Seismic tax policy shift in the application of penalties for non-compliance

Taxpayers are now incentivized to take a proactive approach to tax risk mitigation as a new UAE penalty regime is announced

 There was a palpable sigh of relief from UAE Taxpayers on Thursday 6 May 2021 as the controversial penalty regime for taxes was turned on its head following the announcement of Cabinet Resolution No. (49) of 2021.  The reaction to the penalty regime changes has been overwhelmingly positive from businesses and tax professionals alike as arguably the most contentious area of the burgeoning UAE tax system appears to have been addressed.  

Many experts believe that the announced changes to the penalty regime should result in a positive impact on overall tax collection in the long run and the new approach fits in well with the UAE’s wider ambition to entice overseas investment and ensure the country is an attractive place to do business.

The Ministry of Finance (“MoF”) and Federal Tax Authority (“FTA”) should be commended for taking proactive action on this matter.  It would have been very easy for the FTA in particular to support maintaining the status quo following its well-publicized Supreme Court success in a crucial case on the application of late payment penalties with respect to voluntary disclosures.  Although many will point out that the FTA is not responsible for drafting tax legislation, it is reasonable to assume that it must have been one of the drivers behind such a transformation to the penalty regime.

What changes were made to the penalty regime?  

Almost everything.

The full list of amendments have been well documented elsewhere and this Article is not intended to be a comprehensive guide on the new penalty regime.  However, the changes that I believe will have the most positive impact on Taxpayers and the FTA concern the application of penalties on Voluntary Disclosures.

A Voluntary Disclosure is the mechanism by which Taxpayers pro-actively amend previously submitted Tax Returns in order to rectify an historic error, without the intervention by the FTA.  There are a number of reasons why it is beneficial for the FTA if Taxpayers make Voluntary Disclosures.  For example, it saves the FTA time and resources as it typically should not need to undertake as many Tax Audits.  Tax collection should also increase as Taxpayers proactively report tax that was under-reported historically.

Consequently, you would expect the penalty regime to incentivize Taxpayers to submit Voluntary Disclosures.  At one level, the old penalty regime did this by applying a 5% penalty on the tax benefit (i.e. under-reported tax) calculated as part of a Voluntary Disclosure, compared to a 30% penalty when the Taxpayer has been notified of a Tax Audit and a 50% penalty if the error has been identified during a Tax Audit.  However, this was effectively negated by two other key parts of the regime:

• The infamous 1% daily penalty that was applicable from 1 month after the tax became payable, with a cap of 300%; and
• The start date for calculating when the tax became payable was the payment date for the Tax Return in which the error occurred in.

If the policy is to encourage Taxpayers to submit Voluntary Disclosures then the impact of the above is disastrous.  Although this author strongly believes that the vast majority of businesses want to pay the correct amount of Tax, it is easy to envisage the fear many Tax Managers and CFOs would have felt undertaking a review of historic Tax Returns more than one year old.

Any error resulting in additional tax payable was likely to result in an accompanying 311% penalty following the submission of a Voluntary Disclosure.  With those sorts of figures involved it was virtually impossible not to contest the application of penalties, resulting in additional professional service and legal costs.  With a statutory limit of 5 years for the FTA to issue a Tax Assessment as part of a Tax Audit, perhaps it was better from the businesses perspective to roll the dice and not to look in the first place…

Clearly, the above approach is neither prudent nor correct, but we have to acknowledge that this was a genuine dilemma for many Taxpayers, particularly when the sums involved could have a material impact on the financial viability of the company.

Fortunately, the new penalty regime removes this predicament for Taxpayers and is now aligned to a policy of encouraging Voluntary Disclosures, with the following changes:

• There is now a staggered penalty applicable to the calculated tax benefit ranging from 5% to 40% depending on how much time has passed since the submission of the Tax Return;
• The daily penalty has been replaced with a 2% penalty becoming applicable immediately followed by a 4% penalty each month thereafter (the 300% cap remains); and
• Crucially, the due date for the penalty calculation has been amended to 20 business days after the submission of the Voluntary Disclosure.

How does this impact Taxpayers in practice?

The obvious effect is a significant reduction in the value of penalties that are likely to be levied.  For example, a Taxpayer that identifies it under-reported output tax of AED 1,000,000 in its most recent 3 VAT return periods should now only expect a penalty of AED 50,000 assuming it submits a Voluntary Disclosure and makes the necessary payments within the 20 business day deadline.  Not a trivial sum, but under the old penalty regime the same Voluntary Disclosure could have resulted in a penalty of approximately AED 2,000,000+ (depending on the exact timings of the errors).   

As a result, Taxpayers are now financially incentivized to perform reviews of historic Tax Returns annually and to make payments of any previously under-reported Tax quickly, rather than wait for Tax Audits.  The cost of performing an annual tax review should now be outweighed by the higher penalties associated with delays to Voluntary Disclosures and the penalties due following Tax Assessments.  

Another upshot is that we are also likely to see a dramatic reduction in the number of penalty cases at the Tax Dispute Resolution Committee and local Courts, the back-log of which was a well-known issue.  Perhaps not great news for lawyers, but overall this will free up valuable time, resources and costs for Taxpayers and the FTA alike.

What was the reason behind the changes?

Unless MOF or the FTA releases an accompanying paper explaining the rationale behind the new penalty regime we will never know the full background.  However, we can make some educated guesses that help us form a clearer understanding.

Firstly, this just makes sense from a policy perspective.  The Article has already summarized the reasons why the old penalty regime could actually have the undesirable effect of encouraging Taxpayers to not submit Voluntary Disclosures so I won’t repeat the point.

An effective Tax Administration has to have a collaborative and trusting relationship with its Taxpayers.  They will never agree on everything but a combative relationship is detrimental to both parties and the country as a whole.  Although communication channels between Taxpayers and the FTA can always develop (e.g. with more public consultations, regular industry meetings, etc.) the FTA will have been aware that the old penalty regime was extremely controversial and Taxpayers were growing increasingly frustrated and angry for being penalized for what they could have considered to be “doing the right thing”.  The new penalty regime addresses the concerns that Taxpayers had and hopefully will result in an improved relationship with the FTA.

Taxes and the approach of the Tax Administration is never the determinative force when businesses are choosing where to operate.  However, it does factor into the decision making process and can make countries more appealing to investors.  The UAE has generally been making moves to encourage overseas investment into the country and the new penalty regime certainly aligns itself with the wider message that the UAE is a business friendly environment.      

Summary

Like many, I believe the new penalty regime is a welcome and much needed positive development for Taxpayers.  I am of the view that Taxpayers should dedicate more resources to tax risk mitigation and should proactively review historic positions, something that I have consistently encourage clients to think about.  I have been concerned from the outset that the old penalty regime inhibited this approach.  

I will be extremely interested to see whether the new penalty regime ultimately results in more Voluntary Disclosures being submitted and subsequently a higher annual Tax collection.  Hopefully, the FTA will perform an analysis in due course and make the results publicly available as it would be nice to see whether the changes that everyone has been pushing for were justified and whether the tax policy theory outlined in this Article actually works in practice.

Disclaimer: Content posted is for informational & knowledge sharing purposes only, and is not intended to be a substitute for professional advice related to tax, finance or accounting. The view/interpretation of the publisher is based on the available Law, guidelines and information. Each reader should take due professional care before you act after reading the contents of that article/post. No warranty whatsoever is made that any of the articles are accurate and is not intended to provide, and should not be relied on for tax or accounting advice.

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