Aurthur: Ferdie Schneider, National Head of Tax, BDO South Africa
Valued-Added Tax (VAT) systems theoretically extend their bases as wide as possible to minimise economic distortionary effects so as to impact as little as possible on consumer choices. However, certain supplies of services still escape the VAT net, often due to their ‘difficult to tax’ nature. These typically include financial services.
South Africa has one of the broadest (or most inclusive) VAT bases in the more than 160 jurisdictions that have VAT systems. Many VAT systems apply a broad brush approach when exempting financial services. Significantly, VAT systems often exempt ‘pure’ financial services and although intermediation or facilitation services could technically be taxed under a VAT system, these also often escape the VAT net as well.
A couple of decades ago, South Africa embarked on a journey to slowly but surely extend its VAT base to tax more and more financial services. Perhaps one of the most meaningful studies on this was done by the VAT committee of the Katz Tax Commission in the mid-1990s. This study extended the VAT base further when certain previously exempt financial services became subject to tax. These mainly included intermediation services.
Scrip lending poses some possible VAT questions
Although it is arguable whether the South African VAT system can be broadened to tax even a bigger portion of supplies of financial services, there is definitely room to refine the tax legislation to enhance certainty and provide more clarity. A typical example is the current legislation and its application to scrip lending.
The legal consequences of and intentions of the parties to scrip lending differ, which give rise to some difficulty in applying basic VAT principles to these types of transactions. Scrip lending is often entered into by traders or brokers on the one hand and pension funds on the other. As pension funds have a fiduciary obligation towards their members, they are most often prohibited from placing the balance sheet of the fund at risk. This makes for minimal growth, especially in the absence of a portfolio that diversifies beyond equity investments (such as real property).
This often only leaves scrip lending to ensure at least some yield on the equity side, in the form of scrip lending fees. The intentions of the scrip-lender and scrip-borrower are mostly that of a loan agreement with the shares being the asset that is made available for a period in return for a scrip lending fee and eventual return of the same or similar shares. However, as these shares are mostly if not always listed shares, they can only be transferred from the lender to the borrower through actual share certificates which requires registration in the name of the new shareholder. This legally requires transfer of ownership.
As a change in ownership happens, this effectively gives rise to a supply for VAT purposes and should theoretically not be treated as a ‘loan’ type of arrangement. SARS in practice potentially does not strictly apply the letter of the law and potentially disregards the change in ownership and the consequential VAT effects. However, the VAT law has not been adequately drafted to cater for this. Comparing the law to what happens in practice is often vastly different.
Interest is possibly biggest ‘escapee’ of VAT on financial services
Possibly the biggest ‘escapee’ of VAT on financial services is interest. The main reason for this is again that interest is economically a ‘difficult to tax’ income stream. Economically, interest comprises of (i) compensation for risk; (ii) compensation for the time value of money; and (iii) compensation for an intermediation element. VAT should arguably (and in theory) not apply to the first two components, but should apply to the intermediation element. However, other than for applying a ‘proxy’ to separate the intermediation component, this is seemingly impossible to do. Some studies have been done to try and extend the VAT base to tax this component in the past. Such studies include those of English and Poddar that assessed the viability to tax interest using an accounting type method to approximate the intermediation element. An alternative to this can also be to use the ratio of interest received, less interest paid, and apply such ratio to interest received, which would then become subject to VAT. These methods are not without complications and difficulties and it would in practice be very unlikely for SARS or other revenue authorities to implement in the foreseeable future.
Another area of interest in VAT on financial services is VAT on imported services, or more commonly referred to as reverse charging in many foreign VAT jurisdictions. Reverse charging is effectively a VAT neutrality or anti-avoidance measure that applies to services acquired from abroad with the intention to apply them otherwise than to make supplies subject to VAT in South Africa. This would typically include VAT registered vendors who make taxable and exempt (such as financial services) supplies and who import these services in the exempt side of the business.
Where this happens the vendor is required to self-assess and declare VAT to SARS on these services that it imports. The same rule applies to individuals who import services (such as e-services) for private use or enjoyment. The individual should actually declare VAT on these imports and make payment to SARS. This is a very weak piece of legislation as it is almost completely impractical to police.
VAT in the short term and long term insurance areas
Another area of interest in the VAT on financial services space is that of insurance and the varied treatment of short term versus long term insurance. Many VAT systems across the globe exempt short term and long term insurance for VAT purposes, although a separate tax is often imposed outside of the VAT system on short term insurance. South Africa, on the other hand, imposes VAT on short term insurance and exempts long term insurance.
The VAT treatment of short term insurance has its own complexities which include certain deemed supplies on claims payments made and received; the timing rules applicable to premiums and payments; and the valuation rules. Long term insurers, on the other hand, often invest in taxable type of activities, such as real property, which then gives rise to VAT apportionment of input tax deductions of VAT on expenses incurred – in itself a difficult concept.
A further ‘taxing’ part of VAT on financial services includes the fact that financial services which typically would be exempt if supplied in South Africa, become subject to zero rating if supplied cross-border. This then allows vendors to claim VAT on expenses incurred to make these ‘now taxable supplies’ which gives a VAT advantage. The simple reason for this is that VAT is a destination based tax which seeks to tax final domestic consumption and free from VAT any foreign consumption. National Treasury has in the past considered removing the zero rate on cross-border financial services, but after further examination did not proceed with this action.
The bottom-line, therefore, is that there are many complexities surrounding VAT on financial services, a reality which will temper any mooted changes to the current system.