VAT on Financial Services and Islamic Finance in KSA: Treatment, Exemption and Input Tax Credit

On January 1, 2018, the Kingdom of Saudi Arabia (KSA) introduced Value Added Tax (VAT) as part of a broader initiative across the Gulf Cooperation Council (GCC) member states, following the GCC VAT Agreement. In KSA, the approach to VAT on financial services aligns with recent global practices. This means that VAT is largely exempt for financial services based on implicit margins, while services charged on an explicit fee basis are subject to VAT.

This blog will provide a detailed discussion on the scope of VAT in financial services in KSA, including which services are exempt from VAT, which services are subject to VAT, the VAT treatment of Islamic finance, VAT recovery, input tax credit, and the challenges in implementing VAT in KSA.

Definition and Scope of Financial Services

The GCC Agreement does not provide a definitive definition of "financial services." Each member state is allowed to determine the scope and definition of financial services in their domestic laws. 

The Agreement states that financial services will generally be exempt from VAT, but member states can adopt different mechanisms.

Scope of Financial Services in KSA VAT Regulation

The KSA VAT Regulations provide an inclusive list of services considered as financial services. These services include, but are not limited to:

• Acceptance of deposits and other repayable funds.
• Granting of credit and loans.
• Operating current, deposit, and savings accounts.
• Transactions related to money, including currency exchange.
• Transactions related to securities, such as shares, bonds, and other similar financial instruments.

Islamic Finance

Islamic financial products are treated in a way that ensures their VAT treatment is equivalent to conventional financial products. (This is covered in detail below)

Financial Services Provider

VAT exemption on financial services is not limited to licensed financial institutions. Any entity, including group treasury businesses and secondary financing activities, can make exempt financial supplies.

VAT Treatment of Financial Services

In general, Financial Services are exempt form VAT. This VAT exemption applies to financial services where the consideration is an implicit margin (e.g., interest, spreads). Explicit fees for financial services, such as advisory fees, commission, and commercial discounts, are typically taxable.

Implicit Margin: Exempt

Implicit Margin refers to the revenue earned by financial institutions through the difference between interest rates or other financial spreads without directly charging a fee for the service. This margin is not explicitly stated as a fee or commission but is embedded in the financial transaction.

Typically, financial services with revenue generated from implicit margins are exempt from VAT. This is because taxing these margins can be complex and administratively burdensome.

Characteristics:

• Not separately itemized in transactions.
• Difficult to quantify precisely for tax purposes.
• Reflects the inherent profit from financial intermediation activities.

Examples:

• Interest Spread: The difference between the interest rate a bank charges on loans and the interest rate it pays on deposits. For instance, if a bank lends money at 5% interest and pays 1% interest on deposits, the 4% difference is the implicit margin.
• Foreign Exchange Spread: The difference between the buying and selling rates of a currency. If a bank buys USD at SAR 3.74 and sells at SAR 3.76, the 0.02 SAR difference is the implicit margin.

Explicit Charges: Taxable

Explicit Charges refer to direct fees, commissions, or other charges that a financial institution explicitly imposes on its customers for specific services. These charges are clearly stated and itemized in the financial transaction documentation.

Explicit charges are generally subject to VAT because they represent direct compensation for services rendered. 

Characteristics:

• Clearly identified and separately stated in financial documents.
• Easy to quantify and administer for VAT purposes.

Examples: Advisory Fees, Service Fees, Credit Card Fees, Commission, and so on

Exempt and Taxable Financial Services under VAT in Saudi

Financial services, including banking services, are generally exempt from VAT unless an explicit fee, commission, or commercial discount is involved.

Exempt Financial Services

The following banking services are exempt from VAT:

• Money Transactions: This includes issuing, transferring, or receiving money, securities, notes, or orders for payment.
• Financial Instruments: Issue, transfer, or receipt of money, securities, or any payment instrument. Dealing with any financial instrument like derivatives, options, swaps, credit default swaps, and futures.
• Credit and Credit Guarantees: Credit and credit guarantees are exempt from VAT in Saudi Arabia, unless specific considerations like explicit fees or commissions apply.
• Interest and Lending Fees: Interest or lending fees charged with an implicit margin, applicable to loans, credit cards, mortgages, and other lending arrangements.
• Account Operations: Managing current, deposit, or savings accounts, including deposited funds.
• Islamic Finance Products: These Shari’ah-compliant products, which mimic the intention and results of conventional financial products, are treated similarly for VAT purposes.
• ATM Withdrawals: Cash withdrawals from ATMs inside the Kingdom are exempt; however, VAT applies to withdrawals from ATMs outside the Kingdom.
• POS Transactions: Points of Sale services within the Kingdom are exempt from VAT when used for payments, though VAT applies if the goods or services purchased are taxable.

VAT-Applicable Financial Services

Certain banking services attract a 15% VAT:

• Money Transfers: VAT applies to general money transfers, both internal and external, including transfer fees.
• Card Services: VAT applies to late fees, renewals, and associated charges on debit cards, credit cards, and prepaid cards.
• Bank Accounts: VAT is charged on services related to current, savings, and deposit accounts, as well as certifications, bank statements, electronic banking, and chequebook issuance.
• Financial Services: Charges for finance leasing, hire-purchase, mortgage loans, and other asset-backed financing are also subject to VAT.

VAT Treatment of Islamic Finance

Islamic finance refers to financial activities that comply with Sharia (Islamic law), which prohibits interest (riba) and speculative activities. 

Here are the basic principles of Islamic Finance

• Equivalence with Conventional Finance: Islamic finance products, although involving transactions that may differ in form from conventional financial products, are treated similarly for VAT purposes. The implicit profit earned by Islamic finance providers is treated as an exempt supply.
• Substance over Form: In transactions where Islamic finance involves buying and selling taxable goods (e.g., Murabaha, Ijara), VAT should be applied based on the underlying economic reality rather than the contractual form.  This ensures that Islamic financial transactions do not incur additional VAT charges compared to their conventional counterparts.

Here is the VAT treatment of the Islamic Finance Products

Commodity Murabaha

 In Murabaha, a financial institution purchases goods and sells them to the customer at a profit margin. 

The KSA VAT Regulations provide that the transfer of goods in such transactions may be disregarded for VAT purposes if the intent is not to transfer possession of the goods (e.g., in commodity Murabaha).

This rule avoids unintended VAT charges on the transfer of goods, focusing instead on the financing aspect, which is exempt.

Example

In a Commodity Murabaha financing arrangement, a bank purchases a commodity for $10,000 and then sells it to a customer for $12,000, payable in instalments. This $2,000 profit margin represents the bank's implicit financing profit. 

VAT Treatment

For VAT purposes, the initial purchase by the bank is a standard taxable supply, subject to VAT. However, when the bank sells the commodity to the customer, the transaction is treated as a financing arrangement rather than a simple sale of goods.  

This approach reflects the substance over form principle, where the $2,000 profit margin is treated as an exempt supply, similar to interest income in conventional finance. Consequently, the customer’s subsequent sale of the commodity in the market for $10,000 is a standard taxable supply, subject to VAT.

Explanation

This VAT treatment ensures that Islamic finance products, like Commodity Murabaha, are taxed in a manner consistent with their economic reality. By focusing on the financing aspect rather than the sale of goods, the bank's profit margin is exempt from VAT, aligning the treatment with conventional financial products and avoiding unintended VAT charges that could arise from treating the transaction purely as a sale of goods. 

This approach promotes tax neutrality between Islamic and conventional financial products, ensuring fairness and consistency in VAT application

Ijara and Other Lease-Based Products

Ijara (leasing) involves the financial institution purchasing and leasing an asset to the customer. For VAT purposes, lease payments reflecting the implicit profit are treated as exempt supplies, like interest payments in conventional leases. 

Profit-Sharing Arrangements (Mudaraba and Musharaka)

Mudaraba (profit-sharing) and Musharaka (joint venture) arrangements are treated in a manner that the profit share is exempt from VAT. The key consideration is ensuring that the return on these investments is not taxed differently from conventional interest income.

VAT Recovery and Input Tax Credit

Value Added Tax (VAT) recovery for financial institutions in GCC states involves specific methods to reclaim input taxes, depending on the nature of expenses incurred:

• Direct Attribution of VAT Recovery: This method allows financial institutions to directly reclaim VAT incurred on expenses that are exclusively related to taxable supplies. It requires clear documentation and segregation of expenses directly attributable to taxable activities.
• Pro-rata Calculation for Non-Attributable Costs: For expenses that cannot be directly linked to either taxable or exempt supplies (e.g., common overheads), a pro-rata method is used. This involves calculating the percentage of VAT recoverable based on the proportion of taxable supplies to total supplies. 
• KSA’s Default Recovery Method Based on Output Value: In Saudi Arabia, the default method for VAT recovery is based on the value of output supplies made by the institution. This approach ties the recoverable VAT amount directly to the value of taxable supplies provided, influencing recovery rates accordingly.
• Alternative Proportional Methods and Approval Requirements: Saudi Arabia permit alternative proportional methods for VAT recovery, such as transaction count or sectoral methods. These alternatives require prior approval from tax authorities and must pass reasonableness tests to ensure compliance with VAT regulations.

Conclusion

VAT treatment in KSA distinguishes between financial services exempted based on implicit margins, such as interest and spreads, and those subject to VAT, which include explicit fees and commissions. Also, Islamic finance is treated similarly to conventional finance for VAT purposes. 

Accurately allocating input tax credits is essential for financial institutions to claim input tax credits and manage operational costs.