Rechtsanwalt, Partner, Head of Employment & Reward, Germany
Partner, Head of Banking & Restructuring
Out-Law Guide | 03 Sep 2019 | 1:48 pm | 16 min. read
As corporate entities in Gulf Cooperation Council (GCC) countries get to grips with value added tax (VAT), they will need to carefully consider the most appropriate form of holding company and corporate group structure. Their decision should take into account the potential VAT costs, and potential for error on inter-company supplies, market value application, deeming provisions and restriction of deduction entitlement for VAT on costs.
Given the strict penalty regimes in the region, it is important that this analysis is done in advance and re-assessed on a frequent basis, so as to minimise the risk of error and the application of fixed and tax or time-geared penalties. As this is likely to be an area which develops overtime, businesses should take a prudent approach to the application of the laws and seek clarification from the relevant tax authorities, particularly where sufficient clarification has not been provided within the tax authority guidance.
Here, we look at the most significant VAT implications for holding companies and corporate groups located within the GCC region. We deal with corporate group activities within a single GCC member state only and refer to the VAT regimes of the Kingdom of Saudi Arabia (KSA), United Arab Emirates (UAE) and Bahrain, as we await the other GCC member states implementing their domestic VAT regimes.
A corporate group will generally consist of at least one 'holding company' which holds the shares of other entities within the corporate group; together with one or more 'trading companies' which carry out specific activities within the group for the purpose of generating revenue.
In its basic form, the main purpose of a holding company is simply to hold shares in other corporate entities. This 'holding of shares' is not generally viewed as a supply for VAT purposes, as it does not involve the supply of goods or services in return for consideration. A 'passive' holding company of this nature, which undertakes no other activities, it unlikely to be entitled to register for VAT purposes on the basis that it is not 'in business' or undertaking an 'economic activity'
Given the strict penalty regimes in the GCC, it is important that analysis is done in advance and re-assessed on a frequent basis, so as to minimise the risk of error and the application of fixed and tax or time-geared penalties.
In the absence of a VAT registration, all costs incurred by a passive holding company which are associated with its holding of shares would not be recoverable from the tax authorities. However, it is unlikely that a holding company of this nature, with no active trading activities, would incur many costs outside of its annual audit fees, set-up legal fees etc.
This treatment of passive holding companies as having no economic activity, and therefore no deduction right for VAT on costs, has been confirmed within guidance issued by the General Authority for Zakat and Income Tax (GAZT) in the KSA and the National Bureau for Revenue (NBR) in Bahrain. However, the Federal Tax Authority (FTA) of the UAE is yet to publicly confirm its view in published guidance.
A holding company may be viewed as 'active' for a number of reasons.
The holding company may be involved in the trade of buying and selling shares in other companies. In this case, its holding of shares is solely with the intention of a future sale for the purpose of generating profit. This activity of 'trading in shares' would be viewed as an exempt activity for GCC VAT purposes, and therefore would not be subject to VAT. Any VAT incurred on associated costs would not be deductible by the company as they would be directly attributable to an exempt activity, which does not grant deduction entitlement under the GCC VAT regime.
Alternatively, the company may hold shares in its role as the 'holding company' within a corporate group while undertaking other activities outside its passive holding of shares. These activities may include holding the central management of group which makes key decisions on behalf of the group as a whole; hosting the main IT, finance, HR or other functions of the group; holding legal ownership of real estate used by the group; undertaking its own trading activities independent of the other group trading entities; obtaining necessary group finance, licences and approvals; etc.
Given that VAT is a transaction tax, each individual activity undertaken by an active holding company should be assessed in order to determine whether it is a 'supply' for VAT purposes – i.e. a supply of goods or services in return for consideration. This may depend on whether the other members of the group receive any direct benefit from the activity, similar to the benefit that would be received if this activity was undertaken for the group by an independent third party. Due regard should also be given to the meaning of 'supply of goods' and 'supply of services' as set out within the VAT legislation of the relevant GCC member state.
Where it is determined that a supply of goods (e.g. a supply of assets) or a supply of services (e.g. management services) is being made, it is then important to identify any consideration directly linked to these supplies. This could be in the form of cash or credit recognised in the financial statements. It may also be represented by consideration in kind – where, for example, a related entity within the group provides goods or services to the holding company as payment for the goods or services it is receiving. Non-monetary consideration should be valued based on market value principles, as set out in the VAT legislation of the relevant GCC member state. In the event that any consideration, regardless of its form, is paid or due directly in return for the goods/services supplied by the holding company, VAT should be accounted for at the applicable rate.
The situation is more complicated where the consideration paid by a related entity to the holding company is viewed as below market value. In this case, the holding company may be required to assess the fair open market value of the supplies and to account for VAT at the applicable rate on this value, regardless of the consideration actually paid.
The definitions of 'related parties' and the ways in which 'market value' should be determined are fairly similar across the GCC member states:
This related party/market value rule is applicable across the GCC member states only where the consideration is less than market value, the supply is taxable and the recipient would have less than full input VAT deduction entitlement (i.e. where the recipient has some exempt or non-business activities to which the cost relates).
This is, in essence, an anti-avoidance provision to ensure that the price for any supply is not set at a nominal value between related parties where the recipient does not have full recovery in order to minimise VAT cost. The result of this provision is that the relevant tax authority will continue to receive an accurate level of VAT on the end consumption of the supply based on the 'value-added' throughout the supply. Note: the definition of 'related party' becomes important here as this 'market value' principle only applies where the parties to the transaction are related.
In the absence of any consideration payable by the receiving entity of goods/services from a holding company, deeming provisions must be considered, in order to assess whether they are applicable. The application of deeming provisions would result in there being a deemed consideration (e.g. cost) for the supply on which the holding company would have to account for VAT at the applicable rate. This would therefore create a real VAT cost for the holding company, unless the transaction is restructured and/or re-financed within the group.
As a taxable person, an active holding company should assess its entitlement to deduct VAT on costs based on whether they are directly linked to a taxable, exempt or non-business/non-economic activity.
All VAT on costs directly associated with a taxable supply by a holding company to a related corporate group entity should be fully deductible, regardless of whether market value or deeming provisions have been applied - for example, costs associated with a centralised IT, finance or HR function which are periodically billed to related corporate group companies. This is also the case for any trade supplies that the holding company makes to third party customers.
All VAT on costs directly associated with an exempt supply by a holding company to a related corporate group entity or a third party customer should be fully restricted from deduction – for example, costs associated with the provision of loans or finance to corporate group companies.
An appropriate apportionment methodology should be used where an active holding company incurs 'general' overheads which cannot be directly attributed to one of its taxable, exempt or non-business/non-economic activities, in order to determine a fair and reasonable portion of costs which should be deducted. All GCC member states require that an annual apportionment review of the methodology used vs. actual activities be performed, and an adjustment is generally required for any difference - especially where the difference is in favour of the taxpayer.
The above deduction rules apply to all taxable persons. However, there is an extra layer of complexity which results from the status of a holding company: even where the holding company is 'active' by undertaking business activities and making supplies for VAT purposes it continues to hold shares in related corporate entities, which as discussed is not in itself viewed as a business/economic activity for VAT purposes. As such, there is a risk that a portion of a holding company's costs should always be viewed as 'associated' with this non-business activity, and that therefore a portion of deduction entitlement should be restricted.
This point has been debated between taxpayers and tax authorities, as well as being assessed by many courts around the world. While there have been many developments on this topic over the last decade, it is an area that continues to create ambiguity and risk for corporate groups and holding companies. Many corporate groups globally withhold a portion of VAT incurred on general overheads of the holding company to reflect its passive holding of shares, even where clear guidance on the amount to be restricted has not been issued by the local tax authorities.
The KSA and Bahrain tax authorities have touched on the concept of passive holding companies in their guidance notes, albeit not to a great extent; and it is understood that an allocation of costs should be assigned to this 'passive' holding of shares and restricted. However, there is no methodology set out in the law, or percentage indicated within associated guidance. The UAE tax authority has to date issued no guidance on whether it will seek a similar restriction for UAE-based holding companies and so, for now, a risk remains. Corporate groups should therefore seek to agree an appropriate restriction methodology with the relevant tax authorities in order to mitigate any potential risk. Alternatively, a corporate group may consider proposing that no restriction is required to the relevant tax authority, based on global principles and court rulings.
In addition, there are many corporate groups where a holding company may passively hold shares in a number of subsidiaries (providing no other supplies of goods or services to these entities) while actively managing other subsidiaries (by providing management services and other supplies). This will create yet another layer of complexity when determining the correct deduction entitlement.
Lastly, holding companies which arrange for certain goods/services to be supplied on behalf of group companies should make sure to assess whether such costs are disbursements or reimbursements for VAT purposes, when determining its deduction entitlements on associated VAT charged. All costs which have been incurred by a holding company in its own name to support its onward supply of goods/services to related group companies should be deducted by the holding company based on normal deduction rules, i.e. as reimbursements. All costs which are costs of a related company (i.e. contracted in another company's name) for which the holding company is simply acting as 'paymaster' and recharging should not be deducted by the holding company, but instead should be recharged together with any VAT incurred i.e. as a disbursement. It is important that invoices received by the holding company in relation to reimbursements and disbursements are received in the correct entity name, so as to avoid any 'trapped VAT' in the supply chain.
As corporate groups can take many different corporate structures, it is important that each entity within the group assess its role, its activities, its costs and its associated VAT obligations. Generally, entities within the corporate group will be required to register for VAT, charge VAT and issue tax invoices, where required, for supplies to other corporate group members and/or its holding company. Certain charities, government entities and/or joint ventures may not have full reporting requirements.
For many entities within the group, similar VAT consequences to those set out above may arise in terms of market value application for supplies to related parties; deduction entitlement where the entity holds shares in other entities within the group; deeming provisions where goods/services are provided to other group members free of charge; disbursements and reimbursements; etc.
These are all tricky areas of VAT law in which businesses often make mistakes, resulting in the need for voluntary disclosure and review and assessment by tax authorities as part of tax audit procedures. The continued application of incorrect treatments or incorrect deduction entitlement can result in accumulated VAT liabilities and/or penalties for the group. It is generally difficult to argue 'VAT neutrality' where a transaction is treated incorrectly but would have been VAT neutral overall for the tax authority when considering the group as a whole, as the tax authorities tend to assess each taxable person separately in its own right even where they are related parties within the same corporate group.
It is therefore important for corporate groups to identity these matters and set out the group's approach as part of its overall VAT governance structure. This should set out a clear consistent approach across the group, a clear audit trail of the group's VAT treatment and internal procedures to ensure adequate controls for these matters.
Establishing a VAT group of all/some of the corporate group members, including the holding company, can be an efficient way to mitigate and/or reduce the risk of error, cash flow burden and real VAT costs resulting from the concepts set out above.
Members of a VAT group can disregard any supplies between themselves for VAT purposes – i.e. no VAT would be required to be charged, no tax invoices would be required to be issued, and no market value or deeming provisions would need to be applied. The downside is that all members of the VAT group become joint and severally liable for the VAT obligations, liabilities and penalties of all other members of the group.
The successful grant of VAT group status by the relevant GCC tax authority will depend on whether the relevant criteria are met by all entities; and whether the tax authority feels that the application of VAT grouping would result in more efficient collection of the group's tax liabilities and is not being sought for the purposes of tax evasion.
The criteria for VAT grouping differ slightly between GCC member states, although generally the following is required:
Bahrain also requires that each entity must be a taxable person and registered for VAT purposes at the time that the group application is submitted. In comparison, the KSA only requires one entity to be a taxable person; and the UAE simply requires the entire VAT group as a whole to meet a voluntary registration threshold of AED 187,500 (US$51,000). There are also some specific criteria for government bodies and charities.
Based on these criteria, non-legal persons such as private individuals and certain partnerships/joint ventures would not be able to join a VAT group. Similarly, non-resident businesses which only have local VAT registration but no establishment would also be excluded from VAT grouping. It does, however, appear that fully exempt entities would be accepted in the KSA and UAE, provided that the other criteria are met.
From a holding company perspective, it is clear that only an active holding company is intended to be approved for VAT grouping by the authorities.
Even where the criteria are met, the grant of VAT grouping is not guaranteed. Approval of a VAT group application is fully at the discretion of the relevant GCC tax authority. The authority is able to decline the VAT group application in full, accept only certain members to the group and change the VAT group status at a later date.
Additionally, obtaining the agreement of all corporate group members for a VAT grouping application may depend on the level of external investor involvement. For example, if one of the corporate group members is 40% owned by an independent investor, the investor may not be willing to agree to take on joint and several liability for VAT with the tax authorities for all other members of the corporate group.
The application of VAT grouping provisions generally reduces the administrative burden of a corporate group, increases cash flow efficiency and, in certain limited circumstances, reduces real VAT costs. However, there are also some challenges introduced by the use of a VAT group. This is especially true where the group engages in exempt activities, inter-group transactions and holding company activities.
As mentioned above, it is the obligation of every taxable person to assess the use to which its costs have been put in order to determine its right to deduct any VAT incurred on such costs. This exercise generally involves a legal entity carrying out a 'direct attribution' exercise between its taxable and exempt, if any, activities, restricting any VAT not attributable to business or economic activities and applying a suitable apportionment mechanism for 'general overheads'.
All members of a VAT group are viewed as one single taxable person. Therefore, any inter-group transactions which were previously categorised as 'taxable' or 'exempt' are now viewed as 'outside the scope' for VAT purposes, as they are no longer supplies to another taxable person: they are treated similarly to inter-department recharges within a single legal entity. This means that the direct attribution and apportionment exercise becomes a lot more complex. Often, the VAT group member who is 'incurring' VAT on costs from an external third party needs to identify whether they can be directly attributed to a taxable or exempt supply made by the group as a whole to an external customer, in order to correctly assess the group's overall deduction entitlement. This can prove very challenging, if not on occasion impossible, where the VAT group members do not have centralised IT systems, or have independent management structures which do not coordinate closely on a day-to-day basis.
The application of VAT grouping provisions generally reduces the administrative burden of a corporate group, increases cash flow efficiency and, in certain limited circumstances, reduces real VAT costs.
In addition, VAT grouping often results in certain costs which were previously attributable to taxable or exempt supplies becoming general overheads of the group as a whole. Depending on the level of deduction entitlement of the entity incurring the cost (based on its taxable and exempt activities and its apportionment methodology) versus the overall deduction entitlement of the group, this may result in lower or higher deduction entitlement on such costs. This can be a difficult and time-consuming exercise to analyse in advance of forming a VAT group, and an additional task to be undertaken as part of the VAT compliance process each period. Annual apportionment reviews must still be undertaken by the group as a whole. The group may also end up with more than one apportionment methodology for the group, where it has very distinct areas of its business and it is agreed with the relevant tax authority that one single apportionment method would not correctly reflect the drivers of the costs across all divisions.
As we have seen, some members of a corporate group may not able to join the VAT group, whether due to their exclusion by the tax authority or their shareholding structure. Where this is the case, the group will need to implement new policies, procedures and controls to ensure that VAT group members and non-VAT group members are clearly identified to all within the business, are assessed differently and the correct treatments for supplies and VAT on costs applied.
It is not unusual to have a corporate group with a 'limited' VAT group and associated errors made by staff in VAT treatments, inter-company billing etc. due to a lack of communication, training and policies/controls to ensure consistent and accurate application of the VAT rules.
There are many ways in which a corporate group may be restructured: the creation of a new entity or branch; the sale of current group entities; a merger with a third party; or the transfer of a business from another group into a current group entity. When this happens, the 'port-restructuring' VAT status of the group should be assessed to ensure that the application of all relevant VAT rules are re-assessed and any necessary changes implemented by the business.
This may require the reassessment of the group apportionment rate, the reallocation of costs directly to taxable/exempt activities, the application of market value and deeming provisions to related entities which are not within the VAT group, the deduction entitlement of any new holding company structures introduced, etc.
Although many businesses do assess the VAT consequences of the actual restructuring exercise itself, the post-restructuring reality for the corporate group is often overlooked. This can create the potential for error and the application of penalties.
Rechtsanwalt, Partner, Head of Employment & Reward, Germany
Partner, Head of Banking & Restructuring