Business COMMENTARY: Outsourcing carries a hidden tax cost for banks

Competition is exerting pressure on businesses to become more efficient through focusing more on their core capabilities while increased reliance on technology, its increased complexity makes outsourcing of services a popular option.
 Paul Frobisher Mugambwa
Paul Frobisher Mugambwa

Competition is exerting pressure on businesses to become more efficient through focusing more on their core capabilities while increased reliance on technology, its increased complexity makes outsourcing of services a popular option.

Yet, Value Added Tax (VAT) exemption for banks is holding back the use of outsourcing. It creates a price differential between the cost of contracting and performing services in-house, a disincentive for banks to seek outside expertise which weakens their competitiveness in the marketplace.

The Government recognizes that stimulating the private sector—particularly with regard to competitiveness—requires broadening and deepening the financial sector. Therefore, putting banks in the same VAT position (whether they outsourced a contract or undertook it in-house) would stimulate competitiveness as well as increase opportunities for Rwanda entrepreneurs.

Currently, banks cannot recover all the VAT that they pay on goods and services they buy since they do not charge VAT on many of their services. As banks outsource their activities, the external provider is required to charge VAT. However this VAT is not recoverable in full.

If a bank outsourced some of its tellers, direct sales executives or cash in transit services, for example, the provider of the workforce or services would be required to charge VAT. On the other hand, if the bank provided the workforce in-house itself, it would not have to pay VAT. Thus, the cost of services in-house would automatically be less expensive by 18 per cent than outsourcing.

Outsourcing therefore carries a hidden tax cost for banks. A bank would only acquire outside services when the perceived value of obtaining those services externally exceeded the cost of in-house provision by the amount of the VAT.

To provide parity between an in-house service and an outsourced service, VAT exemption could be shifted further down the supply chain so that the service outsourced to a third party would be exempt from VAT, ensuring that these costs would not bear VAT. This solution only resolves the limited subset of outsourcing contracts that are core to processing financial transactions, however, the VAT distortion would remain for the vast majority of outsourcing scenarios.

A more universal solution would be a widening of the VAT exemptions to encompass outsourced services provided to banks by allowing exemption only where the business provides predominantly exempt services. 

Another option involves accepting that VAT will be charged on the contract but allowing banks to recover part of the VAT so that it again finds itself in a similar position as if it had undertaken the contract in-house. Governments like Australia choose this solution when introducing their VAT system.  The VAT exempt business is automatically entitled to reclaim from the tax authorities a fixed proportion of the VAT incurred on the outsourcing contract.  The proportion to be recovered is set at an estimate of the labour element of the underlying contract – 75 percent was chosen in Australia.  The balance is treated as input tax in accordance with the “normal” rules.

Finally, the Government could leave the VAT provisions the same but alter the taxable amount that should be applied to VAT. This involves disregarding the actual amount of the contract and replacing this with a value that would have been subject to VAT under the in-house scenario- say 25 percent  in the above example.

There are many options for providing parity between in-house and outsourced services. The Government should consider implementing measures to introduce VAT parity to encourage outsourcing, improve competitiveness and stimulate entrepreneurship and growth.

Paul Frobisher is a Tax Manager at PwC Rwanda Limited. Email frobsiher.mugambwa@.rw.pwc.com

 

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