Another VAT Hurdle

Another VAT Hurdle

• 08 February 2021
• VAT
• PWC

Background

On 18 December 2020, the Supreme Court of Appeal (‘SCA’) handed down its judgment in the matter of Consol Glass (Pty) Ltd v The Commissioner for the South African Revenue Service (1010/2019) [2020] ZASCA 175. The case concerned an appeal against additional VAT assessments raised by SARS against the appellant, Consol Glass (Pty) Ltd (‘Consol’). The additional assessments disallowed input tax deductions by Consol relating to services provided by local vendors, and imposed VAT on imported services procured by Consol. Consol lodged an objection against the additional assessments, which was disallowed by SARS. After unsuccessfully appealing the additional assessments in the tax court, Consol appealed to the SCA.

The Consol group manufactures and sells glass containers. During April 2007, Consol acquired the businesses of Consol Limited and two of its subsidiaries as going concerns. This acquisition formed part of a reorganisation of the Consol group. After the acquisition, Consol commenced trading, continuing the glassmaking businesses previously conducted by the three companies.

Consol was able to make these acquisitions by securing debt funding in the form of issuing Eurobonds. The debt, as well as Consol’s obligations to pay interest and redeem the bonds, was denominated in Euros. However, as Consol’s revenue was Rand-based, it also entered into collateral hedging agreements to cover the risk of Rand volatility against the Euro.

The cost of servicing Consol’s Euro debt, and securing hedge cover for its Euro exposure, became increasingly expensive over the period from 2007 to 2012 due to the volatility of the Rand and its depreciation against the Euro. As a result, Consol sought competitive funding in the South African market to replace the Eurobond debt and unwind its hedging positions. A consortium of banks provided some R5bn, which was used to redeem the Eurobonds and unwind the hedging instruments (hereinafter referred to as the ‘refinancing transactions’).

Consol procured services from local service providers, who advised on the arrangement and drafted agreements to put in place the refinancing transactions. Foreign service providers were also asked to advise on the early redemption of the Eurobonds and the unwinding of Consol’s hedging positions.

Consol deducted input tax on the local costs incurred and did not declare VAT on imported services for the foreign costs incurred.

Issue

The definition of ‘input tax’ in section 1(1) requires that goods or services be acquired ‘for the purpose of consumption, use or supply in the course of making taxable supplies’. If the services were acquired for any other purpose, the definition of ‘input tax’ would not be met, and Consol would not be entitled to the input tax deduction.

The definition of ‘imported services’ in section 1(1) contains a similar test however the requirement in this instance is whether the services are ‘utilised or consumed in the Republic otherwise than for the purpose of making taxable supplies’. An obligation to declare VAT arises only to the extent that such imported services are used for purposes other than making taxable supplies.

It was therefore of vital importance for the SCA to determine the purpose of the services being acquired by Consol, and specifically whether such services were acquired for the purposes of making taxable supplies, or for other purposes.

Arguments

SARS’s view

The Commissioner submitted that both the local and foreign services were acquired to make an exempt supply in the form of financial services. The Commissioner was of the view that in securing the loans from the consortium of banks, Consol was issuing a debt security, which constitutes ‘financial services’ falling under section 2(1) (c). The provision of financial services is exempt from VAT under section 12.

In SARS’s view, Consol was not entitled to deduct input tax for the VAT incurred on the cost of the local services on the basis that such costs were incurred in the course of making exempt supplies. Similarly, in SARS’s view, the foreign services met the definition of ‘imported services’ and Consol had an obligation to declare VAT thereon.

Consol’s view

The grounds of appeal put forward by Consol was that the Eurobonds were initially used to acquire assets which enabled Consol to manufacture and sell glass containers and thus make taxable supplies. The refinancing transactions substituted the foreign debt with local debt and permitted Consol to continue the same business it had acquired in 2007 – i.e. the making of taxable supplies through the manufacture and sale of glass containers – and therefore it had been correct in deducting input tax, and not declaring VAT on imported services.

Judgment

The SCA dismissed the Commissioner’s argument that the costs were incurred by Consol in the course of making exempt supplies. The SCA concluded that the enterprise carried on by Consol was the manufacture and sale of glass containers and neither the original issuance of Eurobonds nor the subsequent loans secured locally could be seen as transforming Consol’s enterprise into that of one supplying exempt financial services. Under these circumstances Consol was the borrower and the recipient of financial services, and not the lender and the supplier thereof.

Despite the SCA’s dismissal of the Commissioner’s argument regarding the supply of financial services, it was still necessary to consider whether the services were acquired in the course of making taxable supplies. In doing so, the court considered whether a functional link existed between the original issue of the Eurobonds and subsequent local financing, and the making of taxable supplies.

Consol’s appeal rested on the premise that the Eurobonds were used in 2007 to acquire the businesses from Consol Limited in order to make taxable supplies. The SCA however found that this acquisition did not make any material change to the operating businesses acquired by Consol, that is, the reorganisation of the Consol group was of no consequence to the enterprise carried on by these businesses as it continued the business of manufacturing and selling glass containers both before and after the reorganisation.

It further stated that the refinancing was intended to place Consol in a position to continue to fund the original reorganisation, but at a lesser cost. What the savings achieved by Consol permitted it to do then was a matter of effect rather than purpose, something that was beyond the remit of the case.

The SCA found that Consol’s premise did not hold, and that there was no functional link between the issue of the Eurobonds and the making of taxable supplies. As a consequence, there was also no functional link between the costs incurred to affect the refinancing agreement and the making of taxable supplies. The SCA dismissed Consol’s appeal with costs.

The takeaway

The VAT Act provides limited guidance on how close a relationship there needs to be between costs incurred and the making of taxable supplies, for the costs to be considered incurred ‘in the course of making taxable supplies’. The court has cautioned against taking a very restrictive interpretation in this regard, as such interpretation could disregard the diversity and complexity of a modern economy.

The SCA’s judgment, in our view, confirmed the principles established in the De Beers case, where the court determined that there should be a causal link between expenses incurred and the enterprise’s taxable activities for the expense to qualify for an input tax deduction.

Bearing in mind the aforementioned, it is important to note that businesses, even if only making taxable supplies, cannot assume that all their expenses will qualify for input tax deductions. It is therefore critical that all costs incurred should be analysed on their own merits, and should the costs incurred not have a functional link to the activities a business conducts in making the taxable supplies, they will not qualify for an input tax deduction. The same principles need to be applied when considering whether a person has a liability to declare VAT on imported services: that is, if there is no functional link between the foreign service costs and the person’s taxable supplies, a VAT liability for imported services will arise.

We must caution that this judgment does not imply that the VAT incurred on all financing transactions is not deductible or, with regard to foreign services, will always result in a liability to pay VAT on imported services. The SCA was very clear that where the financing was wholly or partly for the acquisition of goods or services for the purposes of making taxable supplies, such would have a functional link to the making of taxable supplies. In such circumstances, input tax would be wholly or partly deductible.

This article first appeared on pwc.co.za.

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Webinar Commentary

Webinar commentary on VAT: Exempt Supplies is available here.

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