VAT and Islamic finance: A complicated relation
Now that two countries in the Gulf Cooperation Council (GCC), Saudi Arabia and the UAE, introduced a value added tax (VAT) regime for the first time ever, and the others are bound to follow, questions arise how such a consumer tax relates to Islamic finance products.
Rating agency Fitch said in a statement ahead of the VAT introduction that it would be a key test for the region’s Islamic finance industry regarding tax parity between conventional and Islamic finance transactions, warning it could affect all the main pillars of the industry: Islamic banks, sukuk, takaful and Shariah-compliant corporates and fund managers.
The agency argues that due to the complexity of Islamic finance products, VAT would have a higher impact than on conventional financial transactions. Therefore, if the planned tax treatment for Islamic finance activities is not made clear in the underlying regulatory framework of each country, the uncertainty could reduce Islamic finance activity and attractiveness in the short term.
For example, the conventional financing of, let’s say, a machine for a manufacturing business, is very straightforward. If the customer of a conventional bank requires finance to purchase a $1,000 machine, the conventional bank will lend $1,000 to the customer who then purchases the asset and can recover any VAT paid for the machine in his tax declaration for the fiscal year. When the customer repays the loan after some time, the additional costs for him will just be the VAT-exempt interest to be paid to the bank.
In an Islamic finance deal, let’s take an underlying simple murabaha (purchase and sale) structure, the financing – in the absence of specific VAT provisions – will be inevitably more expensive. The bank buys the machine for $1, 000 plus VAT and resells to the customer with a profit but also with outward VAT, thus the costs for the customer will be significantly higher. Even in the case both the bank and the customer can recover VAT on the machine purchase, the bank will still have to pay VAT on the profit it charged its murabaha client. A VAT charge also adds to any instalment payments in a murabaha structure, while a conventional transaction would not have VAT added to regular interest payments.
It is worth noting that murabaha is only one form of Islamic finance. The tax impact could be even bigger for more complex transactions. Adding to that, the VAT cash flows involved add a higher burden to accounting for all parties and much more recording requirements of each transaction for the annual audit.
And still, it is not written in stone that the bank is able to get back VAT it paid for the machine, since normally VAT can be reclaimed only on goods and services that are wholly related to a company’s normal conduct of business, and not the brokering of industrial goods by a bank, like in the above example. This would make the costs of an Islamic finance deal for the machine purchaser disproportionally high and far more complex in terms of accounting as compared to a conventional loan.
In case a private buyer, who is not VAT registered and/or, for instance, buys an item such as a car for his own end-use through Islamic finance, he would not be able to get any VAT repaid in the process.
Furthermore, the above examples only deal with Islamic financing of tangible goods. It becomes much more difficult and complex when a company needs to borrow working capital or capital as allowance for not yet-specified future uses under Islamic finance contracts. VAT applicable in those cases could by far exceed costs for a conventional loan in the absence of specific regulations.
The adoption of VAT in the GCC follows the a respective GCC framework which defines VAT as “tax imposed on goods and services that should be paid by any individual engaging in economic activity with the intent of making profit.” Basically, the framework constitutes that financial services are exempt from VAT and this should be included specifically in the local VAT law of a country, alongside with other products and services that receive special treatment or exemptions.
But this does still not make VAT inexistent in Islamic banking. For example, even though the regulation on the UAE VAT law has a detailed definition of financial services and distinguishes products and services on which VAT is applicable – and exempts Islamic finance facilities with profit rates – there can still be hidden taxes on financial transactions particularly on explicit fees and commissions related to a financial transaction, which, by definition,, are more common in Islamic than in conventional banking.
For large transactions or a higher amount of transactions a company client makes with an Islamic bank in a VAT environment, there is a high likeliness that more overhead costs are taxable which could have a cascading effect.
Saudi Arabia, in turn, has adopted a narrow exemption model with respect to financial services in which margin-based services are exempt from VAT and fee-based services will be taxable. But, the country’s VAT regulation states that “Islamic finance products which simulate the intention and achieve the same results of conventional finance products” will be treated in the same manner as conventional products.
That said, countries with dominant Islamic finance industries, including Malaysia, Indonesia, Turkey and Pakistan, have provided for some form of tax neutrality or equality for Islamic finance transactions.
For example, Malaysia, which introduced a Goods and Services Tax in 2015 – which is broadly equal to a VAT – clearly rules out that supplied goods or services are taxed by VAT under any Islamic financial arrangement. The consequence is that in Malaysia, to both the customer and the bank, using Islamic financing has theoretically the same VAT applications as using conventional finance, since the intermediate supplies that take place within the Islamic finance transaction are ignored for tax purposes.
This model would possibly be the way to go for the remaining GCC nations with regards to VAT and Islamic finance.
Due to the complexity of Islamic finance products, VAT would have a higher impact on them than conventional financial transactions, according to rating agency Fitch
This article originally appeared on GulfOptions