Getting out what you put in… A recap on the deductibility of input tax

The entitlement of a vendor to claim input tax deductions in respect of expenses incurred is generally not disputed where a vendor makes wholly taxable supplies. VAT is therefore generally not considered to be a large component of a business’s cost base as most VAT registered businesses will be entitled to claim a credit or refund of VAT paid to the extent that they conduct an enterprise that makes taxable supplies.

There has, however, been a great deal of controversy and uncertainty surrounding the claiming of VAT input credits, particularly where mixed taxable and non-taxable supplies are made, and also in the context of expenses relating to corporate actions. This uncertainty regarding the deductibility of input tax credits in certain instances has created a VAT risk for many vendors. This article will briefly provide an overview of the differing views held by the courts and the South African Revenue Service (SARS), and in so doing, will highlight the relevant considerations when determining whether the VAT incurred for purposes of certain corporate actions may qualify as an input tax deduction. 

In Income Tax Case No. 1744 65 SATC 154 (ITC 1744), the appellant, a manufacturer of steel shipping containers, employed the services of a company specialising in the venture capital markets to undertake two share placings, so as to raise capital to manufacture containers. The appellant claimed the VAT incurred on the company’s fees as an input tax deduction on the basis that it would not have been in a position to manufacture the shipping containers had it not raised the capital. The appellant argued that the services were therefore acquired for the purpose of consumption, use or supply in the course of making taxable supplies. The court, however, found against the appellant, and, relying on a judgment of the European Court of Justice handed down in 1995, held that a direct and immediate link is required between the incurral of the service and the making of taxable supplies. The court held that the immediate purpose of incurring the expense was to make an exempt supply, being the issue of the shares, and regarded the ultimate purpose as irrelevant. 

In the subsequent case of Commissioner for SARS v De Beers [2012] ZASCA 103 (12 June 2012), which was heard by the Supreme Court of Appeal (SCA), the respondent, De Beers Consolidated Mines Ltd (DBCM), required the services of independent financial advisors to consult and advise its board on whether a proposed restructuring transaction to be entered into was fair and reasonable. DBCM was legally obliged to acquire the independent financial advisor services in order to protect the rights and interest of independent DBCM unit holders. DBCM claimed input tax deductions in respect of the services acquired which claim was then rejected by SARS.

The Tax Court, which first heard the matter, found in favour of DBCM and dispelled the reasoning in ITC 1744 by favouring a more generous commercial approach, requiring that there only be ‘some link’ and not a ‘direct link’ to the expense incurred and the making of taxable supplies before a deduction can be made. The decision of the Tax Court was, however, set aside when the case was taken on appeal to the SCA. The SCA in the De Beers case adopted a more restrictive approach to the allowing of VAT input credits, and in applying the ‘direct and immediate link’ test, dismissed the contention that where a vendor wholly carries on taxable activities, that all its expenses, including expenses relating to corporate actions that may arise, are attributable to such taxable activities. The SCA in the De Beers case chose to follow a restrictive approach in keeping with earlier European Union judgments, and with ITC 1744, despite the fact that subsequent judgments handed down by the European Court of Justice have since developed along different lines.  

The definition of input tax as set out in s1 of the Value-Added Tax Act, No 89 of 1991 (VAT Act) requires that goods or services must be acquired for the purpose of consumption, use or supply in the course of making taxable supplies. Various South African judgments dealing with the phrase “in the course of” indicate that in order to claim an input tax deduction, there must be some relationship between the consumption or use of the services or goods and the making of taxable supplies. These judgments have not required a direct or immediate link as required by the Tax Court in ITC 1744, and subsequently by the SCA in the De Beers case.

South Africa does not have a ‘direct link’ requirement. Our requirement is that goods or services must have been acquired for the “purpose of consumption, use or supply in the course of making taxable supplies”. It is also important to note that the legislature did not use the phrase “directly in connection with” (as is the case in s11(2)(l) of the VAT Act for example), which would have required a close and uninterrupted relationship.

Developments in the European Union in cases such as Kretztechnik AG v Finanzamt Case C-465/03 2005 and Skatteverket v AB SKF Case C-29/08 2008 also evidence a shift from the restrictive application of the direct and immediate link test to a more generous approach requiring only that there be a link to the overall business activities of a taxpayer. From the De Beers judgment, it is clear that South African courts disregard the developments in other jurisdictions. 

The De Beers judgment, having established certain guidelines and principles regarding the claiming of input tax for VAT purposes, seems to have left us with more questions than answers, leaving taxpayers to now have to defend input tax deductions on costs that they were not required to defend before. 

Even though the De Beers judgment casts light on the South African approach to the deductibility of input tax, the debate surrounding this issue remains very much alive. The SCA in De Beers declined to follow certain international precedents that have developed, and are continuing to develop, along more generous lines and it therefore seems that both SARS and the South African courts will continue to follow a more restrictive approach going forward.

Although overturned by the SCA, the judgment of the Tax Court in the De Beers case not only took into account international developments, but was also more aligned with the actual wording used in the VAT Act, thus giving effect to the neutrality principle of VAT. 

It is submitted that the approach adopted by the SCA in the De Beers judgment conflicts with the neutrality principle of VAT, and it is expected that the application of the approach taken by the SCA, will result in businesses carrying a VAT cost for legitimate business expenses incurred in the course of their taxable activities, albeit not directly and immediately linked thereto. The question of whether a vendor will be entitled to claim input tax deductions in respect of expenses incurred relating to corporate actions will therefore need to be carefully considered on a case by case basis, and in the context of its enterprise activities.

As mentioned above, the SCA in the De Beers case dismissed the contention that where a vendor carries on wholly taxable activities, that all its expenses are attributable to such taxable activities. This approach seems to be overly restrictive and it is likely that the principles adopted by the SCA in the De Beers case will be challenged by many South African vendors in future.