South Africa: VAT Apportionment: An Unintended Penalty?

The stated policy of the South African Revenue Service (SARS) not to make value-added tax (VAT) apportionment rulings effective retrospectively to prior financial years has been questioned on several occasions. The matter was recently considered by the Tax Court in the case of Taxpayer v Commissioner for the South African Revenue Service (VAT2063) [2019] ZATC 2 (15 November 2019) where the Tax Court found in favour of SARS.

The taxpayer in this case provides money-transfer services within Africa, mobile phone credit and bureau de change services. The taxpayer therefore makes both taxable and exempt supplies for VAT purposes and is thus required to apportion the VAT it incurs on its expenses between taxable and exempt supplies.

The taxpayer apportioned the VAT on its expenses but did not have prior written approval for the apportionment method it applied. The taxpayer then applied in its 2017 financial year to SARS for approval to apply an appropriate apportionment method. SARS issued a binding private ruling to the taxpayer in which it approved the application of a transaction count-based (TCB) method. The ruling was made effective from 1 March 2016, being the commencement of the financial year in which the taxpayer applied for the ruling.

The taxpayer requested SARS to make the ruling effective retrospectively to 1 February 2014, which request SARS refused. The taxpayer appealed to the Tax Court against the decision of SARS. The Tax Court found in favour of SARS on the basis that the standard turnover-based method (STB) as set out in Binding General Ruling 16 (BGR 16) was the only ratio applicable to the taxpayer until SARS issued the binding private ruling, and that proviso (iii) to section 17(1) of the Value-Added Tax Act 89 of 1991 (VAT Act) expressly precluded SARS from issuing a ruling that had effect prior to 1 March 2016.

Proviso (iii) to section 17(1) provides that where a method for determining an apportionment ratio has been approved by the Commissioner, that method may only be changed with effect from a future tax period, or from another date which the Commissioner considers equitable, but such other date must be within the taxpayer's year of assessment for income tax purposes.

The issue under consideration was whether proviso (iii) prohibits SARS from granting a ruling to apply an appropriate apportionment ruling retrospectively to prior financial years, or whether a taxpayer is, in the absence of a specific ruling, compelled to apply the STB method for those years even if it does not yield a ratio which fairly represents the extent to which the taxpayer applied its resources for making taxable supplies.

The Constitutional Court in Metcash Trading Ltd v Commissioner for South African Revenue Service & Another 63 SATC 13, stated that to evaluate the cogency of a constitutional challenge of certain provisions of the VAT Act, one must have some understanding of the VAT system, which is sophisticated, and its provisions are numerous and complex. It stated further that the VAT Act is interlarded with many terms of art, some of which are defined, and others bear a special meaning in their context. It is considered that the same approach should be followed in considering the context and purpose of the VAT Act and determining the application of its provisions.

A fundamental and important feature of a VAT system, unlike any other tax, is the entitlement to deduct VAT incurred on expenses from the VAT charged on the supply of goods or services, to determine the VAT payable on the "value added" by the taxpayer in each tax period. Where a deduction is not granted, it impacts on pricing, distorts consumer and producer choices and has a cascading effect (tax is levied on tax). One of the reasons why South Africa replaced its sales tax system with VAT was to eliminate these distortions and the cascading effect of the sales tax system, which did not allow for deductions.

The right to deduct VAT is however limited to the extent that a vendor acquires goods or services for the purpose of consumption, use or supply in the course of making taxable supplies. Where a vendor makes both taxable and exempt supplies, the VAT may only be deducted to the extent that expenses are fairly attributable to making taxable supplies.

Section 17(1) of the VAT Act provides that the extent to which VAT is deductible in these circumstances, is determined by the Commissioner in terms of a binding general ruling or a binding private (or class) ruling. The extent to which the deduction may be made must be determined by the Commissioner on a fair and reasonable basis which fairly represents the application of goods or services for making taxable supplies.

SARS issued BGR 16 in terms of section 17(1), which prescribes the application of a turnover-based method of apportionment. A taxpayer may apply this method without any specific prior written approval by the Commissioner, on the condition that it may only be used if it is fair and reasonable. If it is not fair and reasonable, BGR 16 requires that the taxpayer must apply to SARS to use an alternative method.

A turnover-based method such as the STB method as prescribed by BGR 16 will only yield a fair and reasonable result if there is a constant relationship between every output transaction (taxable or exempt) and the VAT incurred on expenses. It also assumes that the profit margin of taxable and exempt transactions is substantially the same. In practice, this will hardly ever be the case. The only real advantage of a turnover-based method is that it is simple to calculate (K Zacharopoulos, Value-Added Tax: The Partial Exemption Regime).

It was common cause in Case No VAT 2063 that the STB method as prescribed by BGR 16 did not yield a fair and reasonable apportionment ratio, and that the TCB method was a suitable or appropriate apportionment method for the taxpayer's enterprise. Yet the Tax Court effectively ruled that the taxpayer was required to apply the STB method in prior financial years even though it had no resemblance to the extent to which the taxpayer actually applied its resources for making taxable supplies. The Tax Court's decision was based on its interpretation of proviso (iii) to section 17(1).

With reference to proviso (iii) to section 17(1), the Tax Court stated that it cannot be that a vendor who is enjoined to apply to use an alternative method, but fails or refuses to do so, should be placed in the same position as a vendor who applies timeously. However, one of the generally accepted principles of VAT policy is that it must ensure neutrality, i.e. that taxpayers in similar situations carrying out similar transactions should be subject to similar levels of taxation.

Proviso (iii) to section 17(1) applies where a taxpayer applies an approved apportionment method, and then seeks to change such an approved method. Once an appropriate apportionment method has been determined and approved, the taxpayer should apply such method consistently from year to year. Where circumstances change which warrant the application of a different, more appropriate method, then the new method may only be applied from a current date or from the commencement of the current financial year, whichever is equitable. Proviso (iii) does not seem to find application where a taxpayer has never previously applied any apportionment method or has applied an unapproved apportionment method.

The STB method is rarely representative of the extent to which a taxpayer applies its resources for making taxable supplies. Requiring a taxpayer to apply an inappropriate apportionment method seems to be contrary to the overall construct and mechanism of the VAT Act. A taxpayer should not be required to pay substantially more VAT than what is properly levied in terms of the VAT Act, simply because of an omission to timeously apply for approval to apply an appropriate apportionment method. Section 17(1) and proviso (iii) are not intended to serve as penalty provisions.

The application of an apportionment method which does not fairly reflect the extent to which a taxpayer actually applies its resources for making taxable supplies, impacts on the neutrality principle, on pricing and has a cascading effect, which are all best avoided under a VAT system. To avoid a similar situation, taxpayers who make both taxable and exempt supplies are best advised to apply timeously for prior approval to apply an appropriate apportionment method.

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