A Conundrum? The VAT Consequences of a PBO Entering into a Joint Venture with a Third Party
20 November 2013
Posted by: Author: Prof Daniel Erasmus
Author: Prof Daniel Erasmus (TRM Services)
A public benefit organisation ("PBO”) is a nonprofit company with members that includes the following objects as set out in its Memorandum of Incorporation: "… to develop technology and materials in support of such objectives...”. The PBO wants to enter into a Joint Venture arrangement with a company ("the Company”) that is able to contribute the skills and expertise "… to develop technology and materials in support of such objectives...”. But it only wants to do so if there are no adverse value-added tax ("VAT”) consequences.
A joint venture is usually a classic partnership which must have the following essentialia to be a valid partnership (the South African courts rely in general on Pothier’s formulation of the essentialia. His formulation was expressed as follows in a well-known excerpt from Joubert v Tarry and Co 1915 TPD 277):
• Each party must bring something to the partnership, whether it be money, labour or skill;
• The partnership must be carried on for the joint benefit of the partners;
• The object is to make a profit; and
• The contract of partnership must be a valid contract.
The PBO in terms of a typical Memorandum of Incorporation approved in terms of section 30 of the Income Tax Act 58 of 1962 ("the Income Tax Act”) is entitled to the payment of an amount due and payable in terms of a bona fide agreement between the PBO and another (in this case the other company partner in the Joint Venture), and to make payment in respect of any legal obligation binding on the PBO. These MOIs do not usually specify what type of bona fide agreement or legal obligation, and as such it can be accepted that this could be a partnership agreement, provided that the objectives of the PBO are not compromised.
Therefore, if a partnership is formed between a PBO and the Company specifically to develop intellectual property where the Company supplies the expertise, and the PBO contributes the funding required, where both partners are entitled to the use of the intellectual property developed, a legitimate partnership would be formed, that would not transgress the objectives of the PBO. What are the VAT consequences: If the partnership makes taxable supplies of goods and services that exceeds R1 million in turnover, then the partnership is a person that must register for VAT purposes separately. But it depends on whether or not that partnership will make supplies that generate turnover from consideration for the supplies. That in turn is affected by the provisions of section 10 of the Value-Added Tax Act 89 of 1991 ("the VAT Act”) where one of the parties receiving supplies in the form of partnership benefits from the partnership, cannot claim an input tax credit if there was a charge for those benefits.
Remember the partnership is structured so that the funds contributed by the PBO will be used to develop the intellectual property, and the Company will provide the skills to develop the intellectual property, as the respective contributions of the partners to the partnership. Both the PBO and the Company will be entitled to use the intellectual property created in the partnership. That is the benefit to each partner. A benefit in specie, and not money or profits in the form of money. Money is not ‘goods’ for VAT, so the supply of money falls outside the ambit of VAT.
With regard to the contributions of the partners to the partnership: the supply of money is excluded from the definition of goods, so any monies made available by the PBO to the partnership as part of its partnership contributions will not attract VAT as it is receiving no supply of goods or services in exchange for its partnership contribution. It has a right to participate in the fruits of the partnership, where it is entitled, for no further consideration, to use the developed intellectual property, as its share of what the partnership produces. The moneys contributed by the PBO will be used in the partnership to pay for any expenses in the partnership for developing the intellectual property using the skills of the Company.
In the case of the Company’s contribution, any goods or services in the form of skills (which are widely defined) made available by the Company in the course or furtherance of its enterprise when making its partnership contribution, will attract VAT if the company is registered as a VAT vendor, and the Company receives consideration therefor. But it is not receiving any consideration. The Company is contributing expertise as its contribution to the partnership in exchange for the right to participate in the fruits of the partnership in the future, for no further consideration, to use the developed intellectual property as its share of what the partnership produces. There is arguably no value attached to that right to participate as it is new and undeveloped.
The one problem into the future is around section 10(4) of the VAT Act, where the entitlement by the PBO and the Company to the use of the partnership’s developed intellectual property may be considered to be "10(4)(a) a supply… made by a person for no consideration…; and (b) the supplier and recipient are connected persons in relation to each other; and (c) if a consideration for the supply equal to the open market value of the supply had been paid by the recipient, he would not have been entitled under (the input tax provisions) to make a deduction of the full amount of tax in respect of that supply, the consideration in money for the supply shall be deemed to be the open market value of the supply…”.
However, the partnership does not need to register for VAT, as it generates no turnover so the problem ends there. But assume that it did generate a turnover exceeding R1 million, and had to register for VAT, the problem becomes a real one for the partner receiving a supply as a partnership distribution for no consideration, where the partner cannot claim input tax credits. A typical PBO in this position would be an educational institution exempt from VAT. Then section 10(4) can become a real problem. This would mean that the PBO, like an educational institution, has to reimburse the registered partnership to compensate it for the output VAT payable on the connected person supply to the PBO at the open market value. As the PBO is not registered for VAT, there would be no input tax and a 14% VAT outflow would arise out of the use of the IP.
However, it is unlikely that the intention of the legislature in respect of the ‘connected person’ section was to go so far as to include as consideration a partner’s share of ‘profits in specie’ where that partner cannot claim input tax credits, where the distribution to the partner is free of any consideration at that point in the transaction. But then, SARS is always looking for new angles of interpreting complex provisions, and there is no guarantee that they will not attempt to apply such an interpretation to these facts. In light of the contentious nature of proposed arrangements such as the one discussed, it is prudent to apply to SARS for a binding or non-binding ruling in terms of Chapter 7 of the Tax Administration Act, No, 28 of 2011 before anything is implemented.
This article was first published in TaxTalk magazine - November/December