VAT and Apportionment - Some Considerations
The South African VAT seeks to tax final domestic consumption, through taxing local private domestic consumption, and removing tax from exports through the zero-rating mechanism (destination-based VAT system). The ideal VAT system is broad-based with no or limited exceptions of supplies of goods or services not subject to VAT. However, certain supplies by their very nature cannot be taxed under a VAT system. These include difficult to tax supplies such as certain components in financial services that do not represent immediate consumption but elements of saving or investment, which should by design not be subject to VAT. These are often subject to VAT exemption, such as advancing of credit (which contains an interest component). Exempt or semi-exempt businesses are effectively treated as final consumers as they are not permitted to claim some or all of their VAT on expenses incurred.
Other supplies not subject to VAT are often referred to as meritorious goods or services, which escapes the VAT net due to socio-economic or other meritorious reasons, although the mechanisms applied by some VAT systems may have had an inverse effect. Using a tax system to achieve non-tax objectives are a contentious issue.
Generally, the full amount of VAT on goods or services acquired locally or imported for the purposes of making taxable supplies can be deducted as input tax. However, if goods or services are imported or purchased locally partly for taxable and other non-taxable purposes (mixed purpose), only a portion of the VAT or notional input tax may be claimed. If goods or services are not acquired exclusively in the course of making taxable supplies, the taxable portion and claimable input tax must be determined.
2 When to Apportion
Before applying VAT apportionment, the first step is to determine whether the expense can be directly attributed to a taxable or non-taxable purpose. Direct attribution means that the VAT expense will have to be attributed according to the intended use or purpose of the goods or services acquired. Direct attribution means that permissible expenses are incurred either wholly for the making taxable supplies, in which case the VAT can be deducted in full or wholly for the making exempt supplies or other non-taxable purposes, in which case no VAT can be claimed as an input tax deduction.
VAT apportionment only applies to expenses that have been incurred partly for the purpose of consumption, use or supply in the course of making taxable supplies and partly for exempt or other non-taxable purposes. If it is clear that the expense must be apportioned, the next step is to calculate the proportion of VAT which may be claimed as an input tax deduction. This is termed the apportionment ratio and is expressed as a percentage. The most common VAT on expenses incurred that needs to be apportioned are general business overhead expenses, bur for certain exceptions.
Table I Direct Attribution and Apportionment
If the goods or services acquired will be used exclusively or wholly for a particular purpose, the VAT on those supplies can either be deducted in full (wholly for taxable supplies), or not at all as it does not qualify as input tax (wholly for exempt or non-taxable purposes). In applying the concept of direct attribution, the manner in which expenses are incurred and the actual application of the goods or services in the business must be examined.
If a vendor only makes taxable supplies, the goods or services will usually be acquired exclusively for taxable supplies, and the VAT may be deducted in full. If the goods or services are acquired for taxable and non-taxable activities (exempt and non-enterprise activities), the first step is to determine whether the expense is incurred wholly for taxable, exempt or other non-taxable purposes.
Apportionment Ratio Calculation
If it is clear that the expense cannot be directly attributed wholly to a taxable, exempt or other non-taxable purpose, the second level of enquiry is to determine the portion of VAT which qualifies as input tax, based on the extent to which the intended use is for taxable purposes. The apportionment ratio must be determined by using an approved apportionment method to produce a fair and reasonable proportion of VAT that can be claimed aa an input tax deduction.
Table II Apportionment Calculation
The only pre-approved method apportionment VAT method, which does not require prior written approval from the Commissioner, is the turnover-based method and may be applied without a specific ruling to use another method. If the turnover-based method is inappropriate as it produces an absurd result, is impossible to use, or does not yield a fair approximation of the extent of taxable application of the enterprise’s VAT-inclusive expenses, the vendor must request SARS to allow a more suitable alternative method. If a specific ruling is granted which is found to be inappropriate at a later stage, the vendor may not revert to the turnover method without a specific ruling from SARS.
In deciding the appropriateness of the turnover method, the vendor must apply a reasonable and common-sense approach. The method must be “fair and reasonable” and properly reflect the manner in which the vendor’s resources (business inputs) are applied to make taxable and nontaxable supplies.
Although the term “fair and reasonable” is a subjective concept, vendors applying the turnover method should aim to be objective to obtain a “fair and reasonable” result, also from the Commissioner’s perspective. The result must also be justified as appropriate in the vendor’s circumstances. If a company applies an apportionment and undergoes a major restructuring, or the nature of the business and taxable and non-taxable supplies change, the vendor must approach the Commissioner to confirm the appropriateness of the current method.
The apportionment percentage should not produce an excessive or extreme result, for example so that either a ratio of 0% or 100% is achieved. If an extreme result is achieved, it may indicative that the formula is inappropriate or applied incorrectly.
The effective date of application of a change in an approved methodology will be within the year of assessment (if the vendor is a taxpayer) or within 12 months ending on the last day of February or the last day of the vendor’s financial year (if the vendor is not a taxpayer), during which the application for the method was made.
de Minimis Rule
If the apportionment ratio (taxable use) is equal to or exceeds 95% of the total use or consumption, the full amount of VAT can be deducted as input tax. The calculation must exclude the value of goods or services supplied in respect of which an input tax deduction was specifically denied. The apportionment percentage should be rounded off to two decimal places.
In effect, the VAT Act mandates 5 steps which should be followed to determine the extent to which VAT incurred on an expense can be deducted.
Table III Apportionment Steps
An apportionment method must produce a “fair and reasonable” result. If not fair and reasonable or inappropriate, the vendor must apply to SARS for an alternative method. Vendors using their previous year’s turnover to determine the current year’s apportionment ratio must make an adjustment (the difference in the ratio when applying the current and previous years’ turnover) within six months after the end of the financial year. The turnover-based method is generally calculated using information extracted from the financial statements. The financial statements may not always specify the information required to accurately calculate the turnover method (i.e. the income statement reflects income comprising of both taxable and exempt supplies or other non-taxable receipts). Vendors should then ensure to keep adequate accounting records to establish the actual value of taxable supplies, exempt supplies and other non-taxable receipts.
A vendor must determine the apportionment ratio for every tax period. It is not always practical to accurately determine the apportionment ratio in terms of the turnover method in every tax period. Vendors are permitted to calculate the estimated percentage using the turnover figures from the previous year’s financial statements, and to apply that percentage to claim input tax deductions in every tax period for the current year. An adjustment must be made for shortfalls or overestimations in the percentage used, when the audited financial statements for the current financial year become available, and the actual percentage can be calculated. This is a practical administrative arrangement and does not alter the provisions of the VAT Act.
New enterprises with no past financial statements, may use an estimate based on expected taxable turnover in terms of the enterprise’s business plan or forecasts for every tax period. An adjustment will still be required within six months of the financial year-end to account for differences between the estimated apportionment percentage used, and the actual extent of taxable supplies as determined from the audited financial statements.
3 VAT Apportionment Methods
Vendors need to assess the appropriateness of various methods of apportionment to ensure equity. Methods of apportionment which, at least, should be considered include the turnover-based method, employee numbers or time-based method, floor space-based method, transaction-based method of apportionment, the varied input-based method of apportionment, or a hybrid of the methods.
The turnover-based method calculates the total value of all taxable supplies as a ratio of total value of all income received. The turnover-based method of apportionment formula is set out in BGR 16. Total income could include taxable income, interest income, dividend income, and other non-taxable income. The turnover-based method is calculated as follows:
Table IV Standard Turnover Method of Apportionment
Other methods of apportionment may be applied if approved by the Commissioner. Some of them are touched on below.
Employee Numbers or Time-Based
To apply the employee numbers or time-based method a vendor needs to determine the number of employees or time spent by employees on income categories. The number of employees or time spent by employees to generate taxable income is then calculated as a percentage of the total number of employees or time spent by all employees. This calculation may be complicated if a vendor’s employees are required to perform services which generate both taxable and exempt income. A further complication that may arise is that employees, more often than not, do not keep detailed accounts of their time spent, which makes it difficult or sometimes impossible to differentiate between time spent on transactions to generate taxable income as opposed to exempt income. The employee numbers or time-based method of apportionment may therefore, depending on the circumstances, not always produce an appropriate and equitable result.
In terms of the floor space method of apportionment, a vendor is required to calculate the percentage of floor space used solely to generate taxable income as a percentage of total floor space. If a vendor’s employees are required to perform activities which either relate to taxable or exempt supplies and they clearly occupy space which correlates to taxable or exempt purpose, the floor space method of apportionment may make sense and could give an appropriate and equitable result.
In terms of the transaction-based method of apportionment a vendor needs to calculate the ratio which the number of taxable transactions bears to the total number of transactions. If the main income streams of a vendor result from activities related to the earning of taxable and exempt income, the transaction-based method could give an appropriate and equitable result. Transaction count could theoretically provide an appropriate and equitable basis to apportion or determine effort to generate taxable as opposed to exempt income but may not always be appropriate.
The varied input-based method of apportionment calculates the VAT on expenses incurred wholly for taxable purposes as a percentage of VAT incurred for taxable and exempt purposes.
4 Problems with the Current Apportionment Provisions
All for one and one for all
Vendors encounter various problems with the current VAT apportionment regime. One of them being the legislator’s approach of “all for one and one for all”, which elevates the importance of the standard turnover method of apportionment as the only pre-approved method of apportionment, and effectively discriminates against other “fair and reasonable” methods.
Conceptual Problems with the Turnover Method
The standard turnover method’s reliance on income or turnover may not always equitably reflect the effort and risk applied in a business and may therefore not always be an appropriate measure to decide the portion of VAT which relates to taxable as opposed to exempt supplies. The turnover method’s inappropriateness could also, for some vendors, be accentuated by economic conditions such as exchange rate or interest rate fluctuations or volatility. An economic down cycle could, for example, reduce income from exempt supplies which, in turn, would release more VAT to be claimed since the apportionment ratio would increase. An intuitive deduction could have it that it takes more effort and VAT to generate lower levels of income, in times of lower interest rates, which is of course illogical. The turnover-based method of apportionment may, as a result, not always give an appropriate and equitable result.
Backdating Method and SARS’ discretion
The turnover method may not always produce an equitable result and would require the vendor to apply to SARS to use a different method. These methods are often only granted with prospective effect, which seems counter-intuitive and unfair, especially if the circumstances of the vendor have not changed.
5 Court Precedent and SARS Rulings
The Courts have often considered the concepts of direct attribution and apportionment for VAT purposes. Two broad tests on direct attribution have developed over the last number of years (especially in Europe), namely the immediate purpose and the ultimate purpose. The immediate purpose test considers the immediate purpose for which VAT on an expense has been incurred to determine the deductibility of the VAT, whereas the ultimate purpose test considers the ultimate intent or effect of the VAT on expenses incurred.
SARS has also issued a number of rulings relating to VAT apportionment and direct attribution. Many of these rulings are industry specific (but for the standard turnover method), Such rulings issued include those to the Banking Industry, Retail Industry, Universities, and Micro-Lending Industry.
6 What Needs to Change
The legislator will need to reconsider its approach to VAT apportionment, including its default to the turnover method of apportionment, and the retrospective application of a different method if it will yield a “fair and reasonable” result. To this extent, National Treasury (and/or SARS) should reconsider its approach to VAT apportionment and, as part of this process, also consider treatment in similar VAT systems such as New Zealand, Canada, Australia, and Singapore, which all operate a worldwide (as opposed to a territorial) VAT system such South Africa. The legislator should also consider levelling the playing fields and publish all VAT apportionment Rulings, even on a no-names basis, which illustrates the different methods granted. This will enhance transparency
7 In sum
The VAT Apportionment regime in South Africa is not always perceived as a fair and reasonable approach by taxpayers and consultants alike and may be due for a complete overhaul.
Dr Ferdie Schneider
082 771 4157
August 23rd, 2019 12:21
~ by Ferdie Schneider ~