Saudi VAT increase: What are the long-term implications?

In a sudden decision, Saudi Arabia announced that from July 1, it would be hiking its value added tax (VAT) from 5 per cent to 15 per cent.

The move, aimed at supporting the government as revenues plummeted due to the drop in oil prices, expectedly led to inflation in the market.

From a legal perspective, these are the implications of the decision:

Impact for taxpayers

Taxpayers that carry out VAT exempt supplies and unregistered entities (such as passive holding companies) are not allowed to recover (all of) the input tax incurred on their expenses. As a result of the rate increase, VAT exempt taxpayers will incur more irrecoverable VAT, which increases the cost of doing business.

This may lead to an increase in consumer prices, causing (additional) inflation as the VAT exempt taxpayer may pass on the additional cost in the price of its goods and services.

If the VAT exempt taxpayer is in the middle of a supply chain, it will have a knock-on effect on businesses further down the line. For example, a bank may – as a result of an increase in cost – hike up the interest rate charged to a retail business. The retail business will have to increase the price of its goods to offset the cost increase (or accept lower profitability).

VAT exempt taxpayers may also consider insourcing more activities to reduce the amount of irrecoverable VAT incurred. For example, instead of appointing an external IT provider, a bank could employ an IT consultant. VAT does not apply to salaries. Although it reduces cost for the bank, it may not be as efficient as appointing an external consultant. The additional tax changes economic behaviour and may result in market inefficiencies.

Business visitors

The refund mechanism for (business) visitors has not been implemented yet. The higher VAT rate increases the cost for foreign businesses and individuals procuring goods and services in the country. As foreign visitors are not registered for VAT in Saudi, they cannot claim back the VAT, effectively increasing the price by 15 per cent.

This could have a negative impact on – for example – the tourism and event industry in the kingdom. Saudi may be less attractive as a holiday destination or for luxury shopping, especially since neighbouring GCC countries such as the UAE and Bahrain apply a lower rate while countries like Oman do not impose VAT at all.

Admission to events taking place in Saudi Arabia is subject to the local VAT rate, irrespective of the origin of the visitor. As a result of the absence of a refund mechanism and an increased VAT rate, event organisers may consider having the event in other jurisdictions with a lower rate, or those with an operational VAT refund mechanism or special scheme for event organisers such as the UAE.

Cross-border transactions

Services provided by Saudi-based companies to those based outside the kingdom are in principle subject to zero VAT. However, exceptions apply and the tax authority looks closely at taxpayers applying the zero rate of VAT. In case the zero rate does not apply, the non-resident company cannot get a refund for the VAT incurred as per the above. For multinational companies that operate in Saudi, this could increase the cost significantly. These companies may need to reconsider their structure or transaction flows to minimise the impact of the rate increase.

Managing the tax

A taxpayer is effectively collecting the VAT from the consumer for the government. As a result of the rate increase, the amount of VAT that is “managed” by the taxpayer on behalf of the government increases significantly on both the input (cost) and output (revenue) side.

Getting it wrong can have significant financial impacts. The penalty for under-accounting VAT is 50 per cent of the underpaid amount. With a VAT rate of 15 per cent, this means a potential financial impact of 22.5 per cent of the fee received by the taxpayer. Taxpayers should review the VAT treatment of transactions carefully and have documentation in place to support their position.

Impact on consumers

VAT, being a tax on consumption, is borne by the end-consumer. The rate increase results in an inflation of consumer prices. As the VAT regime in Saudi has a broad base and a single rate, there are no substitutes. For example in jurisdictions with multiple rates, a consumer may have the possibility to adjust their consumption from products subject to the standard rate to those with a reduced or zero rate of VAT.

The government could consider introducing a lower rate or expand the scope for the zero rate of VAT and include – for example – basis necessities. This would reduce the impact of the VAT increase on inflation of consumer prices. Possibly to counteract the negative effect of the rate increase, the government exempt certain real estate transactions from VAT as per October 4, 2020. Although this is a welcome move, additional exemptions (as would an introduction of a reduced rate or more zero rating) would result in a more complex VAT regime that is more costly to administer – both from a tax authority and business perspective.

Bastiaan Moossdorff is a senior tax adviser at Baker McKenzie Habib Al Mulla