Introduction of GCC-wide value-added tax could boost Bahrain's revenue

Bahrain, like other financial centres in the GCC, has successfully marketed itself as a low-tax environment in a bid to attract investment from across the globe. The majority of companies operating in the kingdom face no corporate tax at all, with only gas and oil companies engaged in exploration, production and refining facing a levy on income of 46%. There is no taxation at all on dividends, capital gains and payrolls, and there is no withholding tax on dividends, interest, royalties, technical services or branch remittances. There is also no taxation of personal income in Bahrain, an important part of the unwritten social contract between rulers and populations across the Gulf. This light touch taxation strategy has served Bahrain well in the decades of hydrocarbon-fuelled economic growth it has enjoyed over recent decades. What the government has denied itself in corporate and personal income taxation revenues has for the most part been adequately compensated for by the revenue derived from the hydrocarbons sector. By establishing a globally competitive regulatory environment the kingdom has pressed this advantage further, growing a vibrant financial sector populated by domestic, regional and global heavy hitters that have benefited substantially from the reduced outgoings that the taxation framework has demanded.

NEW ENVIRONMENT: The decline in oil prices which began in the second half of 2014 has, however, resulted in a new disposition with regard to taxation – not only in Bahrain, but across the entire region. After years of stability, oil prices declined by 40% in 2014, from the mid-year high of around $115 per barrel. By January 2016 a new low of under $30 per barrel had been reached, while news began to circulate that global investment in oil exploration and production had fallen to $550bn in 2015 from the $700bn of 2014. While a modest recovery in oil price later in 2016 brought some relief to finance ministries in the region, most observers do not foresee a significant recovery in the mid to long term: according to Riyadh-based Jadwa Investment, commercial crude stocks were still above their long-term average in the fourth quarter of 2016 and are expected to keep rising until mid-2017. While the Organisation of the Petroleum Exporting Countries production cuts may strengthen prices to some extent in 2017, a restoration of the $100-plus level of oil prices remains a distant prospect.

The message to the oil producers of the GCC is very clear: a period of low or volatile oil prices threatens to render them increasingly vulnerable to structural fiscal deficits if they are not able to diversify their economies and sources of revenue. Consequently, boosting revenue is a significant concern for Bahrain’s Ministry of Finance. The IMF, in a review of the region’s various tax policies published in late 2015, identified Bahrain as one of two GCC countries where oil reserves are expected to be exhausted sooner than their regional neighbours. The kingdom, therefore, urgently requires alternative sources of income.

REVENUE BOOSTING: Despite its traditional reluctance to increase the taxation burden on corporates and individuals, Bahrain has made advances in numerous parts of the economy in a bid to boost its non-oil revenue. These include a 5% levy on tourism, a 12% sales tax on petrol and a stamp duty on real estate. It has also sought to leverage its expatriate workforce by imposing monthly fees on foreign workers, the revenue from which is directed to the training of Bahraini nationals. However, the income derived from these initiatives remains minimal. In 2014, according to the IMF, the non-oil tax revenue of Bahrain stood at 0.6% of GDP. A low figure even by GCC standards, where non-oil taxes play a famously small part in the fiscal operations of regional governments.

This, however, is set to change with the introduction of a new tax in the kingdom which promises to open up a useful revenue channel for the government. After years of speculation, an agreement signed in February 2016 by Gulf ministers has at last made the introduction of value-added tax (VAT) to Bahrain a certainty. According to the agreement, regional governments will begin the implementation of VAT by January 1, 2018, after which time they will have a year to fully establish the new tax. The precise timing of the rollout of VAT is a matter for each individual country, and the detailed framework which will reveal exactly which goods and services will be subject to the tax was yet to be revealed at the close of 2016. However, while some uncertainty remains as to the new system’s detail, there is no doubt that Bahrain’s businesses and consumers will soon be contributing to the government’s coffers in a new way, and therefore much attention has lately been paid to the tax’s potential impact on the economy.

The proposed rate of 5% is a modest one compared to that being adopted by other emerging markets. Egypt, for example, started its new VAT system in 2016 at a rate of 13%, which it plans to increase to 14% in the FY 2017/18. The average VAT rate in the advanced economies of Europe, meanwhile, is around 20%. However, while Egypt’s adoption of VAT is in large part a transition from an already existing sales tax, the lack of a similar framework in Bahrain means that the new 5% levy on goods that VAT represents is a significant alteration to its famously low-tax environment.

CHALLENGES: Aside from the financial impact of VAT, Bahrain’s business community is also faced with the practicalities of implementing the new framework. For example, companies operating enterprise resource planning (ERP) platforms will have to revise their systems to enable them to charge and recover VAT, while those without ERP infrastructure will be compelled to implement manual VAT accounting processes. The latter will include everything from ensuring invoice templates contain the relevant fields for VAT accounting, to altering the business structure in order to avoid unnecessary cash-flow or absolute VAT costs arising, particularly on inter-company transactions. Moreover, all companies will need to revise the terms of business, with clients to make sure that VAT correctly becomes a cost to customers and not to suppliers. Given the amount of preparation necessary for Bahraini firms, it is little wonder that accountancy firms were throughout 2016 assiduously highlighting the need to plan for the tax’s introduction. These included global giants such as KPMG and PwC, both of which held seminars in Manama as part of a region-wide initiative to tap into the increased business that the VAT will generate.

IMPLICATIONS: The introduction of the GCC-wide VAT offers a number of favourable outcomes to the government. According to the IMF, a VAT system has been implemented in more than 150 countries. The 5% levy to be introduced across the GCC will not result in anything approaching that level of revenue contribution, but there are substantive gains to be made by its introduction nonetheless.

The IMF forecasts a $568m windfall in terms of revenue for Bahrain, assuming a 5% rate, which is equal to about 1.6% of the kingdom’s GDP. Beyond the revenue gain, the economy will benefit in less tangible ways from the introduction of the tax. For example, VAT is simpler to implement than other indirect tax; the broad-based nature of the tax, and the fact that it targets consumption, reduces the opportunities for evasion that a simple sales tax is vulnerable to. In addition, VAT is transparent in nature; its burden on consumers is mitigated by the fact that it is collected in small fragments at numerous stages of production and distribution; 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), thereby removing the incentive for businesses to vertically integrate in an attempt to avoid paying taxes on inputs to the production process.

Perhaps just as important is the useful model established by the multilateral introduction of the tax across the GCC. If Gulf countries are ever to follow the advice of the IMF and implement a comprehensive corporate tax framework — something most analysts consider an unlikely prospect in the short term — it will most probably be undertaken on a similarly multilateral basis in order to avoid undue competition within the region.