EY expert on how VAT will impact the GCC's PPP construction projects
Businesses have been surprised by the wide-ranging impact of VAT, Mena indirect tax partner at EY writes for CW
How has value-added tax (VAT) affected the GCC's economy to date, and how might it impact the building and construction sectors – which are increasingly witnessing greater private-sector participation – in the years to come? Stuart Halstead, Mena indirect tax partner at EY, one of the world's 'big four' accounting firms, explains in this exclusive piece for Construction Week.
Substantial investment in infrastructure by Gulf Cooperation Council (GCC) governments has led to an increased interest in public-private partnerships (PPP).
This method of procurement involves companies in the private sector delivering public infrastructure capacity under long-term arrangements, bringing increased efficiencies and leveraging expertise from specialists working outside of the government. PPP providers will take on a share of the project risk from the government. In return, the private sector party will secure a reliable future stream of revenue.
Kuwait and Dubai were the first in the GCC to embrace this model of procurement by establishing legal frameworks to encourage and facilitate PPP. With Saudi Arabia’s Vision 2030 aiming to reduce reliance on oil and increase private sector participation in the economy, PPP is likely to become a vital delivery method for some of its planned megaprojects.
The VAT rate in the GCC is one of the lowest in the world, but can multiply to substantial figures on multibillion dollar projects.
The implementation of VAT is well under way in the GCC, with Saudi Arabia and the UAE implementing their legislation on 1 January, 2018. Bahrain has also introduced its VAT system from the start of 2019.
Many businesses have been surprised by the wide-ranging impact of VAT, and it has given rise to unique challenges across different industry sectors. Key provisions of the GCC VAT legislation create challenges for providers and procurers of PPP projects. Given the variety in PPP structures, each mode of construction, funding and delivery should be assessed on a case-by-case basis when looking at the potential VAT implications.
VAT and the PPP lifecycle
The typical PPP project lifecycle involves four phases: identification, bidding, construction, and operation. Each phase presents important considerations from a VAT perspective.
Identification, bidding, and construction
Major infrastructure projects are typically associated with large costs and long lead times; VAT will be payable by the project company on the construction costs. A key principle of a VAT system is the ability for a business to offset the VAT incurred on purchases (input tax) against the VAT charged on sales (output tax). Under this concept, VAT is generally meant to fall as a cost to the end consumer.
In the GCC VAT system, if a business’s input tax exceeds its output tax it should be entitled to a VAT refund from the relevant tax authority. Applying this principle, a newly established PPP project company should be able to obtain periodic VAT refunds from the tax authority throughout the duration of the construction process. However, companies may face delays when submitting refund claims to the relevant tax authority.
If a project company appoints an engineering, procurement and construction contractor rather than carrying out construction in-house, this will increase the VAT outlay.
Long refund delays can affect the working capital position of any business, but are particularly burdensome for project companies involved in high-value construction work. Additional funding must be sought from lenders, leading to increased financing costs. If a project company appoints an engineering, procurement and construction contractor rather than carrying out the construction in-house, this will increase the VAT outlay further, given the increased reliance on external labour.
At 5%, the VAT rate in the GCC is one of the lowest in the world, but can still multiply to substantial figures on multibillion dollar projects. For projects where the construction phase straddled the VAT implementation date, the PPP provider may not have considered the complexities of the potential tax impact when preparing its tender bid. Without the correct protections in the agreement, any additional financing costs could fall entirely on the provider.
When preparing the financial model for PPP proposals, bidders should now consider the uncertainty around VAT refund timings, and should factor the additional financing costs into their pricing structure. The bidder should also seek to include mechanisms in the contract that can automatically adjust the agreed price upwards in the event of a delayed VAT refund.
Following the construction phase, the PPP provider will operate the infrastructure and receive payments that reflect the services delivered. If we take the example of a power plant, the provider may be paid directly through user charges (for example, the sale of power), by the procurer through a unitary charge (such as capacity payments), or by a combination of the two.
The GCC has opted for a wide VAT base, with limited exemptions and zero ratings when compared to other jurisdictions. Despite this, PPP providers will still need to consider the nature of their services to determine the appropriate VAT treatment.
Parties involved in PPP procurement should take a proactive approach to VAT analysis.
Unitary charges paid by the procurers are normally for general services, and are likely to be standard-rated at 5%. However, user charges made to individuals have the potential to be zero-rated or exempt depending on the VAT rules adopted in the country in question.
The distinction between zero-rated and exempt income is an important concept in VAT. Input tax relating to exempt income is not recoverable, and will represent a cost to the business. Input tax that relates to taxable income is generally deductible, and can be offset against the output tax charged to customers.
The future of PPPs in the new GCC VAT landscape
PPP is still a relatively new concept in the GCC when compared to other jurisdictions, however, the move to drive more private sector engagement is expected to increase their use in the future. With VAT now in the picture, PPP providers will face increased complexities and uncertainty. On the other hand, procurers seeking to lessen the risk associated with infrastructure construction may have to face the reality of increased costs and irrecoverable VAT.
Parties involved in PPP procurement should take a proactive approach to VAT analysis, and seek advice at the primary stages of the project life cycle. By identifying potential VAT risks and inefficiencies early, steps can be taken to reduce the possibility of additional costs.