Less than three years after the introduction of VAT on 1 January 2018, KSA has decided in a surprise move to increase the VAT rate very substantially from 5 to 15%. The measure is implemented amongst other measures intended to improve fiscal balance in the Kingdom.

KSA MoF announces fiscal reform

In a press release on 11 May 2020 issued by the KSA Ministry of Finance, H.E. Mohammed Al-Jadaan, the KSA Minister of Finance announced important fiscal reform as a result of the current economic circumstances. It will be suspending cost of living allowances and increasing the VAT rate from 5 to 15% as from July 2020. In addition, it foresees spending cuts in some of the landmark Vision projects.

The KSA Ministry of Finances owes the reform to triple economic trouble. Firstly, an important decrease in oil demand and therefore in oil revenues for the state. Secondly, lockdowns and other measures have stalled or halted economic activity in the Kingdom. Thirdly, the unplanned government expenses contributed towards the fiscal imbalance. 

Before the crisis, the IMF had already advised KSA to increase its VAT rate to 10%. KSA now went above and beyond.

The KSA VAT system

KSA introduced VAT on 1 January 2018 at a standard rate of 5%. Widely hailed as a success in terms of government income, it brought in in excess of 12.16 billion dollars in the first year, more than double its own initial estimate.

The KSA VAT system is based on the GCC VAT Treaty, signed by all six GCC Member States. The GCC VAT Treaty is based on the EU VAT directive in its 2010 version.

KSA gave its own spin to VAT, amongst others excluding in practice government supplies from VAT, introducing “refunds” for medical services to locals and houses built by locals, and having refunds for government entities (the equivalent of so-called “compensation funds”). It also introduced restrictions to supplies of services made by KSA suppliers to recipients abroad, ensuring additional VAT revenue.

Interestingly the 5% VAT rate is foreseen by the Treaty and would require unanimity to be amended.

Impact of the change 

Generally the increase of VAT causes a short term increase in spending before the increase, and a short term decrease right after the increase. The VAT rate hike then gets gradually absorbed by the economy and should theoretically be neutral. 

 A hike in the VAT rate does impact consumer confidence though. From a business perspective, those businesses which may have cared less about a mere 5% VAT, will now increasingly turn their attention to transactions subject to VAT to ensure compliance and, more importantly, no VAT leakage.

The economy is currently in a fragile state and therefore this measure will have been carefully weighed.

Speed of KSA fiscal reform

The speed of fiscal reform in KSA has been phenomenal. While in 2017 it had been dealing for some time with withholding taxes ranging from 5 to 20%, corporate tax of 20% and Zakat at 2.5%, in a time span of three years, it:

-       Introduced Excise Tax

-       Introduced VAT

-       Introduced extensive transfer pricing legislation impacting FY2018

-       Introduced country by country reporting impacting FY2018

-       Amended the Zakat legislation

-       Broadened the Excise Tax base

 The speed of these reforms is staggering and the General Authority of Zakat and Tax is trying to keep up with the policy decisions.

 Businesses preparing

Businesses will need to take the VAT rate increase into account in their pricing strategies and have very little time to do so. The VAT rate hike will have to be implemented in about 6 weeks.  

POS systems, billing systems, contracts, Pos, may need to be adapted. An increase of the VAT rate goes beyond a simple push on the button unfortunately.

The interesting development will be that for contentious matters, such as whether e.g. “distribution services” should be subject to VAT, the increase will draw the attention again to these matters. 

With the business refund scheme in KSA still not in place, this will only increase the cost of doing business in KSA.

 Will other Gulf States follow?

The UAE introduced VAT at the same time as KSA and Bahrain a year later in 2019. The UAE and Bahrain are in a very similar situation as KSA. All three have introduced VAT recently, the UAE simultaneously with KSA and Bahrain one year later. The other three GCC countries have not yet introduced VAT. All GCC countries are dependent on commodities for government income and spending. Therefore, the economic impact of COVID19 is similar in the three GCC States which implemented VAT. However, the more important short term situation is the low oil price. The low oil price has very heavily dented government revenues and therefore drives reform.

Given the similarity and the interdependency of the KSA economy with the UAE and Bahrain, it is not inconceivable that these countries will follow suit. The situation of the UAE may be slightly different since it is a confederation and not a unitary state. The dynamics between the Emirates may play out differently. On 11 May the UAE Ministry of Finance also issued a press statement saying it does not plan a VAT hike, as a reaction to KSA's announcement.