x Abu Dhabi, UAEWednesday 20 September 2017

Applying VAT to Islamic finance products can get complicated

Some countries have introduced laws to level the playing field between Islamic and conventional finance when it comes to the relationship between VAT and financial products

The Federal Tax Authority intends the application of VAT to deliver the same outcome for both conventional and Islamic finance. Mona Al Marzooqi / The National
The Federal Tax Authority intends the application of VAT to deliver the same outcome for both conventional and Islamic finance. Mona Al Marzooqi / The National

Taxes are fundamentally involuntary contributions towards the costs of providing civil services.

Years ago, on a trip to Istanbul, my companion and I visited the tomb of one of the Ottoman rulers. At the entrance, an amount by way of contribution was suggested. Either the sign was out of date or I read the value incorrectly – by many zeros, as the table thumping sentry soon hollered: “More contribution. More contribution.”

What I experienced was a fee masquerading as a matter of interpretation. It is not so for VAT, which is unequivocally a tax levied on the end user of something supplied as a service or consumed as goods. But wrap it within Islamic finance and unique entrants into the rules of transactions are thrown up.

The Federal Tax Authority (FTA) intimated that there is an intent to ensure that the application of VAT will deliver the same outcome regardless of whether the transaction is conducted using a conventional or Islamic finance approach.

Some tax authorities across the world have attempted to create a reasonably level playing field between the two. Unfortunately, it is not easily achievable without creating de facto bridging rules, or added complexity if you like, to negate the additional costs that Islamic finance introduces.

Let’s look at two simple products and how VAT handicaps them vis-à-vis their competition. Take a bank-funded purchase of a car for Dh50,000 and lets evaluate how these two financing approaches affect the two types of purchasers. This buying and reselling of an asset, is called a murabaha transaction.

Purchaser one is VAT registered and can reclaim the VAT on items bought. A clever procurement function working in sync with their finance function will time the purchase to best match the end of a VAT reporting period and secure payment terms of at least thirty days. This effectively cancels out the short-term cash call on the VAT element of the purchase. Happily, this applies equally to both conventional and Islamic financing.

Purchaser two is not registered for VAT, so must pay it. It is here that a price differential will now come. In conventional financing, the money is borrowed at, say 10 per cent, interest. The final cost is Dh50,000 for the vehicle, Dh2,500 VAT and Dh5,000 in interest over the period of the loan, totalling to a cost of Dh57,500. With Islamic finance, the bank purchases the asset and sells it at a mark-up, say 10 per cent, to be paid over 12 months. The mark-up is agreed between the parties at the outset and no interest is charged. But this unregistered purchaser faces an additional cost of Dh250 for using Islamic financing.

Interestingly, given that the finance sector is typically a very complex tax environment, as much of its earnings are VAT exempt, there is a positive. By increasing the amount of murabaha transactions, it will increase an institutions’ proportion of sales that are within the tax framework, enabling it to increase the percentage of overheads it can claim VAT on. In theory, this saving could be passed to their non VAT registered customers, partially cancelling the cascading effect.

That deals with financing for tangible goods. What happens where an organisation needs to borrow working capital, monies for which there may be a number of potential use, the decision on which will only materialise over a short, but future period of time. Theoretically Islamic finance cannot support this requirement.

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The solution is to use a tawarruq. A term agreement is put in place for the purchase of a highly liquid asset; say any heavily traded metal. The bank purchases it and sells it to a borrower, who promptly sells it and gains use of the funds.

As the Islamic finance firm is unlikely to be a commodity player, it shouldn’t be able to reclaim the VAT on its metal purchase. However, it is reasonable to assume that the FTA will legislate to allow it to reclaim all VAT on transactions that fall within the definition of a tawarruq. For such a firm, VAT should be charged on the sale to the borrower. Although nominally allowed to reclaim VAT, it is only on goods and services that are wholly related to its normal conduct of business.

Assuming the bank raise their purchase price by 10 per cent, the customer is now effectively paying 15.5 per cent on their loan due to their inability to reclaim VAT. This is 5.5 per cent higher than conventional banking plus a provision for the spread loss on the disposal of the metal.

VAT should be charged on the sale to the borrower. Although nominally allowed to reclaim VAT, it is only on goods and services that are wholly related to their normal conduct of business. Unless they are commodity traders, it is unlikely they will be able to reclaim the charged VAT.

Additionally, there is no reason that they will be able to sell the metal for the same price it was purchased. After all, markets price using a spread, this representing the fee of the market makers.

Assuming the bank uplift their purchase price by 10 per cent, the customer is now effectively paying circa 15.5 per cent on their loan due to their inability to reclaim VAT. This is 5.5 per cent higher than conventional banking plus a provision for the spread loss on disposal of the metals.

This issue could be avoided by conducting the transaction within a bonded environment, ie, the VAT framework would not apply.

Whereas countries like Malaysia and Singapore have legislated to level the playing field between conventional and Islamic finance by recognising its religious underpinning, the United Kingdom have dealt with the issue in a not dissimilar manner but with a secular approach.

Customers have enough difficulty understanding conventional finance. Investment in training to ensure product sales persons can comfortably communicate their Islamic finance offerings will be essential.

David Daly is a chartered accountant (Cima) who leads a consultancy practice in the UAE