How to design a new tax system

Customers at a cafe in the Dubai Mall.

Only the most courageous political leader dares to introduce a tax hike, so how does a region like the UAE create an entirely new tax regime?

How does an oil-rich region, that has never before taxed its people, go about introducing a tax system? That’s the current project in the United Arab Emirates (UAE), which brought in a value-added tax (VAT) of 5 per cent on 1 January 2018. 

In recent history, the UAE has enjoyed enviable riches thanks to oil revenue, which has bankrolled infrastructure, schools, universities, hospitals and clinics, land reclamation projects and various impressive feats of engineering. However, the flows in those rivers of black gold have begun to ease as a result of a number of factors, including the global financial crisis, increased oil production in the US, and the Organization of the Petroleum Exporting Countries’ (OPEC) inability to convince member states to cap annual production levels. 

With government incomes in the Gulf states falling, tax – long accepted as a part of life in the rest of the world – was finally put on the agenda. 

In early 2017, the six Gulf Cooperation Council (GCC) states – Bahrain, Kuwait, Saudi Arabia, Oman, Qatar and the UAE – agreed to bring in a VAT in the next 12 to 24 months. The intention was for all states to launch the tax at once on 1 January 2018, but since then, four territories have announced they will not be ready for another year. The original deadline will only be met by Saudi Arabia and the UAE.

Professor Michael Walpole, head of the School of Tax and Business Law at UNSW Business School in Sydney, says the main issue for the UAE will be making it simple for businesses to understand and comply with the tax system.

 When Walpole presented to the Tax Institute on the topic of VAT design, he quoted Dutch economist Professor Sijbren Cnossen.

“Cnossen said the key desirable features of a VAT are: fairness between categories of goods and supplies, meaning, for example, you don’t have a higher VAT on baked beans than you do on restaurant meals; neutrality, meaning you don’t interfere with customer choices or create distortions in consumer behaviour, and make the tax very broad; adherence to the destination principle to ensure you tax only in the place of consumption and, for example, don’t tax exports; low administration and compliance costs, which means making it simple for business; and political robustness, which is keeping the tax safe from political interference,” Walpole says.

“These would be the key features and challenges in the UAE right now.” 

Of course, there’s also the small, added complication that the UAE didn’t have a tax office until a few months ago.

Since the announcement of the new VAT in the UAE, Paul Drum FCPA, head of policy at CPA Australia, has travelled several times to the region where he has been working with local CPAs on this issue and on other matters.

“Change of this type always takes some time to settle in, and just because the VAT has now commenced it does not mean all the work is done and dusted.” Drum says. “Our members have been working assiduously to ensure businesses manage their VAT obligations appropriately.”

All types of food, even fresh produce and staples such as rice, attract a VAT of 5 per cent in the UAE and Saudi Arabia.

Background to a new taxation system

The GCC Tax Policy Paper, produced by the International Monetary Fund (IMF) in 2016 for the annual meeting of ministers of finance and central bank governors in Saudi Arabia, states: “The large and rapid decline in oil prices has led to sharp cuts in GCC government spending and a slowdown in economic activity since 2015. Despite these efforts and projected reforms, the fiscal deficit for GCC countries is projected to widen to 11 per cent in 2016 and to remain above 4 per cent of GDP in 2021.”

At another meeting in 2016, this time in Abu Dhabi, the IMF’s managing director Christine Lagarde began her address by quoting philosopher and economist Adam Smith. “Little else is required to carry a state to the highest degree of opulence … but peace, easy taxes, and a tolerable administration of justice,” she said. “It is striking that he [Adam Smith] singled out taxation alongside peace and justice as the key to a successful society. This insight is now more important than ever.”

There are two ingredients of taxation for successful 21st century economies, Lagarde explained. One is a country’s ability to generate robust revenue and therefore provide public services – education, health, infrastructure, law and order and so on – that creates a strong base on which a society can grow. 

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“We all know that, right now, there is in many countries a pressing need to generate higher and more reliable revenue, although not necessarily for the same reason,” she said. “For example, oil-exporting countries are adapting to a new reality of low commodity prices … and some advanced economies, especially in Europe, need higher fiscal revenue to bolster their economic recovery and financial stability.”

The second ingredient, she said, was consistent international taxation, or a means by which governments mobilise revenues in a global economy. The GCC and UAE’s move into a taxation environment, then, would not only be good for the member states but also for the global community.

What does it mean for business?

For companies doing business in the GCC states, the most important fact to recognise is that each will treat the new VAT differently. There will be varying launch dates for the new tax, different amounts charged and changing regulations between territories.

“Each VAT is not a cookie-cutter model of the others. They will all have their own special rules,” Drum says. “Each territory has reserved the right to determine certain features of the new tax.”

Gerard Seeber is Austrade’s senior trade commissioner in the Middle East and North Africa. Based in Dubai, Seeber has witnessed the implementation of the new tax from ground level. The tax itself was accepted surprisingly comfortably by the population, he says, as it was clearly explained that in order to continue offering high levels of service, the government required funds. However, that doesn’t mean things will be simple for businesses in the affected region.

“The challenges for businesses are really around technology, training of staff and aligning themselves with whatever the new tax body is going to look like,” Seeber says. “The Big Four accounting houses are going to be well positioned to work with the bigger end of town. But in the SMEs, there will be issues because a lot of them are quite small and relatively informal in the way they do business.”

“SMEs are going to have to come up with systems, technology and staff that are going to manage the demands of the new tax. They are going to have to train those staff. There will be opportunities for smaller consultancies and advisory firms that target SMEs. There’s a huge opportunity there. However, it’s going to be a huge challenge for a lot of these smaller companies simply because they have never had to operate in such a manner.”

Seeber and Drum agree that there will likely be a short goodwill period after 1 January 2018, for businesses to ensure they are in alignment with regulations. Penalties will likely be introduced fairly quickly after that, to ensure all businesses are on board and prove the government is serious about the success of the new tax.

For the more than 2000 Australian companies that export their products to the UAE (two-way merchandise trade is worth A$6.4 billion), the responsibility is on the importer to ensure tax laws are adhered to, says Seeber. However, businesses must be aware that this could affect margins, depending on how businesses are competing in their space. “People have to keep an eye on how competitive they’re going to be if they’re adding another 5 per cent onto their retail prices.”

That said, Seeber doesn’t think that there will be a consumer spending slowdown, once prices rise in line with the VAT.

“You’ve got a large population of workers who are housed and fed, and who send most of their money home. Their discretionary spending has never been huge,” he explains. “Then you’ve got the middle and upper levels, and tourists, who are simply going to spend what they need to spend. Five per cent won’t turn them off.”

Walpole believes the low rate of the new VAT indicates the UAE is simply putting a toe in the water, preparing a working tax system so that it’s in place when oil revenues really do take a sharp dive.

“It’s important to set the rate at a high enough level to make it worth the effort,” he says. “Japan went for many years with a VAT rate of 5 per cent (originally 3 per cent) and they could have been spending more to collect than they were collecting. That’s partly why they raised the rate a few years ago. As an introduction to a new tax, a lower rate makes it more acceptable, politically. It may well be that this is the thin end of the wedge. Once a working tax is established, the rate can be raised without major disruption.”

Among the Gulf Cooperation Council states, only the UAE met the 2018 deadline for bringing in a VAT.

Understanding the challenges

Challenges exist for businesses and regulators alike with the new tax. There is a feeling, Drum suggests, that the government is creatively developing the system as it goes, remaining dynamic and flexible enough to receive and interpret feedback along the way and to fold this feedback into the system as it moves forward. The government is, if you like, conducting live market research within the actual market, rather than behind closed doors with focus groups.

“As we speak right now, while we have the law and regulations we do not have the necessary cabinet decrees,” Drum says. “If you think about Australia’s system, we have a mature system of tax laws and regulations, so if there is a change there will be interpretations from the ATO on how they will apply the law, and there will be public compliance guidelines, and so on. There will be a raft of products that accompany the law, as well as the administration forms, the online forms, and things like that. The UAE is starting from scratch.”

“It’s important to set the rate at a high enough level to make it worth the effort.” Professor Michael Walpole, UNSW Business School

The UAE simply hasn’t had the need for federal tax authority until now, so the challenge of recruiting staff and of figuring out what educational and supportive materials are required in order to support the law may present some challenges in the short term.

“That is what’s happening at the moment,” Drum says. “All of the necessary bits and pieces aren’t yet in the public domain. Remember, the law only came out in September [2017], so they are creating a VAT in just three or four months.”

The benefit of the tax, as Lagarde pointed out, is that a VAT system, even at a low, single-digit rate, could raise up to 2 per cent of GDP. Perhaps more importantly, it lays the groundwork for future introductions of other types of tax, should they become necessary.

“Creating successful, 21st-century economies requires robust government revenues and an international tax system that works for everybody,” Lagarde said. “These ingredients are essential for growth, fairness and development.” 

VAT facts for business in the UAE

What is the VAT rate and who does it apply to?
The UAE VAT rate is fixed at 5 per cent and is levied on the supply of all goods and services, including commercial buildings and hotel services, unless explicit provision is made to impose a zero rate or exemption.

What is awarded a zero rate of VAT?

The zero rate has so far been applied to health and education services, as well as the supply of investment precious metals, the first supply of residential buildings, the supply of international transport of passengers and goods, and exports. Local passenger transport, bare land, the supply of residential buildings and some financial services are exempt from the tax.

Which businesses must register?
If a business’s taxable supplies and imports exceed AED375,000, the business must register. A business with taxable supplies and imports below that value may also register voluntarily if its supplies or imports exceed AED187,500.

How does a business register for VAT?

All registrations are online, via the Federal Tax Authority website

Read next: Low oil prices force tax reform


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February 2018
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