Adopting a new tax system, Saudi Arabia and the UAE deliver a shock to companies and consumers—and reassurance to foreign investors.

Author: Chloe Domat

Five percent: That’s all it takes to start a small revolution. In January, Saudi Arabia and the United Arab Emirates introduced the Gulf region’s first value-added tax. This decision marks a major step away from the oil-dependent system, a shock for companies and consumers based there, and perhaps, a move to a more sustainable fiscal mechanism for the world’s pivotal energy-producing region.

The VAT, which became effective in the two countries on January 1, is a tax on transactions. Businesses must add the 5% charge on all sales. In the case of a product that goes through a manufacturer, a distributor and a retailer, the tax gets applied three times; but businesses can recover the VAT charged on purchases. In countries where few taxes existed previously, the new responsibility to calculate and collect the VAT represents a challenge to businesses, but introduces new discipline in corporate accounting that foreign investors may welcome.

“There used to be no taxes at all, no form of control, no public audits. We could do anything we wanted with our accounts,” says the founder of a small training and education services company based in the UAE. “Now VAT is the first measure that forces companies to have clear accounting.”

Global institutions applauded. “The VAT is a milestone achievement in strengthening the tax culture and tax administration of the country,” concluded the International Monetary Fund in a report on its May Article IV mission to Saudi Arabia to assess economic and financial developments in the kingdom and discuss policy with government and central bank officials.

Establishing a VAT to help Gulf states compensate for low oil prices and diversify their economies has been on the table for a number of years. The idea is to create new sources of revenue for the state, ideally to spend on infrastructure projects. In 2015, all six Gulf Cooperation Council states signed an agreement setting out the general terms for a “uniform imposition … of VAT at a rate of 5%.” Each country then began to adapt the measure to its own legal framework. After countless meetings and deliberations, Saudi Arabia and the UAE jumped in. Bahrain, Oman, Qatar and Kuwait are expected to follow in coming years.

To smooth the process, the Emirati Ministry of Finance started giving VAT-awareness sessions in March of last year. The goal was for business leaders to start implementing the necessary strategic, operational and financial adjustments in advance. Yet a Deloitte survey a month later found that 69% of GCC businesses were concerned that they may not be prepared for VAT introduction by 2018. Indeed, according to the survey, over 50% of respondents didn’t believe the tax was actually going to be implemented. The considerable gap between private-sector perceptions and government announcements prompted companies to stall.

“It went too fast. There was no time for preparation. Even now, six months later, companies are still struggling with tax registration,” says Jad Rizk, managing partner of SK-Touch, an interior-design studio based in Jeddah, Saudi Arabia. “I hired a consulting firm, but they don’t know what to advise. It’s a whole mess.”

Businesses and customers are still struggling to understand and adapt to the new law. For some, such simple items as invoices issued in 2017 but paid in 2018 have become headaches, and the temptation to stay under the radar is strong.

“So far, I don’t see that they are really checking who pays or not,” the UAE training-company founder says. “I will abide by the tax, because I fear that the government will enforce some kind of control mechanism. Fines in the UAE can be really tough, and my company is too small to survive it.”

In Saudi Arabia, the government has introduced a mobile app to help customers make sure that shops are applying the new tax correctly. Users can calculate the VAT amount applicable on an invoice and scan the QR code on the VAT certificate; they are encouraged to report fraud.  As of May, the application had been downloaded over 1.4 million times. 

Short-Term Inflation

With the big exception of the United States, the vast majority of countries in the world apply VAT. In Europe, the rate averages around 20% while in the other regions it usually stands between 10% and 15%. The main advantage of VAT is that it’s a transparent, neutral and easily collected tax that can generate large revenues. On the downside, VAT is difficult to implement at first, imposes high compliance costs and tends to hit low-income people harder than the rich.

In the short term, VAT is bad for foreign investors because it is costly to implement. At the end of the day, however, businesses are not the ones paying for VAT, customers are. Longer-term, a VAT should boost investor trust in the UAE and Saudi Arabia.  As in other countries that have introduced a VAT, the immediate impact in the two Gulf states has been a sudden rise in prices. According to the IMF’s forecast, inflation will increase from -0.9% in 2017 to 3.7% this year in Saudi Arabia and from 2% to 4.2% in the UAE. This is having mixed effects on companies operating in the two countries.

“Our business dropped by 40%, because the tax numbers are adding a lot on contracts, so you see clients holding their purchasing decisions,” says Rizk, who has opened an offshore company to avoid some of the taxes. “It’s a shame, because the absence of taxes was the only thing attracting companies to settle in Saudi Arabia.”

At the same time, he admits that his Jeddah studio has also benefited somewhat from the general price rise. “With people spending more on taxes, we are receiving new requests from customers who want to make their house ‘smart’ to save on electricity bills and all energy-related consumption,” Rizk says.

In Saudi Arabia, VAT introduction, combined with a revised bill-calculation system, resulted in a 300% increase in electricity prices in just a few months. Gasoline prices have gone up between 80% and 120% following subsidy cuts.

Despite fears that the VAT could tarnish the business environment and reduce GCC countries’ attractiveness in the short term, most analysts agree it was a good decision. Both the UAE and Saudi Arabia are eyeing high returns from the new tax. The UAE expects to collect around $3.3 billion in the first year.

Saudi Arabia, confident that extra revenue will pour in, has announced its biggest budget ever for fiscal 2018: $261 billion. Standard & Poor’s predicts that VAT introduction will boost Saudi government revenues by 1.7% to 2% of GDP. To be as realistic as possible, S&P based its conclusions on a collection efficiency ratio of 50% to 60%, reflecting an effective tax rate of 2.5%-3%, lower than the 5% statutory rate. The IMF concurs, forecasting an increase in GDP growth. The IMF predicts Saudi Arabia will step out of recession to reach 1.7% GDP growth in 2018, then stabilize around 2%; while the UAE will jump from a 0.5% growth rate in 2017 to 2% in 2018 and stabilize around 3%.

Key sectors such as healthcare, education, transportation and food have historically been exempt. Other industries, such as aviation, diamonds, gold and precious metals in the UAE, received case-by-case exemptions to maintain competitiveness.

The introduction of VAT is a milestone for the GCC. Even if initial steps are shaky, the reform marks the end of an era. Oil-producing countries are no longer an exception to the rule. By adopting a more conventional revenue system, they have embarked on a journey toward an economic model more aligned with the developed world.