3 December 2009 | Belinda Doshi & Nick Beecham

The imminent change to “place of supply” VAT rules could negate cost savings of offshoring financial services. Brush up on your contract rights before tackling this, says Belinda Doshi

Financial services and insurance firms should be aware of an important change to VAT rules due to come into effect on 1 January 2010. The change is to the “place of supply” rules adopted by the EU in 2008.

Under current VAT rules, where cross-border services are provided by one business to another, the basic place of supply rule for VAT purposes is to treat the supply as taking place in the country where the supplier is based. This means where the supplier is outside the EU, no VAT is payable. This has produced a considerable tax incentive for offshoring.

There are several exceptions, but the basic rule applies to certain outsourcings of back-office administrative services, such as call-centre operations.

From 1 January, business customers will have to account for the reverse charge to VAT on the costs of these services – unless they qualify for exemption in their own right as financial or insurance intermediary services.

Instead of paying VAT to the supplier abroad, the UK business declares a liability to pay VAT through its VAT return. It can recover a proportion of this VAT in the same VAT return in accordance with its VAT status. An exempt-sector business, such as a financial services or insurance firm, will be unable to recover the reverse-charge VAT in full, giving rise to a cost.

This could have significant financial repercussions given the recent boom in the offshoring of these types of services.

If your business has not already done so, it will need to calculate to what extent it will be affected by these changes. In particular, do additional tax costs outweigh cost savings produced by any offshoring?

In the longer term, you will need to consider how this will impact on your outsourcing strategy. Should you continue your current offshore arrangements or consider bringing certain services back onshore? Should you change location to a lower-cost offshore centre to offset any additional costs caused by the change? This will be a complex assessment based on cost reduction, service delivery and data security.

Even if your cost savings will take an immediate hit from the VAT change, this does not mean you cannot take action to mitigate this. One way forward is to review your offshoring agreements to see whether you can squeeze extra value from suppliers. This may be particularly appropriate where an agreement was signed two or more years ago.

Before approaching suppliers you will need to get up to speed on your contractual rights. What rights do you have to see your service provider’s costs and profit margin under any open book arrangements? At which governance board should strategic reviews and costs be raised? What are your rights regarding benchmarking? How do you exercise these? Can you de-scope certain services or change offshore location? What are your termination rights? And what are the likely risks and costs relating to these actions?

Even if you do decide to continue your current offshoring arrangements on the same terms, knowing your contractual rights is vital when considering your next move at the end of the contract term.

* Belinda Doshi is a technology and outsourcing lawyer at Field Fisher Waterhouse. Nick Beecham, tax partner, also contributed