Federal, State and local governments generally provide services to the public for free or at a reduced charge. If governmental entities were required to collect VAT on such services, valuation and collection issues would arise. On the other hand, certain government services are provided at a cost commensurate with their fair market value (e.g., some city-owned parking garages). In such cases, the governmental entity may be viewed as if in competition with a private enterprise that offers the same service. It may be appropriate to subject such a sale to the VAT. Finally, intergovernmental relationship issues arise if a State or local government is subject to a Federal VAT on its purchases of goods and services. Even if the relationship issues could be resolved, there may be administrative problems in having all governmental entities register for the VAT and file the appropriate returns.

The bill would attempt to resolve these issues by providing that a governmental entity would not be required to pay VAT on the goods and services it purchases or collect VAT for the performance of its services (with the exception of services for which a separate fee is charged). In this way, governmental entities would not be burdened by the VAT on their purchases and most governmental entities would not be required to collect VAT pursuant to the performance of their services. In essence, such entities would have the benefits similar to exemption without the related cost of having to pay VAT on their purchases. Those governmental entities that charge a separate fee for their services would be required to collect VAT, as are private enterprises that perform similar services. However, the governmental entities would not be required to pay VAT on their purchases. Issues could arise under the bill as to whether it is appropriate to subject to VAT the performance of traditional government services where a nominal fee is charged (e.g., automobile licenses).

Exempt organizations

Under the bill, taxable transactions engaged in by an entity described in section 501(c)(3) of the Code (i.e., entities organized and operated for religious, charitable, educational, etc. purposes) would be zero rated unless such transactions are part of an unrelated business. Section 501(c)(3) organizations would be allowed a credit for all the VAT they were paid. In addition, sales of property or the performance of services by any tax-exempt entity other than a section 501(c)(3) would be also zero rated unless the sale involves a specific charge or fee.

The analysis of the issues relating to the taxation of tax-exempt entities is similar to that of governmental entities. Specifically, the issue arises as to whether it is appropriate to subject to the VAT either the purchases or activities of entities that have been granted income tax relief. In addition, it may not be possible to value the services provided by such entities. Although it may not be appropriate to subject most tax-exempt entities to the VAT, activities through which such entities compete with taxable entities may appropriately be subject to the VAT.

The bill would treat charitable organizations in much the same way that governmental entities are to be treated. Specifically, section 501(c)(3) organizations would not be required to collect VAT on

activities other than activities for which they would be taxable as unrelated business income. Unlike governmental entities, such entities would be subject to the VAT on their taxable purchases, but would be able to obtain a refund for the entire amount paid. Taxexempt entities other than section 501(c)(3) entities would be subject to the VAT on their activities for which a separate charge had been made.

4. Treatment of real property

In general, the bill would tax the sale or lease of business or nonbusiness real property by applying the VAT rate to the amount paid by the purchaser or lessee.32 A seller of real property would receive a VAT credit for the VAT paid on the purchasing, constructing, or improving of the property. A lessor of real property would receive a credit for the VAT paid on the purchasing, constructing, improving, or maintaining of the leased property.

The bill would provide an important exception to these general rules by providing preferential treatment for certain housing. Under the bill, the sale or lease of housing used as a primary residence would be taxed at a zero rate. Thus, none of the value added with respect to housing used as a primary residence would be subject to tax. 33

The bill would treat sales of new nonbusiness real property differently from sales of existing nonbusiness real property. While new nonbusiness real property would be taxed on the full sales price, existing nonbusiness real property would be taxed only on the difference between the sales price and the adjusted basis of the property. However, under the bill, amounts incurred before the effective date of the VAT would not be included in basis. Therefore, existing nonbusiness real property not previously subject to the VAT would be taxed on the full sales price.

This special treatment accorded existing nonbusiness real property is not relevant if the rate of tax is zero. Because housing used as a primary residence is zero rated under the bill, no VAT is imposed with respect to both new and existing housing used as a primary residence. However, nonbusiness real property that is not used as a primary residence, such as second homes, would be taxed to the extent VAT was not paid on previous sales.

Under any VAT, the preferential treatment of certain items increases the costs of administration and compliance. The preferential treatment of principal residences in particular adds complexity to the administration of the VAT. Unlike the preferential treatment of food, it is necessary for sellers and lessors of housing to

32 Instead of applying a VAT to the purchase price of an asset, the VAT could be applied each taxable period to the rental value of the housing provided during that period. This would theoretically provide the same tax treatment as up-front application of the VAT because the purchase price of a capital asset should equal the present value of the expected rental stream. However, the amount of rental value for each year is difficult to determine without actual rental payments.

33 An alternative method of providing preferential treatment for housing would be to provide a VAT exemption for (rather than zero rating) the sale or lease of housing used as a primary residence. If housing used as a primary residence were exempt from the VÅT, a seller or lessor would neither pay tax on their sales nor receive credits on their purchases. Consequently, the value added by those other than the seller or lessor would be subject to tax. As with other preferentially treated items, exemption of housing at the retail level provides substantially less tax benefit to the taxpayer than zero-rating.

determine how the housing will be used (i.e., whether the buyer or lessee will use the property as a principal residence.) In addition, difficult administrative issues may arise if a portion of the purchase price is attributable to nonhousing components (for example, appliances and other amenities, or business use of the home) or if a portion of the rent is attributable to nonhousing services (for example, parking or other facilities). In such cases, the preferential treatment of principal residences may be available for consumer goods other than housing.

The preferential treatment of principal residences may also reduce economic efficiency. The additional tax incentive for residential housing provided by the bill could encourage the purchase of residential housing beyond economically efficient levels. The tax treatment of housing in the bill does not, however, favor owner-occupied housing over rental housing, as does the current income tax. 5. Determination of the location of goods and services

The bill generally would define taxable transactions as sales of property in the United States, the performance of services in the United States, and the importation of property into the United States. Exports would be subject to tax at a zero rate.

A VAT can be designed on the origination principle, whereby goods and services are taxed where produced, regardless of where they are consumed, or on the destination principle, whereby goods and services are subject to tax where they are consumed, regardless of where they are produced. Virtually all VATS, including the VAT proposed in the bill, are based on the destination principle. In order to implement the destination principle, exports must be relieved of the domestic VAT and the domestic VAT must be imposed on imports. This treatment of exports and imports is referred to as the border tax adjustment.

The border tax adjustment of a destination principle VAT serves two purposes. By taxing imports and not exports, the border tax adjustment generally ensures that the tax base for the VAT is domestic consumption. In coordination with VAT systems in other countries, border tax adjustments also ensure that value added taxes do not distort international trade and leads to neither taxation in multiple jurisdictions nor exemption from VAT in any jurisdiction. For purposes of performing the border tax adjustment, it thus is necessary to determine the location of potentially taxable transactions. The rules for determining the location of a transaction for tax purposes are known as source rules.

The bill would provide for border tax adjustments by subjecting imports to tax at the standard 5-percent rate and subjecting exports to tax at a zero rate, thus permitting refunds for previously paid VAT on the exports. Under the bill, imported property would be sourced where delivery takes place, except that real property would be sourced where the real property is located.

Services are typically more difficult to source than tangible goods. The bill generally would source services according to where the services are performed. This rule, while administratively simpler than some other alternatives, violates the purest form of the destination principle. For example, a U.S. firm may contract for services performed abroad but for use in the United States. Such a

transaction presumably would not be subject to tax under the bill. However, the destination principle argues that this transaction should be a taxable transaction. Since the seller of the services may have no other connection with the United States, it may be administratively infeasible either to collect the tax from the seller or to identify the purchase of the service as an import and levy the tax on the importer. Likewise, services performed in the United States for use abroad ought to be exempt from tax under a strict interpretation of the destination principle, but would be taxable under the bill.

The problem of some services provided abroad being exempted from domestic VAT may not be a serious problem. As long as the sales of the purchaser of the service is subject to VAT, no tax revenue will be foregone. Since the cost of services provided would be reflected in the final sales of the purchaser, and thereby subject to tax, the full amount of VAT would be collected regardless of whether the seller of the service paid the VAT. The full amount of VAT would be collected because there would be no offsetting credit for previous VAT paid on the services purchased. Only in the case of exempt purchasers would the tax on foreign-provided services be avoided.

Value added taxes in other countries differ somewhat in their sourcing of services. The Sixth Directive of the European Communities generally provides for sourcing the service in the country where the supplier is established. 34 Under the directive, however, certain services, such as patent licenses, advertising, financial operations and certain others are sourced in the country of the establishment of the purchaser. It is necessary, therefore, under the directive, to determine the location of the seller's or purchaser's establishment. To the extent that sourcing rules can be harmonized among taxing jurisdictions, the number of transactions subject to tax by multiple jurisdictions or no jurisdictions can be reduced or eliminated.

For services performed both inside and outside the United States, the bill would provide that the service would be sourced in the United States if 50 percent or more of such service is performed in the United States; otherwise, the service would be sourced outside the United States. Examples of services performed both inside and outside the United States include international transportation and communications services.

The Internal Revenue Code, for purposes of determining whether income is within or without the United States, generally allocates and apportions income and expense between U.S. and foreign source income, including gross income earned partly within and without the United States (sec. 863). Special rules apply for international transportation and communications income so that half of the income is sourced within the United States and half without. Rules similar to these existing source rules in the Code could serve as an alternative to the source rules in the bill. The rule in

34 Sixth Council Directive of May 17, 1977, "On the Harmonization of the_Laws of the Member States Relating to Turnover Taxes-Common System of Value Added Tax:_Uniform Basis of Assessment," Official Journal No. L145, reprinted in 2 CCH Common Mkt. Rep., par. 3165 (1977).

the bill would eliminate the need to allocate and apportion sales of services based on the percentage of the service connected to different locations. Under the bill, transactions would either be subject to full tax or no tax depending on whether more or less than 50 percent of the service is provided in the United States. Because of the all-or-nothing nature of the source rule in the bill, significant pressure may be placed on the accurate determination of the percentage of service provided in the United States in those cases where the percentage may be near 50 percent. Presumably, for cases where the percentage provided in the United States is not near 50 percent, the rule in the bill would be administratively easier than an apportionment rule.

6. Treatment of insurance and other financial services

a. Treatment of insurance and other financial services

Under the bill, the provision of insurance would be considered the performance of services, and, consequently, would be subject to the 5-percent VAT that generally applies to the sale of property or the performance of services in the United States. In the case of insurance, the amount subject to tax would equal the excess of (1) the portion of the premium attributable to insurance coverage over (2) the actuarial cost to the insurer of providing the insurance coverage.

The provision of financial services by banks, savings and loans associations, and other similar entities would also be considered the performance of services. The bill provides, however, that the rate of tax imposed with respect to interest would be zero (i.e., zero rated).

b. Issues relating to the application of a VAT to insurance and other financial services

In general

One of the most difficult issues that must be addressed in developing a VAT is the treatment of insurance and other financial services. It is generally believed that based on considerations of economic efficiency and equity, all services (including financial services) should be included in the base of any VAT and should be taxed at the rate that generally applies to ordinary goods and services. A VAT that exempts or zero rates insurance and other financial services would create an artificial incentive to purchase these services rather than other taxable goods or services, and, consequently, would distort consumer preferences and the efficient allocation of resources. In addition, because higher-income individuals generally purchase greater amounts of insurance and other financial services than lower-income individuals, the exemption or zero rating of these services would make a VAT more regressive.

Notwithstanding these considerations, nearly all countries that currently impose a VAT provide an exemption for insurance and the lending activities of financial institutions. 35 The principal ar

35 All countries that are members of the European Economic Community (EEC) provide a VAT exemption for the lending activities of banks and similar financial institutions and for insurance, reinsurance, and related services performed by insurance brokers and agents. Some countries that exclude insurance from the VAT impose a separate retail tax on insurance.