ACT: VALUE-ADDED TAX ACT, NO. 89 OF 1991 (the VAT Act)
SECTION 17(1) – APPORTIONMENT
SARS published a new Draft Binding Ruling (version 3) in October 2023 for public comment due by 03 November 2023. This is the second article in a series of articles and will deal with some exclusions of the Ruling.
This BGR prescribes the method to be used in determining the ratio contemplated in section 17(1).
Background
Section 17(1) provides the extent to which a vendor may deduct tax payable in respect of goods or services acquired partly for the purpose of making taxable supplies and partly for some other purpose (for example, exempt supplies, private use, or other non-taxable purposes) is determined by means of a ratio determined by the Commissioner in terms of a ruling contemplated in Chapter 7 of the TA Act (a binding general ruling) or a ruling under section 41B (a VAT class ruling or a VAT ruling).
EXCLUSIONS (a few examples only)
Extraordinary income
Extraordinary income is non-recurring income received due to exceptional circumstances that are unlikely to be repeated.
From a VAT apportionment perspective, extraordinary income would have a significant impact on the quantum of income received by a vendor without affecting the normal expenses incurred year on year. The inclusion of such income in the apportionment formula would therefore severely distort the apportionment ratio as there would be a material fluctuation from one year to another whilst the mixed expenses, and the use thereof in the vendor’s business, would have remained unchanged.
Based on the above, extraordinary income should be excluded from the apportionment formula.
“Extraordinary income” is defined for VAT apportionment purposes as non-recurring income received due to exceptional circumstances that are unlikely to be repeated. An example of extraordinary income is dividends received as a result of a re-organisation or liquidation of a company under sections 44, 46, or 47 of the Income Tax Act.
The value of any goods or services supplied where input tax on those goods or services was specifically denied under section 17(2)
A vendor is prohibited from deducting input tax on certain items listed in section 17(2). These include, among others, the following:
- Goods or services acquired for purposes of entertainment; and
- The acquisition of “motor vehicles” as defined in section 1(1).
In both the above instances, those vendors that do not generally supply entertainment or “motor car” as defined (and are therefore allowed the deduction), would not normally buy and sell the items on a regular basis. The goods or services purchased would be of a capital nature and the subsequent supply thereof would automatically be excluded from the apportionment formula as a result thereof. In addition, it would be inequitable to include the income on the sale of such goods or services (or any indemnity payment received therefrom) where the vendor was originally disallowed (by legislation) any input tax deduction in relation thereto.
Manufactured interest and dividends received by the borrower of a securities lending arrangement
Securities lending arrangements8 are becoming more prevalent as a manner for vendors to make a profit on the buying and selling of securities (which includes equity shares). This means that the borrower borrows the security with the intention to almost immediately on-sell. The borrower may be in possession of the security for a period, however small, before the security is on-sold.
A borrower is required to make manufactured payments to the lender to ensure the lender is placed in the same position had the securities lending transaction never taken place. Should the borrower receive any interest or dividends on the security in the short period that the security is held, such interest and dividends are not really the borrower’s as they must, contractually, be paid to the lender. As the manufactured payments are not included as part of the profit and loss on the trading transaction, any dividends or interest received on these lending arrangements should also be excluded from the formula by the borrower.
The lender of the securities must include the manufactured interest or dividends received from the borrower in its apportionment formula as follows: Manufactured interest/dividend × (prime rate − JIBAR)
The sale of a capital asset
The VAT incurred on capital expenditure is generally deducted as a once-off at the time when a vendor acquires the said asset. Although the asset is used throughout the trading process, it is not one of the resources that, on an ongoing basis, forms part of the pool of expenses that are subject to the apportionment ratio. It is also accepted that vendors earning trading income are not in the business of selling off their capital assets on an ongoing basis, as that would be un-business-like and would severely influence the ability of the vendor to continue trading. Therefore, the sale of capital assets is generally an extraordinary event that is not expected to occur continuously.
With regard to the extraordinary nature of the sale of capital assets together with the possible substantial values attached thereto, the inclusion of the income earned on the sale of capital assets in the apportionment formula would distort the apportionment ratio in that it would not fairly reflect the use of those resources to which the apportionment ratio is applied.
Due to the significant costs involved in acquiring capital assets, it may be necessary for vendors to determine whether an alternative apportionment method is required for specific capital assets. The vendor must evaluate the specific circumstances and intended use of the capital asset to determine the most appropriate method for the specific asset and, if need be, apply for an alternative method.
What is a capital asset?
In short, a capital asset is an asset that enables a vendor to trade but is not the trade itself.
Consider a vendor selling ovens. To this vendor, the ovens are the trade itself and therefore constitute trading stock which is not capital of nature. However, should a bakery buy the oven, the oven enables the bakery to produce baked goods; the baked goods being its trade. To the bakery, the oven is a capital asset.
The circumstances of each case must be evaluated to determine the nature of a specific asset.
The most important factor to consider is the intention of the vendor when acquiring and subsequently using the asset. As intention is a very subjective test, various factors must be used to determine and substantiate that intention. Some factors that may assist in determining whether an asset is capital in nature, are as follows:
- Trading stock is not a capital asset.
- The asset is held with a certain degree of permanency.
- Linked to the above, the asset is held for a lengthy period of time. Although this test is not conclusive on its own, it could be convincing when deliberated with other factors.
- The type of asset is not commonly bought and sold by the vendor on a regular basis.
- An asset that stays mostly intact, and which is rather used to produce wealth.
The distinction between trading income and income of a capital nature is not a new concept in tax and has been the subject of various disputes and court cases over the years. Chapter 2 of the Comprehensive Guide to Capital Gains Tax provides in-depth examples and discussions on how to distinguish between income and capital. These principles can also be applied as guidance in determining whether an asset is capital in nature for VAT apportionment purposes.
Interest
- Earned from the vendor’s current account (meaning, the account used for day-to-day business operations)
It would be difficult for any business to function without a bank account used every day to both receive and make payments. The vendor’s intention when opening a transactional bank account is therefore never to earn the interest thereon, but rather to facilitate transactions within its business. The income in this account is generally a result of payments received from third parties or customers as a result of trading activities and not investment activities by the vendor.
As the interest rates on a transactional account are very low, businesses rarely hold money in a transactional bank account to earn interest. A vendor would rather transfer any excess funds to a call or similar account where the interest rates are much higher. The business decision to effect such a transfer reflects a vendor’s purpose of earning investment income in the form of interest. It is for this reason that any interest earned from a call or other investment account is included in the apportionment formula.
- SARS Interest.
A third article will deal with the application of the amendments to the apportionment formula.