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Zero-rating of certain services – Legislative oversight: a hiatus between goods and services?

Monday, 13 April 2015   (0 Comments)
Posted by: Author: Seelan Moonsamy
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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 where 

  • the goods are supplied by a vendor to a non-resident not registered for VAT in South Africa;
  • the 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 supplies.

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, 2005), was:

"…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 VAT.  

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 competitiveness” 

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 transactions.

This article first appeared on the March/April 2015 edition on Tax Talk.

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