Out-Law Analysis | 22 Nov 2016 | 10:18 am | 4 min. read
It would be very easy at this stage to ignore the VAT debate and hope that implementation is abandoned – but the developing insurance industry in the Gulf should ignore these developments at their peril. While there is a possibility that could still happen, there is no doubt that those businesses that have developed a robust strategy to deal with VAT will be more strongly positioned in the market.
In June, the ministers of finance of the six Gulf Cooperation Council (GCC) states approved an in-principle agreement to provide a common framework to develop national tax regimes. While we do not expect details of the framework to be published until the final quarter of 2016, the announcement was an important step towards developing common principles to guide the policy and structure of VAT at a national level.
Simultaneously, each GCC country continues to develop an individual VAT regime. While there is a requirement for all GCC countries to have VAT in place by the end of 2018, they are working to implement it by 1 January 2018 to avoid distortions between those who have and have not implemented a tax regime. It remains to be seen whether every country will be ready to launch in under 18 months.
Cost base implications
All businesses will face a host of operational issues as a result of the introduction of VAT. However it has the potential to seriously skew the cost base of the insurance industry in particular, subject to the details of the final regime.
If the European model of VAT is adopted then insurance income, which will be 'output' for VAT purposes, will be exempt from the tax. This may seem like good news - but the related restriction on the recoverability of 'input' VAT on purchases is most definitely not good news. This would increase the costs of expenses such as professional fees; outsourced back-office services including claims settlement services; data storage; and even facilities management.
At the same time, outsourced services tend not to benefit from the VAT exemptions on insurance services and the VAT on these services cannot be recovered by an insurance company. This creates a challenge for the insurance industry given that outsourced services are predicted to grow; new areas of technology and distribution channels are being developed; and competition for secure and efficient e-commerce and data transfer services is intensifying.
Outsourcing – precedents from Europe
In Europe, the difficulty of bringing services outsourced by insurance companies within the VAT exemption was highlighted in March of this year, by the decision of the Court of Justice of the European Union (CJEU) in the Aspiro case.
Aspiro SA is a Polish company providing insurance settlement services outsourced by insurance companies. It argued that its claims settlement services were exempt from VAT on the grounds they were entirely related to the business of the insurance company and indispensable to it under article 135 of the EU's Principal VAT Directive. However, the CJEU ruled that its services were not exempt because they did not involve the sourcing and introduction of prospective clients to the insurer.
Helpfully, the court outlined the two conditions which had to be met for the activity to quality as providing services related to insurance transactions under article 135. Firstly, the service provider must have a relationship with the insurer and the insured party. Secondly, its activities must cover the essential aspects of the work of an insurance agent, which the CJEU said consisted of sourcing prospective clients and introducing them to the insurer. Although Aspiro met the first condition - it performed its activities in the name and on behalf of the insurance company - it did not satisfy the second condition.
The commercial impact of this ruling is that VAT had to be charged on the services but could not be recovered by the insurance company, and so became a real additional cost. While it is expected that the initial rate of VAT in the GCC will be around 5%, and so substantially lower than Poland's standard rate of 23%, rates tend to rise over time and thus this case is helpful in understanding the potential impact of VAT on insurance companies' outsourced services.
GCC framework and lobbying
At this stage, we do not know how the GCC will apply VAT to financial services and even whether it will be applied in a consistent way between countries. Regardless, the insurance industry should consider lobbying to influence the way in which insurance income is treated for VAT purposes. Even if the basic taxability of premiums and commission cannot be changed, there may still be scope to influence how outsourced related services are treated.
VAT and competition
There is no guarantee that each country in the GCC will adopt a uniform approach to the taxation of financial services. Even if the framework is similar, there remains scope for one country to treat outsourced services differently – potentially creating a competitive advantage for the insurance industry and the outsourcing market in that location.
Implications for contracts
VAT could be introduced as early as 1 January 2018, and many long-term outsourcing and other service arrangements will be for a contract term that straddles that date. These contracts should include provisions for either allocating the potential economic cost of VAT, or providing a mechanism for agreeing the allocation. Many standard tax change clauses will not work for VAT.
In Europe, VAT has been a source of many disputes between taxpayers and the tax authorities, including conflicts between national VAT laws and the relevant EU directive. At this stage it is not expected that the GCC VAT framework will be binding on all countries, but it may be important when interpreting uncertain new regulations.
Either way, there is a need for all countries in the GCC to develop tax dispute resolution procedures to cover the new tax. Partial exemption calculations, for example, are often more of an art than a science, and unless there is a procedure for agreeing these in advance they are likely to result in many more disputes. By providing greater certainty to businesses, some countries may inadvertently develop a competitive advantage over their neighbours.