Less than three years after the introduction of VAT on 1 January 2018, KSA has decided in a surprise move to increase the VAT rate very substantially from 5 to 15%. The measure is implemented amongst other measures intended to improve fiscal balance in the Kingdom.
KSA MoF announces fiscal reform
In a press release on 11 May 2020 issued by the KSA Ministry of Finance, H.E. Mohammed Al-Jadaan, the KSA Minister of Finance announced important fiscal reform as a result of the current economic circumstances. It will be suspending cost of living allowances and increasing the VAT rate from 5 to 15% as from July 2020. In addition, it foresees spending cuts in some of the landmark Vision projects.
The KSA Ministry of Finances owes the reform to triple economic trouble. Firstly, an important decrease in oil demand and therefore in oil revenues for the state. Secondly, lockdowns and other measures have stalled or halted economic activity in the Kingdom. Thirdly, the unplanned government expenses contributed towards the fiscal imbalance.
Before the crisis, the IMF had already advised KSA to increase its VAT rate to 10%. KSA now went above and beyond.
The KSA VAT system
KSA introduced VAT on 1 January 2018 at a standard rate of 5%. Widely hailed as a success in terms of government income, it brought in in excess of 12.16 billion dollars in the first year, more than double its own initial estimate.
The KSA VAT system is based on the GCC VAT Treaty, signed by all six GCC Member States. The GCC VAT Treaty is based on the EU VAT directive in its 2010 version.
KSA gave its own spin to VAT, amongst others excluding in practice government supplies from VAT, introducing “refunds” for medical services to locals and houses built by locals, and having refunds for government entities (the equivalent of so-called “compensation funds”). It also introduced restrictions to supplies of services made by KSA suppliers to recipients abroad, ensuring additional VAT revenue.
Interestingly the 5% VAT rate is foreseen by the Treaty and would require unanimity to be amended.
Impact of the change
Generally the increase of VAT causes a short term increase in spending before the increase, and a short term decrease right after the increase. The VAT rate hike then gets gradually absorbed by the economy and should theoretically be neutral.
A hike in the VAT rate does impact consumer confidence though. From a business perspective, those businesses which may have cared less about a mere 5% VAT, will now increasingly turn their attention to transactions subject to VAT to ensure compliance and, more importantly, no VAT leakage.
The economy is currently in a fragile state and therefore this measure will have been carefully weighed.
Speed of KSA fiscal reform
The speed of fiscal reform in KSA has been phenomenal. While in 2017 it had been dealing for some time with withholding taxes ranging from 5 to 20%, corporate tax of 20% and Zakat at 2.5%, in a time span of three years, it:
- Introduced Excise Tax
- Introduced VAT
- Introduced extensive transfer pricing legislation impacting FY2018
- Introduced country by country reporting impacting FY2018
- Amended the Zakat legislation
- Broadened the Excise Tax base
The speed of these reforms is staggering and the General Authority of Zakat and Tax is trying to keep up with the policy decisions.
Businesses will need to take the VAT rate increase into account in their pricing strategies and have very little time to do so. The VAT rate hike will have to be implemented in about 6 weeks.
POS systems, billing systems, contracts, Pos, may need to be adapted. An increase of the VAT rate goes beyond a simple push on the button unfortunately.
The interesting development will be that for contentious matters, such as whether e.g. “distribution services” should be subject to VAT, the increase will draw the attention again to these matters.
With the business refund scheme in KSA still not in place, this will only increase the cost of doing business in KSA.
Will other Gulf States follow?
The UAE introduced VAT at the same time as KSA and Bahrain a year later in 2019. The UAE and Bahrain are in a very similar situation as KSA. All three have introduced VAT recently, the UAE simultaneously with KSA and Bahrain one year later. The other three GCC countries have not yet introduced VAT. All GCC countries are dependent on commodities for government income and spending. Therefore, the economic impact of COVID19 is similar in the three GCC States which implemented VAT. However, the more important short term situation is the low oil price. The low oil price has very heavily dented government revenues and therefore drives reform.
Given the similarity and the interdependency of the KSA economy with the UAE and Bahrain, it is not inconceivable that these countries will follow suit. The situation of the UAE may be slightly different since it is a confederation and not a unitary state. The dynamics between the Emirates may play out differently. On 11 May the UAE Ministry of Finance also issued a press statement saying it does not plan a VAT hike, as a reaction to KSA's announcement.
Over supply of oil and under demand due the current economic crisis caused by COVID-19 has led to WTI prices for oil fall below zero as at 21 April 2020. Storage capacity is near full and therefore expensive. In the present situation, sellers are paying buyers to take oil off of their hands.
The situation is complicated for the oil sector and adds another “unprecedented” badge to the state in which the world currently finds itself in dominated by a health and economic crisis. Like oil companies, tax authorities now also face the task of having to consider how their legal frameworks apply to negative oil prices. We analyse those issues below.
Buyers are doing sellers a service for VAT purposes
At first sight Value Added Tax rules are made for transactions happening with a positive value. They calculate VAT on the price agreed with the customer. Whether the VAT laws implicitly assume that the transactions are always at a positive value is probably debatable, but certainly not unreasonable.
The tax authorities are expecting VAT revenue on the sales, not having to refund VAT to the sellers. Although the VAT law allows you to sell at a loss, to make no sales but have the intention of selling and still recover input VAT, hand out goods for free (taxed as deemed supplies), it does not foresee the situation of negative values charged when a good is sold.
The current situation is very similar to a furniture store charging a pick up fee for picking up your old furniture. The furniture store receives the ownership of the old furniture for free and charge a service fee for the pick-up. It then goes on to perhaps on-sell the old furniture, up-cycle it or use it for its own purposes.
Irrespective of the technical debate, tax authorities will be lukewarm to the idea to allow sellers to issue invoices with negative values. This would effectively mean that for each sale made, the tax authority would have to refund VAT to the seller. The only negative values allowed to be mentioned by sellers are usually reserved for credit notes. It therefore stands to be reasonably expected that tax authorities will take the view that buyers are rendering a service to the sellers. Therefore the buyers will need to issue an invoice to the sellers.
Depending on the applicable place of supply rules, that service will then effectively be subject to VAT, or not. Given that most of the sellers and buyers will be businesses with full input VAT recovery, that should not constitute an issue.
With the place of supply rules in the individual GCC countries, which deviate from the GCC VAT Framework, and their mix up with the zero rating rules (oddly imported from New Zealand), this may trigger some additional concerns for foreign sellers, which may be charged with 5% GCC VAT when the service relates to a good in the GCC. Even though a business refund is foreseen, it is only currently effectively available in the UAE, and only on condition of reciprocity.
In the UAE, VAT registered buyers of crude or refined oil are expected to apply the reverse charge mechanism on the domestic purchase of these goods. Instead of reverse charging on purchases for negative amounts, they will now likely need to apply VAT on a service. In a domestic context, this means an additional 5% VAT added for the seller, which, recoverable as it may be, will lead to added pre-financing for the seller. In KSA, local traders were already used to applying 5% VAT to each other. In Bahrain, a zero rate applies for oil and oil derivates.
It is safe to say that this is uncharted territory and that diverging opinions on the topic may emerge.
Non deductible expenses and additional withholding taxes
The situation from a corporate tax point of view seems, again prima facie, slightly more straightforward. The corporate tax is generally calculated on the basis of the books of account of the seller. From a financial point of view, and from a conceptual point of view, those books could record negative revenue (Note: the author of this article is not an accounting expert).
Negative revenue goes untaxed, because the business is not making positive sales. However, does the negative revenue constitute a deductible expense which reduces your corporate tax liability? This issue will surely be hotly debated with the tax authorities in the GCC which will be required to take a stance.
Additionally, in countries with broad withholding tax provisions on services, like KSA, there may be an additional element of surprise. The main concern with the fact that buyers may now be providing services to the sellers, is that when such a service takes place in an international context, the Saudi payer may need to apply a withholding tax (subject to relief in double tax treaties).