Part of a regular series on the imminent tax and what is means to you
Although value-added tax (VAT) was famously called “a simple tax” when first introduced in the UK by Sir Anthony Walter, then the country’s Chancellor, it is highly doubtful that businesses in the Kingdom of Saudi Arabia (KSA) and the United Arab Emirates (UAE) wholeheartedly agree with his statement from the past. The plethora of VAT-related challenges faced by firms operating in the banking industry, in particular, are indeed significant. This is attributed to a variety of factors, including the highly regulated nature of the industry, the multitude of complex information systems used by banks, as well as the inherently involved nature of financial services. We aim to provide a high-level overview of some of the issues that local and regional banks are due to face with the introduction of VAT in Bahrain and the remaining Gulf states.
The VAT legislation in place in the UAE and Saudi Arabia makes the VAT treatment for supplies of financial services seem straightforward. Interest fees, as well as all types of fees charged with an implicit margin (e.g. effective currency spread), are exempt supplies from a VAT perspective (i.e. no tax to be levied). On the other hand, financial services payable through explicit fees are considered taxable supplies. However, the impact of VAT on banking operations does not end here.
Although the majority of businesses do not bear VAT as a cost but merely act as collection agents for the tax authority, the picture is different when it comes to firms making exempt supplies, such as most financial institutions. More often than not, a significant proportion of VAT incurred by these firms becomes a business cost. It is important for the management of banks to understand the direct impact that this has on their bottom line and to consider undertaking a product repricing exercise in order to safeguard their operating margins.
Islamic banking activities are even more involved than the activities rendered by conventional financial institutions. This is because Islamic banking aims to provide financing and investment solutions while adhering to the principles of Shari’a. As a result, Islamic banking products almost invariably involve the transfer of ownership of an underlying asset, as such introducing an additional element that needs to be properly accounted for from a VAT perspective. The VAT legislation of the neighboring GCC states contain the general provision that Islamic finance products are afforded the same VAT treatment as the conventional products which they are structured after. The incorrect interpretation of this single clause is the reason behind the widespread misconception regarding the applicability of VAT to Islamic banking transactions. To be clear, Islamic banks must ensure that the proper VAT treatment is applied to the sale of an underlying commodity in any Islamic finance transaction. Several factors must be taken into account to determine this, including whether or not it is intended that ownership of this commodity will pass to the borrower permanently or only temporarily. This is particularly relevant for commodity murabaha (tawarruq) transactions.
There are also additional VAT considerations for banks that operate in the region through a parent entity/regional headquarters which provides management and administrative services to branches and/or subsidiaries located in other jurisdictions. Firstly, in the event that the regional headquarters enters into procurement agreements with vendors for purchasing goods or services from which an establishment in another jurisdiction is to benefit, care must be taken to ensure that, for VAT purposes, the purchase is attributed to and recorded by the proper establishment. This may not necessarily coincide with the contractual arrangement in place. In addition to this, the proper VAT treatment for cost reimbursements between a parent entity and its regional branches/subsidiaries depends on a number of factors that must be carefully examined before a conclusion is reached.
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