While brokers and insurers are exempt from VAT, their suppliers may not be - and the 2.5% hike could bite hard

We've all seen the headlines: cash-strapped pensioners will have to pay an extra £100 a year, retailers face declining sales, pubs already in danger of closing down could lose their few remaining customers. The VAT hike from 17.5% to 20% has sparked all manner of grim news stories, further adding to the sense of economic woe.

As part of an industry in which it is hard to assess at what stage value is actually added, insurance insurers and brokers have been exempt from VAT. This means that VAT is neither recoverable on business purchases nor included in the selling price.

This should mean that insurance – in many lines a discretionary purchase in a time of downturn – remains relatively inexpensive and retains more policyholders.

However, the reality is that insurers and brokers face yet another squeeze on margins.

No escape

Head of VAT and insurance premium tax services at accountant TMF, Richard Asquith says that VAT is now “a big expense” for insurers and that they could be “less profitable by anything up to 2.5%” because of the VAT rise.

While exempt themselves, insurers and brokers still use suppliers that charge VAT, so outsourcing payroll or administrative work will now be more expensive.

It used to be possible to get an exemption on industry-specific outsourcing, such as claims management, as opposed to areas typical across business, such as human resources and payroll.

In other words, these suppliers were not allowed to pass on VAT costs to the insurance companies using their services.

A shrinking loophole

However, since a European Court of Justice judgment against financial services group Arthur Andersen in 2005, this VAT exemption has become less and less available to UK insurers, meaning it is yet another cost to absorb.

Although not allowed to charge VAT specifically, insurers would have been able to pass on any increases in costs to customers pre-credit crunch. Asquith says that today’s soft market means that this is simply not possible.

“This could be the straw that breaks the camel’s back,” he warns. “If outsourcing, be it call centres or IT, is now another 2.5% more expensive, insurers might bring those functions back in-house.”

This would mean that not just the 2.5% rise is mitigated, but that a whole 20% in VAT is saved. Suddenly, outsourcing no longer looks quite such a cost-efficient way of doing business.

Get the price right

Indirect tax partner at accountant Littlejohn, Robert Jones says that of more immediate concern is ensuring that suppliers do not overcharge. The VAT increase came into effect on 4 January and savvy firms may have arranged early invoicing of supplies of up to perhaps £100,000 ahead of this date.

If this early invoicing has not happened, insurers should instead demand to know exactly when work for them took place. Although service providers are not legally obliged to split their invoices pre- and post- such a rise, Jones argues that most reputable suppliers will have detailed timesheets.

“The main issue is to ensure that you are charged the correct amount of VAT,” Jones explains. “The invoice should reflect that services rendered include VAT at 17.5% before 4 January, and 20% afterwards.”

For the bigger insurers, a simple demand to provide a detailed breakdown should be sufficient, as suppliers will be keen to retain their business. Jones suggests that big companies should pay particular attention to their lawyers: legal fees are so significant that just a 2.5% rise could translate into huge amounts of money.

Brokers' burden

As naturally smaller organisations with ever-tightening balance sheets, brokers can struggle more than insurers with cost-base increases.

Broker Network chairman Grant Ellis says that brokers must simply resign themselves to the VAT hike.

“I’ve been broking since the 1970s and this issue has always been a thorn in the side of brokers,” he sighs. “There was a two-year period where Customs & Excise allowed us to reclaim some VAT, but that was a while back. This is probably a battle that we lost a long time ago.”

With no way of reclaiming the VAT, Ellis insists that brokers must treat the rise as “an inflationary cost”. And the best way of eating into inflation is to be more productive.

Ultimate risk

While there are measures that can be taken to combat the tax, it is inevitable that the VAT rise will hit every participant in the industry to some extent.

At the very least, it will mean that customers have less money in their pockets. Even if there is no VAT on the policies they want, consumer spend elsewhere could rise enough to persuade them to take a risk and reduce their insurance cover. And that's bad news no matter how the VAT hike is mitigated.

Mark Leftly is deputy business editor at The Independent on Sunday