In an article first published in the 8 September issue of Tax Journal, Matthew Greene and Anastasia Nourescu explain what the VAT Terminal Markets Order is, why it is useful and how the government plans to reform it.

At the Tax Administration and Maintenance Day on 27 April 2023, HM Treasury and HMRC announced a suite of planned technical tax consultations and legislative changes. Those proposals and draft legislation were published on 18 July 2023 to great fanfare, although one development has largely flown under the radar: the consultation on the legislative reform of the Value Added Tax (Terminal Markets) Order 1973, often referred to simply as the “Terminal Markets Order” or the “TMO”. This may be because commodity markets are seen as more niche and less glamorous than, say, the multinational top-up tax or R&D tax relief. However, the VAT zero rate on certain commodity transactions is a valuable simplification measure and any changes to it deserve attention.

 

What is the Terminal Markets Order?

Commodity markets have come a long way since the TMO was first introduced in 1973. The volume of transactions has grown exponentially due to increasing consumption. Taking aluminium as an example, global production has increased five-fold since 1978, according to World Bank figures.

The VAT treatment of commodity trades normally varies depending on the type of transaction. For example, commodity futures and actuals are taxed based on the liability of the underlying asset, whereas the premium paid for commodity options is always standard rated as it is a supply of the right to buy a commodity.

The TMO is a small piece of legislation with a big impact. It provides for the zero rating of certain commodity transactions on named commodity exchanges or “terminal markets”. Terminal markets are commodity markets in a central trading site, such as London, and they are distinct from local markets in the country of the commodity’s origin. The terminal markets that benefit from the zero rate are listed by name in the TMO and include the London Metal Exchange, the London Bullion Market and the London Cocoa Terminal Market. The commodities traded on these markets include precious metals, agricultural goods, energy products and carbon emission allowances.

The listed markets are huge and there is a very high volume of transactions taking place through sophisticated electronic platforms, which allow such trades to happen in a short period of time. The purpose of the TMO is to simplify VAT accounting for such transactions, as declaring VAT on each and every taxable transaction would be an overwhelming administrative burden. Zero-rating certain transactions on these markets also improves liquidity in the market and mitigates any impact on cashflow. The application of the zero rate in this context leads to a tax-neutral outcome, as the VAT paid by one party to the transaction would be reclaimed by the counterparty in any event. This also mitigates the risk of missing trader fraud in supply chains, particularly those involving precious metals, which have a history of being used to facilitate VAT fraud.

The TMO covers transactions between market members and non-members that do not result in physical delivery of the underlying commodity (including spot trades and derivatives such as forwards, futures and options), as well as some sales of physical goods between members in the circumstances set out in Article 3(2)(b).

The zero rating of commodity transactions on certain terminal markets was permitted as a derogation from EU law, initially under the Sixth VAT Directive and subsequently under the Principal VAT Directive.

In 2018, the European Commission commenced infraction proceedings against the UK on the basis that the application of the TMO infringed EU law. The Commission argued that the UK’s amendment of the TMO to zero rate additional commodity derivatives transactions far exceeded what was initially envisaged under the derogation, such that it breached single market rules by providing London’s commodity markets an unfair competitive advantage. In 2020, the Court of Justice of the European Union held that the amendment and extension of the TMO had breached the UK’s obligation to seek the EU Council’s approval for any such changes. Although the UK government was required to liaise with the Commission in light of this decision, it is unclear whether this happened and there have been no subsequent amendments to the TMO. This is now a moot point following Brexit.

 

The proposed reforms

As the UK is no longer bound by EU law, the government is consulting on potential reforms of the TMO. The aim is to modernise, update and simplify the legislation, while preserving the existing benefits and making it easier to amend the TMO in response to changes in the market.

According to the consultation, the government “seeks to move away from list-based legislation and adopt a principle-based approach” to establish whether a transaction falls within the scope of the TMO. The main proposed changes are as follows:

  1. Defining a terminal market – At present, the exchanges and market associations to which the TMO applies are listed in the legislation. To make it easier to amend these, the government is proposing to dispense with the list and move to a principle-based approach, which would include a set of criteria that a market would need to meet to fall within the scope of the TMO. These are criteria that HMRC currently uses in deciding whether a market should be covered by the TMO, but the government is proposing to formalise these and remove the list of recognised markets in Article 2(2). Alternatively, the government may maintain a list, but move it to a VAT Notice to allow it to be more easily updated.
  2. Defining a market member – The government proposes to define “persons ordinarily engaged with dealings on the market” to avoid confusion as to the definition of a market member for the purposes of the TMO (which is restricted to certain levels of membership of a market). Alternatively, the government may maintain a list of member classes within a VAT Notice. These would be consistent with the guidance currently set out in VAT Notice 701/9.
  3. Defining qualifying transactions – The government proposes to adopt a principle-based approach to the transactions that fall within the scope of the TMO, as the legislation does not currently specify what types of contracts are covered. Set criteria would have to be met for a transaction to be zero-rated, which are likely to include the following:
    • The contracts must be futures, forwards, options and spot trades exercisable at a later date;
    • The transactions must be wholesale trades between businesses;
    • The underlying commodity must either be physically delivered or there must be an option for such delivery;
    • The trades must take place on a recognised terminal market; and
    • The trades must be made by a market member covered by the TMO.
  4. Specifying commodities traded – At present, the terminal markets to which the TMO applies are listed within the TMO, but the commodities themselves are not. The government is proposing to specify the commodities that fall within the scope of zero-rating within the TMO itself. The commodities proposed to be included in this list are those currently traded under the TMO, namely precious metals, agricultural goods, energy products and UK Emissions Trading Scheme allowances.

The government is also proposing to formalise the principles according to which it decides which commodities to include within the TMO, i.e. that the transactions would be taxable if made under the normal operation of VAT law, that they meet “specific standards that are recognised internationally”, and that they are traded in sufficiently high value and volumes to require simplification and prevent VAT fraud.

  1. Investment gold – There is no proposal to amend Articles 4 to 7 of the TMO, which apply the zero rate to supplies of investment gold in certain circumstances. If the supplies in question do not meet the zero-rating criteria, they may be either exempt or taxable under the provisions of Group 15 of Schedule 9 to the Value Added Tax Act 1994.
  2. Future changes to the TMO – The government is requesting details of any upcoming changes in the operation of commodity exchanges and market associations. This will enable it to ensure that any changes to the TMO reflect the most up to date industry position and any recent developments.

Comment

It has been five decades since the TMO was first introduced, during which time commodity markets have shifted considerably. The TMO warrants a refresh, and the government’s intention to modernise and update it while retaining its benefits is welcome. However, the present list-based approach in the TMO does provide a rare level of certainty in the context of the taxation of financial services. It is hoped that the move to a principle-based approach will not inject an unwelcome dose of uncertainty or confusion into this area.  The advantages of the current approach are apparent from the fact that no disputes in relation to the TMO have been heard and decided by the Tribunal so far.

The government is angling for more principle-based tests as part of the TMO, as it considers that “to maintain an up-to-date list might be challenging because markets frequently rename, re-structure or merge”. While this is understandable, moving to a principle-based approach would be at the expense of certainty to taxpayers. It would shift the burden of assessing whether a market falls within the scope of the TMO to market users, is potentially liable to cause uncertainty and could lead to disputes.

It is expected that market participants will wish to continue to benefit from the current list-based approach. While some of the proposals, such as specifying which market members fall within the scope of the TMO, are an improvement on the current position, providing this clarification by way of a list rather than a test will provide the most certainty.

As regards the proposal to maintain a list of commodities within the TMO, while this would be preferable to any principle-based approach, it is perhaps unclear what it would add to an up-to-date list of exchanges and market associations given the nature of those markets. It is also not clear why there would be a need to enact the principles according to which the government decides which commodities to include in the list, especially as those principles are not entirely comprehensive themselves (for example, the requirement for commodities to “meet specific standards that are recognised internationally”, without specifying what those standards are).

The consultation closed on 12 September 2023. The outcome will be of interest to all commodity market participants and their trade associations, who may wish to submit responses.

 


 

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