A free service is not disqualified as a “taxable supply” in terms of the Value-Added Tax Act, the Constitutional Court has ruled.
The judgment may set a significant precedent for how VAT is approached where no direct monetary exchange is evident, Nicolaas van Wyk, the chief executive of the Chartered Institute for Business Accountants, wrote in Accounting Weekly.
The key aspect of the judgment revolves around the taxability of loan cover under section 16(3)(c) of the VAT Act, he said.
The court addressed whether the fees associated with loan cover, when capitalised (added to the loan principal instead of being paid upfront) should still be considered part of the loan’s credit and, therefore, covered under the loan insurance. The broader legal question concerns whether the provision of loan cover, under these conditions, constitutes a “taxable supply” – that is, whether it is a service provided while conducting business that is subject to tax, Van Wyk said.
“The critical element of the judgment is examining the nature of the transaction and its compliance with the statutory definition of a taxable supply within an enterprise activity. This determination is vital because it affects how such financial products are taxed, potentially influencing the financial services industry’s structuring of such products,” he said.
On 12 April, the Constitutional Court handed down a unanimous decision in favour of Capitec Bank, the applicant. The bank and the South African Revenue Service (SARS) have been engaged in litigation since the revenue collection authority disallowed a deduction of some R71.5 million in Capitec’s VAT return for November 2017.
In a statement on Monday, SARS emphasised that the judgment “is unique and specific to the circumstances surrounding this taxpayer and the particular transaction involved. It is important to note that originally Capitec sought to deduct the full amount of R71m as an input claim. However, the court noted, ‘That is a battle that it has lost.’”
SARS said that because it was “substantially successful” in the Supreme Court of Appeal (SCA), which ought to have awarded a modest 8% to 10% apportionment, legal costs was granted in its favour.
“The Constitutional Court found, however, that Capitec’s initiation and service fees generated a surplus that covered other lending costs, and that an apportionment was appropriate. The Constitutional Court recognised, nevertheless, that the VAT Act makes ‘no explicit provision for apportionment in this situation’ and therefore ordered SARS to consider an apportionment methodology,” SARS said.
Context: the nature of Capitec’s lending activities
Capitec’s commercial activities include lending money to unsecured borrowers. When it lends money, it charges interest and initiation and service fees. The fees comprise between 5% and 13% of the total consideration that Capitec receives from the borrower.
In terms of the VAT Act, VAT must be levied on goods or services supplied by a vendor “in the course or furtherance of any enterprise carried on” by the vendor.
Section 2(1) of the Act deems the supply of certain “financial services” to be exempt from VAT. One of these financial services is the provision of credit at a cost to the recipient.
But this is subject to the proviso that providing credit is not deemed to be a financial service “to the extent that the consideration payable in respect thereof is any fee, commission, merchant’s discount or similar charge, excluding any discount cost”.
Capitec’s lending activities have two components: the charging of interest, which is exempt from VAT, and charging fees, which is an enterprise activity. In line with this, Capitec does not charge VAT on interest, but it does charge VAT on the fees it levies and claims input tax deductions attributable to the charging of those fees.
To protect itself against the risk that unsecured borrowers might be unable to repay the loans upon retrenchment or death, Capitec took out insurance policies. The cover amount was slightly more than the amount that Capitec would lend to the unsecured borrowers.
According to the terms of its standard lending contract, Capitec does not charge fees for the provision of loan cover.
Capitec made loan cover payments of R582 383 754 from November 2014 to November 2015.
In its VAT return for November 2017, Capitec deducted R71 520 812, which was the tax fraction of the amount the bank paid to customers as loan cover. In doing so, Capitec relied on section 16(3)(c) of the VAT Act.
This section permits a vendor to deduct, from its output tax, the tax fraction of any amount made to indemnify another person in terms of a contract of insurance, provided that the supply of the insurance contract constitutes a taxable supply.
SARS disallowed the deduction, saying the supply of the loan cover did not constitute a taxable supply. SARS took the view that the loan cover was provided for no consideration and thus had no value. Alternatively, that the loan cover constituted an exempt supply.
Consequently, SARS issued an additional assessment.
SARS made no point of the fact that the deduction was only claimed in November 2017.
Litigation in the Tax Court and the SCA
Capitec objected to the assessment. SARS disallowed the objection, and Capitec took the matter to the Tax Court.
The Tax Court upheld the appeal and set aside SARS’s additional assessment.
Aggrieved by the Tax Court’s decision, SARS appealed to the SCA, which ruled in favour of SARS in 2022. It found that Capitec was in the business of providing credit, not insurance, and the provision of credit was an exempt supply.
Further, although a minor component of Capitec’s business was a taxable supply (the charging of fees), this did not convert the exempt supply into a taxable supply. Since the loan cover was provided for no consideration, Capitec was not entitled to rely on section 16(3)(c).
The Constitutional Court accepted Capitec’s submission that the matter entertained the apex court’s jurisdiction. Section 167(3)(b)(ii) of the Constitution authorises the court to decide on a matter that “raises an arguable point of law of general public importance” that it ought to consider.
Free of charge is not disqualified from being a ‘taxable supply’
The Constitutional Court held that the matter must be approached on the basis that the loan cover was provided free of charge.
A “taxable supply”, as contemplated in section 7(1)(a) of the VAT Act, must be supplied in the course or furtherance of an “enterprise”, as defined by the Act.
“The definition of ‘enterprise’ requires that the enterprise or activity must be ‘carried on continuously or regularly’ and must be one in the course or furtherance of which goods or services are supplied to another person ‘for a consideration, whether or not for profit’. It expressly includes any enterprise or activity carried on in the form of a commercial or financial concern,” Judge Owen Rogers wrote on behalf of the court.
But the definition of “enterprise” does not require that all goods or services supplied in the course of that activity must be supplied for a consideration. The requirement is that the activity must be one in which goods or services are supplied for a consideration.
Section 10(23) of the Act envisages that a supply may be made for no consideration. Judge Rogers said it is clear from this section that any supply, whether taxable or non-taxable, may be a supply for no consideration. If the latter, it is assigned a value of nil for any purposes relevant to the Act.
“What flows from this is that if a vendor, in order to advance the interests of its enterprise in which goods are sold for consideration, offers shoppers a free item as a marketing ploy, the free item, although it is a taxable supply, has a nil value, and so the VAT on that supply in terms of section 7(1)(a) is also nil. It is nevertheless important for such items to be classified as taxable supplies, because on this depends the vendor’s right to deduct, as input tax, the VAT it had to pay in acquiring the goods which it supplied free of charge. In terms of section 17(1), the vendor is only entitled to a deduction as input tax to the extent that such goods were consumed, used, or supplied ‘in the course of making taxable supplies’,” the judge said.
The court therefore found that Capitec’s supply of the loan cover was not disqualified from being a “taxable supply” merely because it was supplied free of charge.
Important: the purpose of the loan cover
According to the judgment, SARS relied on a statement, in Capitec’s 2016 annual report, to the effect that the bank had insurance against bad debts but did not charge its clients credit life or retrenchment insurance, “as this is built into the interest rate we charge our clients”.
“This again confuses the policy issued by the insurer and Capitec’s contract with the borrower. It matters not from what pot of money – the interest or the fees – Capitec regarded itself as meeting the cost of the premiums it paid the insurer. In order to determine whether the loan cover is an exempt, taxable or mixed supply, it is the purpose of Capitec’s provision of the loan cover to its borrowers that is important,” Judge Rogers said.
It was undisputed that Capitec provided free loan cover to make its loan offering to unsecured borrowers more attractive.
The court, therefore, found that the loan cover was a mixed supply, made in the course or furtherance of Capitec’s exempt activity of lending money for interest and its taxable activity of lending money for fees. These were not separate activities; there was a single activity of lending money for consideration, which consisted of both interest and fees.
Nevertheless, in view of the section 2(1) proviso, this single activity had to be treated as consisting of two notional components: one an exempt activity, the other an “enterprise” activity.
Contrary to the SCA’s finding, the court held that unpaid fees do not lose their character as fees when capitalised, and the capitalisation had no legal significance on the question whether the supply of loan cover was a taxable supply in terms of section 16(3)(c).
Partial deduction
The court considered four potential possibilities for the deduction of VAT where insurance is supplied in the course of an exempt activity and an “enterprise” activity.
It considered Capitec’s assertion that it was entitled to deduct the full amount of the deduction. The court rejected this, saying the fee-earning component of Capitec’s enterprise activity was only 5% to 13% of the total consideration that Capitec receives from the borrower.
The court found that the principle of appointment of was implicit in section 16(3)(c), interpreted in the context of the VAT Act as a whole. Case law supported the court’s view that, where the Income Tax Act did not expressly provide for apportionment, apportionment was a practical solution yielding a fair and reasonable result in the circumstances.
Capitec, in its pleading before the Tax Court, did not seek such an apportionment but a deduction of the full payments made in terms of the insurance contract.
Although Capitec did not plead partial deduction as an alternative, the Constitutional Court found it should not be penalised for its failure to do so.
“This judgment concludes that SARS should not have disallowed the objection in full. SARS, as an organ of state subject to the Constitution, should not seek to exact tax which is not due and payable.”
The Constitutional Court upheld the appeal and set aside the orders of the Tax Court and SCA. The court remitted the matter to SARS for further assessment.
It ordered each party to pay its own costs in the Constitutional Court and the Tax Court. Capitec was ordered to pay SARS’s costs in the SCA, including the costs of two counsel.
Commentary from ENSafrica
Law firm ENSafrica said the judgment clarifies some important principles relating to VAT.
In its view, the most striking aspect of the judgment concerns apportionment where vendors conduct a partly taxable and a partly exempt enterprise. It remains to be seen whether this will open the door for multiple methods of apportionment within a single enterprise.
“The financial impact on vendors (including input tax that has not been claimed in the past) and whether this judgment will result in an amendment to certain provisions of the VAT Act will become apparent as these important principles are better understood,” ENSafrica said.
