gument for exempting or zero rating insurance and the lending activities of financial institutions is that it is difficult as a practical matter to determine what portion of the premiums received by insurers and what portion of the deposits received by banks and other similar financial institutions should be subject to tax. The principal service provided by insurers to policyholders is the pooling of risks of loss. The primary service provided by banks and other similar entities to depositors is intermediation (i.e., the pooling of money for the purpose of investing). The imposition of a VAT on the gross amount of premiums or deposits received would result in a tax that bears no relation to the value added by insurers and other financial institutions.

Determination of taxable amount in the case of insurance

In the simplest case, the value added by insurers may be measured by the excess of the premiums received over the claims paid. The premiums paid for most life insurance contracts, however, includes a savings element that does not represent value added by the insurer for insurance services. Under a consumption-type VAT, the savings element of insurance contracts should not be included in the VAT base.

The bill attempts to address this concern by including in the insurer's VAT base only 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 bill, however, does not provide guidance on how to determine the portion of the premium attributable to insurance coverage or the actuarial cost to the insurer of providing the insurance coverage. For example, in the case of single premium whole life insurance, it is unclear under the bill what portion of the premium is attributable to insurance coverage because the single premium funds the cost of insurance for the life of the insured. With respect to the actuarial cost of providing insurance coverage, it is uncertain under the bill whether the cost is to be based on industry-wide actuarial data or the insurer's own experience, and, if the latter, how to determine the insurer's own experience.

În order to avoid these difficult questions, it has been suggested that an alternative system apply to insurance.36 Under this system, insurers would be subject to VAT on the gross amount of premiums received. Upon the occurrence of a claim, the insurer would gross-up the amount of the claim by the VAT rate in effect at that time. The insurer would be permitted to claim an input credit for the amount of the gross-up.37

Under this system, an insurer would be taxed solely on the value of the risk-pooling service that it provides without resorting to estimates or industry averages to determine the portion of the premi

36 See Barham, Poddar, and Whalley, "The Tax Treatment of Insurance Under a Consumption Type, Destination Basis VAT," 40 National Tax Journal 171 (1987).

37 The treatment of the policyholder under this system would vary depending on whether or not the policyholder was a business. In the case of a business policyholder, an input credit would be available for the VAT imposed on the premium payments. At the time of a claim, the amount of the gross-up would be considered VAT payable by the business. In the case of a nonbusiness policyholder, no input credit would be available as premiums are paid and no VAT would be payable with respect to the amount of the gross-up.

um attributable to insurance coverage or the actuarial cost of insurance. Nevertheless, such an approach may be criticized for not taxing the value of the financial intermediation services provided by insurers that issue life insurance with a savings element.

In order to address this criticism, it has been suggested by some that insurers should be subject to a subtractive-method VAT or an additive-method VAT in lieu of the credit-method VAT.38 If a subtractive or additive method of computing VAT liability was adopted with respect to insurance while the rest of the economy was subject to a credit method, an adjustment would be necessary to insure that business purchasers of insurance obtain a credit for the VAT paid by insurers.

Determination of taxable amount in the case of lending activities of financial institutions

In the case of lending activities,39 the value added by banks and other similar financial institutions may be measured by the excess of interest received from borrowers over the interest payable to depositors, reduced by the cost of purchased inputs. In order to tax this value added, it has been suggested that financial institutions be taxed on interest received from borrowers and that depositors be taxed on the interest paid by the financial institutions. In the case of nonbusiness depositors who cannot claim an input credit for such tax, however, this approach would result in the imposition of tax on interest income, which may be contrary to the purpose of a VAT.

In order to avoid the imposition of VAT on interest paid to nonbusiness depositors, it has also been suggested that insurers and other similar financial institutions be taxed under an additive or subtractive method VAT. The principal criticism of an additive system is that it requires a determination of the profits of insurers and other financial institutions, and, historically, it has been difficult under an income tax system to accurately determine such profits. It may also be difficult under an additive-method VAT to make accurate border adjustments that would be in compliance with GATT. A subtractive-method VAT for insurers and other financial institutions would pose similar problems.

Additional issues

If it is determined that the provision of insurance and the lending activities of financial institutions should be included in a VAT, at least two additional issues must be addressed. First, because a

38 Under a subtractive-method VAT, the base to which the rate of tax applies would be determined for any taxable period by subtracting the total cost of inputs from total sales. Under an additive-method VAT, the base to which the rate of tax applies for any taxable period would be determined by adding together all the elements of value added including wages, rents, interest, and net profit. Under either a subtractive or additive-method VAT, the entire value added by insurers, including the value of financial intermediation services, should theoretically be included in the VAT base.

39 The discussion contained in this section addresses lending activities of banks and other similar financial institutions because such activities pose the most difficult VAT issues. In the case of other goods or services provided by financial institutions, such as the rental of safe deposit boxes or the issuance of checks, a separate charge is generally imposed with respect to these goods or services. A VAT should apply to these goods and services under the general rules applicable to goods or services. Difficulties would arise, however, if a separate charge is not imposed or the charge does not reflect the full value of the good or service.

destination-based VAT only taxes services provided in the United States, rules are necessary to determine where insurance and lending activities are provided. Most countries that impose a VAT on insurance treat insurance services as occurring where the risk is located. Consequently, if a U.S. person insures a foreign risk, no VAT would be imposed on the transaction. Conversely, if a foreign person insures a Ū.S. risk, the transaction would be subject to the U.S. VAT. This approach may create collection problems in the case of foreign insurers that have no other connection with the United States. Second, it must be determined how the VAT is to apply to insurance and lending transactions where premiums or deposits are made before the effective date of the VAT and claims are paid or withdrawals occur after the effective date. A similar issue arises if the tax rate changes after the effective date.

7. Administrative provisions

a. Liability for VAT and invoicing

Under the bill, liability for the VAT would be imposed on the seller of property or services. In addition to paying the VAT, the seller would be required to provide a tax invoice (setting forth the amount of VAT imposed on the sale, the name and identification number of the seller, the name of the purchaser, and certain other information) to the purchaser if the seller has reason to believe that the purchaser is a taxable person. The invoice would have to be furnished no later than 15 business days after the "tax point" for the transaction.

Generally, a purchaser would not be allowed to claim a VAT credit with respect to a transaction unless it has received a tax invoice in which it is named as purchaser.

b. Small business exemption

The bill would permit certain small businesses to elect not to be treated as a taxable person except with respect to imports and the sale or leasing of real property. If an election is made by a small business, no tax would be imposed on its sales and no credit would be permitted for VAT paid on its purchases.

A person could elect to be exempt under the bill if its taxable transactions do not exceed $20,000 for a calendar year and can reasonably be expected not to exceed $20,000 for the next calendar year. The election, however, would terminate on the first day of the second month following any calendar quarter in that next year if the following has occurred:

(1) aggregate taxable transactions for the calendar quarter exceed $7,000, in the case of the first calendar quarter; or

(2) aggregate taxable transactions for the first two calendar quarters exceed $12,000, in the case of the second calendar quarter; or (3) aggregate taxable transactions for the first three calendar quarters exceed $17,000, in the case of the third calendar quarter. An exception from the VAT for small businesses could substantially reduce compliance and administrative costs. An exception for small business could also, however, distort economic behavior. The existence and extent of the distortion would depend in part on the identities of the parties to a transaction. In certain transactions,

exempt small businesses would be favored over businesses subject to the VAT. For example, if an individual needs to have $1,000 of plumbing work performed on a personal residence, the individual would prefer that the plumbing be performed by an exempt plumber (who would charge $1,000) rather than by a taxable plumber (who would charge $1,000 plus a $50 VAT).40

On the other hand, in other transactions businesses subject to the VAT would be favored over exempt small businesses. For example, assume that under the previous example a grocery store is in need of the plumbing and the work involves $800 of materials and $200 of labor. The exempt plumber would be required to pay $40 VAT on its purchase of materials, and, because it is exempt, would neither be permitted to claim a credit for the VAT it has paid nor issue a VAT invoice so that the grocery store could claim a credit for the VAT paid with respect to the materials. Thus, the exempt plumber would charge $1,040 for his work, and the grocery store would not be permitted to claim a credit for the $40 VAT. In addition, when the grocery store raises its prices to offset the $1,040 plumbing expense, it will charge VAT a second time on the $40 VAT the plumber previously paid.

The treatment of a plumber who is subject to the VAT would differ. A taxable plumber would also pay a $40 VAT with respect to the materials, but would charge $50 VAT on the entire transaction and claim a credit for the $40 VAT previously paid on the materials. The grocery store similarly would be allowed to claim a credit for the $50 VAT that it pays the plumber. The grocery store would pay the plumber $1,050 ($1,000 for the plumbing plus a $50 VAT), but, because the grocery store can claim the VAT it paid as a credit, the cost to the grocery store is in effect $1,000. The grocery store would charge its customers the theoretically correct VAT on the overhead attributable to these plumbing costs, and would not have to raise its prices by an additional increment to compensate for the "double VAT" that would be paid if the work were done by a VAT-exempt plumber. If the size of the small business exemption were increased, these distortive effects would be more pronounced.

In addition, because the bill would permit small businesses to elect to be treated as exempt from the VAT, small businesses would likely make the election based on the types of customers they generally deal with, which could increase the distortive effects as compared with a non-elective small business exemption.

c. Time for filing return and claiming credit

Under the bill, the taxable period for the VAT would generally be a calendar quarter. A taxpayer would, however, be allowed to elect a calendar month as the taxable period. A taxable person would be required to file a VAT return during the first month following the close of each taxable period. The return would reflect the VAT due on taxable transactions with a "tax point" in the period as well as the VAT credit allowed for the period. To the

40 This example assumes that both plumbers provide work of the same quality at the same price and that all of the economic burden of the VAT is borne by consumers.

extent provided in regulations, monthly deposits of estimated VAT liability may be required.

The "tax point" describes when a taxable transaction occurs for purposes of the requirement that a taxable person furnish a tax invoice, as well as for purposes of determining in what taxable period the transaction must be reported. For a sale of property or services, the determination of the tax point would depend on whether the taxable person employs the cash method or an accrual method of accounting for Federal income tax purposes. In the case of a cash method taxpayer, the tax point would be the date that the taxable person receives payment for the goods or services. In the case of an accrual method taxpayer, the tax point would be the earlier of the date that the taxable person (1) should accrue income or loss with respect to the sale, or (2) receives payment for the goods or services. In the case of imports, the tax point would be the date that the imported property is entered (or withdrawn from warehouse) for consumption in the United States.

A VAT credit with respect to a purchase transaction would be allowed for a taxable period only if certain conditions were met. The taxable person would be required to have (1) paid or accrued (depending on its method of accounting for Federal income tax purposes) the VAT as part of the purchase price, and (2) received a tax invoice from the seller with respect to the transaction. The VAT credit would generally be allowed for the first taxable period in which both of these conditions were satisfied.

Many countries that impose a VAT use the calendar quarter as the taxable period.41 Many countries also permit variations from the generally required schedule. Some permit (as does the bill) taxpayers to elect a calendar month as the taxable period. This election of a shorter taxable period may be of assistance to taxpayers that seek a more rapid refund of VAT that has been previously paid. Some countries also permit certain taxpayers to utilize a longer taxable period, such as a calendar year. Small businesses are often eligible for this longer taxable period in order to reduce the administrative burden that is imposed by a VAT.

A related issue is the time when deposits of VAT must be made. The bill would provide that regulations may require monthly deposits of VAT liability. Other deposit periods could also be considered. For example, under present law, corporations must deposit income taxes withheld from their employees and social security taxes as frequently as eight times a month (depending upon the size of the amounts to be deposited). A requirement that estimated VAT deposits be made with increasing frequency as the amount required to be deposited increases may help minimize collection problems for the Government. It would also be possible to require relatively infrequent deposits for some entities, such as small businesses. This can ease the administrative burden on these taxpayers. The Japanese VAT reportedly utilizes infrequent deposits by small businesses to encourage them to comply with the VAT (by giving them the use of the VAT they have collected for a period of time before it must be deposited). Decoupling the VAT deposit require

41 See ABA report, page 127.