As the European Union moves closer to establishing its "definitive" VAT system, the Task Force is asked to examine the benefits of maintaining or establishing reduced VAT rates on accommodations and other travel-related services and make a recommendation for action or no action.

VAT Defined

Value Added Taxes are a form of indirect consumption tax assessed on the value added to goods and services at each stage of production: primary, manufacturing, wholesale and retail. VAT is considered a consumption tax because it is imposed on consumable commodities and services and its costs are borne ultimately by the final consumer. Value added taxes are applied to the production and distribution of goods in more than 130 countries worldwide, including all 15 Member States of the European Union.

Since the common VAT system was introduced in the 1970s, its declared objective has been to create the conditions necessary for the establishment of an internal market characterized by healthy competition, under which the taxation of imports and the non-taxation of exports in intra-Community trade would be abolished. This commitment underpinned the objective of designing a VAT system which was tailored to the internal market and operated within the EU area in the same way as it would within a single country, i.e. to introduce a system of taxation where goods and services would be taxed in the Member State of origin.

The First VAT Directive, issued on April 11, 1967, required that by January 1972 each Member State was to “replace its system of turnover taxes by the common system of value-added tax, but without an accompanying harmonization of rates and exemptions”. It specified that “the common system is to be based on the neutrality principle: within each Member State similar goods and services are to bear the same tax burden, whatever the length of the production and distribution chain.” The purpose was to achieve transparency in the "de-taxing" of exports and "re-taxing" of imports in trade within the EU.

In 1970, the European Commission made the decision to finance its budget via contributions from each of the Member States. Payments were to be based on a proportion of VAT that was “obtained by applying a common rate of tax on a basis of assessment determined in a uniform manner according to Community rules,” The Sixth VAT Directive of 1977 established parameters for a uniform basis for assessment that ensured each Member State had a broadly identical “VAT base”, i.e., similar VAT rates for the same transactions.

The next major change occurred in 1991, when legislation was adopted for the purpose of establishing transitional VAT arrangements and simplifying the VAT system. The goal was “to abolish tax controls at internal frontiers for all transactions carried out between Member States, to approximate the VAT rates applicable to those transactions and to make provision for a transitional phase of limited duration that will ease the transition to the definitive arrangements for the taxation of trade between Member States.”

There remained several critical issues to address, such as developing a clearing mechanism for the distribution of VAT receipts, and determining the degree of harmonization of rates that such a regime would necessitate. Nevertheless, eliminating custom controls within the EU area in 1993 necessitated the reformation of the VAT system operating up to then on the destination principle.

The destination principle implies that consumption taxes are levied where the products are consumed by both final consumers and producers. The rates of VAT and excise applied are those of the country of final consumption, and the entire revenue accrues to that country's Exchequer. As traded goods leave one country, they are "de-taxed" (e.g. in the case of VAT, zero-rated); and are then "re-taxed" on entering another. This system ensures production neutrality, since indirect taxes do not discriminate between foreign and domestic producers, and exports are exempt from domestic taxation. However, this principle requires the monitoring of cross-border trade flows and administrative co-operation since goods and services travel free of tax. Complex documentation was necessary for goods transiting Member States, and an EC report concluded that the system was costing intra-Community traders around 8 billion ECU, or 2% of their turnover.

One solution initially proposed by the European Commission involved a change to the so-called origin principle. The origin principle implies the taxation of goods and services where produced, regardless of where they are consumed. Instead of being zero-rated, transactions between Member States liable to VAT would bear the tax already charged in the country of origin, which traders could then deduct as input tax in the normal way. It has advantages in that it can be applied without border controls, and since exports would no longer travel tax-free, the potential for tax fraud would be lower. However, the origin principle introduces the possibility for the tax system to discriminate between domestically-produced goods and imports. The full move from the destination to origin principle would also induce significant changes in the distribution of VAT revenues across countries. EU countries with a trade surplus vis-à-vis the EU area would thus collect extra VAT revenues, compared with the existing regime of export zero-rating, while deficit countries would have to be granted a VAT credit on their intra-community business purchases. Estimates showed that there would have been substantial transfers of tax revenues, notably to Germany and the Benelux countries from the rest.

To ensure that VAT receipts accrue to the country where consumption takes place, a mechanism to redistribute VAT revenues across countries would thus be required. The Commission therefore proposed the establishment of a clearing system to re-allocate the VAT collected in the countries of origin to the countries of consumption. This approach, however, would have required numerous information exchanges and transaction costs. Thus, the Commission later proposed a mechanism to reallocate VAT collected, using as a basis aggregate consumption, to ensure that VAT receipts accrue to the EU country where consumption takes place, thus compensating countries for VAT paid on goods that are exported.

The EU finally adopted an alternative system that contained both origin and destination principles. The destination principle remained intact for the VAT-registered traders (i.e., the business sector). Though tax controls at frontiers have been abolished, traders are required to keep detailed records of purchases from, and sales to, other countries, and the system is policed by administrative cooperation between Member States' tax authorities. This was intended to ensure that the VAT levied in each Member State reflected the volume of consumption there, and it was meant to guard against substantial transfers of revenue from one Member State to another. Non-EU companies that export to the EU are taxed at import; exported goods are zero-rated and not subject to the VAT.

The origin principle was applied to cross-border purchases by the final consumer (individuals). Individuals can now purchase goods anywhere in the EU area and return to their home Member State with their purchases without any further tax liability (with the exceptions of new vehicles and mail order transactions).

Such a dual system attempts to fulfill the requirements of an internal market without frontiers while allowing room for maneuver at the national level in the establishment of VAT rates and the collection and auditing of the tax.

The VAT system entered its transitional phase on January 1, 1993, and the concepts of importation and exportation were eliminated with respect to transactions carried out between Member States. Intra-Community sales and purchases of goods were treated in the same way as those taking place within the Member States; the "Single Market" had become a reality, and national borders ceased to exist within the EU.

The transitional period was meant to last through 1996 at which time a "definitive" system was to have been established, based on payment at "origin." The European Commission was required to submit proposals for a definitive system before the end of 1994, and the Council was to reach a decision on it before the end of 1995. However, no formal legislative proposals appeared. Instead, the Commission has shifted its emphasis from a move to a "definitive" system towards measures to improve the present "transitional" arrangements.

The Commission published a technical note titled "Description of the General Principles" in 1996 that outlined elements of the definitive system. The report specified the following:

• The "place of taxation" would no longer be where goods are located, or services provided, but where the suppliers' business was established;
   
• Invoicing and deduction of input tax would be according to the origin system;
   
• VAT rates would be harmonized "within a rather narrow band."
   
• The allocation of VAT revenues would be separated from the VAT system itself, and be carried out according to national consumption statistics;
   
• The Sixth Directive would be revised to make the system simpler, with fewer derogations, exemptions, options and special régimes;
   
• Steps would be taken to avoid differing national interpretations of VAT law; the role of the VAT Committee would be strengthened; and cooperation between tax authorities improved.

In June 2000, the Commission published a Communication titled "A Strategy to Improve the Operation of the VAT System within the Context of the Internal Market." It outlines a new list of priorities and a timetable for decisions. The report considers new strategies to simplify, modernize and standardize the VAT system. It emphasizes the uniform application of implementing rules in the Member States and closer administrative cooperation between them to combat fraud.

When the Commission reviewed VAT rates in 1987, their original proposals centered on "approximation" within two tax bands: a standard rate between 14% and 20%; and a reduced rate between 5% and 9%. By 1992 the Commission called for the following provisions regarding VAT rates:

The first Commission report on the results of this agreement concluded that it was working satisfactorily. There were no significant changes in cross-border purchasing patterns since 1 January 1993, nor any significant distortions of competition or deflections of trade through disparities in VAT rates. The Commission therefore proposed no change in the 15% minimum; but suggested a new maximum rate of 25%. The Council in December 1996 accepted the first of these proposals; but only agreed to make "every effort" not to widen the current 10% span. No new proposals on VAT rates were made in the Commission's 1997 Report on the working of the system. However, a renewed proposal to fix VAT rates in a 15% to 25% band was made in 1998- though this was subsequently rejected by the European Commission.

The European Parliament (EP) broadly supported the Commission's original 1987 proposals for VAT rates, but, as a result of the revisions that took place in the years that followed, was only able to support the 15% minimum standard rate. The EP proposed that the application of a reduced rate to certain essential goods and services should be mandatory rather than optional and voted against the proposed 25% upper limit in 1997. However, in 1998 the EP approved a 15%-25% standard rate band under certain conditions.

Recently adopted VAT legislation includes Directive 2001/41/EC, mandating that the minimum standard VAT rate set by Member States must be 15%, which will be in effect at least until December 31, 2005. While the EU mandates certain guidelines for the VAT, the implementation and administration of VAT remains a matter of national law in each of the fifteen Member States and therefore rates vary considerably among certain types of products.

Under the current arrangements, Member States apply a standard rate of VAT of at least 15% and have the option of applying one or two reduced rates (which must not be below 5%) solely to certain goods or services of a cultural or social nature. The temporary retention of existing zero rates and extra-low rates (i.e., below 5%) is authorized. These arrangements have led to reductions in the number of VAT rates and to appreciable cuts in those rates. The principle of taxation in the country of consumption for goods and services intended for taxable persons, at the rates and under the conditions applicable in that country, has been retained pending the introduction of the definitive system for taxing trade between Member States. The aim is to eliminate possible distortion of competition and relocation of activity while rates are insufficiently aligned. These arrangements are therefore designed to reinforce Community integration, while safeguarding the financial interests of the Member States.

In March 1996, the EC identified the three main challenges that would be the key elements of the European Union's tax policy in the years ahead:

It was with this in mind that, in July 1996, it presented a work program designed to speed up the changeover from the transitional VAT system to a definitive common system, as previously analyzed. This program comprises five phases running from the end of 1996 to the middle of 1999. It covers the general principles of VAT (physical scope, taxable amount, definition of taxable person, exemptions, approximation of VAT rates, etc.), the place of taxation, i.e., the principle of taxation at the place of origin (territorial scope of VAT, place of taxation and control of taxable persons), transitional measures for the changeover to the final system, the maintenance of special schemes and the machinery for allocating the tax revenue between Member States.

In 1997, the EC published a Communication titled “Job creation: Possibility of a reduced VAT rate on labor-intensive services for an experimental period and on an optional basis.” An ensuing Directive allowed those Member States wishing to do so to experiment with the operation and impact, in terms of job creation, of a targeted reduction for labor-intensive services for a maximum of three years from 1 January 2000 to 31 December 2002.

All services had to satisfy the following requirements: