There has been uncertainty regarding the VAT treatment of options supplied in return for premiums specifically, whether they are exempt or taxable for VAT purposes.
The latest public clarification issued by the Federal Tax Authority (FTA) vide clarification No: VATP014 discusses the VAT treatment of financial options and option premiums.
Option and option premium
A financial “option” gives the holder the right to buy or sell the underlying financial instrument at a specified price.
An “option premium” is the fee received for selling an option.
The seller has the corresponding obligation to fulfill the transaction – to sell or buy – if the buyer (owner) “exercises” the option.
An option that conveys to the owner the right to buy the underlying financial instrument at a specific price is referred to as a call option
An option that conveys the right of the owner to sell the underlying financial instrument at a specific price is referred to as a put option.
VAT treatment of options
Article 42 of the Cabinet Decision No. 52 of 2017 on the Executive Regulations of the Federal Decree-Law No. 8 of 2017 on Value Added Tax governs the VAT treatment of financial services.
Article 42(3) specifies that the “issue, allotment, or transfer of ownership of an equity security or a debt security” is exempt for VAT purposes.
The terms “equity security” and “debt security” are defined in Article 42(1):
- The phrase “debt security” means any interest in or right to be paid money that is, or is to be, owing by any Person, or any option to acquire any such interest or right;
- The phrase “equity security” means any interest in or right to a share in the capital of a legal person, or any option to acquire any such interest or right.
As may be seen from the definitions, debt securities and equity securities include options in acquiring underlying interest and rights. As a consequence, options related to debt securities and equity securities are exempt from VAT in accordance with Article 42(3).
It should be noted that the above treatment does not apply to options in respect of underlying commodities or other non-debt and non-equity instruments – where such options are supplied in return for explicit premiums, they will be taxable in accordance with Article 42(4).
Let us understand options this with an Example
A potential homeowner sees a new development going up. That person may want the right to purchase a home in the future, but will only want to exercise that right once certain developments around the area are built.
The potential home buyer would benefit from the option of buying or not. Imagine they can buy a call option from the developer to buy the home at say AED 400,000 at any point in the next three years. Well, they can—you know it as a non-refundable deposit. Naturally, the developer wouldn’t grant such an option for free. The potential home buyer needs to contribute a down-payment to lock in that right.
With respect to an option, this cost is known as the premium. It is the price of the option contract. In our home example, the deposit might be AED 20,000 that the buyer pays the developer. Let’s say two years have passed, and now the developments are built and zoning has been approved. The home buyer exercises the option and buys the home for AED 400,000 because that is the contract purchased.
The market value of that home may have doubled to AED 800,000. But because the down payment locked in a pre-determined price, the buyer pays AED 400,000. Now, in an alternate scenario, say the zoning approval doesn’t come through until year four. This is one year past the expiration of this option. Now the home buyer must pay the market price because the contract has expired. In either case, the developer keeps the original AED 20,000 collected.
This option will be taxable in accordance with Article 42(4).
Adjustments for incorrect treatment:
Where a supplier has incorrectly treated the supply of exempt options as subject to VAT at 5% before 31 July 2019, they should issue a tax credit note to the recipient correcting the VAT treatment.
Output tax on such options which has been accounted for on a prior VAT return can be adjusted by the supplier in the VAT return for the period in which the credit note was issued, where the supplier can show that it has issued the tax credit notes and passed them on to the recipients to which the VAT was charged.
A recipient that has already deducted input tax related to such a supply and receives a credit note to correct the VAT treatment would have to negatively adjust the input tax in the tax return for the tax period in which the tax credit note was received.