banking and VAT

6. Special methods

​

6.1 The definition of a ‘special method’

6.2 Get approval for a special method

6.3 What a special method can contain

6.4 Dealing with different parts of your business separately in your special method

6.5 How to determine the recovery rate for residual input tax

6.6 Examples of allocations and apportionments

6.7 Rounding in special methods

6.8 Changes in your circumstances

6.9 HMRC imposing a method

6.10 Annual adjustments when using special methods

6.11 Gaps in special methods

The VAT Act 1994 - Schedule 9, Group 5 (Finance VAT Exemptions)

​

Item number

​

Banking and VAT