While technically VAT operates as a tax on transactions, as a consequence of the credit system, the full burden of the tax is borne by final consumers.
Countries that levy this tax have struggled with this issue, and approaches taken to reconcile theory and practicality are rather diverse
Value added tax is definitely coming to the UAE and an important question is how financial services will be treated. All 160 or so countries that levy VAT have struggled with this issue and the approaches taken to reconcile theory and practicality are rather diverse.
VAT is levied on the sale of goods and services at every stage of the supply chain. Business procurement is relieved from the tax by means of a credit for tax paid on acquisitions against the tax collected on sales. While technically it operates as a tax on transactions, as a consequence of the credit system, the full burden of the tax is borne by final consumers.
VAT taxes the value of transactions, which is relatively simple where explicit fees are charged - such as a lawyer charging hourly rates or the price of a pair of shoes - but difficult where implicit fees are charged as is the case with some types of financial services. The value of intermediary loan services is the differential between interest paid to depositors and charged to borrowers minus costs incurred due to loan default. Fees for pooling services, such as insurance, consist of the spread between insurance premiums collected and insurance benefits paid out.
Two of the most common policy approaches are exempting and zero-rating of financial services. When services are exempt no VAT is charged on these services, but the supplier can also not recover any VAT incurred on its inputs, which are related to the exempt services. As a result, financial services are actually taxed under the exemption system and this can lead to distortions as tax accumulation, artificial vertical integration, and a tax-induced preference for insourcing over outsourcing.
Under zero-rating also, no tax will be collected on the services but providers can recover related input VAT. As a result, financial services would be fully relieved from the tax.
Excluding financial services from the tax through zero-rating is not only contrary to the character of the VAT as a general consumption tax, but would also significantly reduce the tax base and, thus, revenue for the government as financial services constitute an important and large economic sector.
The GCC VAT framework agreement implies that as main rule financial services will be exempt, but each member state may apply any other tax treatment to financial services. The rules within the GCC will, therefore, likely differ, and the UAE has to make a crucial decision.
In addition, financial institutions often render other services for explicit fees that in most countries are taxed in the traditional manner. Input credit allocation becomes a problem for financial institutions where some VAT paid on procurement may be fully recoverable, other input-VAT non-recoverable, and a third category of input-VAT needs to be pro rated to exempt and taxable output to determine the percentage that can be recovered. These allocation rules will be determined per GCC member state. It is recommended that the UAE government does so in close cooperation with he financial institutions and external experts to arrive at a flexible pro rate formula that does justice in its application to the specifics of individual institution while safeguarding government revenue interests.