Should the Gulf introduce VAT?

The International Monetary Fund (IMF) this week recommended the UAE implement a special excise on cars and broaden the corporate income tax, as well as push ahead with the planned tax on consumer goods, to help counter oil revenue losses.

The organisation has told the country’s economists the taxes could generate an additional 7.4 percent of non-hydrocarbon domestic product, replacing some of the $42 billion the UAE is expected to loss from oil export revenues this year, compared to 2014.

The IMF has recommended a 15 percent special excise on cars and extending the existing 10 percent corporate income tax to more companies.

They also said an impact study would be needed before any broadening of the corporate income tax could be considered.

This move is nothing new, in February representatives from the six GCC nations met to thrash out long awaited proposals to introduce value-added tax (VAT) in the region.

Experts claim it is the strongest indication yet that the GCC could finally take steps to introduce a tax that would alter the way in which regional economies are structured — and mark an end to their tax-free selling point.

A Gulf VAT was first mooted in 2007 as a way of broadening the revenue base of oil-dependent countries, with negotiations involving all six nations to avoid one becoming more competitive in the region than others.

The plans were shelved as the effects of the global economic crisis and Arab Spring took hold, but the drop in oil prices at the end of last year — though less pronounced in recent weeks — is thought to have spurred governments into action.

An IMF report published in December, provided additional impetus. “With oil prices declining by 40 percent since June, the importance of diversification is once again highlighted,” the IMF said. “While governments in the region have made some progress toward economic diversification, for example, increasing spending on infrastructure, health, education and industry, much remains to be done.”

While the detail has yet to be worked out — at the time of publication the GCC financial committee had proposed a levy of between 3 percent and 5 percent but disclosed no further information — imposing any VAT on a predominantly tax-free region that attracts millions of expatriates and so-called ‘retail tourists’, will be a complex procedure.

But if the authorities get it right it could help to rebalance local economies, maintain public services and diversify income streams in a region overly dependent on oil. Here, Arabian Business analyses the issues and offers suggestions for what a Gulf VAT could look like.

The first task facing the committee is to decide which items to tax and which to exempt.

Bob Swarup, principal of financial advisory firm Camdor Global, says: “The GCC has a rich vein of consumer items, including clothes, cars, jewellery and electronics, and service industries such as consultants, oil services, accountants and other financial services, whose transactions are the obvious first port of call as a small levy will make little difference to the price paid, and generate significant stable revenues.”

However, general foodstuffs and non-luxury items are likely to be exempt “chiefly for socio-political reasons”, he says. “Food and energy were a key factor in stoking tensions in the Arab Spring, and policymakers are cognisant of this. Imposing VAT on such items would hit the lower echelons of society hardest, so would be the most regressive form of taxation if deployed initially.”

Therefore, the most likely and least controversial system would be to follow the precedent set by countries such as the UK that have established VAT systems that distinguish between day-to-day necessities that are VAT exempt, and luxury items and certain professional services that attract VAT, says Jonathon Davidson, chairman of the British Business Group of Dubai and the Northern Emirates.

“The key is not to affect the lower-income end of the demographic but to apply VAT to items where consumers can exercise a choice and do without the item if they choose to.”

However, he says the line between luxury and non-luxury foodstuffs must be clearly delineated to avoid disputes such as the “Jaffa Cake” case in the UK, which went to court in 1991 to determine whether the product was a biscuit or a cake and subject to the standard VAT rate of 17.5 percent. Happily for Jaffa Cake lovers, the court ruled the product was a biscuit and therefore exempt.

Pharmaceuticals would probably be exempt from VAT because of sensitivities around Sharia law and policy, notes Christopher Bovis, professor of International and European Business Law at Hull University Business School in the UK. And Colm McLoughlin, executive vice-chairman of Dubai Duty Free, suggests children’s clothes and reading materials should be exempt “to weigh revenue gains with the possible burden on family households”.

On the other hand, luxury clothing, jewellery and watches would be obvious targets for a VAT as would cigarettes, fuel and cars — all of which are “incredibly cheap in the Gulf”, says Nick Cully, a director at Dubai-based Sovereign ‎Corporate Services. “There are too many cars on the road so if VAT was added people might be dissuaded from using them.”

The general understanding is that if a VAT is introduced in the GCC it would be a comprehensive one with minimal exemptions. “Sectors that are typically given exemptions internationally include medicine, education, real estate and basic food. Financial services sectors are typically exempted from VAT as it is difficult to tax this sector, particularly in relation to interest income,” notes Ashok Hariharan, partner at KPMG and regional head of tax for the Middle East and South Asia.

However, as fees and commission earned by the financial services sector are normally subject to VAT, the GCC would need to agree on whether to give an exemption to this sector or to ‘zero-rate’ such services.

“The implication of zero-rating a particular item is that while there will be no VAT collected from the consumer, intermediate businesses would be able to get a refund from the government for the input VAT they have suffered in the supply chain.

“In an exemption regime, although there will be no output VAT, companies would not be able to claim refund for the VAT accrued in the supply chain, resulting in an added cost to business and more revenues to the government,” Hariharan says.

The biggest challenge for the GCC committee is to align exemptions with countries’ socio-economic priorities based on varying demographics. Sherif El Kilany, Cairo-based tax partner Middle East and North Africa (MENA), at EY, says countries with large well-off expat populations such as the UAE may not be so worried about imposing VAT on standard foodstuffs and traditionally exempt items as countries with local populations. This approach would backfire, he adds, if expats were put off from living and working in the Gulf because of perceived higher costs.

Cully agrees: “The majority of expats are in the UAE due to the fact that there is no tax — the more official taxes that are imposed, the more people will reconsider their reasons for being here and we may start to see them move to other low-tax jurisdictions, such as Singapore, where the tax regime is more transparent.”

Practically, the VAT discussions will amount to a “horse trade” between the countries involved, all of which will have different views, says Gary Richards, a tax partner at law firm Berwin Leighton Paisner. As with all emerging policies grey areas must be clarified to reduce the potential for loopholes and tax evasion.

“For example, would some food exemptions carve out certain supply routes where it was considered appropriate to charge VAT?” he says. “Or, if VAT was imposed on commercial property, would it be up to the owner or occupier to pay it, and would VAT still apply if the building was subsequently converted to residential use?

“And would VAT be imposed at the time of exportation of importation? Would businesses that receive services from abroad be required to charge themselves VAT as if they had bought locally?”

All of these are as much political as technical questions and the risks are high. Failing to introduce clear rules on exemption and watertight policies for collecting the tax could fuel the growth of an illegal black market economy.

“Lessons should be learned from market economies with established VAT regimes to avoid creating a parallel black market based on cash transaction to avoid VAT,” Bovis says. “The system for collecting VAT needs to be integrity driven and effective.”

Penny Clarke, programme director BSc Accounting at Manchester Business School in the UK, agrees. “Implementing VAT in the GCC is bound to cause some consternation among those who are not used to paying taxes. There might be compliance issues. Would some Gulf citizens be granted exemptions because of family connections, for example?”

The introduction of VAT could negatively hit the retail sector, too. McLoughlin of Dubai Duty Free says: “Any expansion of the differential between downtown and duty-free prices gives a price advantage to our customers. However, the taxing of duty-free products needs to be given very careful consideration as airport revenues are vital for infrastructure growth and Gulf economies as a whole.”

A VAT on luxury goods could drive Russian, Chinese and European ‘retail tourists’ — who play a significant role in many Gulf economies — elsewhere, warns Mohi-Din BinHendi, president of BinHendi Enterprises.  He says he hopes this problem could be resolved by covering such items with a customs duty instead.

In general, experts say that if these issues were addressed and VAT was introduced thoughtfully and at the proposed rates it would be a positive move. The GCC is one of the few small pockets globally where there is no VAT and, from a revenue generation point of view, it would add significantly to the governments’ coffers. KPMG, which is researching the potential impact of a Gulf VAT on behalf of one GCC country it refuses to name, claims revenues from VAT would “far exceed” those being realised from corporate tax by the four GCC states that impose the tax: Saudi Arabia, Kuwait, Qatar and Oman. Pitted against the predicted inflation rise that would come about as a result — a one-off hit of less than 5 percent, says Hariharan — the short-term economic impact of a Gulf VAT may not be that severe.

Problems may arise if the GCC follows countries such as Europe and Singapore in imposing ever steeper VAT rises over the years. Singapore’s introductory 3 percent VAT has risen to 10 percent. “VAT is a very easy tax to hike when there is economic necessity,” warns Chas Roy-Chowdhury, head of global taxation at the Association of Chartered Certified Accountants (ACCA).

For now, the GCC will be closely monitoring VAT-regulated economies, particularly those that recently introduced the tax, or those that are preparing to this year, such as Malaysia. The IMF announced last week that Egypt, which introduced a 10-12 percent VAT last year, can expect 3.6 percent GDP growth in 2014/15, rising to 5 percent in the medium term, which is encouraging news for the region.

“Paying systemises things and creates a balanced economy,” says BinHendi. “It’s good to take, but it’s good to give, too.” Arabian Business