The Saudi Zakat, Tax, and Customs Authority (ZATCA) has published the Guideline - VAT Exemption of Real Estate Supplies and its Effect on the Proportional Deduction Formula. The guideline outlines the method, requirements, and obligations for exempting real estate supplies from VAT and its effect on the proportional deduction formula as set forth in the Tax Laws and Implementing Regulations issued by ZATCA. It also provides an explanation for the definition of a real estate financier and the alternative method of proportional deduction of input tax that can be used by some taxable persons. The main text of the guidelines, which also includes several examples, is as follows:
Overview of the Correct VAT Treatment of Real Estate Supplies
With effect from 4 October 2020, the VAT treatment of the real estate supply has been changed from taxable supplies to exempt from tax by Royal Order No. (A/84) issued on 14/2/1442H. As such, the real estate transaction became subject to the Real Estate Transaction Tax (RETT) at the rate of 5% of the total value of the real estate transaction, whatever its condition, form, or use was at the time of the transaction.
This change resulted in a reduction of the proportional deduction ratio of residual input tax for businesses engaged in supplying Shariah-compliant financing products which involve the purchase and sale of real estate. Consequently, the Authority was keen to clarify the provisions of the Law and the Implementing Regulations, which regulated the special provisions for the alternative proportional deduction method so that it is applied in cases where it would be difficult to apply the default method.
For the purposes of VAT, a supply of Real Estate is made where a supplier sells or rents Real Estate located in the Kingdom of Saudi Arabia ('KSA') as part of his economic activity.
As such, the sale of all types of real estate in the Kingdom (including commercial, residential, or bare land) is exempt from VAT. The real estate transactions are, however, subject to RETT at 5% of the total transaction value at the transaction date, pursuant to implementation of the provision of the RETT Implementing Regulations issued under Ministerial Resolution No. 712 dated 15/02/1442H.
It should be noted that the supply of leasing commercial or other non-residential real estate is subject to VAT at the rate of (15%), and the rental of residential properties is exempt from VAT.
In principle, any VAT incurred by a taxable person on the purchase of goods or services supplied to him is deductible, provided the goods or services are used for the purpose of carrying out an economic activity in the course of making taxable supplies. For example, a bank may charge an explicit fee for issuing cheque books to account holders, and this fee would be taxable at the standard rate of VAT. Consequently, input tax on expenses which are fully and directly attributable to this supply, such as the printing costs of the cheque books, would be fully deductible. The taxable person is required to obtain and retain a tax invoice to document the input VAT amount paid or payable.
Input tax incurred by a taxable person which is wholly attributable to exempt supplies is not deductible and represents a business cost component. For example, a bank making an exempt supply of financial services may incur explicit fees specifically relating to that supply. Such fees would be wholly attributable to the exempt supply and therefore the input tax incurred on the legal fees would be fully non-deductible.
The input tax which cannot be wholly attributed to only taxable or exempt supplies (residual input tax) is required to be apportioned to accurately reflect the use of goods or services in the taxable portion of the business. For example, a business making both taxable and exempt supplies would be unable to wholly attribute overhead costs or expenses such as office utilities or internet expenses or stationery or software costs to either taxable or exempt supplies and the input tax which is deductible on such overhead costs would need to be determined pursuant to the following apportionment:
Pursuant to the Unified Agreement and the Implementing Regulations, a Taxable Person can apply for the proportional deduction method if the input tax is related to goods and services used to make taxable and exempt supplies, and input tax cannot be deducted save within the limits of the proportion referable to the taxable supplies.
The default method to apportion residual input tax is based on the value of taxable supplies as a proportion of the total supplies made by the business, as provided below:
Taxable supplies / (Taxable supplies + Exempt supplies)
Once a percentage is computed based on the formula above, the amount of residual input tax is multiplied by the said percentage to determine the amount of residual input tax which is deductible by the business. VAT relating to the restricted elements listed in Article 50 of the Implementing Regulations should not be deducted.
Impact of Exemption of Real Estate Sales on Proportional Deduction
The change in the VAT treatment of sales of Real Estate from taxable to exempt affects the default proportional deduction calculation resulting in an overall reduction in the proportional deduction ratio and lower deduction of residual input tax.
The banks and financial institutions that are engaged in providing Islamic financing products (which involve the purchase and sale of Real Estate) have in many cases experienced a particular impact on their input tax deduction position, despite the purchases making up residual input tax being used in a similar way.
ZATCA accepts that the objective of banks and financial institutions is to provide financing to their customers, rather than to sell real estate. The purchase and sale of real estate by such banks and financial institutions is carried out in accordance with Shariah principles for financing, and solely in order to facilitate the financing activity.
While the sale of real estate is a regular feature of a financier's activity, the high value of exempt real estate supplies in the denominator could be distortive and result in a recovery percentage which does not reflect the use of goods or services comprising residual input tax in the taxable portion of the business.
ZATCA may review the proposed alternative method of proportional deduction pursuant to an application filed by the taxable person where the default method does not accurately reflect the taxable person's use of goods and services supplied to it. Consequently, ZATCA may approve or reject the proposed alternative method of proportional deduction. It should be noted that Real Estate Financiers licensed by the Saudi Central Bank can apply for an alternative method of proportional deduction in order to exclude the amount of exempt supplies of Real Estate made as part of a financing arrangement for the purposes of the proportional deduction calculation, and ZATCA may approve the use of such a method.
Alternative Method of Proportional Deduction for Real Estate Financing
This alternative method is the same as the default method, except that the supplies of real estate by way of transaction/disposal are excluded from the value of exempt supplies. Therefore, the following formula would apply for the proportional deduction percentage:
Taxable supplies / (Taxable supplies + (Exempt supplies - Exempt Real Estate supplies as part of financing products))
It should be noted that exempt real estate supplies which are not a part of the supply of a Shariah compliant financing product are not eligible for exclusion from the denominator in the alternative method.
Clarification of Real Estate Financing as a VAT Exempt Supply
The real estate financing principle is based on providing funds to the person to whom finance is provided, with many financiers providing Shariah compliant real estate financing where real estate is bought and sold as part of the financing product provided. As such, tax-exempt real estate supplies will therefore become high, and it is likely that the application of the default method of proportional discount would give a different reflection of the use of overhead costs for taxable and exempt supplies.
Therefore, any real estate financier licensed by the Saudi Central Bank that makes real estate supplies as part of a financing product can apply the alternative method referred to above after the, and such after the real estate financier submits a request to ZATCA to apply this alternative method, taking into account the time period specified in Article 51 (9) of the Implementing Regulations.
For the purpose of applying the alternative method, the Licensed Real Estate Financier shall meet the following:
Where the taxable person meets the aforementioned criteria as a Real Estate Financier after October 4, 2020, the date of eligibility for using the alternative method will be the date that the taxable person met such criteria. Conversely, where a Real Estate Financier ceases to meet the aforementioned criteria (for example, due to change in its regulatory licensing), the taxable person will no longer be able to use the alternative method from the date on which it ceased to meet such criteria.
Therefore, ZATCA was keen to clarify the provisions of the law and the implementing regulations which allow the use of an alternative deduction method where the value of the exempt real estate supply can be excluded from the proportional deduction formula.