It is common for contracting parties to enter into a settlement agreement to settle a contractual dispute. this is often the preferred route where parties want to settle a dispute expeditiously and eschew the financial and time implications of taking a matter to court. Typically, a settlement agreement would involve one party (Party A) paying another party (Party B) in full and final settlement of the dispute. A feature of settlement agreements (to ensure that the dispute is "over"), includes a clause that states that Party B, in return for the payment made by Party A, would release Party A from any and all claims Party B has against Party A.
Where both parties are VAT registered, the VAT consequences of the settlement agreement must be evaluated prior to the parties ratifying such agreement. This begs the question as to whether the payment made by Party A to Party B in order to settle the dispute, comprises "consideration" for a supply made by Party B. If the answer is in the affirmative, then VAT must be accounted for. However, in many cases, the parties fail to take into account the VAT consequences of the settlement amount paid. In other words, the settlement agreement is silent on the issue of VAT. Where the settlement agreement does not stipulate whether the settlement amount is inclusive or exclusive of VAT, the settlement amount is deemed to be inclusive of VAT at the standard rate of 15%, in terms of section 64(1) of the Value-Added Tax Act, 1991.
It follows that the enquiry to determine whether VAT must be levied on a settlement amount received, is whether or not the payment of that amount is made for a supply of goods or services. This involves an interpretative exercise based on the VAT legislation and the surrounding facts and circumstances (which is often encapsulated in the settlement agreement itself). As a general matter, amounts received as compensation for losses or damages suffered are not consideration for any services supplied – these payments fall outside the VAT net. This article does not focus on these types of payments made in terms of a settlement agreement.
Is there a supply?
In line with the impositioning section 7(1)(a) of the VAT Act, there needs to be a "supply" of something (ie, goods or services) in order for the said section to be invoked. Since the South African VAT legislation was modelled on the New Zealand Goods and Services Act ("GST Act"), the principles laid down by the New Zealand courts have had persuasive value in South African courts. South Africa's Supreme Court of Appeal ("SCA") in handing down VAT judgments, has also utilised some of the principles handed down by the New Zealand courts in this regard.
The New Zealand courts have recognised the following important principles:
"....Although services are defined as meaning anything which is not goods, it is still necessary for there to have been a supply of something."
"It is fundamental to the GST Act that the tax is levied on or in respect of supplies. It is not a tax on receipts or turnover; it is a tax on transactions ........."
The term "supply" is widely defined in section 1(1) of the VAT Act to include "...performance in terms of a sale, rental agreement, instalment credit agreement and all other forms of supply, whether voluntary, compulsory or by operation of law,... and any derivative of "supply" shall be construed accordingly". The term "supply" has been interpreted by the New Zealand High Court as meaning "to furnish with or provide".
Based on the foregoing and in consideration of a typical settlement agreement, in return for the payment of the settlement amount, Party B would surrender its right to pursue legal action against Party A. Could it be said that the surrender of a right to pursue legal action is the "supply" of services (assuming there is nothing corporeal or tangible that may connote a supply of goods)? Notwithstanding, the fact that the definition of "services" in section 1(1) of the VAT Act is of wide import and includes "...cession or surrender of any right..", as a starting point, there must be a supply.
Interestingly, the New Zealand Revenue Authority published its interpretation statement regarding the GST treatment of settlement agreements. Where a typical settlement agreement between A and B includes a clause to the effect that B would forebear to sue in the future, such a clause may suggest a supply from a GST perspective. However, for a supply to be taxable, it must first be made in the course or furtherance of a taxable activity. The interpretation interrogates whether there is a "supply" in the form of services from B to A in return for the payment from A as "consideration? In terms of the definition of "services" (ie,"... anything done or to be done including the granting, assignment or surrender of any right or the making available of any facility or benefit but excludes supply of goods or money"), an act of giving up a person's right including a promise not to pursue a legal claim against another person ie, forbearance to sue, is "services".
However, in order for a forbearance to sue to qualify as a supply of services, it must be given in return for a consideration; in other words, there needs to be a nexus/connection between the supply and consideration –this requirement has also been confirmed by the South African Revenue Service ("SARS") who recognised that although the definition of "consideration" is very wide and includes any payment which is in respect of, in response to, or for the inducement of the supply of any goods or services, there must be a sufficient nexus between the supply and the payment for the supply to constitute consideration.
In C of IR v New Zealand Refining Co Ltd, it was held that despite the wide definition of consideration, "there was a practical necessity for a sufficient connection between the payment and the supply". That case concerned a series of payments made by the New Zealand Government to the New Zealand Refining Company, pursuant to an agreement to release the government from an earlier undertaking. The issue that arose was whether those payments were consideration for any supply made by the refinery company. In order to receive the payments, the refinery had to be operational on the date of payment, failing which the only recourse was to withhold payment.
The Court of Appeal noted there was an expectation among the parties that the refinery would continue to operate, but that there was no contractual obligation to that effect. The government's only recourse in the event that the refinery ceased to be operational was to stop making payments. Although the payments were intended as an inducement to keep the refinery open, they were not linked to any identifiable supply. It was held that there were no obligations between the parties as if the refining company failed to meet the conditions for payment, the only recourse to the Crown was to withhold payment. The lack of any element of reciprocity between New Zealand Refining and either the Crown or third parties meant that the payments were received in the course of New Zealand Refining's taxable activity but were not payments made in consideration for any supply by New Zealand Refining.
The New Zealand Revenue Authority is of the view that where the agreement not to sue is merely a mechanism in order for A to ensure finality in the dispute, and does not have a separately attributable sum ascribed to it, there is no supply for VAT purposes. If there is a separate and ascribable value attached to the forbearance to sue, GST would be chargeable.
South African context
Based on the dictum of the SCA, it is noted that the interpretation of statutory provisions (eg, the definition of "supply"; "services"; "consideration", etc) in New Zealand vis-à-vis that of South Africa can be done, as these definitions are similar and have the same functional equivalent as the definitions in South African VAT legislation.
In summary, in order to determine the VAT implications of a payment made in terms of a settlement agreement, one has to unpack the following:
- is there a supply made by the payee (ie, supplier) to the payor (ie, recipient)?
- is the payment received in respect of, in response to, or for the inducement of that supply?
- is the supply made in the course or furtherance of the enterprise of the supplier?
- what is being supplied?
It is manifest that the above analysis would depend on the nature of the settlement agreement and the applicable VAT provisions – the starting, as enumerated, would be to enquire: is there an underlying supply that is linked to this payment? Failure to apply one's mind to the settlement agreement, may result in a loss being realised in the hands of the payee as the payor may request a tax invoice from the payee in order to claim an input tax deduction on the payment made – this is normally when the parties scramble to determine the VAT implications of a settlement amount made; this often results in further costs being incurred and is counterintuitive as this also prolongs the settlement process. Another consideration is that the payee must properly analyse the VAT implications of a settlement agreement owing to the fact that it has to discharge its onus of proving that such amount is not subject to VAT (if that is indeed the case), when SARS enquiries as to the VAT implications of the settlement payment received – failure to do so will, most likely, result in the imposition of penalties by SARS.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.
