This guide was last updated in February 2019
VAT is a consumption tax on transactions, generally borne by the end consumer. For VAT to flow through a supply chain effectively, each business in the chain must have an entitlement to deduct the VAT it incurs on its purchase transactions ('input VAT').
In most VAT regimes, businesses must bear certain low levels of non-deductible input VAT as prescribed by law. They must all consider the extent to which their taxable transactions relate to exempt activities, through a full restriction and/or apportionment exercise. This is a self-assessment process, and so the obligation is on the business to understand the apportionment process and manage its deduction rights correctly.
The VAT incurred on 'mixed' costs - that is, overheads and other common costs across the business - cannot be deducted in full. Only the portion of such VAT which is demonstrated to be used by the taxable side of the business may be recovered. An apportionment methodology is required to identify the portion of VAT on mixed costs which most accurately reflects the use of those costs for taxable activities.
What sectors is apportionment relevant to?
The GCC VAT agreement sets out certain sectors to which the individual GCC states may apply VAT exemption, under national law. The United Arab Emirates (UAE), Kingdom of Saudi Arabia (KSA) and Bahrain have implemented a mixture of these exemptions, on a limited basis to date.
These sectors are set out below, together with a non-exhaustive summary of the types of businesses mainly affected:
- education sector - none implemented;
- health sector - none implemented;
- real estate sector - property rental businesses, real estate master developers, employers supplying residential accommodation;
- local transport sector - domestic taxi (land, sea or air) service providers, domestic bus, tram or train service providers;
- financial services - banks and other financial institutions, insurers and reinsurers of life insurance, foreign exchange, financial leasing, commodity trading, Islamic financing and other financial service providers, FinTech companies, holding companies providing inter-company loans.
Input VAT deduction criteria
A VAT-registered business is generally entitled to deduct VAT it incurs on purchases of goods or services ('costs') for the purposes of its business on its periodic VAT return. This is to the extent that such costs are attributed directly to:
- taxable supplies (including zero-rated taxable supplies); or
- supplies that would have been taxable had they been made in the relevant GCC state.
Before making a deduction, the business must ensure that it holds a valid tax invoice (or relevant customs documentation in the case of imports); and that it has paid, or intends to pay (subject to criteria) that invoice.
Generally, costs directly attributable to exempt activities are non-deductible.
Note that in some limited cases, deduction may be obtained for VAT on costs relating to certain exempt transactions which are supplied to foreign customers.
Direct attribution exercise
The business needs to separate its costs for each tax period between the following categories:
- costs directly attributable to non-business activities - non-deductible;
- costs directly attributable to taxable business activities - deductible;
- costs directly attributable to exempt business activities - non-deductible;
- costs directly attributable to mixed business activities (a mixture of taxable and exempt) - apportionment methodology required.
It may not be possible to perform this categorisation at a General Ledger Account level, and so transaction-level analysis may be required. This is where automation becomes critical in mitigating the risk of error and ensuring VAT compliance, together with sufficient internal VAT processes and controls.
The business needs to be able to demonstrate that its attribution is performed on a reasonable basis which clearly and fairly reflects the use to which the costs are placed.
Performing the apportionment
In essence, an apportionment methodology should look at the driver of the costs, measured as a share of the taxable part of the business in comparison to the full business, to identify the correct portion of VAT deductible.
Most VAT regimes implement one "standard" apportionment methodology: generally turnover, input VAT, headcount of staff, floor space of a building, etc. KSA and Bahrain have chosen the value of supplies as their standard method, whereas the UAE has chosen the input VAT methodology.
A business may apply to the relevant tax authorities to use a special/alternative method if it does not view the standard method of apportionment as correctly reflecting the use of the costs between taxable and exempt activities. Each tax authority has its own conditions for requesting, approving and applying special/alternative methods.
Certain factors may affect apportionment calculations and therefore may make the process more complex. These may include: costs associated with non-economic activities; costs blocked from deduction under the law; supplies outside the scope of VAT; and supplies within VAT groups.
How often should apportionment be completed?
Apportionment calculations are usually performed annually, on an estimated or prior year basis, with a 'look-back' or 'through-up' required at the year end, based on actual values for the year together with an associated adjustment.
The KSA has adopted the normal annual approach. The UAE and Bahrain have adopted a more frequent, period-by-period apportionment calculation obligation, followed by a year-end adjustment calculation.
In the UAE, the year end adjustment should be declared in the first tax period of the subsequent tax year. In the KSA, it must be completed in the last tax period for the current tax year. Bahrain gives taxpayers the option of including the adjustment in either of these two periods.
Each state has produced specific guidance for businesses assessing their tax period and tax year. Generally, a tax period is monthly or quarterly, and the tax year is 12 months. However, these may not be a calendar quarter or year.
Process and record-keeping
Each business in the GCC which undertakes some or all exempt activities should:
- give consideration to its deduction rights and potential apportionment obligations;
- identify and implement internal processes for the steps and calculation of the 'standard' apportionment method in the relevant country; and
- consider alternative methods and perform an analysis to ensure that the most accurate method of apportionment is used for the specific business activities. Any application for an alternative method should be submitted to the relevant tax authority, together with all required documentation.
A record should be retained of each individual apportionment analysis and calculation should be retained within the books and records of the business, together with evidence of where any required adjustments were processed through the periodic VAT returns.
Fixed and tax-geared penalties are applicable where a business fails to:
- complete a finalised and accurate apportionment exercise;
- declare the necessary amounts in the periodic VAT returns; and
- retain supporting books and records.