Credit providers and borrowers should take note of a recent court case concerning the deductibility of interest and related finance charges. They should also pay attention to a recently published draft interpretation note on value-added tax (VAT) and debt collection. Both have the potential of increasing the cost of debt.
VAT and debt collections
In terms of a draft interpretation note issued by the South African Revenue Service (Sars), credit providers will not be entitled to deduct any VAT incurred in the process of providing credit or recovering a debt. The provision of credit is considered exempt from VAT.
The costs that are not recovered, or the losses incurred by a credit provider because it cannot recover the debt, will ultimately be passed on to the consumer, PwC says in a recent Tax Alert.
PwC says the draft interpretation note relates to the deduction of input tax by a credit provider in respect of debt collection activities. Sars views the provision of debt in a credit sale as a separate and distinct activity to supplying the goods or services. Someone who buys and sells widgets, for example, will be able to claim input tax. However, a credit provider who provides credit without supplying any underlying goods or services will not be able to claim input tax.
When providing credit, there is generally a monthly administration fee, as well as an interest charge. Interest payments are VAT-exempt, but the administration fee is taxable. The credit provider can apportion the VAT and claim back some of the cost.
However, a problem arises if the debtor defaults and a debt collector must be called in. The debt collector generally charges 15% for its service. The credit provider is unable to claim this amount and carries the cost.
The debtor must come up with money to pay the outstanding amount and is charged so-called prescribed amounts (phone calls or letters written by the debt collector), and VAT of 15% is levied on the amount.
The debtor, even if he is registered for VAT, will not be entitled to deduct any VAT relating to the debt collection process because the credit provider, not the borrower, acquired the debt collection services.
In its draft note, Sars gives an example of a bank lending R10 000 to a vendor who subsequently defaults on the payment. The bank gets a debt collector to collect the outstanding amount of R7 000.
The debt collector is paid commission of 20% (R1 400) on the debt collected and declares VAT on the commission and the prescribed amount of R700. His VAT costs are deductible.
In the case of the bank, the recovery of the debt collection costs is not received for “any supply” that is made to the defaulting debtor and therefore the bank cannot charge VAT.
The debt collection service relates to the collection of debt and not to “consumption, use or supply” while making taxable supplies. “As such, the bank cannot deduct the VAT on the debt collection services as input tax,” explains Sars.
The deadline to comment on the draft interpretation note was 7 October.
Interest and similar finance charges
Companies that incur finance charges should also take note of a recent court case regarding the tax treatment of related or similar finance charges.
Jackie Arendse, professor of taxation at Academy One, referred to the Tax Court’s decision during a tax update by The Tax Faculty. The case dealt with the disallowance by Sars of certain finance charges that were incurred before the definition of “interest” in the Income Tax Act was amended. The phrase “related finance charges” was changed to “similar finance charges” in 2017.
In this case, a company that is involved in property investment and management, including the letting of property for rental income, raised funds for the purpose of property development.
It incurred interest costs, but also raising fees, debt origination fees and certain structuring fees (related finance charges) on the loans. It deducted the interest and the related finance charges during the 2016 year of assessment when the definition still contained the words “related finance charges”.
However, Sars disallowed the related costs amounting to R19.5 million and imposed an understatement penalty of 50% of the tax owed.
The matter went to court. Sars argued that the fees did not amount to related finance charges, because they were payable upfront, they constituted once-off payments, and they were not linked to the duration of the loans.
The court considered case law from 1955 and 2012 and found that the deductions must be allowed. The matter was remitted to Sars to raise a new assessment. The understatement penalty fell away.
Arendse notes that there must be a factual causal link between a borrower’s obligation to pay the amount in question and the lender’s extension of credit to the borrower in order to deduct similar finance charges.
She says it is unclear what the outcome for the taxpayer would have been if the court had to consider the tax treatment of “similar” finance charges because there is not yet any case law following the 2017 amendment.
Amanda Visser is a freelance journalist who specialises in tax and has written about trade law, competition law and regulatory issues.
Disclaimer: The information in this article does not constitute legal or financial advice.
