In May 2020, the KSA announced an increase in the standard VAT rate from 5% to 15% effective from 1 July 2020. Transitional rules for supplies spanning the date of the VAT rate change (1 July 2020) were introduced. In brief, these transitional rules state that if you entered into a contract prior to 11 May 2020 for supplies to be made after 1 July 2020, the 5% rate would still apply until the end of the contract, the contract renewal date or 30 June 2021 (whichever occurs first), if the customer is entitled to recover the VAT charged by the supplier in full, or if the customer was a government entity.
These transitional rules were optional, and even if the conditions were met, you could choose to apply VAT at 15% from 1 July 2020. B2C supplies were simply immediately subject to 15% VAT, as were imports of goods.
Meanwhile, the other GCC countries which implemented VAT, i.e. the UAE, Bahrain and Oman continue to apply 5% and have no plans currently to increase the VAT rate. The average VAT rate applied in the EU is approximately 21%. KSA therefore still has a relatively reasonable rate.
End of transitional period
Businesses currently applying the transitional regime, will no longer be able to avail it, and need to be mindful to apply 15% VAT for supplies rendered as from 1 July 2021.
You may still be making supplies under a contract entered into prior to 11 May 2020, where this contract has continued and was not subject to renewal, i.e. there was no cessation or renewal of the contract to trigger the end of the application of the 5% rate. In this case, where you are still charging VAT at 5%, this must end on 30 June 2021. For goods or services supplied before 30 June 2021 the 5% rate can still apply, however for all supplies made from 1 July 2021 the VAT rate of 15% must apply.
Action to be taken
Where business are currently still applying 5%, this will need to be increased as of 1 July 2021. The boxes in the VAT return where 5% output or input needs to be reported, may remain for some time. Tax payers may need to issue credit notes for initial supplies subject to 5%, and the recovery of input VAT can be done during a period of 5 years.
For businesses that had been availing the transitional regime, the cash flow impact will be significant. Caution needs to be taken as well as to expense invoices, as invoices with the wrong VAT rate will not be claimable.
Where do we go next
The Crown Prince of KSA, H.E. Mohammed Bin Salman (“MBS”), announced recently that the 15% VAT rate is a temporary measure that may last only for the coming 5 years. Increasing the VAT rate was necessary to help the ambitious government toward realizing its KSA 2030 vision.
MBS stated that the rate will reduce to a rate of 10% or even 5%. Undoubtedly, there will be new transitional provisions then.
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Since the inception of VAT in the UAE in January 2018, the Federal Tax Authority (FTA) had put in place a strict penalty regime. It was much stricter than its neighbour Saudi Arabia, which implemented VAT at the same time. In terms of the types of penalties, it was not the harshest, since both Bahrain and Oman later imposed prison sentences for what are often considered administrative oversights.
The tax authorities were also very active from the start in 2018, mostly imposing automatic penalties, as our survey back then showed (https://aurifer.tax/news/vat-survey-shows-fta-is-very-active/?lid=482&p=14). However, the authorities also imposed their so-called 2-4-1 penalties for late payment, which were the most impactful. A business making a mistake and being audited would be subject to a fixed penalty of up to AED 5,000, but also a penalty of up to 356% of the unpaid tax. The predicted pushback in terms of litigation followed, as scores of tax payers challenged penalties, on whatever basis they could find. The litigation was potentially mainly in the interest of litigators.
The Federal Cabinet listened to the concerns of tax payers, and now decided to act and to reduce the penalties, but also propose a penalty amnesty for penalties applied under the old regime. Cabinet Decision No. 49 of 2021 amends provisions of the Cabinet Decision on Penalties (No. 40 of 2017) and enters into effect 60 days after the issuance, i.e. 28 June 2021.
In most circumstances, the new regime will be more beneficial. It should be noted as well, that there is still an FTA Decision to be expected to implement the changes.
First off the FTA would like to give all tax payers a clean slate. Tax payers having outstanding penalties under the old regime, i.e. imposed on 27 June 2021 or before, can benefit from a 70% waiver, provided they settle the penalties on or before 31 December 2021. This is surely to add substantial cash to the Federal budget.
What is currently not clear, and might be in the announced FTA Decision, is how to handle penalties against which tax payers have filed a reconsideration, have gone before the Tax Disputes Resolution Committee (“TDRC”), or have gone before the administrative courts. Insofar as we know, the FTA has not been open to negotiated settlements for these types of litigation, but perhaps this is an opportunity for tax payers and the FTA to agree on a settlement, even if they are already before court.
As a comparison, KSA until recently was offering a full waiver of all penalties for voluntary disclosures. The Cabinet has not opted for the same approach, though it offers a partial amnesty.
New penalty regime
What’s new in the new penalty regime then? A number of fixed penalties have been lowered (e.g. late registration, late deregistration, filing incorrect tax return, …). However, the paradigm shift came in the late payment penalties.
Where before, a tax payer was subject to the 2-4-1 penalties, i.e. 2% for paying one day late, 4% for paying a week late and 1% per day after one month, the monthly penalty is now only 4% (in addition to the 2% penalty which remains).
However, and this is probably the most fundamental change, in case of a voluntary disclosure or a tax assessment, the late payment penalty only starts to run as from 20 business days after the date of submission of the voluntary disclosure or receipt of the assessment. While this position was advocated before the UAE Federal Court of Cassation, the highest court had ruled that the FTA was correct in applying a penalty since the time of supply (UAE Court of Cassation 14 October 2020, Appeal No. 227 of 2020). The Federal Cabinet now decided that it is the right approach to start calculating late payment penalties after the submission of the voluntary disclosure, and not as of the initial supply.
In other words, under the new penalty regime, if the tax payer pays within 20 days, there is no late payment penalty due.
That does not mean he is completely off the hook as a proportional penalty is due ranging from 5 to 40% calculated on the difference between the tax calculated and the tax that should have been calculated. The range depends on the period elapsed between the error and the date on which the voluntary disclosure was submitted.
There is a substantial difference in the calculation of the penalty. Where the previously law had ambiguity around what constituted “payable tax”, the new regime is clear that any situation will be penalized where there is a difference between the tax calculated, and the tax that should have been calculated. Especially for tax payers in a constant refund position, this may constitute a higher penalty bill.
In order to compare the effect of the amendments in the regime, let us have a look at a few examples.
Example 1 - Supply in January 2018
Company A in January 2018 made a supply which it had incorrectly zero rated. After reviewing its records, it came to the conclusion that it had not exported the goods from the UAE, but instead sold them on the local market. Company A comes to this conclusion on 15 June 2021. Company A has 20 days to file a Voluntary Disclosure.
It now faces the choice between making a voluntary disclosure under the old regime or under the new regime. The goods supplied had a value of AED 300,000 and the applicable VAT was AED 15,000. This is the first time Company A is subject to a penalty for submitting an incorrect tax return.
Old regime New regime
Fixed Penalties AED 3,000.00 AED 1,000.00
Proportional penalties AED 750.00 AED 4,500.00
Late Payment Penalties AED 45,600.00 AED 0.00
Total AED 49,350.00 AED 5,500.00
It is clear that Company A has a real benefit in waiting for the new regime to be in force. However, as illustrated below, because of the dynamics triggered by the tax amnesty, depending on when the mistake is made, business may need to try and have the penalties imposed before or on 27 June 2021.
Example 2 - Supply in January 2021
Company B in April 2021 made a supply which it had incorrectly zero rated. After reviewing its records, it came to the conclusion that it had not exported the goods from the UAE, but instead sold them on the local market. Company B comes to this conclusion on 15 June 2021. Company B has 20 days to file a Voluntary Disclosure.
It now faces the choice between making a voluntary disclosure under the old regime or under the new regime. The goods supplied had a value of AED 300,000 and the applicable VAT was AED 15,000. This is the first time Company B is subject to a penalty for submitting an incorrect tax return.
Old regime New regime
Fixed Penalties AED 3,000.00 AED 1,000.00
Proportional penalties AED 750.00 AED 750.00
Late Payment Penalties AED 900.00 AED 0.00
Total AED 4,650.00 AED 1,750.00
Waiver AED 3,255.00 N/A
Net AED 1,395.00 AED 1,750.00
Company B has an incentive to voluntary disclose the transaction before the new regime enters into force so that the penalties are imposed under the old regime.
Example 3 - Supply in January 2021
Company C in January 2021 made a supply which it had incorrectly zero rated. After reviewing its records, it came to the conclusion that it had not exported the goods from the UAE, but instead sold them on the local market. Company C comes to this conclusion on 15 June 2021. Company C has 20 days to file a Voluntary Disclosure.
It now faces the choice between making a voluntary disclosure under the old regime or under the new regime. The goods supplied had a value of AED 300,000 and the applicable VAT was AED 15,000. This is the first time Company C is subject to a penalty for submitting an incorrect tax return. Company C is in a constant refund position, and even after correcting the January 2021 supply, it remains in a refund position.
Old regime New regime
Fixed Penalties AED 3,000.00 AED 1,000.00
Proportional penalties AED 750.00 AED 750.00
Late Payment Penalties AED 0.00 AED 0.00
Total AED 3,750.00 AED 1,750.00
Waiver AED 2,625.00 N/A
Net AED 1,125.00 AED 1,750.00
Company C has an incentive to voluntary disclose the transaction before the new regime enters into force. Note that we have observed here that the FTA had not applied penalties under the old regime for these kinds of mistakes. However, we would have expected it to treat an over claimed amount in the same way as an underpaid amount.
Example 4 - Failure to register
Company D in January 2021 made supplies worth AED 400,000 but failed to register for VAT purposes. On 15 June 2021 it discovers it had to register for VAT purposes already back in January 2021.
Old regime New regime
Fixed Penalties AED 20,000.00 AED 10,000.00
Waiver AED 14,000.00 N/A
Net AED 6,000.00 AED 10,000.00
Company D has an incentive to make use of the old regime to register for VAT purposes, before the new regime enters into force.
Audit and enforcement
When we conducted our survey back in 2018, we saw a very active FTA. With the additional resources it has gained over the years, it has conducted a great number of additional audits. Especially refund audits have been very prevalent. More regular audits have happened as well, although these often focused on entertainment expenses and non-compliant invoices. In 2023, transactions conducted in 2018 will be statute barred, so we may see additional activity by the FTA to ensure compliance before that date.
Tax payers have consciously being disclosing non compliant transactions and reporting under the old regime, and were hit with penalties, which then often spilled over into litigation.
Once the liabilities are final, or the court case ruled, the file would eventually end up in enforcement. The advantage the FTA had in litigation is the application of the “pay and claim” principle. If the tax payer lost the case, the litigious amount was already paid.
In situations where there was no Tax Disputes Resolution Committee litigation, the liabilities sometimes remained outstanding (with no additional penalty being added), or for businesses in a refund position, the refund was compensated bit by bit by the penalty amount.
Since 2018, the FTA did take a number of steps to encourage compliance and try and move tax payers towards settling their liabilities.
It had for example suspended the application of the automatic reverse charge mechanism for businesses with a customs number and a VAT number which were linked. The only impact of this decision was negative cash flow.
In addition, in early 2021, the UAE appointed judicial officers which have the powers to seize assets. This was seen as a step up in terms of the enforcement in the UAE.
Rather than stepping up enforcement under its tax procedures law (see our article on the FTP law (https://www.aurifer.tax/news/the-uae-publishes-more-detail/?lid=482&p=19) and on the FTP law lacking director’s liability (https://www.aurifer.tax/news/dawn-of-a-new-tax-era--corporate-perspectives/?lid=482&p=14), the UAE has chosen to make it easier to correct mistakes.
It has taken a substantial turn with the newly implemented policy, which will surely have a very beneficial impact on the tax compliance climate in the UAE. While the penalties are still there as a deterrent, there is now a real motivation in most cases to voluntary disclose and to build a more horizontal and transparent relation with the FTA. The move is without doubt a benefit to businesses, in terms of reduced penalties applied for errors made, and a benefit to the FTA, in terms of increased compliance and perhaps additional revenues from this increased compliance and the amnesty.
The United Arab Emirates (UAE) introduced the Economic Substance Regulations (ESR) in April 2019 to be excluded from the EU’s COCG grey list (European Union's Code of Conduct Group) and not to be classified as a harmful tax jurisdiction by the OECD/G20 Inclusive Framework on Base Erosion and Profit Shifting (BEPS).
Not long after its introduction, UAE launched a new (amended) ESR legislation in August 2020, which was based on the outcome of the review of the no or only nominal tax (NOON) jurisdictions, concluded in June 2019, by the OECD’s Forum on Harmful Tax Practices (FHTP). The new law is more aligned to the international standards stipulated in the BEPS Action 5 and is retroactively effective from 1 January 2019.
The new ESR law introduced exciting amendments, such as: granting exemptions to branches and permanent establishments of foreign entities from meeting the substance test, expanding the scope of the distribution and service centre business, extending its applicability to government entities having a global presence, etc. In addition to this, the new ESR legislation granted substantial powers to the Federal Tax Authority (FTA) to oversee compliance, perform assessments and impose administrative penalties on defaulters.
The Ministry of Finance (MoF) also built a dedicated portal for licensees to submit their ESR notifications and reports to encourage compliance. Through this portal, licensees remain up to date about their ESR obligations, receive enquiries and assessment and penalty notices from the Regulatory Authorities (RA) or the FTA through the same channel.
In response to the ESR submissions made by the licensees for FY 2019, the RA and FTA have been reasonably active in asking for explanations and documentary pieces of evidence to substantiate the exemption status or meeting the economic substance test. In certain cases, the Regulatory Authorities have requested licensees to provide their land lease agreements, minutes of board meetings, outsourcing agreements, and other documentary evidence to prove that it meets the economic substance test. In other cases, the request for information was vague and broad, leaving room for a lot of interpretation. It is also observed that the RA/FTA have not hesitated to levy penalties in cases where the licensees have failed to comply with the ESR obligations.
To resolve technical errors, the support team at the Ministry of Finance (MoF) has been responsive over emails and calls. Additionally, licensees are allowed to rectify/amend the submitted ESR notifications or reports without levying additional penalties (although the deadline may be very short, e.g., five (5) business days).
Despite the available guidance and technical support from the MoF, licensees faced several challenges in meeting the ESR requirements, e.g., identifying the ultimate parent entity and/or ultimate beneficial owners in limited liability partnership structures, calculating the income/expense related to the relevant activities in the absence of prescribed methods, classification of the relevant activities, meeting the branch exemption, etc. Licensees also struggled to meet the substance test that requires them to substantiate the fact that they carry out the relevant activity, i.e., they are directed and managed in the UAE, and they meet the "adequacy test", i.e., they have adequate expenditure, premises and employees to conduct their business operations in the UAE, either themselves or through an outsourcing service provider.
With several factors involved in doing business globally, Multinational Enterprises (MNE's) might fail to meet the substance test in the UAE. Failure in meeting the substance test results in an administrative penalty of AED 50,000 for the first offence and AED 400,000 for a subsequent one. Further, it may also result in other countries taking defensive measures such as denying deductions, imposing withholding taxes on payments to companies or applying controlled foreign corporation rules to subsidiaries in such jurisdictions.
The key takeaway from this discussion is:
- Licensees should evaluate whether they carry out a relevant activity in the UAE and be prepared to demonstrate that their core income-generating activities are in line with the income and profits reported in the UAE.
- Licensees that have failed to meet the ESR requirements for FY 2019 must take all necessary steps to ensure they comply with the ESR requirements for FY 2020 to avoid penalties, sanctions and other measures taken by the foreign tax jurisdictions.
- Licensees must retain all documentary pieces of evidence for claiming an exemption status or meeting the substance test.
- Licensees must be vigilant to provide documentary evidence/explanations to the enquiries they might receive from the RA/FTA during the ESR assessment.
- Successively, licensees must ensure they submit the notification within six months from the end of its financial year and if it is liable to submit an ESR report, it must submit it within twelve months from the end of its financial year.
The implementation of ESR by the UAE is subject to a peer review from January 2021 to ensure the standard is effectively implemented by UAE. As a result, UAE may amend its ESR legislation in the future again.
Round 1 of the ESR was underestimated by the businesses, but the RA/FTA took it seriously. Therefore, as a forewarning for round 2, businesses that carry out one or more relevant activity in the UAE must either consider increasing their substance if not adequate or consider alternative restructuring options, e.g., redomiciliation into another jurisdiction, restructuring, liquidation, etc., to dodge the substance requirements. Tax payers who fail to meet the substance test for a second consecutive year will be exposed to a penalty of AED 400,000, and, what is probably worse, the tax authority of the parent jurisdiction will be informed of the lack of substance in the UAE.
Our previously conducted webinar may help in filling out the notifications and forms. Additionally, consistency in meeting the different disclosure requirements is important, as Ultimate Beneficial Owner filings and the Country by Country reporting may require similar information to be disclosed and these disclosures allow reconciliation with the ESR information disclosed.
Round 2 starts with notifications by end of June 2021 for FY 2020. Tax payers have been warned.