Thursday 03, August 2017 by Nabilah Annuar

Creating a win-win state

Will value-added tax be a game changer in the UAE? Dr Allen Baby, Faculty at Emirates Institute for Banking and Financial Studies, Dubai tackles this question.

Over four decades, the UAE has transformed itself from a small $14 billion economy in 1975 to a $370 billion force to reckon with today—a true economic miracle. While the period saw oil prices go through the troughs and peaks, the country’s economy managed to sail ahead due to the strategic diversification efforts and bold economic reforms.

The rationale behind taxation

Though the UAE’s economy is largely diversified today when compared to its peers in the GCC region, oil continues to make up nearly 65 per cent of government revenues. A 2017 analysis by the International Monetary Fund (IMF) has estimated the fiscal breakeven oil price for the UAE a price level that would eliminate the country’s fiscal deficit—at around $71 per barrel.

Oil prices: lower for longer?

With clean energy bringing an unprecedented disruption to a market dominated by hydrocarbon fuels, there is a growing consensus in the energy sector today that low oil prices are here to stay for the foreseeable future. Given this context, policymakers have started to realise the fallacy of depending on hydrocarbon revenues in the long run.

Solar power prices have fallen by more than 80 per cent in the past few years, challenging more conventional sources of energy. In 2016, China doubled its solar capacity in just one year, and the UAE recorded the world’s cheapest solar energy bid at 2.42 cents per kilowatt-hour—a clear testament to the tremendous potential clean energy holds. A Bloomberg analysis has indicated that if the electric cars segment continues to grow at the current rate, it could off-set the demand for nearly two million barrels of oil per day by 2025—an equivalent of the current supply glut.

With long-term structural changes in the dynamics of the energy market, governments must embark in a new direction to make it through the turbulent times and emerge stronger once the storm blows over. The strongest economies of today are of countries that have adopted bold economic reforms at some point in their history, despite all odds. A prime example of a bold reform is the upcoming introduction of value-added tax (VAT) in the UAE. IMF estimates that the move will increase government revenues from non-oil sectors by as much as 2.7 per cent of non-hydrocarbon GDP.

Indirect taxes & VAT

An analysis of the global taxation principles shows that indirect taxes are perceived to be unfair and regressive, as they do not discriminate between the rich and the poor, requiring equal contributions from everyone regardless of income. For instance, if a bottle of water is purchased, irrespective of whether the person is rich or poor, they would pay the same tax on it. In case of direct taxes, the poor are generally excluded from the tax slabs or the slabs are low and a rich person would pay more tax based on his higher income.

The only way to mitigate this unfavourable perception is to keep the tax rates reasonably low and exempt basic goods and services from taxation so that the move does not hurt the common man. This is the fundamental rationale behind setting the VAT at a low rate of five per cent in the UAE. The well-known Laffer curve theory suggests that lower tax rates increase productivity and generate significant government revenues. The success of similar measures in countries such as Singapore and Canada has amply proven the accuracy of this premise.

A study by IMF shows that implementation of VAT has been successful in diversifying the revenue base of comparable economies with large commodity resource base. The average contribution of VAT towards government revenues in emerging and developing commodity exporters is around five per cent of the GDP.

Impact of VAT on banking industry

Upon the implementation of VAT in the UAE, the banking industry is expected to feel a multidimensional impact. Certain banking transactions will fall within the ambit of the tax law. While the original financial intermediation part of the banking business, which includes deposits and loans, and margin based products like trading in shares, bonds, forex etc. are exempt under the law, certain services would be taxable.

Select fee-based financial services, for instance agency services, custodial services, advisory services, asset management services and brokerage services, will also be subject to VAT. While the related costs will largely be passed on to the clients, banks might have to bear at least some of them. 

On the other hand, the introduction of VAT could indirectly open a world of opportunities in SME financing. As mentioned earlier, SMEs account for 90 per cent of registered companies in the UAE. However, the cumulative amount of bank finance this vital segment receives represents less than four per cent of total loans. This is mainly due to the high levels of risk banks face in lending to SMEs due to the lack of transparency in small business financials and frequent instances of artificially inflated figures.

The implementation of VAT in 2018 and corporate income tax in the future could significantly increase transparency in business through compelling companies to improve their bookkeeping and reporting standards. As an invoice-based tax system that requires proper documentation, VAT could make reporting bogus sales and inflating financial statements a thing of the past. A more transparent climate is anticipated to prevail that will encourage banks to take a chance on financing more SMEs, given the reduction in the associated risks.

Adopting VAT is a bold and forward-looking move that has the potential to change the foundations of fiscal policy in the UAE and enable the country’s diversified economy to grow from strength to strength regardless of the oil prices. In the long run, the introduction of VAT will be a win-win solution for the government, companies and consumers alike.

Impact of VAT on businesses

The introduction of VAT on goods and services in the UAE will affect businesses in the country in various ways. While the consequences could be negative at first, given the low tax rate and the fact that most of the costs will be passed on to the end consumers, the step is unlikely to have any significant impact on the profitability or competitiveness of businesses in the long run, especially for large companies.

However, nearly 90 per cent of companies in the UAE are small and medium-sized enterprises (SMEs), operating primarily in the trading sector. VAT could pose a real challenge for the SME segment, as the cost of compliance can be much higher than the direct financial implications of the tax.

SMEs often lack full-fledged finance departments and will most likely need expert help in calculating and filing their taxes. They will also need to acquire suitable tax software to facilitate recordkeeping. This could hike up their operating costs, resulting in a negative impact on their margins in the near term. Some companies, such as small service providers, may have to bear the costs themselves, as their clients may not be willing to absorb the increase by paying more for the services.

The initial guidelines from the Ministry of Finance specify that companies with a turnover of $100,000 and above must register for VAT in the first year, while the second year will see the limit lowered to $50,000.

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