14. Input tax recovery
The deduction of input VAT is the key concept which distinguishes a multi staged consumption tax such as VAT, from a single stage consumption tax (such as certain sales taxes).
The principle is that domestic input VAT can be deducted from domestic output VAT. This usually happens in the periodical VAT return filed by the taxable person. The most important condition however is that the deduction of input VAT for a taxable person only is allowed to the extent that the makes taxable supplies. If the taxable person does not exclusively make taxable supplies, then his right to deduct input VAT can also not be complete. In article 46 is mentioned how a taxable person should calculate his right to recover input VAT when he does not make exclusively taxable supplies.
The time of supply or tax point rules described in articles 23 and 24 of the Agreement determine also when the taxable person receiving supplies of goods or services or importing can deduct this VAT as import VAT. As such, the time of supply will not only determine the liability for the supplier of importer to account for VAT but will also determine on the receiving side when this person can deduct the input VAT.
When a supply is subject to a reverse charge mechanism, the deduction is only allowed when the output VAT has also been paid.
Excluded input VAT deduction
Article 45 of the GCC VAT Agreement excludes the deduction of input VAT on certain purchases of goods and services or imports. The principle laid down in paragraph 1 is an unnecessary repetition of the underlying principles of the GCC VAT Agreement. If goods and services purchases are not used for an economic activity then VAT on these purchases is not deductible.
A person that does not have an economic activity falls outside of the scope of this legislation anyways and cannot claim the deduction of input VAT. However, a taxable person could have income which comes from a non-economic activity, such as the passive receiving of dividends. In that case, any input VAT related to that income is not deductible for VAT purposes. There are no rules in the Agreement with respect to the situation where a taxable person makes taxable and exempt supplies and receives income which is outside of the scope of VAT. Since this is subject to great controversy in the European Union, this may have been a missed opportunity.
What the first paragraph also targets is the situation where goods or services are acquired and they are consumed, i.e. they are in a stage of final consumption.
In KSA, article 50 of the Implementing Regulations excludes the deduction of input VAT on entertainment, sporting and cultural services on this basis. The same holds for catering services in hotels, restaurants and similar venues. Any VAT with respect to goods and services related to Restricted Motor Vehicles is also not deductible. Finally, in the same article there is a catch all provision stating that VAT on any goods or services used for a private or non-business purpose is not deductible.
The second paragraph concerns prohibited goods. An example of such a prohibited good is the sale of alcohol in KSA. Any VAT which would have been charged to a taxable person in KSA with respect to such goods will not be deductible.
Article 46 of the GCC VAT Agreement determines how taxable persons should treat the situation where they are not solely making taxable supplies (taxed and zero-rated supplies), but also other types of supplies. These are designated in the Agreement as non-taxable supplies. It is not clear whether this is meant to include only exempt supplies or also income which is out of scope for VAT purposes.
This article puts forward the principle that not all of the input VAT can be deducted by a taxable person when he does not exclusively make taxable supplies.
It is then left up to the individual Member States to develop a methodology. This methodology should respect the underlying principle of neutrality for VAT purposes. VAT should not constitute a cost for a business and should flow through a business.
In the European Union and jurisdictions worldwide based on the same legal framework, many different types of methodology are used. Although based on the same legislation, i.e. the European VAT directive, the methods are diverse. Where they differ, the most is in their approach towards tackling the calculation of input VAT when a taxable person receives income which is out of scope for VAT purposes.
In KSA article 22 of the KSA VAT law refers to the Implementing Regulations. In article 51 of the KSA VAT IR a direct attribution method is set out.
In such a direct attribution method, all purchases are directly attributed to either taxable supplies (which makes VAT on them fully deductible) or exempt supplies (which makes VAT on them not deductible). Any types of purchases for which it is not possible to link them directly to either taxable supplies or exempt supplies are deductible based on a proportion method (sometimes referred to as a "pro rata").
This pro rata is the default method in the Agreement and KSA, in line with most countries in the EU. It is a fraction calculated on the basis of turnover. In the numerator, the value is included of the taxable supplies made by the taxable person in the last year. In the denominator that same value is included, but it is increased with the exempt supplies.
Percentage of allocation=
The value of taxable supplies made by the taxable person in the last calendar year (T)
The total value of taxable supplies and exempt supplies made by the taxable person during the last calendar year (T+E)
In the UAE, articles 58 and 59 refer to the VAT Executive Regulations. The calculation will be relatively complicated because of the staggered introduction of VAT in the UAE (taxable persons which need to file on a quarterly basis will not file their returns according to calendar quarters).
In the UAE, the default rule is the direct attribution method (mirroring the UK approach). If it is not possible to make a direct link, then the proportional method needs to be applied. In the UAE, this method is designated as the "partial exemption method". These need to be apportioned between the taxable and exempt components of the supplies and only the proportion of VAT incurred on expenses for provision of taxable supplies can be classified as ‘recoverable input VAT’ while all other classifying as ‘irrecoverable input VAT’.
Post direct attribution, a standard method should be applied to calculate recoverable portion of ‘mixed’ input tax through the ratio of: input tax relating to taxable supplies (T) to the sum of the input tax relating to taxable supplies (T) plus the input tax relating to exempt supplies (E).
Recoverable ‘mixed’ input tax = T/T+E
This designation is only used in the UK since it is relatively confusing terminology, since not the exemption is partial, it is the turnover of the taxable person which is partially exempt. This triggers a consequence on the input tax side.
There is no method to address the situation where a taxable person receives income which is outside of the scope of VAT.
Alternative methods are also proposed based on outputs, transaction counts or sectoral methods. In the UAE, the use of such a special alternative method is subject to approval of the FTA and will only be able to be applied as of 2019 and is subject to certain conditions.
Passive holding companies
In its basic form, a holding company's main purpose is to simply hold shares in other corporate entities. This "holding of shares" is generally not viewed as a supply for VAT purposes, as it does not involve the supply of a good or a service in return for consideration. Therefore, if this holding company undertakes no other activities, it is unlikely that it would be entitled to register for VAT purposes on the basis that it is not "in business" or undertaking an "economic activity" for VAT purposes.
In the absence of a VAT registration, all costs incurred by this type of passive holding company which are associated with its holding of shares would not be recoverable from the tax authorities (e.g. auditor, accounting, secretarial expenses, legal expenses, …). With no active trading activities, it is unlikely that a passive holding company of this nature would incur many other costs.
This position has been confirmed in ZATCA's Economic Activity and VAT Grouping Guideline.
Active holding companies
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 (regardless of whether market value or deeming provisions have been applied), should be fully deductible, e.g., 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, in accordance with the deduction provisions set out within .
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, e.g., 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 either its taxable, exempt or non-business/non-economic activities, in order to determine a fair and reasonable portion of such costs which should be deducted, in accordance with . An annual apportionment review is required in order to perform a "look back" on the apportionment methodology used versus actual activities, and an adjustment is generally required for any difference in use. Further detail may be reviewed within the ZATCA Input Tax Deduction Guideline.
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, which is that even where it is active by undertaking business activities and making supplies for VAT purposes, it continues to hold shares in related corporate entities. As we have mentioned above, this holding of shares in itself is not generally viewed as a business or economic activity for VAT purposes. As such, there is a risk that a portion of a holding companies' costs should always be viewed as associated with this non-business activity and therefore, a portion of deduction entitlement should be restricted. We have seen this point debated between taxpayers and tax authorities, in addition to being assessed by many judges of the court across the globe. While there have been many developments in this regard over the last decade, it is an area that continues to create ambiguity and risk for corporate groups and holding companies in many regions. For example, many corporate groups across the globe withhold a portion of VAT incurred on general overheads of the holding company as associated to its passive holding of shares.
The ZATCA mention within their Economic Activity Guide that the passive holding of shares is not an economic activity. They then later within the Guide mention that entities which undertake both economic and non-economic activities would need to identify a fair and reasonable basis (which is not set out within on the Value Added Tax Law ( Approving the Value Added Tax Law) or the Guide) to apportion any costs which are associated to both types of activities. It can therefore be understood, that holding companies in the KSA would be expected to assign some portion of VAT on costs as non-deductible due to their passive holding of shares. This exercise would however need further consideration with ZATCA in order to mitigate risk.
In addition, there are many corporate groups where a holding company may passively hold shares in a number of subsidiaries (i.e., provide no other supplies of goods or services to these entities) and actively manage other subsidiaries (i.e., by providing management services and other supplies). This creates yet another layer of complexity in determining correct deduction entitlement.
Lastly, holding companies which arrange for certain goods or services to be supplied on behalf of its group companies should ensure 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 or 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 a "pay master" 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 the invoice 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.