Zero-rating of certain services – Legislative oversight: a hiatus between goods and services?
13 April 2015
Posted by: Author: Seelan Moonsamy
Author: Seelan Moonsamy (ENSafrica)
Seelan Moonsamy argues that legislature should
consider introducing a provision similar to section 11(1)(q) into the ambit of
section 11(2), to address the current shortcomings of the VAT treatment of
so-called loop transactions.
South Africa operates a destination-based VAT system, which means that
exports are zero-rated and imports are subject to VAT at the standard rate of
14 per cent. The upshot of the destination-based VAT system is that it is
designed to tax the consumption (in economic parlance) that takes place in
South Africa. The destination principle also ensures that there is no double
taxation in the sense that the taxing jurisdiction is the one where consumption
of the goods or services takes place.
Neutrality is also an important part of the design of the VAT system.
This is because vendors receive credits for business inputs and the final
consumers of the goods and services bear the tax. It follows that only
registered vendors are entitled to claim input tax deductions for business
inputs; foreign persons that are not registered as vendors in South Africa are
not entitled to claim an input tax deduction for business inputs. However,
foreign persons receive relief in the form of a zero-rating of certain supplies
made to them. More specifically, some countries operate what is commonly
referred to as a business-to-business ("B2B”) relief mechanism in order to free the
VAT that would have been borne by the foreign persons, when trading with
vendors in those countries.
South Africa has espoused the B2B concept, albeit in a minimalistic
manner. The Value-Added Tax Act (No 89 of 1991) ("the
VAT Act”), has limited instances
of this B2B concept, for example, section 11(1)(q) deals with the zero rating
of the so-called "loop transaction”. In terms of section 11(1)(q) of the VAT
Act, a supply of goods would be charged with tax at the rate of zero per cent
- the goods are
supplied by a vendor to a non-resident not registered for VAT in South Africa;
non-resident contracted with the supplying vendor to deliver the goods to a
recipient in South Africa who is registered for VAT;
- the delivery
of the goods to the local recipient forms part of the supply of the goods by
the non-resident to the local recipient; and
- the goods are
acquired by the local recipient wholly for the purpose of making taxable
The supplier will therefore invoice the non-resident with zero per cent
VAT for the goods delivered to the local VAT registered recipient.
Section 11(1)(q) was introduced into the VAT Act in 2005. The policy
rationale behind the introduction of section 11(1)(q), according to the
Explanatory Memorandum ("EM”) to the Revenue Laws Amendment Act,
"…to ensure that VAT is not a cost to a
client who is a vendor, who contracts with a foreign company that is not a
resident of the Republic and not a vendor”.
Prior to the introduction of section 11(1)(q), the local supplier was
obliged to charge VAT at 14 per cent on supplies made to a non-resident, and
the VAT charged would not be recoverable as input tax by the non-resident;
ultimately this non-recoverable input tax is passed on to the local client of
the non-resident; the introduction of section 11(1)(q) led to the supply by the
local supplier to the non-resident being charged with tax at the rate of zero
per cent, thereby eliminating the cascading effect of the non-recoverable
What about services?
Although the VAT Act differentiates between "goods” and "services”, it
provides for parity of treatment of goods and services (or does it?). A case in
point is that the legislature has not mirrored the "loop transaction” that
exists for goods (as illustrated above) with a "loop transaction” for services,
under section 11(2) of the VAT Act. This is best illustrated by way of example.
Foreign HoldCo (a non-resident) enlists the services of a local service
provider (a VAT registered company) to provide executive payroll services to Foreign
HoldCo’s subsidiary company in South Africa, which is a fully taxable vendor.
The local service provider invoices Foreign HoldCo for the executive payroll
services rendered to its local subsidiary, and Foreign HoldCo in turn charges an
administration fee to its subsidiary to recover, inter alia, the payroll charge.
The scenario depicted above is a veritable issue that has not been
addressed by the legislature; it fits the characteristics of a "loop
transaction”, with the only exception being that the underlying supply is a
supply of services and not goods. In order for the supply by the local service
provider to qualify for zero rated relief, the supply must fall into the ambit
of section 11(2)(ℓ) of the VAT Act (and not be caught by any of the
exclusions contained therein).
In terms of section 11(2)(ℓ)of the VAT Act, a supply of services to
a non-resident would be charged with tax at the rate of zero per cent –unless
the services are supplied directly:
- In connection
with fixed property situated in South Africa; or
- In connection
with movable property situated in South Africa at the time when the services
are rendered, except where the movable property:
- is exported
to the non-resident subsequent to the supply of the services; or
- forms part of
a supply by the non-resident to a VAT registered person and the services are
supplied for the purpose of such supply to the person; or
- Either the
non-resident or the recipient of the services is present in South Africa when
the services are rendered.
The supply of the executivepayroll services in the above examplemay have
qualified for the zero-rating as the services are supplied to a non-resident, but
for the exclusion where the recipient is in South Africa at the time the
services are rendered.Prior to 1994, section 11(2)(ℓ) simply provided for the zero rating of services supplied for and to a
non-resident and who is outside South Africa at the time the services are
rendered. In 1994 the exclusion was introduced that provided that if the
services are rendered directly in connection with movable property situated in
South Africa when the services are rendered, the zero rate does not apply.
According to the EM to the Taxation Laws Amendment Act, 1994, "The application of the standard rate to the
supply of services to foreigners where the goods are in the Republic, has lead (sic)
to criticism, especially in view of the
fact that it negatively affects South African vendors’ international
As a result of the above criticism, the legislature introduced an
exclusion to ensure that where movable property is supplied by a non-resident
to a South African registered vendor (the customer of the non-resident) and
services are supplied by the local supplier to the customer as part of the
supply of the movable property by the non-resident to the customer, the supply
of the services may be zero-rated. The operation of this exclusion resulted in
South Africa’s competitiveness being improved from the standpoint that a
non-resident who transacts with a South African vendor is no longer required to
pay VAT at the rate of 14 per cent on supplies of services received in
connection with movable property situated in South Africa; further, the value
for the South African customer is that any price charged by the non-resident
does not effectively include VAT that is not recoverable by the non-resident.
Regarding the provision of the executive payroll services as in the
example above, the exclusion does not find application as the executive payroll
services are not tied to movable property and therefore these services are
subject to VAT at 14 per cent, which the non-resident cannot recover.
Where to from here?
The legislature has recognised that the competitiveness of South
African vendors supplying services to non-residents (in a loop transaction) is
an important issue as tax cascading would take place if the non-resident
ultimately passed on its VAT cost to the ultimate recipient of the supply in
the form of higher prices. The pragmatism of this arrangement is that the VAT
should not be a cost in a B2B transaction, if the recipient of the supply is
fully taxable and would be entitled to claim an input tax deduction for
business inputs. Stated differently, if the non-resident was excluded from the
transaction and the local service provider were to provide the executive payroll
services directly to SubCo, a fully taxable vendor, the VAT levied would be
fully claimable by SubCo (thereby ensuring that B2B transactions are neutral
for VAT purposes).
The legislature has for some arcane reason not replicated the zero-rating
in the loop transaction scenario (under section 11(1)(q)) for a comparable
supply of services; this has created an uneven playing field between goods and
services, typically in support services where a foreign holding company is
typically in a better position to negotiate cheaper services for its
subsidiaries, owing to its bargaining power. This, inevitably, leads to a
destruction in value for the subsidiary company as higher prices may not
necessarily denote better quality.
Finally, the Organisation for Economic Co-operation and Development ("OECD”) has championed the neutrality concept for VAT in the B2B scenario.
The OECD issued a guideline which stated that with respect to the level of taxation,
foreign businesses should not be disadvantaged or advantaged compared to
domestic businesses in the jurisdiction where the tax may be due or paid. The
OECD stated further that the application of the principle that VAT should be
neutral and equitable in similar circumstances to international trade, implies
that the VAT system should not encourage or discourage an international
business from investing in or undertaking activities in a specific country.
In the example above, in order to achieve neutrality for B2B supplies
in the context of international trade, the legislature should consider introducing
a provision similar to section 11(1)(q) into the ambit of section 11(2), to
address the current shortcomings of the VAT treatment of so-called loop
This article first appeared on the March/April 2015 edition on Tax Talk.
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