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Financial Inclusion and VAT Treatment of Mobile Money Services

Innovations in the financial sector have broadened access to finance and altered the operation of capital markets.  One of the fastest-growing financial technologies (Fintech) resulting from the digital revolution is mobile money services, where customers use their mobile device to receive, store and spend money.  As the advent of Fintech baffles lawyers and regulators alike, money mobile services raise novel legal questions in the realm of tax law.  In a fast-moving area of the law of consumption tax, businesses in the mobile financial services sector should be aware of how different countries around the world are adopting and adapting indirect tax legislation to reflect the digital economy.  Traditionally, many sub-Saharan African countries exempt mobile financial services as part of a collective mandate to promote financial inclusion of the poor.  The aim of this paper is to analyze comparatively the VAT treatment of mobile money services and how it affects financial inclusion of the poor.

Mobile Money: Transaction Model and Relevance to Financial Inclusion

Without a standard regulatory definition of mobile money and electronic money, it is understood to be electronically recorded monetary value allowing a user to conduct transactions through a mobile device; accepted as a means of payment by parties other than the issuer; mirrored by the value stored in a bank account, and redeemable for cash. ((Simone di Castri, Mobile Money: Enabling Regulatory Solutions, Mobile Money for the Unbanked (Feb. 2013),  As such, mobile money transactions operate under complicated models.  However complicated, these mobile money transactions tend to contain the same five functions: mobile communication service, customer interface, transaction processing, and account provision, and settlement. ((See Pierre-Laurent Chatain et al., Protecting Mobile Money Against Financial Crimes: Global Policy Challenges and Solutions 10 (World Bank, 2011),  Each function is provided by a different supplier.  The mobile connectivity is delivered by a mobile network operator while the settlement services are usually provided by banks.  When a settlement is between accounts at two different institutions, an intermediary bank is needed to complete the transaction. ((See id. at 14.))  Customer interface, transaction processing and account provision may be facilitated by various providers, that could either be mobile network operators, banks or fintech startups classified as payment services. ((For example, Celpay is a standalone provider that creates a special menu as customer interface through which transaction commands are sent and account information is received. Staff members, upon receipt of these commands, manually verify if available funds are sufficient and accounts records are generated accordingly.))

Mobile money is a catalyst for financial inclusion and the development of the digital ecosystem for the following reasons: first, mobile money considerably cheaper than other alternative money transfer services due to a higher remittance receipt and fewer transaction costs; ((See William Jack & Tavneet Suri, Risk Sharing and Transactions Costs: Evidence from Kenya’s Mobile Money Revolution, in 104 Am. Econ. Rev. 183, 187 (2014).)) second, well-supervised mobile money can be safer than alternative forms of currency; and third, studies have found that mobile money enhances transaction privacy and autonomy.  Studies have found the promotion of mobile money to have positive effects on financial inclusion of women especially in developing countries where women face more societal barriers to financial services than men. ((See Olga Morawczynski, Examining the Usage and Impact of Transformational M-Banking in Kenya, in Internationalization, Design and Global Development  495-504 (Nurgy Akim ed., Berlin: Springer, 2009).))

 The financial inclusion ecosystem differs from a traditional banking system in many ways.  There are a new set of consumers who are entering formal financial services for the first time – who are often low-income and rural, with many being digitally and financially illiterate.  The rise of technology offers lower-cost and faster-moving products offered by the traditional banking and financial actor in concert with new players such telecommunication companies, differentiated banks, fin-tech and large technology corporations.  These leading-edge digital services call for efficiency in tax designs and government revenue administration in order to facilitate and optimize their developmental outcomes.

VAT Treatment of Financial Services: Concepts and Distortions

The debate about whether to impose Value-Added Tax (“VAT”) on mobile money services is rooted in the debate on taxation of the consumption of financial services by VAT.  VAT is an important pillar in the tax and economic system of most developing countries. In fact, eighty percent of countries in sub-Saharan Africa have adopted the VAT as their consumption tax regime. ((See Francois Gerard & Joana Naritomi, Value Added Tax in Developing Countries: Lessons from Recent Research, Int’l Growth Ctr. 1 (June 6, 2018), Apart from being a significant revenue source, ((Reuven S. Avi-Yonah, Designing a Federal VAT: Summary and Recommendations, at 3. (Law & Econ. Working Papers, 2009), it contributes to a non-distortive trade policy and expands social outlays. ((See Reuven S. Avi-Yonah, The Parallel March of the Ginis: How Does Taxation Relate to Inequality and What Can be Done About It? 5, (Law & Econ. Working Paper, 2014),  In simple terms, the function of a VAT system is to impose and collect on the value added at each stage in the production and distribution of a good or service. ((U.S. Chamber of Commerce, An Introduction to the Value Added Tax 3 (2010),  The most prevalent VAT system is calculated based on a credit-invoice method, where a tax is imposed on each stage of production or distribution.  A tax credit will be provided to taxable persons for all input VAT on purchases of taxable goods or services used in the production or distribution of taxable supplies. ((See id. at 4.))

Traditionally speaking, most VAT systems exempt financial services and insurance from tax because of the administrative difficulty in fitting intermediation services within a transaction-based, invoice credit system. ((See Reuven S. Avi-Yonah, Structuring a US Federal VAT 20 (Int’l VAT Monitor, 2009) 275, 276))  Robert van Brederode and Richard Krever divide the supplies commonly identified as financial services in the VAT context into three categories: 1) loan intermediary services provided to lenders (including persons making deposits in financial institutions) and borrowers; 2) insurance and gambling pooling services; and 3) the provision of intangible investment instruments. ((Robert F. van Brederode & Richard Krever, VAT and Financial Services: Comparative Law and Economic Perspectives 7 (Springer, 2017).))  Satya Poddar makes a more detailed categorization based on the type of the services provided. ((See Satya Poddar, Consumption Taxes: The Role of the Value-Added Tax, in 235 Taxation of Financial Intermediation: Theory and Practice for Emerging Economies 345, 347 (2003).))  Besides definitions introduced in academia, countries have adopted a myriad of distinct categorizations. For example, the draft cabinet decision on the Executive Regulations of UAE law provides that financial services will be exempt from VAT if they are not provided in exchange for an explicit fee, discount, commission, rebate or other payments of similar nature. ((See Art. 42, Executive Regulations of the Federal Decree- on Value Added Tax, No. 52 (2017).))  Canada, on the other hand, identifies financial services by the economic function that is being performed.  The presence of financial risk is what sets financial services apart from non-financial services. ((See KPMG, GST Applicability to the Financial Services Sector in Canada, TS35-01 (Feb. 1, 2011),

While many have argued that financial intermediation services should not be taxed. ((See, e.g. Harry Grubert & James Mackie, Must Financial Services Be Taxed Under a Consumption?, 53 National Tax J. 23 (2000), (arguing that any VAT imposed on financial services distorts production because financial services are an intermediate good that does not provide utility in and of itself.); Michael Keen & Ben Lockwood, the Value-Added Tax: Its Causes and Consequences, 92 J. Dev. Econ. 138 (arguing that any other form of consumption tax would have the same effect as VAT Liam Ebrill et al., The Modern VAT (Washington, D.C.: IMF, 2001). Others refused to differentiate financial services from other services for VAT purposes. ((See Judith Prelims, Tax by Design 156-58 (Oxford University, 2011).))  For example, the Institute for Fiscal Studies takes the position that inability to reclaim VAT on banks’ inputs have led to the overpricing of financial services provided to other business, which ought not to bear any tax. ((See id. at 196.))  In doing so, the current paradigm carries more compliance costs because many financial institutions undertake both exempt activities and taxable activities.  Hence, imposing VAT on financial services creates a bias towards vertical integration since banks self-supply inputs as much as possible to avoid paying VAT on purchased inputs. ((See Kathryn James, The Rise of the Value-Added Tax at 66 (Cambridge University Press, 2015).))

The economic distortions created by the exemption structure also raise major concerns that financial services should not be exempted from VAT.  By providing for a de facto zero tax rate on supplies but denying the deduction of input VAT related to the supplies, the exemption structure leads to tax cascading where the supplies are received by registered business entities other than final customers.  In other words, depending on where in the chain of supply the financial services is provided, the exemption produces qualitatively different tax consequences: if the exemption occurs at the intermediary stage of the supply chain, the effective tax rate will absorb the input taxes levied on intermediate financial institutions that are not credited. ((See Poddar supra, note 14 at 352-54.))

VAT, Mobile Money and Financial Inclusion

Financial exclusion is widely spread in developing countries. A recent report published by the World Bank indicates that while bank account ownership is almost universal in high-income countries, only 54 percent of adults in developing countries have a bank account. ((See Asli Demirguc-Kunt & Leora Klapper, Measuring Financial Inclusion: The Global Findex Database 22 (Policy Research Working Paper 6025, 2012),  The advent of mobile money enabled a reduction in the need for location-specific distribution channels such as ATMs and branches by helping to reduce costs of providing new services.  The importance of mobile technology in expanding financial services to the poor at affordable costs is driven by the fact that its major cost relates to initial development and other fixed costs, with very low marginal costs per transaction or per new customer. ((See Patrick Honohan & Thorsten Beck, Making Finance Work for Africa 95 (World Bank, 2011),  This gave rise to the rapid expansion of mobile money in developing countries leading to increased financial inclusion.

However, when the Kenyan government announced a 10% tax on mobile payments and other financial transactions in 2012, the volume of mobile payment transactions fell by almost 5% in the three months following the introduction of the tax. ((Changing the Mobile, Economist (Jun. 22, 2013),  Similar results have been overserved in Ghana ((Bank of Ghana, Payment Systems Statistics – Third Quarter 2018, and Rwanda.  In response, the Bank of Ghana declares that it will exempt mobile money transactions from VAT.  Experiences of these countries suggest mobile-money specific taxes may lead to inefficiently low consumption and investment in the mobile money sector.  If VAT is chargeable on mobile money, ICT financial services that serve as intermediary suppliers will be facing a commercial conundrum of either reducing its margins or potentially suffering a competitive disadvantage, especially given that the transaction fees that mobile money providers charged are individually quite small.  As such, a marginal price increase might have significant impact on the scale of subscription.  For example, in Kenya, the amount of money remitted increase when transferred using M-PESA compared worth traditional forms of remittances. ((M-PESA Rates, Safaricom, (last visited December 9, 2018))  As shown, if the transaction is within the amount of 1-100 KSHs, there is no M-PESA charges attached. These fees are deducted from user’s accounts and shared by Safaricom on a commission basis with the relevant agent, whereas in Botswana the cost per transaction is a minim of 8 pula (§1.07).

In general, imposing a VAT system shifts the tax burden from high-income earners to low-income earner. ((Calvin H. Johnson, We Don’t Need No Stinkin’ VAT, in Tax Notes 527 (Apr. 2013),  Telecommunications executives have voiced their concern that imposing VAT on mobile money is used as a proxy to tax the small and microenterprises, many of them technology start-ups that often fall through the cracks of government regulation and taxation. ((Anuradha Joshi, Wilson Prichard & Christopher Heady, Taxing the Informal Economy: Challenges, Possibilities and Remaining Questions 12 (ICTD Working Paper No. 4, 2012),  What’s more, VAT can inhibit the process of expanding services to the global market.  Mobile money services providers, including banks and alternative financial institutions, will have to adjust their rates to reflect the new tax. VAT levied on mobile services may result in higher rates charged relative to other sectors when taken into consideration general taxes such as customer duties, money exercise taxes and other sector-specific taxes.  Such a mobile money VAT scheme can directly lead to increased expenses in transferring money by low-income, rural-based consumers.  Hence, VAT on mobile money services is particularly regressive in that the tax burden disproportionately falls on those with lower incomes.  VAT on mobile money also undermines investment at a time when mobile operators and fintech start-ups are already under significant cost pressure to expand their services and address new regulatory requirements.  This clearly runs afoul of the common mandate of promoting financial inclusion.

In addition, the current VAT exemption system needs to be revisited because of its negative externalities including but not limited to tax cascading.  Hence, relevant authorities in developing countries should fully account for the positive externalities arising from the usage of mobile money services, enforcement costs for government.  Besides an objective of applying taxation to mobile money services as a progressive source of revenue while avoiding economic distortions to the largest extent, policymakers need to balance this against a more pivotal agenda to promote financial inclusion.

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Michael Xu

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