How VAT will be applied to UAE free zones is yet to be decided by the new law

A decision on these has been delegated to the Executive Regulations, probably in the fourth quarter

Dubai is the most expensive city to buy a coffee, coming in at $5.70 a cup, according to UBS. Fredy Builes / Reuters

Articles 50 to 52 of the freshly released decree that is the UAE VAT Law covers free zones under Designated Zones.

A decision on these has been delegated to the Executive Regulations, which will probably appear in the fourth quarter of 2017

Free zones in the UAE have been an extraordinary success. The concept has encouraged a substantial migration of commercial skills into the country and complimented the exploitation of the region's natural resources. It has also brought a balance to the economy that has supported the development of the broader onshore economy.

That the UAE experiences the same peaks and troughs that are ubiquitous in older economies is testament to the normal functioning of local markets. More prevalent than the turning of the wheels of the economic cycle is change, which is coming in the form of VAT.

While the treatment of free zones is undoubtedly a contentious issue, today, using the example of a coffee shop, I want to present some options that might resolve a key element bedevilling the finalisation of the national VAT Law.

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Let’s sit for our coffee and consider what a world where all the UAE’s free zones are VAT exempt looks like. Which coffee shop do we visit? Maybe the one that sits a street just outside the free zone boundary or the one that is located just inside it. The former would charge 5 per cent VAT on our bill, the latter no VAT.

Let’s assume that our two neighbouring coffee shops are part of the same chain. Unlikely? Not really. Franchisees are typically contracted to open a total target number of stores or risk being in breach and losing, what is in consolidated form, a profitable business. Sometimes this means accepting an element of customer cannibalisation due to an overlap in its retail catchment areas.

How can we measure the demand elasticity of coffee consumers? We could look at the average monthly sales of the two outlets before and after the launch of VAT on January 1 2018. The rational approach would expect to see sales collapse in the VAT zone as these customers walk the extra five minutes into the VAT exempt zone, saving 5 per cent on their bill.

The measure of the change in demand between the locations would be a measure of the price sensitivity of coffee customers. Taking Dh20 as a price for a coffee, the additional cost would be Dh1. Some would argue that customers are blind to a variance of a single shiny coin. But this raises a better question: does an upward shift in demand in the VAT outlet reflect a strengthening economy? Probably. In the retail sector, you do not count the persons in a mall, you count the bags carried.

More concerned than a coffee customer or the coffee shop owner is the outlet's landlord. In the UAE, it is unlikely each location will have different ones. Facing a competitive marketplace that just handed a pricing advantage to competitors one street away, rents sought are likely to come under downward pressure.

Free zones are usually encircled by an onshore environment. For onshore landlords, the free zones just became the healthy part of a ring doughnut. As I said in the opening, the objective of these zones was to support the development of the onshore commercial environment. There is the potential that VAT might choke flourishing areas on its borders.

I can conceive three responses that address our coffee problem. While all are possible, I imagine the majority of readers will come to a similar solution to the question of how to treat free zones for VAT.

Solution number one would make all retail outlets in free zones charge VAT. Coffee now costs the same everywhere. Retailers and landlords would warmly welcome this levelling of the playing field. However, non-retail businesses in the free zone would be confused and likely furious.

It is difficult to see how the purchase of a coffee could in any way be seen as a cost wholly and necessarily incurred in the conduct of their business, so the VAT could not be reclaimed by a registered entity. Again, on and offshore are in the same position. Say, next door to the coffee shop is a computer retailer. The offshore entities are about to get angry.

Now charging VAT, offshore purchasers cannot reclaim the VAT, whereas the same chain selling the same product from onshore will not charge those entities VAT as it would be considered an export. We have moved from onshore people going offshore to buy coffee to offshore entities going onshore to buy supplies.

Solution number two would be to fence all the free zones. With the competitive landscape now even on both sides of the fence, businesses and consumers alike can be content.

The government’s infrastructure agencies might not like this proposal. The rest of population would follow once the building works began and years of road closures and rerouting commences as the country’s transport master plan is trashed and work begins on a new national strategy.

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Solution number three would be a middle ground. Where the freezone is already fenced, then this would be exempt for VAT purposes. Where it’s not, VAT would apply. This would cause some whining among businesses, which are likely to reach for the free zone’s prospectus that promised tax would never apply.

It might be a stretch for the Federal Tax Authority [FTA] to say that by tax they meant tax on profits or income. As sales tax is to municipality fees, one might argue VAT is to sales tax.

A situation where arbitrage enters the UAE is good for no-one. Preventing this would mean organisations ceding some of the commercial comforts that had been afforded in the past.

Maybe this is the time for the UAE to begin, what should be a lengthy, unwinding of the unfenced free zones. DIFC now facilitates, in restricted circumstances, the ability to trade both on and off shore. I suggest this approach as freezones have succeeded in their original purpose.

David Daly is a chartered accountant (Cima) who leads a consultancy practice in the UAE