The Belgian Carat Tax: Can New Fiscal Regime Trigger Industry Climb to Prosperity – or Did It Come Too Late?

Finance and Trade
28/09/2016 08:49

By Chaim Even-Zohar. Reprinted from Diamond Intelligence Briefs by special arrangement. Read the second part of this article here.

During the last century – and still today – the principal cause of friction between diamond traders and their governments has been the equitable collection of tax. This is because tax administrations have almost universally failed to develop and institutionalize the human capacity to value the diamond inventories of the taxpayers.

Dubious Tax Regimes

Inevitably, governments experimented with a myriad of taxation regimes condoning tacitly agreed “creative accounting” schemes. This has resulted in mostly low-profit or no-profit financial reports. Over time, as manufacturing and trading margins have unfortunately disappeared, this was largely met with governmental disbelief. 

The dubious tax regimes, necessitating some degree of creative accounting, ultimately led to a corrosion of the diamond industry’s relations with bankers – causing a problematic financing environment aggravated in the Basel II/III era, as audited financial reports became the dominant factor in credit decisions. Regulators prohibited banks from accepting a “private statement,” which would supposedly sketch the “true situation,” in lieu of the duly signed financial report.

The establishment of an inventory figure at any given time is challenging to anyone. This especially holds true in a volatile market, in which diamond prices may fluctuate by double-digit percentage figures in either direction. Inventory has increasingly become a very poor indicator for drawing conclusions on a profit or loss account. At the end of the day, the true value of any diamond can only be established at the point of its final sale. Not a day earlier.

The Belgian government has frankly admitted that the current tax regime in its diamond sector cannot be continued. The regime, based on the Fiscal Plan designed in the 1990’s, sets gross and net margin minimums and is supposedly used for “situations where it is not possible to carry out the standard invoicing and inventory-follow up technique to trace individual stones through the commercial process,” according to the relevant European Commission (EC) documentation.

“According to Belgium, the application of the normal tax rules for the establishment of the tax base, including the use of the Fiscal Plan, is cumbersome for the tax administration and inefficient to combat fraud,” says the EC. The “creative accounting” is the direct result of the diamond sector’s desire to meet the tax administration’s “minimum thresholds in terms of gross margin and in terms of net profits that a relevant diamond trader is expected to generate.”

The government realized and recognized that “forcing” diamantaires to “adjust” their annual reports to meet pre-set benchmarks leads to some degree of fictitiousness in financial reports. It may lead to excesses and – mostly – it makes diamantaires vulnerable. In Belgium, there was a de facto situation in which tax inspectors (or police agents for that matter) could randomly walk into any diamond establishment and “find something.” Both industry and government realized that a dramatic overhaul of the tax regime had become an existential issue for the Belgian diamond sector.

The Government’s Tax Decision(s)

The Belgian government has mustered the courage to call “a spade, a spade.” Its honest admittance that its system doesn’t work has far reaching social, legal and economic consequences. The government deserves a lot of respect for frankly acknowledging this state of affairs. It realized that the uncertainties, namely, the legal vulnerabilities to which the system exposed the diamantaires, would lead to the demise of the Belgian diamond sector.

The choice confronting government and parliament was simple: do we or don’t we want a diamond sector? Consciously, the decision was made to create a productive legal and fiscal environment – which would give impetus to renewed growth of the diamond sector. It might bring home companies that left for overseas tax havens.
Through the Carat Tax regime, the government does something that has never been done in the history of any diamond trading center: it broke the umbilical cord between the duly audited financial reports of the diamond companies and the essential parameters in the filed tax returns. This puts an end to “creative accounting”. Every financial report can now meet the highest international standards – without compromises, adjustments, or whatever.

This is what the banking regulators require as a precondition to financing. A highly profitable firm with an impressive equity base will have no incentive – nor will it feel required – to produce figures in line with government expectations. To the contrary: they are incentivized to exceed government expectations.

Gross Profit Margin Fixed as 2.1% of Sales Turnover

How does this work? Belgium’s government decided that the one figure that could be established (and audited) with finality – the sales turnover – would become the basis to assess the tax of every diamond trader and manufacturer. In order not to have to value inventory and not to inspect the cost of sales, it decided that the gross profit margin (GPM) – corresponding to the difference between the sales (turnover) and the direct cost of goods sold – will become a fixed percentage of 2.1% for all wholesale diamond traders. This decision is actually for every trader who sells from his own inventory, irrespective of his business model (consequently specifically including manufacturers and excluding commission brokers).

Thus, the cost of sales are set in advance – irrespective of what the annual report says. This means no creative accounting or fictitious adjustments. Even if your gross profit margin is 15% (utopia!), for tax-return purposes, one can insert a figure equal to 2.1% of sales. Therefore, there is no need for tax inspectors to examine the books. Essentially, when filling out tax returns the “cost of goods” which appears accurately in the audited annual reports will be substituted with a figure equaling 97.9% of the “goods sold” (turnover). Other taxation requirements, such as recognition of certain deductions, etc., remain (almost) fully in force.

In complex tax regimes, the devil is in the details. The proposed Carat Tax, which was first introduced in early 2015, has been debated, researched, subjected to simulations, and fine-tuned for well over a year. In the final version, the initial “bottom line” remained the same, though the methodology has been changed from a lump sum of 0.55% of turnover to the current 2.1% one, because the European Commission asked the Belgian Government to do so. (To be precise: only in fiscal 2017, it will be 0.65% on a one-time basis).

If companies reach the floor of 0.55%, they pay the same as under the “first” mechanism.  The changes were solely cosmetics to pass the European Commission’s state aid scrutiny criteria. The law enacted a year ago by the Belgian parliament will be modified slightly by another law that will be adopted by Parliament soon. It represents a tax regime that meets every conceivable situation occurring in the ordinary diamond and trading business of bona fide Belgian diamond traders.

Sure, new systems are often dismissed with an attitude of “it won’t work.” This time it is different. After spending weeks familiarizing ourselves with the details, we realize that this tax regime most probably will work. The only question is whether it came too late for Belgium. Is it too late for the country’s diamond center to resume its flourishing and future growth?

Predictability and Transparency Guaranteed

The Carat Tax Regime aims at uniformity and clarity. Essentially, to optimize tax collection from the diamond sector, the Belgian government opted for a presumptive tax. A “real system” of business income taxation is based on actual income less expenses. Meanwhile, presumptive tax regimes imply procedures under which the desired tax base is not itself measured but is inferred from some simple indicators (turnover, assets, number of employees, output, etc.), which are more easily measured than the base itself.

Generally, such a method is only adopted if there is no efficient and cost-effective way to establish a firm’s taxable gross profits in a more precise manner. The situation in Belgium’s diamond sector could not be described any more accurately. Moreover, there are several economic sectors in Belgium in which presumptive taxes are applied – this way of tax collection has proven itself over time in the country.

The industry had become exposed and defenseless; it actually operated at “the mercy” of law authorities. The massive migration by Belgian diamond companies to places like Dubai, Israel, India, Switzerland, Luxembourg, Monaco or elsewhere was largely motivated by the uncertain fiscal and related law enforcement environment. No business can responsibly implement long-term business strategies in these conditions.

The Belgian government has now made a U-turn, and the entire Carat Tax Regime is premised on a number of key realities:

Transparency. The annually audited Financial Reports may accurately reflect the profits (or losses) realized. All cost-of-sales expenses can be accurately recorded. Growth in inventory values can be truthfully recorded. Growth in equity (“bringing money home”) can all be reported. None of these factors will impact the tax return that has to be filed. No reason to “adjust books” in a fictitious manner.

Predictability. The predetermined 2.1% gross profit margin is guaranteed not to be changed for 5 years. The bill states that the percentage should be reviewed at least every five years. Another future government coalition (in 2019 or thereafter) could review the percentage without issues. This is a political/strategic deliberation. The mechanism on how to change it, if it will be changed, has already been agreed.

Clarity on Deductibility. There are a wide range of costs (which don’t belong to the cost-of-sale category) that remain deductible from the gross profits. Bad debts, financial costs, all other allowable exemptions, notional interest reductions, administrative expenses, carrying over of losses incurred in the past, or other costs (with a few exceptions). However, if these downward adjustments lead to a net-profit-before-taxes figure lower than 0.55% of sales, the excess deduction will simply be disallowed. Of course, write-offs on inventory can no longer be deducted, and so are some other items.

Integrity of Participants. The “danger” of the rather attractive new regime is that pseudo-diamantaires or outright criminals will infiltrate into the Belgian diamond arena, establishing new companies that show rapidly huge turnovers, enormous inventories, high equity – out of nowhere. They would turn Belgium into a huge money-laundering center. To avoid that, the law has introduced a concept of a “genuine and habitual” diamantaire. Income derived from a non-bona fide player will not be eligible for Carat Tax treatment, but will be taxed on the actual income generated.

No Preferential Treatment to Diamond Sector

It’s not that the diamond sector gets “special treatment.” Under the proposed Carat Tax, diamantaires pay corporate and personal income tax at the normal rates of tax on their net income. The common corporate tax rate in Belgium is 33.99%, but under certain conditions (e.g., if more than 50% of the shares are held by individual shareholders and the company’s taxable income does not exceed €322,500), a reduced progressive rate starting at 24.98% applies. After applying the various deductions, the actual amount of tax money payable by diamond firms will be between 0.14% - 0.19% of turnover, though one may assume that most companies will report well above the minimum.

This seems “low.” But, in reality, it will almost triple the total amount of taxes annually collected from the diamond sector. Simulations by Deloitte Accountants demonstrated this to the Belgian government, Parliament and the European Commission. The promise of a substantially larger tax income, while greatly easing the tax inspection mechanism, was genuinely seen by the politicians as a good deal. 

From a national perspective, the Carat Tax is not really a separate tax regime. It aims to solve the governmental inspection difficulties. It also intends to introduce an approach that provides increased simplicity and establishes a secure, predictable, stable and productive taxation environment for the diamond industry.
The diamond industry has accepted the increased tax burden. Several members of Parliament were actually very suspicious of the fact that the diamantaires were willing to accept the deal. This demonstrates the “distrust” between the diamond sector and the political echelons.

The tax authorities cannot change any of the essential provisions at will. This will need both governmental and Parliament approval. For example, any change in the 2.1% gross profit margin can only be modified by virtue of a law amendment. This percentage was based on a benchmarking study by Deloitte Accountants. In the future, the government can ask Deloitte or any other accountancy firm to update the benchmarks; this will then become the basis of any future reassessment.

The Concept of Mandatory Presumptive Taxation

Presumptive taxation constitutes a well-established tax-revenue-raising instrument in the international taxation firmament. A recent OECD survey on the taxation of enterprises provides evidence as to what extent such approaches have found their way into tax codes of both developing and OECD member countries. Indeed, the search for tax simplification and the fight against tax evasion have led to ever more presumptive schemes – also in European countries. In most instances, these mechanisms are agreed with professional industry bodies. They are of a semi-voluntary nature in the sense that an “opt-out” option generally exists. (In many instances, a subsequent “opt-in” option is generally limited, or not possible at all.)

The Carat Tax, however, is mandatory. All manufacturers and traders in Belgium, who are licensed as diamond traders with the Ministry of the Economy, must report to the tax authorities in accordance to this regime. It’s for licensed traders only. Brokers are, in most instances, excluded, which we’ll further discuss later. Organizations (such as laboratories, machinery equipment producers, banks, the Antwerp World Diamond Centre (AWDC), etc.), which for legal reasons are also licensed as traders, are, of course, also excluded. Only mining companies selling rough in Belgium have the option to opt-in to the Carat Tax regime. 

Let’s be precise. This option applies to sales offices of mining companies that are part of a group of companies that operate kimberlite or alluvial diamond mines. These companies are excluded because they don’t really hold inventories – and they don’t fall into the problematic category of companies that are “difficult to control” from a tax-authority perspective. However, if they choose, they have the option to join the Carat Tax Regime.

Manufacturing Costs Are Not Tax Deductible

It is fair to say that there are hardly two diamond companies alike – but the 2.1% gross profit yardstick applies equally to all. Is that fair? Doesn’t that give manufacturers, who generally have a greater margin, a hidden benefit? After all, the manufacturing of rough and the maintenance of a significant workforce will add significant value to the diamond manufacturer, and, surely, his gross margin must be considerable larger.

The architects of the system have considered that and found that when the manufacturer sells the finished polished, his trading margin is similar to other traders. The manufacturing costs are an essential part of the costs of sale. When these costs are added to the purchase price of the rough, the difference between cost (rough plus manufacturing costs) and sales are comparable to the trading norms.

For that reason, manufacturing costs are not an allowable deduction. To avoid doubt, the fine print of the Carat Tax Regime defines the non-deductible items, which include all wages of workers, costs of polishers, cleavers, sawyers, the costs of chemicals used, of scouring (sanding) the scaife, rentals of polishing equipment, depreciation of plant equipment, etc. In fact, the financing cost of the acquisition of plant equipment is not deductible. Also, when a manufacturer gives rough to an independent contractor (or is otherwise outsourcing the manufacturing), the costs are not a recognizable expense. As we said earlier – the devil is in the details. Things have been thoroughly worked out.

Brokers Are Like Any Other Professional Tax Payer

The Belgian government resorted to presumptive taxation to remedy its inability to value diamond inventory. Diamond brokers (agents), whose income is derived from commissions, don’t own inventory. It is specifically stated that a trader to whom the Carat Tax Regime applies must sell from his own stocks. Brokers receive commissions, fees or other remuneration for providing a service to a third party – the owner of the goods. The broker falls within the general tax system in Belgium, and will pay the tax on his earnings just like anyone else.

Sometimes a broker decides to actually purchase a parcel and then invoices the buyer. This would be a transaction that would fall under the Carat Tax. The law allows the following: a diamantaire may also have other income, not derived from the sale of diamonds, and that income is taxed normally. The same counts for brokers.

In the still rather secretive trading environment where, for valid commercial reasons, the owner of the goods doesn’t want to disclose his identity to the buyer, there may be instances in which the broker may issue an invoice in his own name – even though he doesn’t own the goods or sell from his own inventory. He basically “collects” the money on behalf of the owner as part of the service. The law has specifically addressed this situation as well.

In such an instance, the broker can write on the invoice the notation “diamond invoice issued on behalf of undisclosed principal,” or something similar. He will end up paying the normal tax on his commission, which, for this purpose, would be the difference between the buying and selling invoices. (The parties involved must, of course, ensure that in such a transaction the KYC-requirements of the AML/CFT laws are being kept in mind.)

Minimum Tax for One Director or Owner – Natural Persons

One of the hottest issues in any diamond-trading center is the so-called “minimum tax” of the principal in the company (i.e., the salary or income of the owner). It can also apply to the owner in case the legal status of the business is that of a personal trader and not a company. In Belgium, the government already annually publishes a table of minimum income that must be reported by at least one director or individual in a company. This will remain applicable. [See box on applicable amounts.] However, in the “natural person” business, in which the diamantaire is an independent trader, his reported income cannot be below 0.55% of the business turnover. And if he actually earned less? In that scenario, a certain amount of his business expenses will be disallowed as deductible. He will also end up paying more tax – even though his financial reports clearly state a lower income. That’s the system.

In Conclusion: Common Sense Prevailed

The Belgian government clearly acted to remedy some serious ills. The diamond industry today is different than what it was just a decade ago. The government faced the emergence of large multi-national enterprises in the downstream diamond business.
This is a relatively recent development that received added impetus in the early years of the present decade, when De Beers introduced its Supplier of Choice (SOC) rough marketing mechanism. SOC encouraged – maybe even demanded – vertical integration of the Diamond Trading Company (DTC) sightholders. It “forced” (or cajoled) clients to set up factories in the so-called beneficiation countries.

Rough diamond allocations, which hitherto had been specifically earmarked for trading and manufacturing in certain geographic locations, could now be processed or delivered in countries where the sightholders found it economically most advantageous to do so, mostly Thailand and China, alongside India and the traditional centers. In the case of supplies for trading, we saw the rise of tax-free environments, such as the tax free zones in Switzerland, Dubai, Hong Kong, Singapore, and elsewhere.

De Beers – and then-Chairman Nicky Oppenheimer personally – promoted the rise of the Dubai tax-free rough diamond trading center. The company had both altruistic and selfish reasons for doing so. The dominant rough supplier (followed by others) provided stewardship in a globalization process. On the one hand, it wanted a transparent industry, following best practices also in the fiscal and financial areas. It’s not difficult to be transparent in a zero-tax environment. On the other hand, as some correctly observed, if rough buyers don’t pay taxes, the rough supplier can charge higher prices….  Tax had become a profound competitiveness and competition issue!

Even if that was never officially admitted – the results speak for themselves. The margins left in rough trading minimized and, at times, even disappeared. As it was historically always the world’s largest rough diamond trading center, Belgium was hit more than any other diamond market. Fiscal challenges were further aggravated when transfer-pricing issues arose, which, artificially, would create a sense of international competitiveness for Belgian diamond companies. The pre-Carat Tax regime backfired. Dozens of criminal and civil court cases in recent years are testimony of only some of the non-intended consequences. 

The Belgian government, rather belatedly one might say, realized that it had become imperative to revise its diamond taxation policies. It saw the need to create a fiscal environment that can effectively “combat” the international tax competition faced by Belgian diamond companies. At a minimum, it could try to approximate a fair, level playing field – to give the country’s diamond industry a chance to stay on the map. It has now done so – in a most remarkable manner. Common sense has prevailed – now it’s up to the industry to prove that it hasn’t come too late. 