B&E | Commercial & Financial Risks of the Value Added Tax

B&E | Commercial & Financial Risks of the Value Added Tax

By Grant Huxham and Emmaline Ivy Johnson

Image Attribute: Burj Al Arab, Dubai, United Arab Emirates - Photo: Kunal Mukherjee via Flickr

Image Attribute: Burj Al Arab, Dubai, United Arab Emirates - Photo: Kunal Mukherjee via Flickr

In an effort to mitigate budgetary shortfalls due to plummeting oil prices, members of the Gulf Cooperation Council (GCC) plan to implement the new Value Added Tax (VAT) on January 1, 2018 (and to finalize all tax revenue systems and procedures by early 2019). United Arab Emirates (U.A.E) officials claim that VAT will generate USD 3 billion in national revenue during the first year. With health, education and over one hundred food items exempt, they also maintain that this new tax will have minimal impact on consumers.

VAT is a consumption tax by which the government collects revenue on sales and then refunds the tax difference to the seller. This differs from a sales tax, which requires a business to determine the buyer’s intent. If the buyer intends to purchase merchandise, add value, and then resell it, the seller does not need to impose any tax. On the other hand, if the buyer's intent is to consume the goods in their current state, the opposite is true. This system incentivizes both merchants and consumers to claim that their goods will not be consumed in their current state. VAT is an alternative to sales tax, whereby a tax is charged every time goods are bought and sold. VAT is a temporary payment to the state based on the purchase price that is subsequently refunded after value has been added. This arrangement removes any incentive to inaccurately report consumption because the seller invariably receives a refund. Consumers with no possible refund have no reason to inaccurately report their intended use. In the end, only the consumer is taxed, as is the case with a sales tax.

Direct taxes, like income taxes, necessitate a great amount of institutional framework and preparation. In the U.A.E, as in other GCC countries, it will likely take years (if not decades) to fully develop and implement VAT. At a rate of 5 percent, VAT slowly introduces the idea of taxation to a region that is accustomed to subsidies and government handouts. In February 2016, Christine Lagarde, Managing Director of the IMF, declared, “It is time people are made to understand that public services need to be priced. Either a viable pricing mechanism needs be implemented to fund public services or governments can resort to big borrowings, which is not sustainable in the long term.” The U.A.E is expected to generate revenue from VAT in the sum of 1 to 2 percent of its gross domestic product.

The effect of VAT on UAE consumers will depend on income and spending habits. With essential food items, education, and healthcare exempt, low-income families are unlikely to see a significant difference. As is the case with most economic policies, the middle class will be, over time, affected the most. Consumers in the habit of frequently upgrading their appliances, electronics and automobiles will certainly feel the greatest burden. For them, VAT is unlikely to discourage spending, however, since a tax of USD 50 on a purchase of USD 1,000, while noticeable, is still small. Those in the higher income brackets should not be affected at all.

How will VAT impact the U.A.E’s tourism sector? Dubai is attractive to high-end travelers for its tax-free shopping. Karen Patel, marketing manager of 2GIS Middle East, argues that because tax-free shopping will no longer exist, we may see a decline in tourist spending. Tourists to the U.A.E will be charged a 5 percent VAT and then be taxed again when they reach home. Other analysts consider it unlikely that the 5 percent VAT, which is low by international standards, will cause wealthy tourists to rethink purchases. It is also probable that consumption related to tourism may turn out to be ‘zero-rated’ or ‘exempt’ from VAT. GCC officials may decide that VAT will be levied at a ‘zero-rate’ on hotel accommodations, high-end purchases at the duty-free counter and some forms of public transport.

In order to stay afloat economically, the U.A.E and its fellow GCC members must diversify their sources of revenue. But they must tread carefully. Because their populations are not accustomed to taxation, which is as much a cultural phenomenon as it is an economic one, the 5 percent VAT will allow the U.A.E to diversify without pushing the mostly expatriate middle class to other markets. Moreover, the absence of an income tax (and exemptions for education and health care) will still allow the U.A.E to boast tax-free income as an enticement to foreign workers.

Ultimately, the introduction of the VAT is a soothing mechanism, designed to ease taxation upon U.A.E residents. As oil prices remain low, the GCC will have to continue to diversify and broaden its sources of revenue. The IMF reports that single-digit indirect taxation in the form of VAT is the most viable option for Gulf Arab states in the first stage of taxation, as implementation of direct taxes requires a fairly well developed institutional framework. VAT is by no means the final step, rather just the beginning of inevitable taxation in the U.A.E and other GCC nations. 

Although taxation is fiscal policy considered at the macro-economic level, the implementation of VAT has ramifications also at the micro-economic level with regard to cash flow. VAT is due and payable to the authorities once the sale of goods or delivery of services has occurred, even if the customer has not yet settled the account. Furthermore, VAT is normally payable at the time one imports goods, or when they enter the U.A.E from a free zone such as JAFZA, necessitating appropriate management of cash resources. The net VAT status of an entity also will impact the measurement of liquidity and debt ratios as measured by the banking system (and may, in fact, require a review and appraisal of existing banking facilities).

Apart from the impact of VAT on cash flows and banking facilities, the compliance requirement becomes an additional component that will need proactive engagement by commercial entities and possibly detailed harmonization by GCC governments. For example, in order to claim the VAT paid on imported goods, a VAT-registered entity must possess a copy of the entry form or other customs document. Firms that actively import from overseas for distribution into the U.A.E will be required to ensure that items carry VAT when sold to the next user in the chain. Should these items then be re-exported to another GCC country, two aspects will require careful attention: first, the submission of the export invoice to the local authorities to enable a claim to be made for a refund of VAT paid to date locally (because, typically, VAT is not levied on export transactions), and second, the shipping documentation that complies with the VAT requirements of the new country. (For example: if shrimp draws a one-percent VAT levy in the UAE, the same item may attract a two-percent levy in Saudi Arabia, therefore requiring new documentation to substantiate compliance.) 

From the government's perspective, several factors shape the question of how VAT compliance will be administered. For example, for every service or good delivered – a VAT-able event has occurred. Will the VAT payment be made via paper or electronic submission? How often will tax submission occur? Will the compliance officer have to assess each line item to ensure that the valid and appropriate VAT rate has been applied? What will be the turn-around time of VAT refund claims? Will long lines of tourists claiming VAT back at the airport (as in Manchester or at Heathrow) be acceptable within the GCC environment? How do the governments intend to actually combat ‘carousel’ fraud (a.k.a. intra-community VAT fraud, usually carried out by organized criminal groups which import goods VAT-free from one country and sell the goods in another country while charging the buyer VAT then never paying the tax to the state)?

Will the banks separate VAT liabilities and assets into different bank accounts for clients, or merge them into one operating account? 

All these questions will certainly be answered through forthcoming implementation guidance from the governments concerned. Until that occurs, however, the necessary education and related implementation of VAT systems within commercial entities and banking institutions will be based solely on theoretical guidance. As is evident within the EU, the embedding of a VAT system that works well takes time and, if not addressed properly, carries attendant commercial and financial risks.

About the Authors:

Grant Huxham is an advisor at Gulf State Analytics and the Chief Financial Officer at Health Safety Emirates. 

Emmaline Ivy Johnson is a contributor to Gulf State Analytics.

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