Navigating the VAT challenges of payment services providers (PSPs): When is a payment service VAT exempt?

Payment processing services provided by marketplace payments service providers (“PSPs”) facilitate online transactions between merchants and end-users. From a VAT perspective, these transactions require careful review to determine the correct VAT treatment, in particular as concerns the application of the relevant VAT exemptions. Based on our experience, we have observed that PSPs frequently tend to overuse the VAT exemption for payment transactions. This practice not only increases VAT risk but also results in missed opportunities and potential value loss.

Payment processing

PSPs may offer a range of payment services, including payment gateways, fraud prevention, and payment processing. Focusing on payment processing services, these typically include the verification and validation of payment instructions, the transmission of payment requests, and the collection and remittance of funds. Although these functions are undoubtedly essential for the successful execution of payment transactions between merchants and end-users, this does not automatically imply that the PSP’s service qualifies for VAT exemption.

VAT exemption criteria

Indeed, the Court of Justice of the European Union (CJEU) has adopted an increasingly stricter approach over time in its interpretation of qualifying VAT exempt payments and transfers for VAT purposes. Several significant judgments by the CJEU in recent years have effectively narrowed the scope of the VAT exemption outlined in the EU VAT Directive. These rulings particularly stress the point that, for a PSP’s service to qualify for VAT exemption, the functions performed by the service provider must result in a change in the legal and financial situation of the parties involved in the relevant transaction (i.e. merchants and/or end-users).

One of the crucial points in determining the correct VAT treatment is therefore whether the PSP is directly involved in debiting or crediting the bank account of the merchant and/or end-user in an online transaction. From our market experience, this is typically a function performed by the bank or financial institution of the respective merchant and/or end-user, rather than by the PSP itself. Even though the payment processing services delivered by PSPs often do entail accounting entries and transmission of payment instructions, from a VAT perspective these activities are typically considered to be of a merely technical or administrative in nature, hence not fulfilling the specific and essential functions of a qualifying VAT exempt transaction concerning payments or transfers.

The contractual relationships and the extent of the PSP’s level of delegated authority are also key factors in determining the correct VAT treatment of payment processing services. In practice, there is usually a direct contractual relationship with the merchants (i.e. no direct contractual relationship with the end-users), which tends to limit the PSP’s authority to initiate the actual transfer of funds. Conversely, a PSP that also acts as merchant acquirer would typically execute payment transactions on behalf of the merchant, ensuring the transfer of funds from the end-user's bank (issuing bank) to the merchant's account, and thus is more likely to qualify for VAT exemption.

Mitigating VAT risk

In our experience providing VAT health check and advisory services to PSPs, we often uncover significant VAT risks, including historical VAT exposure. This exposure typically involves VAT liability at Malta’s standard VAT rate of 18% on any VAT-taxable payment processing services supplied to merchants established in Malta, along with associated administrative penalties and statutory interest. Such historical VAT liabilities may extend into personal legal liability for the PSP’s directors and/or other senior officers, thereby creating additional regulatory risk.

Unlocking VAT efficiency

On the other hand, reclassification of the VAT treatment of PSP services from VAT exempt to VAT taxable could significantly enhance the PSP’s eligibility to recover input VAT incurred on their cost base – hence effectively resulting in a significant cost reduction for the PSP. This would be the case even where the PSP’s merchant clients are established outside Malta, hence resulting in no Malta output VAT liability while giving rise to input VAT recovery rights – in essence, the best of both worlds.

Enhanced compliance focus

Admittedly, the VAT treatment of PSPs is complex and depends on the specific circumstances, including the functions performed and the associated contractual relationships. While a thorough individual assessment is necessary to determine the correct VAT position of a particular PSP, it is especially important during this period of increased scrutiny and VAT audits by the tax authorities to carefully evaluate the PSP’s VAT payment and reporting obligations. This ensures compliance, mitigates risks, and unlocks opportunities for enhanced efficiency.

Get in touch

If you would like to discuss how this applies to your business, please reach out to our team of experts. Our team is well-versed in navigating the complexities associated with the VAT treatment of PSP services, and can provide tailored advice to ensure compliance with current regulations. We can help you identify potential risks, optimise your VAT recovery, and enhance the overall efficiency of your VAT processes. By partnering with us, you can gain peace of mind knowing that your VAT obligations are managed effectively, allowing you to focus on your core business activities.

To summarise, here are the key takeaways:

• PSPs often overuse VAT exemptions, increasing risk and missing opportunities.
• The scope of these VAT exemptions has narrowed significantly.
• Direct involvement in debiting or crediting accounts is crucial for VAT exemption.
• Reclassification of services from VAT exempt to VAT taxable enhances input VAT recovery.
• A thorough assessment is essential particularly in view of increased scrutiny and VAT audits.