The costs of Islamic financial institutions will increase. However conventional financial institutions will suffer the same way.
Posted 7 July 2020
Value added tax ("VAT") was pioneered by the European Union, but is gradually spreading worldwide. (Quite often it is called a "Goods and Services Tax" or GST.)
Saudi Arabia recently tripled its rate of VAT. Accordingly my May 2020 column in the magazine Islamic Finance News explored what this might mean for Islamic financial institutions.
You can read it below.
For a more detailed exploration of VAT and Islamic finance, read my article "How should VAT systems treat Islamic finance transactions?"
Last month “The Times” of London reported that Saudi Arabia is tripling VAT from 5% to 15% due to budgetary pressures. Low oil prices have cut government revenues drastically while plans to diversify the economy away from oil are still at an early stage. With high levels of government expenditure, in the time-honoured phrase “Something has got to give.”
What does this mean for the country’s Islamic finance industry?
Never forget that Islamic finance is finance, albeit conducted in a Shariah compliant way. From the inception of VAT in the European Union, financial services have been almost entirely exempt from VAT.
While VAT in Saudi Arabia is only a couple of years old, the Saudi VAT law follows widespread international precedent by also exempting financial services.
Since they provide exempt services, financial institutions do not charge their customers VAT. The problem this creates is that, because they make no taxable supplies, financial institutions cannot recover input VAT on the goods and services that they purchase from others.
For example, to bicycle maker spending $100 on telephone services (billed as $105 including VAT), the actual cost is only $100 because the $5 input VAT it pays within the $105 is recoverable.
However, when a bank spends $100 on telephone services (also billed as $105 including VAT), the bank’s actual cost is $105 because it cannot recover the $5 VAT. After the VAT rate increase from 5% to 15%, that same telephone service will cost the bank $115.
Accordingly, all financial institutions will suffer a hit to their profit and loss account. All purchases of goods and services which are subject to VAT (for example, telecommunications, computing, consultancy services, purchases of stationary, office equipment etc.) increase in cost by 9.5%, by rising from $105 to $115.
This reduction in profitability comes at a difficult time for banks. The low price of oil does not just harm the profitability of oil extraction companies. It also damages the prospects of those many businesses which supply oil companies with goods and services, and the profitability of businesses whose customers are the employees of oil services firms.
Accordingly, I expect an increase in bad debts in the Saudi banking sector.
The other question is whether there is a specifically Islamic financial services aspect?
By and large, I would not expect there to be. As well as making it clear that financial services generally are exempt supplies, the detailed Saudi VAT regulations aim to ensure that Islamic financial services are similarly exempt.
The Saudi “Value Added Tax - Implementing Regulations” were issued on 12 January 2018. Financial Services are covered in Article 29, paragraph 3 which says:
“Islamic finance products, being financial products under contract which are Shari’ah compliant and which simulate the intention and achieve effectively the same result as a non-Shari’ah compliant financial product will be treated in the same manner as the equivalent non-Shari’ah financial product for the purpose of applying exemption from Tax.”
Furthermore, the first half of paragraph 4 adds:
“In cases where ownership of Goods is transferred temporarily as a part of a Shari’ah compliant financial product or as collateral in relation to a financing or other arrangement, but possession of those Goods is not intended to pass permanently to the recipient of the financial product, the transfer of the underlying Goods is not considered a separate Supply of Goods.”
Accordingly, I do not expect Islamic financial services to be suffer any worse (or any better) than conventional financial services.