HMRC’s retrospective change on VAT and contract terminations: practical options for businesses
Out-Law Guide | 16 Aug 2019 | 4:20 pm | 14 min. read
Companies undergoing complex business structuring or restructuring in Gulf Cooperation Council (GCC) countries will have to consider VAT issues now that VAT applies in the United Arab Emirates (UAE), the Kingdom of Saudi Arabia (KSA) and Bahrain.
VAT treatment and the related deduction entitlement for VAT on costs related to restructuring have not yet been well tested or fully clarified by the local tax authorities. Transactions of this nature are generally high value, increasing the risk of high penalties for errors. The penalty regime for non-compliance includes both fixed penalties and tax geared/time geared penalties.
Businesses can reduce the risk of penalties in the self-assessment exercise by seeking clarity from tax experts and tax authorities. They need to give consideration to the form of restructuring being undertaken and the associated VAT treatment and VAT deduction entitlement.
Early identification of any VAT within the structure which will be a real cost to the business will allow the business to take this cost into consideration when assessing its options, including the process for agreeing contract pricing for any merger, acquisition or disposal.
A business can choose which corporate structuring mechanism to use, and the VAT considerations are different for each.
Trading through a new entity in the region can make sense for foreign or GCC-resident companies. It can allow a company to ring fencing activities; to create a local sales and marketing entity for a foreign parent, and enable a joint venture opportunity or special purpose vehicle to tender for local projects.
Different company structures have different VAT implications, which it is important to understand before choosing one.
The establishment of a new company in the region potentially creates a new 'taxable person' for VAT purposes, as this new company may be required to register for VAT purposes.
If the new local company makes taxable supplies exceeding the threshold of 375,000 in local currency, it would be required to register for VAT purposes and will be issued its own tax number (TRN or TIN, as appropriate for the region) by the local tax authority for compliance purposes.
Fixed penalties apply in each country (AED20,000/SAR10,000/BHD10,000) where a taxable person does not register within the required timeframe. As a VAT-registered taxable person a company will need to charge VAT on its supplies where applicable; issue valid VAT invoices, and meet periodic VAT compliance obligations. There are additional fixed and tax/time geared penalties for failing to meet these obligations.
Bahrain's penalty regime is particularly tough as it categorises these types of offences as 'tax evasion', which could result in three to five years imprisonment and a fine between one and three times the amount of any tax due. Therefore it is important that businesses comply on a timely basis and cooperate with the Bahrain Tax Authority in the event of any non-compliance.
Transactions of this nature are generally high value, increasing the risk of high penalties for errors.
Where the new local company is part of a larger local corporate group, its own TRN/TIN and VAT obligations are independent from any other local related entity's VAT obligations, meaning that each legal entity is assessed separately. As a result any supplies of goods and services between corporate group entities would be subject to VAT and tax invoicing rules, similar to third party transactions.
It may be possible to place this new local company within a local VAT group together with its related local corporate group members, though this may be subject to certain conditions as set out within each country's local VAT laws and regulations, which might include obtaining the tax authority's approval. Cross-border VAT grouping of entities resident in different GCC countries is not possible.
VAT grouping would result in the administrative burden of VAT compliance being reduced, together with increased cash flow within the group, through:
All VAT group members are joint and severally liable for the VAT and penalty liabilities of the group as a whole.
The establishment of a branch of a previously incorporated legal entity does not create a separate 'taxable person' for VAT purposes. Instead, the legal entity would now have a new 'fixed establishment' from which it undertakes some of its activities, meaning a head office and a branch are viewed as the same 'person' for VAT purposes.
Local head office
If the head office is a local company then the creation of a new local branch would not trigger a new VAT registration obligation. So the creation of a branch in Abu Dhabi of a Dubai based head office would not trigger a new obligation - the activities of the branch would be part of the overall activities of the local legal entity.
If the branch makes any taxable supplies on which VAT should be charged or purchases any taxable goods and services on which a deduction of VAT may be claimed, this should be added to the head office's sales and purchases transactions in order to assess the local legal entity's VAT registration and compliance obligations. The legal entity should have one valid TRN/TIN only, relevant for the head office and all local branches.
Any transactions between head office and branch domestically within one GCC member state would not be viewed as a 'supply' for VAT purposes. The use of VAT grouping is therefore not relevant in the scenario of a local head office to local branch supplies, and vice versa.
Foreign head office
If the head office is a foreign company established and resident abroad with no current physical presence locally, then the creation of a new local branch may trigger a new local VAT registration obligation for the foreign legal entity. This will depend on whether the foreign legal entity makes any taxable supplies which are taxable for local VAT purposes and where the local branch is related to that supply, meaning the local branch is more connected with the supply than the head office or any other foreign branch. In this case as the foreign legal entity now has a 'place of residence' locally, it would be required to register for local VAT purposes and meet all local VAT compliance obligations, subject to the relevant registration thresholds and penalties for non-compliance.
Cross border transactions between head office and branch are more complex and should be addressed on a case by case basis, with sufficient consideration of both the local VAT rules and the VAT/GST rules of the foreign country.
There are many ways in which a joint venture arrangement may be established.
For example two or more parties may come together and sign a mutually beneficial contract which results in a 'profit sharing' or 'cost sharing' arrangement for a particular activity. This arrangement would not involve the creation of a new entity or branch but instead would simply involve supplies between the parties. These should all be individually assessed based on each party's current local VAT registration status, the type of transactions and VAT treatment.
On the other hand a new legal entity may be established with two joint venture partners both owning for example 50% of the share capital of the company for the equal extraction of profits. In this instance the joint venture company is potentially a new 'taxable person' and its local VAT obligations should be assessed.
Joint venture arrangements can be complex from a VAT perspective and so care and time should be taken to consider both the contractual and commercial reality of each one, before assessing the correct VAT treatment.
A corporate restructuring can be undertaken in many ways and often can be done internally, with no major VAT consequences, for example increasing automation and reducing head count.
Where a restructuring involves external factors, it is important to assess the VAT implications in order to:
Corporate mergers, acquisitions and disposals are methods often used to restructure a business. This might be merging with a direct competitor, acquiring a business which will complement the current business's offering or selling off a less profitable division of the business.
These all have features which will drive the VAT treatment and areas of risk or optimisation.
The issue, supply and transfer of shares is exempt for local VAT purposes. Any VAT incurred on costs directly associated with an exempt supply is non-deductible in a taxable person's periodic VAT return. Therefore, this VAT becomes a real cost for the business and affects its profit margin.
Sale and purchase of shares
If a corporate restructuring is undertaken through, for example, selling shares in a subsidiary company or purchasing shares in the holding company of another corporate group, then this will be an exempt transaction for VAT purposes. It is the seller of the shares which needs to establish the correct VAT treatment. However, both parties need to consider their deduction entitlement for any VAT incurred on costs associated with the restructuring, such as legal fees or tax advisory fees, as there may be a restriction on their ability to recover some or all of this VAT if they are viewed as being directly related to an exempt share transaction.
The context of the share sale together with each party's overall economic activity should be taken into consideration in determining deduction entitlement. This means looking at whether the share transaction was an on-off event or a frequent activity of each party; whether it was an investment or trade activity, and if the party's main economic activities are fully or partially taxable or fully exempt.
The KSA tax authorities have published a guide on transfer of a business for VAT purposes, which provides some insights on how they view deduction entitlement to be determined for each party.
Share swaps, barters and other structures
Corporate restructuring of this nature can also involve much more complex share swaps, barter transactions of other goods or services in return for shares or deferred payment arrangements for share transfers. This creates much more risk for businesses as they often overlook the assessment of the VAT treatment of each element of such swaps or barters.
Given corporate deals of this nature are generally high value transactions, this can create a high risk for a business in the event of error, in the form of outstanding VAT liabilities and associated penalties. Each transaction or payment mechanism which allows the restructuring to take place should be assessed independently in order to assign a VAT treatment and the resulting obligations, including the timing of accounting for VAT where there are deferred settlements, deduction entitlement on costs.
An alternative approach to mergers, acquisitions and disposals is to transfer the main assets, both tangible intangible, of the business being acquired or sold between the relevant legal entities, without the need for a share sale. The assets simply transfer from the balance sheet of the selling entity onto the balance sheet of the purchasing entity, in return for an agreed consideration.
Where this occurs, at times, the selling entity may then be wound-down, liquidated or deregistered following the asset transfer.
There may also be a distribution of shares by the purchasing entity to the selling entity or its shareholders as consideration for the assets transferred.
Transfer of Business
The transfer of a business or an independent part of it to a taxable person, for the purpose of that taxable person continuing the business that was transferred, is not a supply for local VAT purposes - the transaction is outside the scope of local VAT.
In order for this 'transfer of business' (TOB) rule to apply the transaction must therefore meet certain criteria. These criteria differ slightly from one GCC member state to another, however they are generally as follows:
While the KSA and UAE laws state that the transferred assets must be used for "the same" business post transfer, the Bahrain law simply refers to their use to conduct "an" economic activity, suggesting that their use in any business would be sufficient. The Bahrain Tax Authorities have not yet issued any detailed guidance on this topic, however some high level commentary they have provided indicates that they would expect the transferred assets to be used for a "similar" business, potentially leaving a slightly broader scope for their use than the KSA/UAE.
The UAE Federal Tax Authority has also indicated that it is an obligation of the supplier to obtain and retain evidence of the buyer's genuine intention to use the transferred assets for the same kind of business post transfer.
The UAE law states that the buyer must be a taxable person, whereas the KSA and Bahrain laws state that it would be sufficient if the buyer only became a taxable person as a result of the transfer. The UAE Tax Authority has indicated that it would accept the buyer as meeting the criteria as a Taxable Person where it is registered for VAT or has applied for VAT registration (either mandatory or voluntary) at the time of the transfer.
In Bahrain the parties must notify the tax authorities in writing before the transfer occurs. In the KSA, the parties must agree the application of TOB relief in writing between them in advance of the transfer and if they fail to do so, TOB shall not apply. Neither of these obligations exist in the UAE and the UAE Federal Tax Authority has confirmed that TOB would be applied automatically once the conditions are viewed as met. This is regardless of whether the parties understood that TOB rules were applicable.
In the UAE, the Federal Tax Authority has indicated that it would require the business to be a 'going concern' at the time of transfer, meaning that the business should be operational before and at the time of transfer, and that only a short period of closure post transfer, in order for the buyer to prepare the business for operation under new ownership, would be acceptable.
In the absence of detailed guidance in each country or a consistency of the legislative wording across the region, it is generally understood and expected that should a number of assets, such as a stock of computers, phones, printers, screens, be transferred in isolation without the full functions of the business such as a retail store, sales staff, supplier or customer listings, this would not qualify as a TOB in any of the GCC member states.
Similarly, if the assets transferred were subsequently auctioned separately and not operated together as a business, this would not qualify as TOB or TOB would be clawed back if incorrectly claimed. If however, for example, an Indian restaurant was transferred and then was operated as an Italian restaurant, this would be likely to avail of TOB relief.
In the event that the transfer correctly meets the conditions of a TOB, no VAT should be charged and no tax invoice should be issued, although a commercial invoice may be used, in respect of the business transfer.
However, the lack of clarity and the differences in legislative wording across the region creates a risk, associated with a high value transaction, that VAT may not be charged where it is in fact due as a result of the misapplication or misinterpretation of the TOB rules.
The status of any capital assets should also be discussed between the buyer and seller of a TOB so that all Capital Asset Scheme obligations can be met on an ongoing basis.
It is important to also identify any VAT on costs directly associated with the TOB and assess their deduction entitlement. Generally, VAT is deductible where it is directly associated with a taxable supply and non-deductible where it is directly associated with an exempt supply or non-business activities.
In this scenario the TOB itself is not a 'taxable supply' or 'exempt supply' but is a strategic transaction for business purposes. Generally, you would seek to 'look through' to the overall activities of the business and take a deduction for VAT on costs associated with the TOB based on the business's overall deduction entitlement, similar to overhead costs. This 'look through' principle is a mature VAT principle but is not applied consistently across other VAT/GST regimes globally. It is not set out within the local GCC member state laws although the KSA and Bahrain Tax Authority guidance notes are suggestive of this principle.
Technical VAT advice and tax authority clarification should be sought in advance of concluding any such business transfers, so as to minimise risk and any exposure to penalties.
Goods and Services
In the event that a business transfer does not meet the criteria of a TOB, the overall consideration or price for the business sale or part sale should be attributed to the individual supplies of goods (tangible assets) and services (intangible assets) and the appropriate VAT treatment assessed for each – for example, property, stock, employees, machinery, customer/supplier listings, vehicles, IP rights, trade licences and liabilities. All VAT obligations, including the correct invoicing procedures, should be followed strictly for each individual sale.
This allocation of consideration may pose some challenges for businesses as the value of the business as a whole may be greater than the individual value of the goods and services being supplied - there may be an element of goodwill or profit built into the price. As there is no strict procedure within law for this allocation process, a reasonable approach should be taken which reflects the value of each good or service in comparison to the full business and the sale price. The split may be within the contract. If there are multiple VAT rates applicable to the goods and services being transferred and therefore there is a risk that this allocation process if done incorrectly may change the overall VAT liability due, businesses may wish to seek confirmation from the tax authority that the approach taken is viewed as reasonable.
Again, any Capital Asset Scheme adjustments necessary as a result of the business transfer should be assessed and accounted for correctly.
Any VAT incurred on costs associated with the business transfer should generally be deductible on the basis that most goods and services which would form part of an asset transfer would be liable to VAT at 5% or 0%. However, in the event that any good or service supplied as part of the business transfer is exempt from VAT, then an apportionment mechanism should be used for deduction of VAT incurred on associated costs.
Although the consequences of a local company wind-down is that the entity will no longer be in existence and so will no longer have VAT obligations in the region, the process of winding down and closing the company will generally attract some obligations from a VAT perspective, such as:
Each transaction should be assessed, its correct VAT treatment applied, VAT paid to the authorities where due and valid VAT invoices issued. Capital Assets Scheme obligations should be similarly assessed.
It is important to manage the timing of the filing of the last VAT return, the winding down of the business and the application for de-registration. The business should try to ensure that it deducts all VAT on costs associated with its business, but does not retain the VAT registration for any longer than required. This will create unnecessary additional compliance costs which could be avoided. It may also leave the business open to the risk of penalty (AED 20,000 / up to SAR 50,000 / BHD 5,000) for not de-registering on a timely basis, meaning within 20 days of being obliged to de-register in the UAE and 30 days in the KSA / Bahrain.
HMRC’s retrospective change on VAT and contract terminations: practical options for businesses