Introduction of new taxes in the UAE will require careful management

The tax system is one of the key pillars to have supported the UAE’s economic growth over recent decades. The federal government applies no corporate, personal, capital gains, value-added or withholding taxes, while emirate-level tax legislation introduced in the 1960s has never been implemented.

In practice, only a narrow band of business activity contributes to the nation’s revenues: the relatively small number of private oil, gas and petrochemical companies which operate in the state-dominated energy sector pay up to 55% tax on UAE-sourced taxable income, while the foreign banks that have set up operations in the country are subject to a 20% levy. With regard to personal contributions, at the federal level UAE citizens are only required to contribute around 5% of their salary to a compulsory pension scheme, while some municipal charges are levied on individuals living and working in the UAE. The only other form of taxation encountered by UAE residents are service charges of between 5% and 10% imposed on food purchased in restaurants, and a hotel tax of 10% to 15% of the room rate, both of which are collected by the municipality.

This light-touch taxation has proved a winning formula for the UAE. It has allowed domestic businesses to expand their operations at a faster rate than they would have done if burdened with an annual tax assessment, while the absence of personal taxes has drawn foreign nationals to play a part in the UAE’s thriving, open economy.

Revenues

The country’s social and infrastructural development has not suffered from want of taxation income: with healthy oil and gas revenues a constant in annual budgets, and exceeding $120bn during the oil rally of 2012, the government has traditionally had sufficient earning power to drive its bold national development strategy. The depressed oil prices seen in 2014, which persisted throughout 2015, have not substantially altered this scenario: according to the IMF the UAE has financial assets capable of sustaining it for more than 20 years.

However, with oil prices running stubbornly below an estimated UAE break-even price of between $73.80 to $80.80, and the likelihood of the country running a fiscal deficit for the first time since 2009, the question of taxation has come to the fore. While the discussion is not new – various proposals have been explored over the years by both individual emirates and the federal government – announcements in 2015 concerning the imminent completion of draft taxation laws suggest that there is real momentum behind the recent initiative.

Pros & Cons

Three potentially significant taxes are up for discussion, according to the Ministry of Finance: corporate tax, value-added tax (VAT) and a tax on remittances. The main benefit to the government of the introduction of any of them is clear: a useful revenue stream that broadens the tax base and provides a hedge against oil price fluctuations.

Each proposed tax, however, comes with its own set of challenges. In the case of corporate tax, many foreign companies will be protected from it by the fact that they are registered in one of the UAE’s free zones, such as the four industrial zones operated in Abu Dhabi by ZonesCorp or the Khalifa Industrial Zone Abu Dhabi, which is being developed next to the emirate’s major port. While the government benefits from the licensing and registration fees charged to companies setting up at these locations, one of the selling points of the emirate’s free zones has been the multi-decade guarantees against the imposition of corporate tax. For foreign financial firms and the companies that serve them, meanwhile, registering themselves in the new Abu Dhabi Global Market free zone will likely exempt them from federal corporate tax, unless there is a significant alteration to the zone’s terms. The burden of the new tax, therefore, will largely be borne by national companies, which would be a challenging scenario for the government. Another key challenge with corporate tax is the possibility of the UAE being left at a disadvantage with regard to other financial centres in the region. Giving up the nation’s zero-tax status for corporates would represent a sizeable policy shift, and if done unilaterally has the potential to dull the UAE’s competitive edge when it comes to attracting fresh investment.

Remittances

A proposed remittance tax remains a possibility, but again comes with challenges. The UAE is the third-largest remittance market in the world, behind the US and Saudi Arabia, and in 2014 the total amount of money sent home by expatriates reached Dh29bn ($7.9bn).

A highly competitive industry has evolved to service this market, comprising more than 800 branches of money exchanges and more than 140 money-changing agencies across the UAE. While competition has been good for their customers in terms of transfer costs, which are among the lowest in the world, the low-margin, high-volume nature of the segment renders it vulnerable to the imposition of a new tax. Moreover, opponents of the tax assert that it would be easy to avoid through illegal smuggling of cash or by resorting to the informal hawala system, whereby funds to be transferred are simply given to an agent in the country of origin, who instructs the release of a similar sum by an associate agent in the country of destination.

Timing is also a concern: the nation’s remittance industry is adjusting to a regulatory change that has placed a Dh5m ($1.4m) capital requirement on exchanges offering remittance services inside and outside the country, a Dh3m ($817,000) rise on the previous level. A tax on remittances, therefore, has the potential to damage the financial system.

In February 2016 it was announced that VAT will be introduced in the UAE by the end of 2018 at a rate of 5%, with the tax set to be introduced across the GCC at a later date. The introduction of a VAT system might represent an easier start point for the government as it sets about broadening its revenue base. VAT systems have been implemented in more than 150 countries, among which it is the source of around 20% of government revenue. Beyond the new revenue channel that VAT will direct towards the UAE’s coffers, the mechanism offers other advantages: as a broad-based tax on consumption it can secure high and stable revenue and greatly reduce the opportunities for tax evasion that a simple sales tax is vulnerable to; a VAT system could be used to boost exports by offering a zero-rate on export sales; and by not taxing business inputs VAT avoids cascading, by which a good is taxed more than once as it progresses from production to final retail. This latter point helps to maintain production efficiency by removing the incentive for businesses to vertically integrate in an attempt to avoid paying taxes on inputs to the production process.

The fact that the VAT system hits a broader base of society, not discriminating between national or expatriate, individual or company, makes it the easiest form of taxation to implement. As there is no sales tax in the UAE, however, VAT must start with a low rate to avoid a potentially damaging spike in inflation. The IMF has backed the rate of 5%, given the current macro-fiscal environment. This compares to 20% in the UK and France, and 19% in Germany. Yet even this modest rate could bring in extra revenue worth 2.7% of non-hydrocarbons GDP.

The IMF has also suggested that the UAE consider imposing an ad valorem tax (based on the value of the good or transaction) on car owners, to help meet the costs associated with maintaining and widening the UAE’s road network.

The introduction of corporate tax also remains a possibility in the short term, despite the difficulties associated with implementing it. In the second half of 2015 the Ministry of Finance announced that the draft legislation for both a VAT system and corporate tax were being finalised, and that should a final agreement on the laws be reached, “concerned sectors and entities will have around 18 months after imposing the law to implement and fulfil the requirements of their tax obligations”. While details regarding the proposed taxes had not been revealed at time of press, one way in which the corporate tax system might be made more palatable would be to reduce the 20% levy paid by some foreign firms to 10% and extend the tax to UAE companies.

Timing

The larger question concerns timing. The UAE has made clear its desire to move ahead with tax reform in step with a wider GCC process, thereby sidestepping the challenge of competitive disadvantage. Whether the GCC can move on the issue at a pace suitable to the UAE remains to be seen. If not, the UAE has the option of a unilateral move, a route it has already shown itself willing to take with its successful reform of petrol subsidies.