In principle, a fund should be tax neutral: only investments and investors should be taxed. As this is a well-known principle in the income tax field, there is no reason why it should not apply for indirect taxes such as VAT. The EU VAT Directive and the Luxembourg VAT law foresee a VAT exemption for fund management services. While this seems favorable, it actually masks the “hidden” VAT burden.

At first glance, a tax exemption always seems favorable. However, for VAT-exempt services, the service provider is generally unable to deduct the VAT incurred on its costs. This nondeductible VAT is nicknamed “hidden” VAT because it is built into the service price and does not appear on invoices. Therefore, it remains unnoticed by the purchaser, who just pays a higher price.

As a result, this hidden VAT economically breaks the principle of tax neutrality. Also, investment funds generally have no VAT deduction rights; therefore, they suffer from the VAT charged by service providers on non-exempt services such as audit, legal and tax. In the end, both the hidden and the charged VAT result in additional costs for funds and, subsequently, for investors.

Therefore, it is worth exploring the different ways to adapt the VAT rules to effectively ensure the principle of tax neutrality is applied.

There are several ways to solve the hidden VAT issue:

a) Zero-rate VAT

Zero-rated products and goods have no VAT applied to their final price, and despite the absence of VAT on the final price, the provider has the right to deduct the VAT incurred on its costs. This zero rate completely “cleans” or “frees” any tax transaction, even when the purchaser cannot deduct VAT. This explains why the zero rate applies in different EU Member States to goods and services that are considered socially necessary. Under the current EU VAT rules, financial services are not eligible to be zero-rated. Therefore, a change to the VAT Directive would be necessary, requiring a unanimous decision of the 27 Member States—which would have to consider their budgetary cost.

b) Full VAT deduction right and taxation of fund management services

Another solution could be to grant funds full VAT deduction rights and make fund management services taxable. In this case, the hidden VAT would also disappear. Also, funds would no longer suffer VAT on other taxable services such as audit, legal and tax, which is currently the case, making this solution even more beneficial than the zero rate. This would also come with a high budgetary burden, and it would be necessary to modify the VAT Directive to implement this solution.

c) Option for VAT

While the EU VAT Directive exempts financial, insurance and real estate services from VAT, it gives the right to Member States to allow their service providers to choose to apply VAT to these services (except insurance services) . The advantage of this option is that it solves the issue of “hidden VAT”. Luxembourg has exercised this option for real estate transactions (e.g., the sale, rent and leasing of property) but not for financial services. The Directive does not impose conditions on how this option is applied; however, generally speaking, a client-per-client or service-per-service option is preferable to a global option, which implies that clients who cannot or can only partly deduct VAT are charged VAT.

As they are not bound by precise rules, Member States that have implemented the option did this in a very heterogeneous way. For example, in Belgium, this option is only available for payment services and must be exercised for all clients. In Germany, the option is available for a wide range of financial services but not management services, and can be exercised on a service-per-service basis. In France, this option applies to a broad range of services including fund management services. While the option must be exercised for all services under current rules, the 2022 draft finance bill should allow it to be exercised more flexibly, probably service per service. If this finance bill is voted in, it will enter into force as from January 2022.
Austria, Estonia and Lithuania have also implemented the option to tax financial services, and Poland should introduce it as from 2022.

Therefore, under the current rules—i.e., without requiring a change to the Directive, which the 27 Member States would have to unanimously agree to—the only way a Member State can improve the VAT position of investment funds is to introduce the VAT option for fund management services.

VAT deduction right of funds

We should mention the option would only be of interest if the fund could deduct VAT fully, or at least substantially. This implies that funds that only invest in shares and securities (UCITS type of investment funds) must be distinguished from those with assets such as real estate, infrastructure, works of art, etc. Indeed, while a VAT deduction right for the former could prove problematic for “normal” taxpayers in some Member States under current rules and, therefore, for funds, the latter have activities that would usually allow “normal” taxpayers the right to deduct VAT in all Member States. Considering the principle of equality between taxpayers in similar situations, there is no reason that investment funds with these activities cannot deduct VAT. Moreover, they also generally incur proportionally more VAT on their costs, compared with traditional UCITS types of investment funds.

In the long term, we should mention that in 2019, the European Commission launched a review of the VAT rules that apply to financial services, including fund management services. The responses to the European Commission’s public consultation between 8 February and 3 May 2021 shed much light on the industry’s views.

The European Commission’s questionnaire did not address the zero rate and the full VAT deduction right. However, in their comments and additional submissions, around 20 professional associations (out of the 76 that took part), including LPEA, quoted the zero rate as a valuable solution that deserved further consideration, while ALFI and EFAMA called for an investigation into the two solutions. Regarding the option, 75% of the professional associations and businesses that responded said it would be an appropriate solution. These are clear signs that solutions already exist and are either deemed necessary or at least highlighted by taxpayers or their representatives.

In conclusion, if the fund management services exemption is deemed important and beneficial for investment funds and investors beyond a doubt, there is clear room for improvement. Two of three of the possible solutions require a unanimous decision by the 27 EU Member States. However, implementing the option to tax fund management services on a client-by-client or service-per-service basis is an “on the shelf” solution that does not require the European Commission’s authorization. The practicality and benefits of the option are clear, based on its implementation in different Member States. Considering Luxembourg’s unique position, it should seriously consider implementing the VAT option for fund management services with flexible rules.

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