First interim report on South African VAT system : DTC confirms SA has efficient VAT system
The South African tax system has changed significantly since the recommendations of the Katz Commission in 1995, shortly after the introduction of VAT which at the time, signalled a fundamental shift in South Africa’s taxation landscape. It was on this basis that in 2013 the then Minister of Finance, Mr Pravin Gordhan, announced the members of the Davis Tax Committee (“DTC”) that would assess the South African tax policy framework, and its role in supporting the objectives of inclusive growth, employment, development and fiscal sustainability.
Just under two years on, the DTC’s first interim report on South African VAT has been released for public comment. The interim report largely focuses on the role the tax system can play as part of a coherent and effective fiscal policy framework in addressing challenges inherent to the South African economy. “The DTC confirms that South Africa has an efficient VAT system that compares well with international benchmarks. We welcome the comments raised as well as the areas that need to be addressed,” says Charles de Wet, Head of Indirect Tax at PwC Africa.
The VAT gap
The VAT gap is the difference between the VAT that is due in terms of South African legislation and the amount of actual VAT collected by the South African Revenue Service (“SARS”). A key finding of the DTC First Interim Report on VAT is that the gap between VAT collected and VAT due is very small in South Africa.
The VAT gap is created as a consequence of revenue loss through cases of fraud, evasion, tax avoidance, and other miscalculations. As noted by the DTC, the extent of this gap can be used as mechanism to measure the effectiveness of VAT enforcement and compliance measures in South Africa.
“While we have always recognised the significance of VAT in overall tax collections, what this report highlights is the importance of SARS modernisation efforts to become a world-class tax administrator and collections agency,” says de Wet.
Currently, this VAT gap in South Africa is estimated to be about 6% which holds up favourably in global comparisons, and significantly is below typical levels in Europe and Latin America.
The DTC notes that the taxation of financial services continues to challenge VAT design due to the cost of cascading. Cascading occurs where an intermediate supply to a financial institution is subject to VAT and cannot be deducted by the financial institution and becomes a hidden cost. The DTC concludes that while the cascading effect is more prevalent in the banking industry, it is also evident in the life insurance industry, both of which are major contributors to the South African economy.
Like the Katz Commission, the DTC found that financial institutions are not incentivised to outsource certain administrative functions to third-party service providers due to the additional VAT cost and therefore seek to undertake the required services itself (vertical integration). Although this allows for financial services institutions to reduce its VAT cost the knock on effects of this are a reduction in competition, specialisation and potentially growth, in the South African economy.
“Ultimately when a supplier of financial services cannot recover the VAT paid on intermediary services, the irrecoverable VAT forms part of the cost. The financial service provider faces a choice here, where they either raise the price of the services, absorb the VAT cost or find another way of delivering the same service without the VAT cost”, adds de Wet.
“The financial services industry plays a significant role in the South African economy, and importantly, the DTC report urges that further work needs to be done by SARS and National Treasury to consider measures adopted in other jurisdictions to prevent increased costs in these industries.” says de Wet.
“South Africa’s VAT treatment of financial services is unique compared to other jurisdictions as the vast majority of intermediary services in the banking space are taxed, however other jurisdictions have managed this by introducing laws to mitigate additional VAT costs. When introducing Goods and Services Tax in Australia, a conscious decision was taken by the Government there to allow financial institutions in Australia to claim some VAT on intermediary costs. This decision was taken to help grow the financial services industry in Australia and develop a regional hub to compete with other regional markets such as Singapore and Hong Kong. South Africa has a well-placed and stable financial services sector in the region and targeted changes in the VAT legislation could allow this sector to grow and develop further” adds de Wet.
The regulation of electronic commerce remains a focal point for the DTC which has made notable recommendations concerning electronic services supplied by foreign businesses to South African recipients. The taxation of electronic services in South Africa is relatively recent, with regulation having been implemented 1 June 2014, ahead of other countries such as the EU, Australia and NZ which have only now expanded the scope of their legislation.
The DTC sees it as critical that the legislation is flexible enough to keep pace with the fast paced and ever-changing technological environment of ecommerce, an area that it notes further work needs to be done.
While the current electronic services legislation seeks to tax predominately services supplied in the Business-to-Consumer space, the DTC has strongly recommended that this distinction is eliminated and that all transactions (including transactions between businesses) are subject to VAT in the same manner. “This finding is significant as the current SA VAT legislation does not seek to distinguish between B2B and B2C supplier, and it is likely that significant changes to the electronic services regulations will be required to ensure it is consistent with SA’s VAT principles, and to broaden and strengthen its application as our economy modernises.”
While recent reports have suggested that the existing electronic commerce legislation is not broad enough to capture all supplies, and National Treasury has already announced moves to include software into the scope of services, the DTC interestingly notes that, in the case of online advertising, the existing regulation may not need to be amended or changed since it may be argued that the current regulation includes these activities. The DTC has recommended that a guide should be published to clarify the position.
According to de Wet, this signals that the DTC considers the existing regulations in a broad manner whereas businesses and SARS alike have, until now, considered the existing regulations as prescriptive and narrow. Ultimately, however, more flexible legislation will be necessary to ensure our legislation stays relevant and more changes are expected, says de Wet.
Other notable conclusions from the First Interim Report include a recommendation that no further zero-rated food stuffs are added to the existing rules and that more targeted subsidies should be considered in this regard, that so-called ‘place of supply rules’ are introduced into the South African legislation and which are consistent with OECD principles, and that South Africa’s current single rate approach is more efficient that jurisdictions with multiple rates.
On the question of increasing the VAT rate, the report notes that while this would ultimately result in short-term inflation, the impact of an increase in the VAT rate on the economy would be far less severe than that of a rise in personal income tax or corporate income tax, and result in less distortion than an increase in these taxes.
“Any reform of VAT that seeks to address the VAT rate requires that other factors also be addressed. Primarily these relate to the regressive nature of VAT and the perception that a shift from income taxes to VAT will result in greater income and wealth inequality. To this end, the tax system as a whole, and its impact on the SA economy as well as growth objectives and development objectives need to be considered, together with social security benefits, rather than focusing on individual elements.
“Studies carried out by the OECD indicate that broadening the VAT base is the best way of increasing VAT revenues as part of a tax shifting exercise as it improves efficiency and reduces administration and compliance costs. This report confirms that relief for poor households can be better provided through direct transfers (social security) which can be better targeted to specific recipients, rather than through the tax system. South Africa’s VAT system is already fairly broad-based and again the DTC has shown that the benefits of zero-rating are not always received by the intended recipients. For these and other reasons, we hold the view that a reform of the tax mix in South Africa should commence with broadening of the tax base by the elimination of certain zero-rated supplies, with the exception of exports, and any increase in the VAT rate should be considered in tandem with targeted social grants” concludes de Wet.