VAT on Financial Services and Islamic Finance in KSA: Application, Exemptions & Input Tax Credit

Value Added Tax (VAT) system has been implemented in Saudi Arabia which has a huge impact on industries such as financial services and Islamic finance. In Saudi Arabia, with the introduction of e-invoicing, businesses have to be compliant with VAT regulations to avoid penalties and to take advantage of tax benefits. The introduction of e-invoicing in Saudi Arabia and e-invoicing in Riyadh requires financial institutions to adapt to the changing tax regulations. If you are in Riyadh or any other city, it helps businesses and individuals manage their financial transactions better by knowing VAT rules.

VAT in Saudi Arabia modelled after global standards, especially the attitudes towards the taxation of financial services was introduced on January 1, 2018. In general, VAT is not applied to transactions based on implicit margins, such as interest on loans, but applies to services that charge explicit fees, such as advisory or investment management. Likewise, Islamic finance follows VAT regulations that are in compliance with Shariah principles. In this blog, we explore how VAT is applied, exempted and input tax credited in financial services and Islamic finance to help businesses understand how to navigate these regulations.

Definition and Scope of Financial Services

Under the GCC Agreement, the term “financial services” is not defined in a fixed manner, and each member state is left to define and regulate it under its own domestic laws. Financial services in Saudi Arabia are mostly banking, insurance, investment management and credit services. The Agreement itself states that financial services are usually exempt from VAT but, as is the case with other issues, the member states are free to apply their own tax mechanisms. In other words, local tax regulations determine whether some financial transactions are subject to VAT or not, and specifically whether some of them are exempt from VAT or not, including explicit fees, and interest based transactions.

Scope of Financial Services in KSA VAT Regulation

Financial services are defined under the KSA VAT Regulations and some of the services may be exempt or subject to VAT. Specifics of the key financial services that are covered by this legislation are as follows:

• Issuing of cheques and other orders for the payment of money – Banks and financial institutions issue cheques and other orders to pay money to the customers.
• Facilitating credit and loans – The process of granting of credit and loans to individuals and businesses for different purposes.
• Managing deposit, and savings accounts, operating current accounts – Different types of accounts that help individuals and businesses to manage their finances securely.
• Services that involve money transfers, foreign currency exchange, and remittance activities – Transactions related to money.
• Transactions in securities, such as shares, bonds, and other forms of related financial instruments — Trading and management of financial instruments, i.e., shares, shares, Sukuk etc.
• The financial services provided in KSA are very important to its economy and are subject to specific VAT treatments based on the nature of the transaction.

Islamic Finance

Islamic financial products are built in such a way that their VAT treatment is in line with the conventional financial products. Although the contract framework is different, VAT regulations in Saudi Arabia are fair as it applies the same tax treatment to Islamic and conventional financial transactions.

Financial Services Provider

The VAT exemption in Saudi Arabia on financial services is not limited to the licensed banks and financial institutions. Under KSA VAT regulations, any entity involved in financial activities, including corporate treasury functions, group financing arrangements, and secondary lending businesses, can make VAT exempt financial supplies.

VAT Treatment of Financial Services

Financial services are usually exempt from VAT in Saudi Arabia, and this is especially the case when the consideration is based on an implicit margin, for example, interest or profit spreads. The transactions covered by this exemption include loan interest, credit arrangements and margin based financing. But when fees are involved, as in the case of advisory charges, brokerage commissions or commercial discounts, VAT is normally charged at the standard rate of 15%. Taxable financial services are provided by businesses that must register for VAT, charge the correct tax and report. This will help financial institutions and service providers to manage VAT liabilities effectively.

Implicit Margin: VAT Exempt

Implicit Margin is the earnings financial institutions earn from interest rate differences or financial spreads without charging a fee. Since these margins are embedded in transactions and not listed separately, they are usually exempted from VAT to keep the taxation simple.

Characteristics of Implicit Margin

• The margin is not separately itemized in transactions – The margin is not listed separately for the financial product.
• The margin is difficult to quantify for tax purposes – the margin fluctuates with market conditions and it would be difficult to calculate VAT on it.
• It is a reflection of the bank’s financial intermediation profit – the implicit margin is the bank’s earnings from lending, deposits, or currency trading.

Examples of Implicit Margin

• Interest spread – Difference between the interest which the bank has to pay on deposits and interest which it gets on loans. For instance, if a bank charges 5 per cent interest and pays 1 per cent on deposits, the 4 per cent difference is the bank’s implicit margin.
• Financial institutions earn profit from Foreign Exchange Spread – the profit made from currency exchange. The implicit margin is the difference of 0.02 SAR between the amount a bank buys USD at SAR 3.74 and the amount it sells it at SAR 3.76.

Since these margins are inherent to financial transactions, they are VAT exempt under Saudi Arabia’s VAT regulations.

Explicit Charges: VAT Taxable

Direct fees, commissions or service charges that financial institutions charge their customers for specific financial services are known as Explicit Charges. These charges are clearly stated in the financial transaction documents and are therefore subject to VAT unlike implicit margins.

Characteristics of Explicit Charges

• These charges are clearly listed and separately stated – They are clearly listed in financial documents, invoices, or agreements.
• Explicit fees are easy to quantify and administer for VAT – As the value of explicit fees is known and fixed, it is easy to apply and collect VAT.

Examples of Explicit Charges

• Charges for consulting or financial planning services provided by banks or investment firms are referred to as Advisory Fees.
• Fixed Charges – Banking service charges such as account maintaining, or the processing of transactions.
• Annual fees, late payment penalties, and other charges pertaining to credit card services are referred to as Credit Card Fees.
• Brokerage – Fees for commission charged by a broker or intermediary when executing trades, managements of fund or financial transactions.

In Saudi Arabia, since explicit charges are direct payments for financial services, they are generally subject to the standard VAT rate.

Exempt and Taxable Financial Services under VAT in Saudi Arabia

In Saudi Arabia, VAT is not applied to financial services, such as banking and related activities, except when a specific fee, commission or commercial discount is applied. KSA VAT regulations exempt and tax the following financial services.

1. Exempt Financial Services

These are not subject to VAT because they usually comprise implicit margins or are exempted by regulation:

• Money Transactions – Issuing, transferring or receiving of money, securities or payment orders are VAT exempt.
• Exempt from VAT are financial instruments transactions, such as derivatives, options, swaps, credit default swaps and futures in so far as they are not subject to explicit fees.
• Loans and credit guarantees are VAT exempt unless there are special fees or commissions.
• Interest and Lending Fees – Charges with an implicit margin like loan interest, mortgage fees, and credit card financing are not subject to VAT.
• Services such as maintaining current, deposit, and savings accounts are VAT exempted under Account Operations.
• Shariah compliant financing structures, similar to the conventional financial services, are also treated at par with Islamic Finance Products in terms of VAT treatment.
• Cash withdrawals from ATMs in Saudi Arabia are exempt from VAT, but ATM withdrawals from abroad may be taxed.
• Payments made through Points of Sale (POS) terminals in Saudi Arabia are exempt from VAT unless the goods or services purchased are taxable.

2. VAT-Applicable Financial Services

Financial services that are subject to a 15% VAT are mainly where explicit fees or service charges are involved.

• VAT – Transfer fees for domestic and international money transfers are subject to VAT.
• Fees for credit card renewals, late payments and prepaid card services are subject to VAT.
• VAT is applicable on services like bank statements, certifications, cheque book issuance, etc., as well as electronic banking transactions.
• VAT is charged on finance leasing, hire purchase, mortgage loans and asset backed financing.
• The VAT treatment of financial services enables businesses and consumers to meet the regulations without overpaying on taxes.

VAT Treatment of Islamic Finance

Shariah principles prohibit interest (riba) and speculative activities in Islamic finance. The VAT regulations in Saudi Arabia make sure that the Islamic finance products are treated fairly and have parity with the conventional financial services.

Here are the Treatment of VAT in Islamic Finance

• Although Islamic finance transactions are structured differently, they are treated equally with respect to VAT as conventional financial services. Implicit profit earned remains VAT-exempt.
• Islamic Finance Substance over Form – In Islamic finance cases where one is buying and selling taxable goods (e.g. Murabaha, Ijara) VAT is applied on the basis of what is economic reality rather than the contractual structure.

These principles guarantee that Islamic finance is competitive and that it does not attract unnecessary VAT costs as compared to conventional finance.

VAT Treatment of Commodity Murabaha

Commodity Murabaha is an Islamic financing structure where a financial institution buys the goods and sells them to its customer at a profit margin, in installments. Saudi VAT regulations ensure that such transactions are taxed fairly and it is on the financing and not the sale of goods.

1. Example of Commodity Murabaha

• A customer pays $12,000 for a commodity from a bank which has purchased the commodity for $10,000 and has agreed to pay over time.
• The bank’s implicit financing income is $2,000 profit margin, not a separate service charge.

2. VAT Treatment of Commodity Murabaha

The supply of the commodity by the bank on its initial purchase is a taxable supply and subject to VAT.

• The $2,000 profit margin is VAT exempt because when the bank sells the commodity, it is treated as a financing transaction.
• The resale of the commodity by the customer for $10,000 is a standard taxable supply in respect of which VAT is due.

3. Explanation of VAT Treatment

• VAT is based on substance over form principle i.e. the focus is on financing and not the goods transfer.
• With VAT exempted, the bank’s profit margin is tax neutral with respect to conventional interest based loans.
• It avoids unintended VAT charges and treats Islamic finance products fairly and consistently.

VAT Treatment of Ijara and Other Lease-Based Products

Ijara is an Islamic financing method whereby the customer leases an asset from a financial institution that has purchased it. The payments for the implicit profit are VAT exempt, just like the interest payments in conventional leases. However, explicit service fees charged as part of the lease agreement are subject to VAT.

VAT Treatment of Profit-Sharing Arrangements (Mudaraba & Musharaka)

Mudaraba (profit sharing) and Musharaka (joint ventures) involve sharing of investment and returns. These models are also exempt from VAT under Saudi VAT regulations, which means that the profit share in these models is also VAT exempt, and thus tax parity with conventional interest based returns. Nevertheless, the VAT rate of 20% applies to management fees or service charges that are specifically charged under these agreements.

VAT Recovery and Input Tax Credit for Financial Institutions

As far as tax regulations are concerned, financial institutions in Saudi Arabia can recover VAT based on certain methods. If expenses are directly related to taxable supplies, then the recovery process depends on whether expenses are directly linked to taxable supplies or must be allocated proportionally.

1. Direct Attribution of VAT Recovery

• A clear tax credit is available to financial institutions to reclaim VAT on expenses directly related to taxable supplies.
• To be able to recover VAT without disputes, proper documentation and segregation of costs are required.

2. Pro-rata Calculation for Non-Attributable Costs

• A pro rata method of calculating the recoverable VAT is used when expenses apply to both taxable and exempt supplies.
• The calculation is based on the percentage of taxable supplies versus total supplies, so that VAT is fairly distributed.

3. KSA’s Default Recovery Method on the Basis of Output Value

• In Saudi Arabia, VAT recovery is based on the value of taxable supplies and therefore directly affects the amounts of refund.
• Revenue proportions are aligned with institutions with more taxable transactions, and institutions can recover more VAT.

4. Alternative Proportional Methods and Approval Requirements

• VAT recovery has alternative methods such as transaction count or sector based calculations.
• These approaches have to be approved by prior tax authority and must be in compliance and reasonable.

Conclusion:

In order to comply with VAT and to ensure tax efficiency, businesses must understand the VAT implications on financial services and Islamic finance in Saudi Arabia. The introduction of e invoicing in Saudi Arabia and e invoicing in Riyadh requires financial institutions to adapt to the changing tax regulations. Proper VAT classification, whether for implicit margins, explicit charges, or input tax credit, helps in accurate reporting and recovery.

With Islamic finance growing in the Kingdom, it is important to maintain VAT neutrality between conventional and Shariah compliant products. To avoid penalties and obtain tax benefits, businesses must be aware of VAT exemptions, taxable supplies and financial services treatment under Saudi law.