Property development and construction industry – will the VAT foundations be safe?
By Bruce Hamilton, Director Indirect Tax, Deloitte Middle East
It is widely accepted that the application of VAT to the property development and construction industry is one of the more complex areas of the economy. However, if developers take the implementation of VAT seriously and don’t wait too long to start their project, it is possible achieve it. The issue is why this sector is high risk for VAT implementation?
A quick look at the skyline around the GCC should answer that question. It is a fundamental driver of economies of the region and applies, not just to the iconic buildings, but also the world class infrastructure for carving out a place in a region that not that long ago was a desert.
The challenges to a successful implementation of VAT cover three main area – Financial, Commercial, and Operational. In considering these we have set out a few of the issues to be addressed.
The supply of construction services (including materials) is normally subject to VAT at the 5% standard rate. However the ability of developers to recover the VAT charged to them will depend on a number of factors, including whether they have undertaken a robust process of setting their accounting system and processes up to enable them to do so.
We would generally recommend a structured project for them to achieve this outcome. It is essential that they don’t wait for final legislation in the respective GCC states, as this will leave them with insufficient time to ready their accounting and commercial systems to address the changes that will be required.
One of the biggest areas of concern would be planning for cash flow impacts. The sector, which operates on thin margins could be under pressure in terms of meeting the additional requirement of paying 5% VAT on the acquisition of goods or services each quarter on an accrual basis and any refunds from the Tax Authority may, initially at least, take months.
It is critical that developers perform a comprehensive impact assessment and determine the additional cash flow requirements, as this will have an impact on their working capital requirements.
These risks will be many and varied, depending upon the precise operations of the developers and construction contractors. Some of the risks would however include those identified below.
Lead times on larger projects
There tend to be long lead times between the inception of major projects and completion. At the extreme, one simply has to look back at the construction of the Burj Khalifa and the time it took from first excavation in approximately 2003, to completion in 2010. The Expo 2020 project in Dubai is little different.
With many of the major projects on track for the next few years it is likely that many contracts were entered into well before it was clear that VAT was on the horizon. The issue is that most contracts will not include any reference to VAT on the charges that are to be made after 1 January 2018. In future, if the contract price would have been AED 1,000, contractors should be in a position, commercially and legally, to charge AED 1,050 including the VAT, rather than having the VAT taken out of the AED 1,000 charge. This however requires that the contract terms give the Contractor the right to recover VAT in addition to the agreed charge for services.
Property transactions often involve considerations other than money, which can cause complex VAT problems. As an example, an exchange of property interests, such as a surrender of one property in exchange for another, may be completed without any exchange of money. This is a barter transaction and a failure to recognize these transactions for VAT purposes could result in penalties.
It is relatively common for developers to offer rent-free periods and other incentives to prospective tenants of commercial properties. This could trigger a VAT liability for both the tenant and landlord if it is determined that something has been supplied in return for the inducement (e.g. building works, or similar).
Mixed use properties
Depending upon the treatment of residential and commercial properties in the different GCC states, developers supplying both exempt residential and taxable commercial units, could be faced with complicated calculations for recovery of proportionate VAT amounts for each accounting period. This is due to the inability to recover VAT on costs where the developers make exempt supplies.
Registration of subcontractors
Another commercial issue that Contractors need to address is that many smaller subcontractors may not be able to deal with VAT adequately even if registered. The responsibility then falls on larger developers to educate their sub-contractors as to their responsibilities under VAT.
As a result of the nature of this industry sector, there could be a number of operational issues to be addressed.
Treatment of residential v commercial property
This is likely to be addressed in the GCC VAT Treaty, hopefully publicised by the time this article goes to print.
Normally the construction and supply of commercial, industrial, retail properties in addition to the construction of infrastructure, is treated as subject to VAT at standard rate – ie 5% in the case of the GCC. However, the construction and supply of residential properties may, in parts of the GCC be treated as being exempt or zero-rated rather than standard rated for a variety of reasons.
Clearly the preference for the industry would be that such supplies are zero-rated as this will then allow them to claim the VAT incurred during the construction process. It would simplify the manner in which developers would need to account for VAT on the supplies they make, as all construction supplies would be taxable supplies, allowing for the recovery of VAT on costs.
If the first supply of residential property is treated as exempt, this will mean that the developer will not be able to recover VAT incurred during the construction of residential property, but could seek to recover that additional cost when the property is either sold, or leased out.
Other operational issues can arise through existing industry practices and the way they tend to interact with the VAT law.
Examples include dealing with the time of supply where work done on construction is subject to certification. If not dealt with contractually, the recognition of supplies generally occurs on certification rather than the issue of the pro forma invoice.
Another area is the manner in which retention payments are ultimately dealt with. Once again, differences between what is stated in the contracts compared to the industry practice could result in the incorrect amount of VAT being accounted for potentially in the incorrect tax period.
What is the Solution?
Panic is not a solution! As with any construction project, the VAT implementation project can only proceed successfully if properly thought out, and structured. You can’t put the roof on before the foundations are in place.
This being the case, structuring your implementation project would be a good place to start. Seek VAT technical advice, and work with those that have experienced the process previously. Expect VAT to come into effect on 1 January 2018. It is coming, and is soon to be a fact of life.