Dubai and other GCC governments introduce value-added tax

After years of speculation, an agreement signed in February 2016 has brought clarity regarding the introduction of value-added tax (VAT) to Dubai. The UAE, along with states around the Gulf, will begin to implement VAT from January 1, 2018, and will thereafter have a full year to fully establish the new tax.

The precise timing of the roll-out is a matter for each individual country, and the detailed framework, which will reveal exactly which goods and services will be subject to VAT, is expected to be published in late 2016. Statements made by government figures in the first half of 2016 suggest that industries such as health and education will not have VAT applied to them, while staple food items will also be exempt from the tax. However, while question marks remain regarding some of the nuances of the system, there is no doubt that VAT is soon to become a reality for Dubai’s businesses and consumers. Understandably, the attention of most economic observers has now shifted from questions of timing to the effect that its introduction will have on the domestic economy.

The proposed rate of 5% is a modest one compared to that being adopted by other emerging markets. Egypt, for example, is preparing to introduce a VAT system which, subject to parliamentary approval, is likely to impose a rate of around 10%. The average VAT rate in Europe’s advanced economies is around 20%.

A New Page 

For Dubai and the wider UAE a 5% levy on goods and services represents a significant alteration to a famously low-tax environment. The federal government applies no corporate, personal, capital gains, value-added or withholding taxes, and while each emirate introduced income tax decrees in the 1960s these measures have never been implemented. Dubai’s citizens have therefore become accustomed to a very low-impact tax framework, whereby they pay only 5% of their salary to a compulsory pension scheme and in some cases a number of small municipal charges. Businesses contribute relatively little to the government in terms of tax revenue: only a limited number of private oil, gas and petrochemicals 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.

One of the few areas of economic activity to have seen an increase in taxation over recent years is the hospitality sector: in 2014 the Dubai government announced that it would charge a modest “hospitality fee” for hotel stays, as a means to help finance construction work associated with World Expo 2020. The new charge adds to a 20% tax on hotel stays, made up of a 10% service charge and a 10% municipality fee.

These exceptions aside, Dubai’s light-touch tax framework has proved a winning formula, allowing 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 persuaded foreign nationals to relocate to play a part in this thriving, open economy.

Unhindered 

Social and infrastructural development has not been hindered by the low levels of revenue Dubai derives from taxation. Thanks to the federal nature of the UAE, the emirate benefits from the hydrocarbons resources which largely sit outside its waters: sizeable oil and gas revenues are traditionally a constant in annual UAE budgets, peaking at more than $120bn during the oil rally of 2012, granting the federal government sufficient earning power to drive its ambitious national development strategy.

While the lower oil prices seen since 2014 have not substantially altered Dubai’s balance sheet, the effects are more clearly seen in reduced revenues at the federal level. This does not pose a threat in terms of financial stability – according to the IMF the UAE has financial assets capable of sustaining it for more than 20 years – but it has highlighted the importance of revenue diversification at the national level.

Next Step

In June 2016 the UAE’s Ministry of Finance revealed how it intends to implement VAT. The tax will be introduced in two phases, the first of which involves mandatory registration for companies whose annual revenue exceeds Dh3.75m ($1m), while those with revenues of between Dh1.87m ($509,000) and Dh3.75m ($1m) will have the option to register. In the second phase, the starting date for which has yet to be announced, it will become obligatory for all companies to register under the VAT system.

Dubai-based businesses will have a range of bureaucratic demands to meet and adjustments to make to their processes, starting with going through the process of applying for a VAT registration number. Larger firms operating Enterprise Resource Planning (ERP) frameworks will have to revise their systems to enable them to charge and recover VAT, while those without ERP systems will be compelled to implement manual VAT accounting processes. This process will include everything from ensuring invoice templates include the relevant fields for VAT accounting, to altering the business structure to avoid unnecessary cash-flow or absolute VAT costs arising, particularly on intercompany transactions.

All companies will need to revise terms of business with clients to ensure VAT correctly becomes a cost to customers and not to suppliers. For many companies, adjusting to the practicalities of the new framework will be challenging. In its recent assessment of the effect of VAT in the GCC, accountancy firm Deloitte highlighted the importance of businesses “understanding current readiness to adapt a business to a taxed environment is key simply as it will identify those areas which will need to be given priority in the undoubtedly hectic build-up to implementation.”

There are signs, however, that many businesses in Dubai and the wider region are not as prepared as they might be for the changes that they will soon have to adapt to. A poll of 88 listed and non-listed businesses in the Middle East conducted by Deloitte, published in 2016, revealed that although 93% of them acknowledged that the new tax would have some effect on their business, 81% of them admitted that they had not yet incorporated VAT into their financial plans. The next year, therefore, is likely to see a considerable effort on the part of Dubai’s firms to bring their processes into line with the new framework.

Reward 

From the government’s point of view, the prospect of a modest amount of business disruption is a price worth paying for the introduction of a tax which is widely acknowledged to be one of the most effective and equitable routes to increased government income. According to the IMF, a VAT system has been implemented in more than 150 countries, among which it is the source of around 20% of government revenue. The low starting rate of VAT in the GCC suits the UAE well: the nation has never had a general sales tax, and therefore a higher rate would leave it vulnerable to an inflation spike. The 5% level recently agreed upon was backed by the IMF in August 2015, when the organisation also estimated that even this modest rate would, if implemented, bring in extra revenue worth 2.7% of non-hydrocarbons GDP.

Beyond the new revenue channel that a VAT system would direct towards the UAE’s coffers, the mechanism offers a number of 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 can 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) and 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.

Looking Ahead 

While Dubai prepares for the advent of VAT, economic observers are weighing the possibility of the government introducing more revenue-enhancing measures over the medium term. One area of speculation was the subject of a clarification in 2016: in revealing its plans to introduce VAT, the government took the opportunity to announce that a personal income tax and wider corporate income tax were not under consideration for the time being. This will come as a relief to those who feared that the unilateral introduction of these taxes, even at modest rates, would leave Dubai and the UAE at a disadvantage compared to other regional financial centres.

Smaller tax changes, however, remain a possibility. The IMF has suggested, for example, that the UAE consider imposing a 15% ad valorem tax on car owners to help meet the costs associated with maintaining and widening the UAE’s road network.

Remittances 

A proposed remittance tax remains a prospect, but comes with challenges. The UAE is the third-largest remittance market in the world and a highly competitive industry has evolved to service it, comprising more than 800 branches of money exchanges and more than 140 money changing agencies across the UAE. The competition has resulted in low transfer costs which, while welcomed by customers, means that the remittance industry is a low-margin, high-volume one, and therefore vulnerable to the imposition of a new tax. There is also the question of enforceability: opponents of the tax assert that it would be easy to avoid through illegal smuggling of cash or by resort to the informal hawala system, whereby funds are 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 adjustment which 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 undermine the financial system while offering no significant gain to the government.