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Category: GCC Tax
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Discovering DEMPE and Tax Trickery in the Gulf
In recent years the Middle East has been investing heavily in Research and Development (R&D). This has resulted in a number of patents being requested and made room for a number of so-called unicorns, like Careem and Jumia.
Although, according to UNESCO statistics, the Arab States and the Middle East are still behind the Western world in terms of R&D spending per capita, the investments in R&D are substantially increasing.
This article covers the taxation of Intellectual Property (IP) in the Gulf and discusses how international tax developments have had an important impact on the taxation of IP.
How IP is taxed domestically in the Gulf
The Gulf has a few interesting jurisdictions to hold IP. Two Gulf countries, the UAE and Bahrain, do not levy corporate tax and are therefore attractive tax jurisdictions. The other countries have a less or more developed corporate tax system, often coupled with exemptions if businesses are held by GCC nationals.
None of the GCC states have developed specific IP regimes to attract investment in the same way as many industrialized nations have. They may have specific depreciation rates (e.g. Oman allows depreciation rates of 33% per annum).
The absence of specific IP regimes may not necessarily be a handicap, because of the exemption for businesses held by GCC nationals (which are then sometimes subject to Zakat, depending on the country), coupled with relatively low corporate tax rates (only up to 20% in the case of KSA, the highest rate).
Free Zones in the UAE are zones who can guarantee on the basis of their establishment laws that no corporate income tax is levied on businesses established in the Free Zone (although mainland businesses mostly also do not pay corporate income tax). Some of these Free Zones specifically focus on offering licenses for companies who want to locate their IP in that zone.
VAT, introduced in the UAE and KSA on 1 January 2018 and in Bahrain on 1 January 2019, is only charged at a low rate of 5%. Between licensor and licensee, VAT usually does not constitute any issue, because licensees are generally in a position to fully recover any input VAT.
Given the absence of personal income tax in the GCC states, business owners selling their shares in a business holding IP, will be able to realize a capital gain which will go untaxed.
Because of the above described context, the Middle East can be an interesting tax jurisdiction to license IP to other jurisdictions as a holding jurisdiction.
Due to the ease of relocating IP many businesses did so
There are a multitude of types of planning structures which were being used by businesses wanting to locate their IP in more tax friendly countries.
Some are more straightforward. Belgium has its Deduction for innovation income, France has its reduced CIT rate for IP income, Luxembourg had its now abolished partial exemption for income derived from certain IP rights, to name just a few. Switzerland and the UK had their license box and patent box respectively.
Other tax planning structures required more tax trickery and used amongst others gaps in the international tax framework.
Large scale tax planning happened amongst others with American tech companies, who looked at moving their IP to certain European States for tax planning purposes. In the same way, companies can and have been tempted to move their IP to certain jurisdictions in the Middle East.
Moving IP can be taxing
Due to the high mobility of IP, the Western world had been increasingly eyeing tax planning structures with IP, amongst others to avoid that businesses develop IP in the Western world, claim tax credits to then move the developed IP out of the high tax jurisdiction into a low tax jurisdiction or harmful tax jurisdiction.
According to the OECD, the misallocation of the profits generated by valuable intangibles has contributed to base erosion and profit shifting.
In recent years, under the OECD sponsored BEPS project, the Western world has developed a number of tools to fight this practice (e.g. a nexus approach towards claiming tax credits). More specifically for the Middle East, some States have had to introduce economic substance rules and others adopted transfer pricing rules.
For intangibles, the OECD guidance clarifies amongst others that legal ownership alone does not necessarily generate a right to all (or indeed any) of the return that is generated by the exploitation of the intangible. Group companies performing important functions, controlling economically significant risks and contributing assets, are entitled to an appropriate return reflecting the value of their contributions.
In other words, the OECD guidance specifically targets situations where multinationals relocate their IP into a different legal entity which may not have contributed to the IP.
What BEPS means for IP in the Middle East
The BEPS programme, started in 2013, was developed by 44 countries, including all OECD and G20 Members. It has three main objectives:
– Reinstating the coherence of corporate income taxation from an international perspective
– Putting the substance of the economic activities at the core of international taxation, and
– Ensuring transparency in the global economy.
It resulted in the publication of 15 action plans in October 2015, known as the BEPS package.
Out of the 15 action plans, in January 2016 the OECD prioritized 4 key priority measures. These measures are known as the BEPS Minimum Standards. They constitute the BEPS Inclusive Framework. The four Minimum Standards which had to be implemented are:
· Fighting harmful tax practices (BEPS Action 5),
· Preventing tax treaty abuse, including treaty shopping (BEPS Action 6),
· Improving transparency with Country-by-Country Reporting (BEPS Action 13),
· Enhancing the effectiveness of dispute resolution (BEPS Action 14).
The Inclusive Framework Members have committed to implement these actions quickly. All of the six GCC States, except for Kuwait, are a member of the Inclusive Framework. Even if Kuwait is not a member, it is nonetheless expected to implement certain elements of the BEPS Action Plan. Around 137 countries are currently a member of the Inclusive Framework.
The BEPS project explains the recent legislative developments in most GCC States. KSA introduced extensive transfer pricing legislation and published extensive guidance. Qatar, KSA and UAE have also introduced Country by Country reporting.
We can expect further developments with respect to Country by Country reporting in Bahrain and Oman, and ultimately Kuwait as well.
Other relevant BEPS Actions are Actions 8 to 10, which relate to transfer pricing. More specifically BEPS Action 8 relates to intangibles, of which IP is an element. It is BEPS Action 8 which developed the DEMPE criterion covered below.
In the same BEPS context, UAE and Bahrain implemented Economic Substance Regulations.
Economic Substance in UAE and Bahrain
Bahrain and the UAE, on the account of being NOON tax jurisdictions (NO or Only Nominal tax), and at the risk of being considered harmful tax regimes, have introduced Economic Substance Regulations. Bahrain did so in early 2019, the UAE a bit later in the same year. The introduction of Economic Substance Regulations was a consequence of the implementation of BEPS Action 5.
It was important that both Bahrain and the UAE implemented these Regulations, since being on the so-called OECD blacklist can have important consequences for foreign trade with the UAE and Bahrain. The UAE and Bahrain are now no longer blacklisted by the OECD.
Economic Substance Regulations focus on a number of highly mobile activities or regulated activities and require businesses to maintain a certain degree of substance. In absence of having such substance, the business can be fined. In addition, the local competent authority (often the Ministry of Finance) may exchange information on the local business with a foreign tax authority. It will therefore flag a risk, which may lead to a tax audit.
One of the activities which Economic Substance Regulations looks at is Intellectual Property. In the UAE, there is even a rebuttable presumption that a business which licenses Intellectual Property does not meet the Economic Substance Test. It is up to the business to meet the DEMPE criterion. We explain further in this article what that DEMPE criterion is.
Transfer pricing in the Gulf
Transfer pricing is a relatively recent concept in the Gulf. Although many countries had a similar provision in their tax legislation requiring that transactions be at arm’s length, some Gulf countries recently introduced more extensive transfer pricing legislation. We explained above that this is a consequence of the OECD BEPS project.
BEPS Action 8 looks at the taxation of intangibles and suggests the use of the below explained DEMPE criterion. KSA, which has the most advanced transfer pricing legislation, has endorsed the OECD’s TP guidelines and therefore also the DEMPE criterion.
BEPS Action 13 requires businesses to file a country by country report. Qatar, KSA and the UAE have all introduced Country by Country reporting based on the OECD models. Country by Country reporting is only a requirement for multinational businesses with a consolidated turnover in excess of 750 million EUR (or the equivalent in local currency). Table 2 of the Country by Country report requires taxpayers to flag whether the entity in the respective tax jurisdiction is involved in holding or managing intellectual property. This requirement is specifically with the objective of zooming in on the use of intellectual property.
What is DEMPE
In the recently implemented Economic Substance Regulations and transfer pricing legislation, the so-called DEMPE criterion is used. DEMPE stands for Development, Enhancement, Maintenance, Protection and Exploitation.
DEMPE helps both taxpayers and tax authorities achieve an accurate assessment of transactions to help with the determination of appropriate transfer pricing. By identifying the entities that perform DEMPE functions in a transaction, taxpayers can ensure that they are complying with the OECD’s BEPS guidelines.
The DEMPE functions can be performed by several entities of the group. However, if the mere function of a legal entity is holding the IP, under the DEMPE criterion, it will not be able to claim any profit whatsoever in the tax jurisdiction where the IP is held.
Any income generated as a result of that IP is owned by all the parties that perform the DEMPE functions. So, rather than the IP owner receiving the full amount of the returns generated by the intangible, these instead have to be divided between the relevant parties, in line with each entity’s contribution to the value of the IP.
In other words, if a UAE or Bahraini company solely hold the IP, it will not be entitled to any profit. In addition, if royalties are charged to group licensees abroad, these charges may potentially be considered as not being at arm’s length and therefore nondeductible for the payer.
The Gulf is right in investing more in IP
Government and private backed investment in R&D are increasing in the Gulf. Homegrown IP will more easily satisfy the DEMPE criterion.
With the increased importance of the DEMPE criterion and sources of information for foreign tax authorities with respect to IP, tax planning with IP may prove more challenging. A mere location of IP into a Gulf country will not be viewed favorably by foreign tax authorities.
Some of the Free Zones may want to consider increasing the requirements for businesses wishing to hold their IP in the Free Zone since a company purely holding the IP and licensing it will not satisfy the DEMPE criterion. On the other hand, the DEMPE criterion offers a real chance for the Gulf to build on its recent experiences as an R&D hub.
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Blockbuster bankruptcies and tax in the Gulf
The UAE and the wider GCC in recent times have seen a few blockbuster bankruptcies with the downfall of Abraaj and Drake & Scull undergoing substantial restructuring to name just a few. As debt management becomes a greater area of focus, so do the tax consequences of debt management. The writing off of receivables, the transfer of receivables and insolvency, bankruptcy and liquidation all have important consequences from a tax point of view.
With four out of the 6 GCC countries applying corporate income tax, the direct tax consequences of debt management were already familiar to businesses. With 3 out of the 6 GCC countries implementing VAT, analyzing the tax consequences of debt management, now also needs to include a VAT analysis. This article summarises some of the most important issues for debt management.
Tax due to the tax authority
Tax payers who file their tax returns but do not pay their tax to the tax authority are faced with stiff fines. The obvious objective is to discourage non-compliance. The UAE is notorious for imposing the highest late payment penalties for tax purposes, which can go up to 300% of the tax due in the case of the UAE (Cabinet Resolution No. 40 of 2017 on Administrative Penalties for Violations of Tax Laws in the UAE – Table 1). The penalties in Bahrain and KSA are also steep and are very similar. The penalties depend on the type of tax liability, with for example KSA not harmonizing penalties for corporate tax and VAT.
With such high penalties imposed, they sometimes result in financial hardship. In KSA, a tax payer who finds himself in financial hardship can request an installment plan (article 71, 1 KSA Income Tax Law), but will still be subject to 1% late payment penalties per month (article 77, 1 KSA Income Tax Law). The late payment penalties for VAT purposes are higher in KSA (5% for each month).
However steep the fines may be, if the tax authority is not a secured or preferred creditor, it stands a much lower chance of its claim being settled. For example, the UAE Federal Bankruptcy law nor any of the UAE tax laws list tax claims as preferred claims (only amounts due to government agencies constitute privileged debts – article 189, 1, d UAE Bankruptcy Law). The UAE’s FTA can withhold a credit though when there is still a debt (article 35, 2 FTP Law). The Kuwait Income Tax Law on the contrary foresees that taxes and penalties constitute preferred debt over all other debts, except for salaries, wages and court expenses (article 40 Kuwait Income Tax Law).
When the tax authority is not a preferred creditor, the tax authority must undergo an imposed haircut of the debts a tax payer might have towards its creditors. In KSA, the tax authority can waive tax debts and penalties when their collection is considered impossible (article 79, 4 KSA Income Tax Law).
In most Western jurisdictions, the tax authority is a preferred and high ranking creditor. Interestingly, the UK only recently added its tax authority, HMRC, as a secondary preferential creditor.
Although both KSA and UAE have largely exceeded their objectives in terms of the income generated by VAT, in the longer run, since VAT generates a lot of revenue, they may lose out on some revenue do to insolvencies and bankruptcies.
Tax due on receivables
Potentially, a business comes into dangerous financial waters due to its customers not paying or not paying on time. Some sectors in the GCC, such as the construction sector, are notorious for paying late. Sometimes this may lead to liquidity crises and eventually the bankruptcy of a business.
When the tax payer has paid VAT already to the tax authority, it may benefit from so-called bad debt relief and receive a refund of the output VAT it paid.
Generally, a VAT refund is available where the supplier has accounted for output VAT before receiving payment from his customer and the debt becomes bad or doubtful (hence “bad-debt relief”). Bad debt is the debt that is unlikely to be paid, for example, because of the probable or actual financial failure of the debtor. Bad debts are also generally deductible for direct tax purposes.
The general rules for bad debt relief also apply where the customer becomes bankrupt. Under the bad debts adjustment scheme, creditors will be allowed to reduce the output liability in the VAT return. However, for creditors to claim relief under bad debts scheme, there are a set of conditions, which the creditors have to meet. These conditions are usually similar (and do not apply when accounting for VAT is done on a cash basis):
– Goods or services have been supplied and VAT has been charged and paid
– The creditor has (partially) written off the receivable
– A certain amount of time has passed since charging VAT (e.g. More than six (6) months have passed from the date of the supply according to Article 64 of the UAE VAT law).
Sometimes, it is required that the creditor has informed the debtor that the receivable has been written off. This counterintuitive logic may potentially worsen the issue, since the debtor will not feel particularly motivated to settle the debt after all.
In KSA, for the bad debt relief to apply to amounts in excess of 100,000 SAR, formal legal proceedings need to have been made to collect the tax (article 40, 7 KSA VAT Implementing Regulations).
The refund claim is made in the VAT return and no separate invoice is needed to claim the bad debts from the tax authority.
If as a result of the bankruptcy proceedings, or the improved insolvency of the tax payer, the debt is eventually paid by the debtor, then the creditors will be required to repay to the tax authority the VAT that had been refunded by the tax authority. If partial payment is received then only a proportion of the debt may be claimed.
The bad debts scheme helps the tax payer on the output side, however if the tax payer does not pay his vendors, he may suffer additional adverse financial consequences described as below.
From a direct tax point of view, the mere write off is sufficient to deduct the doubtful receivable from the taxable income of the tax payer (see e.g. article 14, 1 of the KSA Income Tax Law or article 55, 5 of the Omani Income Tax Law).
Tax deductible on payables
Generally, VAT charged to a tax payer can be deducted from the output VAT the tax payer has charged. Usually such a deduction is not linked to the actual payment to the supplier. It is foreseen in the EU VAT directive, the basis for the VAT system in the GCC, only as an option (article 167a Council Directive 2006/112/EC).
Bahrain and KSA followed the EU model. However, if a tax payer does not settle his debts, he needs to correct his input VAT deduction (article 46, A, 3 of the Bahraini VAT law and article 40, 10 of the KSA VAT Implementing Regulations).
In the UAE however, payment of the VAT is an explicit material condition for the input VAT deduction by a tax payer. In the UAE, a tax payer needs to pay or intends to make the payment of consideration for the supply within 6 months after the agreed date of payment for the supply (article 64 UAE VAT law).
The suppliers are required to pay the VAT to the tax authority even if they have not received the consideration from the debtor due to insolvency. This is because the time of supply rules do not take into account payment, unless for advance payments. Only KSA has cash accounting rules for VAT (article 46 KSA VAT Implementing Regulations).
If the customer, the debtor, has already recovered the input VAT on the basis of the tax invoice but eventually fails to pay, he needs to repay the deducted input VAT.
From a direct tax point of view, a natural person or legal entity in KSA is allowed to use a cash basis method instead of the accrual method for this accounting (article 23, 3 KSA Income Tax Law). In Oman and Qatar, the authority can allow a different method of accounting than accrual (article 12 Oman Income Tax Law and article 6 Qatar Income Tax Law).
Haircuts and transfers
So-called “haircuts” can be voluntary or imposed by a tribunal. They constitute a proportional reduction of the debts of a company in order for the company to try to continue its business unburdened by its debts.
Such haircuts can impact taxes due and payables. If the tax authority is not a preferred or privileged creditor, it will simply undergo the haircut and therefore need to make write offs.
Transfers of receivables constitute a good way of improving the liquidity of a business. Whenever a business transfers a receivable worth 100 $ face value in his books for a value of 90 $, he accepts a write off for 10 $. From a direct tax point of view, such a write off will reduce the tax liability.
When the transferred receivable also has a VAT component, matters become more complicated. A logical consequence of the write-off would be that the transferor can recover the output VAT paid on the balance. In the example above that means recovering output VAT on 10$. This VAT regime, like in other jurisdictions, is not always clear and is subject to interpretation and many rulings.
Although clearly no supply is made by the transferor, i.e. he is not supplying the transferee with a service but merely transferring a receivable in his books, tax authorities will sometimes consider this a supply. The UAE for example considers the transfer of a loan portfolio as an exempt supply (p. 28 FTA’s Financial Services VAT guide). This has the necessary consequences from the viewpoint of the input VAT deduction.
Bahrain follows the same treatment for the sale of debt (p. 49 NBR’s VAT Financial Services Guide), as does KSA (p. 18 GAZT’s Financial Services Sector Industry Guideline).
With respect to factoring however, for factoring with recourse, Bahrain and KSA adopt the position that assigning the receivable is an out of scope transaction. The UAE has not made its position explicit.
None of the GCC countries so far have taken a stance on a transfer of the right to claim the reimbursement of VAT on transferred bad debts, although this is an important financing component which can impact margins in an important way.
Administration of insolvency, bankruptcy and liquidation
When a company is struggling financially, it may become insolvent and seek protection from its creditors. It may end up in administration, and potentially in bankruptcy and liquidation. Such procedures can be taken at the initiative of the businesses, its creditors or a third party (e.g. the public prosecutor).
The aspects of insolvency, bankruptcy and liquidation as such are generally not regulated in the tax laws. Instead, as a separate set of legislation, they will impact the tax legislation.
The impact of these sets of legislation on the compliance of a business as such as limited. A business becoming insolvent or going bankrupt does not have a different status vis-à-vis the tax authorities. It continues as a regular tax payer. The same to a certain extent holds when a business goes into liquidation, with the difference that it is the intention to close the business and therefore also reduce the taxable supplies of the business. This means that the business eventually needs to deregister for VAT purposes and potentially make a self-supply. From a direct tax point of view, once the business ceases to exist, it has no tax obligations anymore, apart from a final tax return.
What is required though is that the tax payer communicates to the tax authority that it can no longer be legally represented by its usual legal representative, but instead now has an administrator, a bankruptcy trustee or other managing its tax obligations.
In the UAE, a legal representative needs to give a formal notice to the FTA within twenty business days from the date of appointment along with the evidence of the legal basis of his appointment. Penalties are imposed on the legal representative in the event of failure to inform the FTA in the given timeframe or failure to file the tax return in the specified timeframe. Penalties would be due from the legal representative’s own funds in the event of default. KSA foresees similar provisions, however less strict (article 77, 5 KSA VAT Implementing Regulations). In Oman such a person becomes the principal officer of the organization (article 6, 2, e Omani Income Tax Law).
The Blockbuster Bankruptcy will hit you – so you might as well be prepared
With some uncertainty governing the tax framework of doubtful receivables and bad debt, the different tax authorities will have an important role to play in defining it for financing transactions or in the framework of insolvency proceedings.
Forgetting about the VAT refund procedures or the possibilities for write-offs to impact your direct tax liabilities may prove costful. Suppliers claiming bad debt relief may actually worsen the situation of the debtor.
Given the international economic climate, it is a matter of time before businesses in the GCC are confronted with another blockbuster bankruptcy. Governments and private creditors alike should prepare for the scenario, not just to anticipate a loss and its tax consequences, but also to monitor their liquidity.
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KSA Transfer Pricing obligations
Early 2010’s, following the financial crisis and multiple tax scandals, such as the Panama papers and LuxLeaks, the BEPS initiative was launched by the OECD and the G20. The BEPS initiative is a set of international recommendations meant to prevent Base Erosion and Profit Shifting (international tax avoidance).
As part of the BEPS initiative, Transfer Pricing (TP) rules were put on the agenda worldwide as a means to avoid tax evasion. The first detailed and comprehensive TP rules were designed in the 1990’s. The US published regulations in 1994 and the OECD published guidelines in 1995.
Saudi Arabia is member of the G20 and was expected to adopt a comprehensive set of rules to tackle tax avoidance through transfer pricing rules. Recently, it published these By-Laws on Transfer Pricing (GAZT Board Resolution No. [6-1-19] 25/5/1440H (31/12/2018 G).
KSA’s Income Tax Law had already implemented general anti-TP avoidance measures and approved the arm’s length principle, similar to other GCC Member States. However, these new By-Laws are going a lot further in terms of defining the applicable transfer pricing principles and documentary requirements. The new obligations trigger important compliance obligations and require extensive preparation.
What is a transfer price?
A transfer price is the price agreed between entities of a same group for their internal transactions (‘controlled transactions’). Transfer pricing legislation targets the relocation of profit within the Group: one entity located in a tax haven invoices its supplies (services or goods) at an artificially high price to another entity located in a high tax jurisdiction, successfully decreasing its taxable base.
In order to avoid this artificial profit shifting, the transfer price is required to comply with the arm’s length principle. This principle requests that the controlled transaction price is determined as if the transactions were made between unrelated parties.
Who needs to comply?
All taxable persons under the KSA Income Tax Law including mixed ownership entities subject to both Income tax and Zakat must comply with these By-Laws.
Exclusive Zakat payers are not subject to TP bylaws, but must comply with CbCR requirements if they meet the threshold.
What’s new?
The By-Laws determine the applicable methods and documentation inspired directly by the OECD guidelines and BEPS reports.
KSA has approved the 5 OECD transfer pricing methods:
- Comparable Uncontrolled Price Method
- Resale Price Method
- Cost Plus Method
- Transactional Net Margin Method
- Transactional Profit Split Method
A transfer pricing method other than the ones above can be adopted, provided the taxable person can prove that none of those methods provides a reliable measure of an at arm’s-length result.
Documentation
In line with the OECD recommendations, KSA requires:
- A Master File and Local File to detail the Group and entities’ transfer pricing policy (notably an explanation of the applied transfer pricing method) to be prepared on an annual basis at the time of the income tax declaration (only for MNE Group with an aggregate arm’s length value of controlled transactions exceeding SAR 6,000,000 during any 12 month period);
- The Country by Country Report (CbCR) to be submitted no later than 12 months after the end of the concerned reporting year for MNE groups with a consolidated turnover of more than SAR 3.2 billion.
In addition, it requires a ‘Controlled Transaction Disclosure Form’ to be submitted on an annual basis along with the income tax declaration (no threshold applies).
The By-Laws do not mention the language in which the documentation is to be maintained and filed. However, the FAQs mention that GAZT encourages to maintain and submit documentation in the official language.
It is important to note that these obligations are already applicable to fiscal years ending on 31 December 2018. This implies that the concerned companies must start preparing the required documentation. The latter must be ready within 120 days following the end of the fiscal year, i.e. by the end of April 2019 for the first concerned MNEs. However, a 60 day extension has been provided for the purposes of maintaining the Local File and Master File.
Exceptions
The draft contains certain exceptions for maintaining the Local file and the Master file. Are exempt from these obligations:
- Natural persons;
- Small Size Enterprises;
- Legal persons who do not enter into Controlled Transactions, or who are a party to Controlled Transactions where the aggregate arm’s-length value does not exceed SAR 6,000,000 during any 12 month period.
Adjustments
Where the price is not at arm’s length, GAZT can adjust the tax base accordingly. This can result in a higher tax liability if part of a tax deduction is rejected or if it considered that the KSA entity should have charged a higher price to its foreign affiliate.
GAZT can also be informed of any TP adjustments made in another country, on a controlled transaction made with a KSA resident, if a treaty is in place with this country. GAZT can ensure the changes by the foreign authority are in line with the arm’s length principle. GAZT can subsequently make the appropriate adjustment to take into account the increase in the taxable base by the foreign tax authority.
In case GAZT disagrees with the adjustment, it can communicate and discuss with the respective foreign authority. An existing mutual agreement procedure (‘MAP’) with the foreign authority will be necessary.
Advance Pricing Agreements
An APA can safeguard companies against tax reassessments, as it provides for an agreed transfer price by the Tax Authority regarding specific transactions.
The By-Laws do not currently provide for an Advance Pricing Agreements (APA) procedure.
Tax Audit and penalties
GAZT has been working on TP for many years and is well prepared to enforce the new TP requirements. A specific tax unit, with experienced auditors, has been created to guarantee the correct implementation of these laws.
The By-Laws do not foresee penalties in case of non-compliance. However, the common penalties relating to corporate income tax apply.
Impact on the GCC
Any GCC company performing controlled transactions with a KSA company will have to comply with the KSA TP rules. The valuation of its intra-group sales must comply with the valuation methods recommended by the KSA TP rules.
In addition, GCC affiliates with a KSA headquarter will have to prepare a local file describing their own transfer pricing policy for the transactions with their KSA related parties. Important accounting information will also have to be gathered and transmitted to the KSA headquarter to be compiled in the CbCR.
Concerned entities must start to plan immediately. Practically this does not only encompass preparing the documentation. Companies must also keep evidence of the invoiced work, especially when intangible (e.g. management fees might be requested to be evidenced by proof of rendered services: announcements of internal seminars, memoranda, presentations, emails…). This implies to retain all data regarding intra-group transactions and to draft and maintain the required documentation or information and keep it up to date.
Finally, these new KSA By-Laws open the door to the implementation of TP rules in the other GCC countries, and notably in the UAE. The UAE committed to introducing a CbCR by joining the BEPS Inclusive Framework earlier in 2018.
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More often than not JAFZA offshore companies need to register for VAT
Offshore companies in the Jebel Ali Free Zone Authority (JAFZA) are a special breed in the UAE. An offshore company incorporated under the recently amended 2018 JAFZA Offshore Companies Regulations (“Regulations”) is not subject to the federal commercial laws in the UAE and is not able to conduct any commercial business activities in the country. They are considered as non-resident for commercial purposes but are in fact treated as resident for VAT purposes.
The benefit of incorporating a JAFZA offshore company, amongst others, is to allow foreign investors to hold shares in other companies within the UAE as well as to own property in freehold areas in Dubai.
Assessing the VAT Impact
Like many other companies in the UAE, JAFZA offshores have been impacted by the introduction of VAT on 1 January 2018. Although for all intents and purposes JAFZA considers such companies as “offshore”, for VAT purposes they are not.
JAFZA offshore companies still need to determine whether they need to register for VAT with the UAE’s Federal Tax Authority (FTA). Any business making taxable supplies with a total value exceeding the mandatory threshold of AED 375,000 (+/- USD 100,000) must get registered. Whether or not the JAFZA offshore companies need to get registered will depend on their activity. Although they are not allowed to conduct business in the UAE as per the Regulations, from a VAT perspective they may still receive a business income.
JAFZA Offshore and Rental Income through Property Ownership
In accordance with the Regulations, JAFZA offshore companies are allowed to own property in Dubai, and therefore many offshore companies choose to exercise this right. The purpose of such property ownership would most likely be to obtain some form of rental income.
Any rental income obtained from a residential property is exempt from VAT (in most cases) and does not trigger an obligation to register for VAT.
The situation differs however for offshore companies leasing commercial units and obtaining their rental income as such, since the leasing of commercial properties is considered a taxable supply for VAT purposes, and is subsequently subject to 5% VAT. When the value of such supplies exceeds the VAT mandatory threshold, VAT registration is required. Therefore, any JAFZA offshore company which owns property in Dubai needs to carefully assess the criteria they fall under in order to determine their VAT liability.
Receiving Dividends and Selling of Shares
Since such JAFZA offshore companies act as holding companies, they will often be receiving dividends or income from selling participations.
The fact that the receiving of dividends is exempt in the UAE is unusual from a VAT perspective. Generally, the payment of dividends is out of scope of VAT, like for example in the Kingdom of Saudi Arabia or like in all EU countries.
As such, if the JAFZA offshore company only receives dividends from UAE companies or only sells shares to UAE companies, it will not have to get registered for VAT purposes.
However, when these same transactions are done with non-resident recipients, they are no longer VAT exempt, but they are zero rated. Accordingly, dividends paid to a JAFZA offshore company by a foreign company and shares sold to foreign investors are, for VAT purposes, treated as taxable supplies. Therefore, if the total amount of these transactions exceeds AED 375,000, the JAFZA offshore company needs to register for VAT. Since one of the purposes of setting up a JAFZA offshore company is holding participations, this will often occur.
The rationale behind this rule copied from the EU is not to disadvantage the financial sector when it has to compete with businesses in countries which do not have VAT. However, the unusual position taken by the UAE on dividends has the strange consequence that these JAFZA offshore companies may be required to register for VAT purposes.
Applicable Exceptions
Due to the nature of its revenue, more often than not, a JAFZA offshore company will indeed have to register for VAT.
The FTA does provide certain exceptions from registration in the event a taxable person’s supplies are exclusively zero rated. Therefore, if the offshore company solely exports financial services – by virtue of receiving dividends from participations abroad or selling shares to non-residents – an alternative is to apply for this exception from registration for VAT with the FTA, in order to mitigate the impact of the offshore company’s VAT obligations.
The exception from registration cannot be granted when the offshore company is leasing commercial property and it cannot be granted retroactively.
Penalties and Consequences
All JAFZA offshore companies need to assess whether they need to register for VAT with the FTA. In practice, most JAFZA offshore companies have been under the impression that they do not need to register.
The FTA imposes very strict fines for companies which have not yet registered for VAT. The penalty for late registration is AED 20,000. In addition, a penalty of up to AED 2,000 per return will apply for not filing the VAT return.
Furthermore, in case VAT is due (e.g. leasing of commercial property) and is not paid to the FTA, a daily penalty of 1% may be charged on any amount that is still unpaid one calendar month following the deadline for payment (with a maximum of 300%). In addition to that, a penalty of 50% on the amount unpaid to the FTA will be imposed as well.
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The UAE and Bahrain part of the BEPS Inclusive Framework
Confirming their role as pioneers in building a sophisticated and efficient tax network, the UAE and Bahrain took strong steps forward to join international efforts against base erosion and profit shifting practices (known as BEPS).
Indeed, both of these countries has joined the BEPS Inclusive Framework, on 11 May and 16 2018 respectively, becoming the 115th and 116th country part of this initiative.
The BEPS programme, started in 2013, was developed by 44 countries including all OECD (34) and G20 Members. It has three main objectives:
– Reinstating the coherence of corporate income taxation from an international perspectiveThe BEPS programme, started in 2013, was developed by 44 countries including all OECD (34) and G20 Members. It has three main objectives:
– putting the substance of the economic activities at the core of international taxation, and
– ensure transparency in the global economy.
It resulted in the publication of 15 action plans in October 2015, known as the BEPS package.
Out of the 15 action plans, in January 2016 the OECD has prioritised 4 key priority measures. These measures are known as the BEPS Minimum Standards. They constitute the BEPS Inclusive Framework.
The Inclusive Framework Members have committed to implement these actions quickly, and agreed to be subject to peer review to guarantee their effective implementation.
Accordingly, it is now highly likely that the UAE and Bahrain will, in the coming months, strengthen their tax compliance legislation in order to reach rapidly these four requirements, which aim at:
- Fighting harmful tax practices (BEPS Action 5),
- Preventing tax treaty abuse, including treaty shopping (BEPS Action 6),
- Improving transparency with Country-by-Country Reporting (BEPS Action 13),
- Enhancing the effectiveness of dispute resolution (BEPS Action 14).
Therefore, UAE and Bahraini Companies have to anticipate the increasing amount of administrative and tax requirements implied by these new concepts and obligations in the region. They must be ready to disclose several financial and business sensitive information to the Tax Authorities, much like their counterparts in the countries which have already adopted the measures. It is expected that both the UAE and Bahrain will be adopting the necessary legislative measures in the coming few months.
Get in touch for a discussion on the assessment of the impact of these measures in the UAE and Bahrain.
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The Challenges of Drafting Tax Legislation and Implementing a VAT in the GCC
In this article, the authors examine the process of implementing the Gulf Cooperation Council’s Common VAT Agreement and look at the efforts by Saudi Arabia and the United Arab Emirates to introduce their VAT legislation on January 1, 2018.
The six member states of the Gulf Cooperation Council (GCC) have signed an agreement committing to introduce a VAT by January 1, 2019. Saudi Arabia and the United Arab Emirates have pledged to introduce a VAT by January 1, 2018. The remaining GCC states (Oman, Bahrain, Kuwait, and Qatar) are expected to follow over the course of 2018 and to meet the deadline.
Traditionally, the governments of the GCC countries have relied heavily on revenue from natural resources. A protracted period of low prices has challenged that revenue model, leading the GCC countries to consider alternative, stable financial resources to meet the spending needs of the states.
The agreement, titled the Common VAT Agreement of the States of the Gulf Cooperation Council, sets out the basic tenets that the six GCC member states will follow as they introduce the VAT. Thus far, only Saudi Arabia and the UAE have actually issued and published legislation. In the UAE, the publication of the VAT executive regulations is pending, with the VAT treatment of free zones being among the controversial measures that will substantially complicate transactions in the UAE.
The Agreement
In English, the use of the word “agreement” instead of “treaty” is not an indicator of the legal value of the instrument. According to international conventions, the title of a supranational legal instrument does not affect its legal value. The GCC usually calls its international treaties “agreements.” Therefore, calling the instrument an agreement does not suggest the GCC attributed a lesser legal value to it.
The member states typically seem to adopt a practical approach toward complying with GCC agreements. The agreement itself has undergone changes since 2009. Different advisers have contributed to the drafting — in particular, the “Big 4” accounting firms — affecting its structure and wording. While many attorneys in continental Europe also specialize in VAT, in the Anglo-Saxon world taxes are usually viewed as the realm of accountants. Accountants were the main participants in the drafting of this legislation.
Roots in the EU VAT Directive
The agreement was loosely based on the EU VAT directive (2006/112/EC), but it does not strictly follow that model. For example, the agreement does not have rules about tour operator margin schemes, nor does it contain triangulation rules allowing party B in an ABC transaction to avoid registering for VAT in the country of arrival.
The agreement does not take into account the latest version of the European VAT directive. For example, the rules regarding the short- and long- term lease of vehicles that entered into force in the EU in 2013 (Directive 2008/8/EC of February 12, 2008) are not taken into account; neither are provisions on vouchers (Directive 2016/1065 of June 27, 2016). Those are just two examples of rules targeting both legal uncertainty and VAT fraud that are not in the agreement. The two states that have issued VAT legislation have not undertaken any steps to incorporate these changes in their domestic legislation, even though their fiscal sovereignty would definitely allow them to do so.
Likewise, the agreement fails to take into account amendments made to improve collection of VAT from non-established suppliers in the EU. There is no equivalent of the mini one-stop shop in the GCC. The mini one-stop shop is strongly supported by businesses because it substantially simplifies the compliance burden for companies reporting in multiple jurisdictions. Suppliers without prior establishments in the GCC will likely regret that the invoices for their Saudi Arabian turnover need to be in Arabic. Those suppliers also face practical issues with registering for VAT purposes.
Of course, the agreement also does not consider the recent proposals made by the European Commission to amend the VAT directive to tax cross-border supplies of goods and services and to hold the seller liable for the payment of VAT.
The GCC also missed the opportunity to enshrine rules into domestic law for the calculation of input VAT deductions for businesses that have income that is out of the scope of the VAT (such as receiving dividends or subsidies). This is a hot topic before the European courts. The domestic laws of both the UAE and Saudi Arabia have similarly failed to address and solve this issue.
Many of the concepts in the VAT directive and the GCC’s agreement are derived from European civil law. However, in Saudi Arabia there is no codified civil law, and in the UAE there is also only partial legislation. This means that applying EU concepts of property and property transfers to the GCC for VAT purposes may not be straightforward.
Likewise, European concepts do not take into account Islamic financial instruments, and the agreement is silent on the VAT treatment of Islamic finance. The most important characteristic of Islamic finance instruments is that they respect the religious rule that charging (excessive) interest is forbidden. The option chosen seems to
be to simply apply the VAT concepts to Islamic financial products and to pretend that they are non-Islamic products. However, this does not always lead to a desired result. For example, in the remortgage or refinancing market, it could suggest that property is sold several times because the title changes hands multiple times.
The agreement does contain an interesting provision regarding the use of an electronic services system to match intra-GCC supplies of goods and services. This is the real-time equivalent of the European sales listing, and it offers interesting opportunities to combat VAT fraud between the GCC member states. Indeed, it may offer a better alternative for fighting cross- border VAT fraud than the recent proposals by the European Commission to tax cross-border transactions. Regretfully, the electronic services system will not be working on January 1, 2018.
Domestic VAT Legislation in the GCC
The six member states of the GCC are supposed to follow the principles of the agreement when drafting their own domestic legislation. The two member states that have already published their VAT legislation, the UAE and Saudi Arabia, have taken different and noteworthy approaches in their drafting.
Saudi Arabia has taken a fairly unique position on the legal value of the agreement itself. Based on the principle of legality, which is codified in article 20 of Saudi Arabia’s Basic Law of Governance, a tax should be imposed by law. Saudi Arabia has decided, however, that the best way to integrate the contents of the agreement into domestic legislation is by referring to it, a very uncommon legal technique. Because taxation is a sovereign right, a treaty usually limits the powers of a nation to tax. For example, a double income tax treaty limits (among other things) a state’s power to withhold taxes. A treaty cannot constitute the basis of domestic tax legislation. The Saudi approach also creates a complicated situation for the taxpayers because they must consult three legal instruments at the same time: the agreement, the law, and the executive regulations.
The UAE’s legal technique is not unique. However, the wording of its legislation deviates substantially from the agreement and, confusingly, it uses very different wording than the agreement. For example, “exports of services” sounds off-tune for many European practitioners.
How to Interpret and Police the GCC VAT
Another challenge is that there are no interpretation rules for the agreement. These should be drafted. An example of a common rule is “in dubio contra fiscum” (loosely, “when in doubt, don’t tax”), which entails that whenever there is doubt about the application of a fiscal provision, the taxpayer’s interpretation will be followed. Another common interpretation rule is that taxes should be the exception, not the rule. Therefore, any imposition of tax should be interpreted strictly because it constitutes an exception to the right to property. There is no preamble and no published drafting history that could help guide interpretation of the agreement. Further, the meeting notes of the GCC are not published, and there are no preparatory parliamentary materials or other works to fall back on. The same holds for the domestic legislation.
Also, the agreement does not foresee a real instrument for policing its rules. There is no international court that will rule on differences in interpretation. There is an article pertaining to dispute resolution, which suggests amicably resolving any disputes and potentially resorting to arbitration.
Conclusion
The changes triggered by the introduction of a VAT in the Arabian Gulf region are massive. Failing to follow regular drafting principles and using relatively unclear terminology causes confusion and will hinder efforts to achieve compliance.
Substantial differences in domestic legislation do not benefit the taxpayer that is active in multiple countries. Those differences are just one example of the consequences and complexity involved in introducing tax legislation in a region that has limited experience with taxes. The next round, including the VAT laws that will be adopted in the rest of the GCC countries, should take lessons from the previous experiences. Hopefully, the tax authorities that are implementing the VAT on January 1, 2018, will also be open to making amendments after the implementation.
by Thomas Vanhee and Misfer Aldheem – published in Tax Notes International (Volume 88 – Number 6 – 6 November 2017)
Thomas Vanhee is a partner with Aurifer Middle East Tax Consultancy in Dubai, and Misfer Aldheem was a legal advisor with the General Authority of Zakat and Tax of the Kingdom of Saudi Arabia. The Authors would like to thank Tax Notes International for having given their permission to publish the article.
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VAT impacts important defense market in GCC
With defense spending in KSA and UAE reportedly currently around 100 billion USD a year combined, the introduction of VAT on 1 January 2018 in those countries will have an important impact on businesses active in that segment.
Governments are generally outside of the scope of VAT. That is especially true in the defense sector, where governments take up one of their most important roles, that is guaranteeing the safety of their citizens.
This entails that when suppliers sell to governments, the VAT which they will charge will not be deductible for the governments. In other words, VAT constitutes a cost for the government.
Both in the UAE and KSA, there will be a list of governmental organisations that can request the refund of VAT charged to them by businesses. When put on this list, these governmental organisations can then ask from respectively the UAE’s Federal Tax Authority and KSA’s General Authority for Zakat and Tax the refund of this VAT.
Even if the Ministry of Defense would be put on such a list, it would have to pay its suppliers first and later recover this VAT. This entails that VAT could potentially weigh heavily on the budget of these Ministries. They will be looking to mitigate these effects and potentially push them to their suppliers.
Long term contracts with governments generally do not cater for the introduction of VAT. In other jurisdictions, international organisations often benefit from a zero rate (sometimes also known as an exemption allowing the recovery of input tax) of any supplies made to them. Supplies made to NATO or SHAPE for example are zero rated. Supplies made to the local military usually do not.
As always with VAT though, the contracts and the supply chain need to be analysed. A US supplier of weapons for the KSA MoD agreeing to deliver 50 millions USD worth of weapons but with the KSA MoD acting as the importer of record would not have to charge and collect any VAT. If however, it has a physical presence in KSA to render installation engineering and training services, it will have to charge KSA VAT at a rate of 5%.
The supply chain usually stretches longer and will involve multiple parties and potentially even foreign governments. It is paramount to analyse the capacity in which all of these parties intervene, as well as their delivery terms, in order to draw any conclusions around the impact of the introduction of VAT. It is most likely currently being relatively overlooked by governments and suppliers, but will no doubt heavily impact them.
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Identifying indirect tax hurdles for your supply chain
When setting up or reviewing their supply chain, businesses seek the most (cost) efficient and lean way for the cross-border movement of their goods. However, when performing this exercise, the indirect tax and regulatory requirements should be duly taken into account in order not to create any unforeseen or hidden (financial) risks.
For example, companies and supply chain experts continuously needs to ask themselves the following questions. Are all the required documents and certificates in place to import goods into a certain country? Are my products classified correctly for customs purposes? How is the taxable base for customs and import VAT calculated? Are there any related-company transactions and have these been taken into account for customs valuation? Are the incoterms in line with the contractual agreements and supply chain reality? How is the preferential and non-preferential origin of my product managed? Are there international sanctions and restrictions related to my products, my business partners or the country of destination? Etc. Non-compliance with the applicable regulations and formalities could lead to severe financial penalties imposed by the Customs and VAT Authorities. But next to the direct cost, companies should also be aware for the indirect financial implications as the cost of supply chain disruptions due to blocked or seized goods cannot be underestimated. In the world of international and cross-border trade, one catch phrase sums it up quite nicely: “if you think compliance is expensive, try non-compliance!”
Luckily, local legislations and international agreements have foreseen in various possibilities and legal tools not only to mitigate the risks, but also to establish an efficient customs and supply chain setup. With sufficient in-depth knowledge of the business combined with legal expertise, asking the right questions allows you to seize short term opportunities.
Are there optimizations possible through product classification or valuation of the import transaction? Am I using the full potential of international free trade agreements? Can I shift costs and responsibilities to my business partner through the use of Incoterms? Are there special customs procedures and arrangements foreseen enabling me to optimize customs duties (e.g. customs warehouse, free zones, temporally import, etc.)? Are there any simplification procedures foreseen enabling me to streamline and optimize my supply chain? Etc.
As the complex and ever-changing legislation brings both risks and opportunities, we would recommend to take a close look at the impact indirect tax requirements and other regulatory formalities have on your supply chain, and how these are currently managed. A good understanding of your business setup combined with a thorough knowledge of the various legal requirements will enable you to mitigate risks and spot opportunities and optimizations. This holds true especially now that VAT will be introduced in the GCC. A mapping of the current supply chain is therefore very important to further determine the appropriate strategies.