In the current tough economic climate, it is common for companies to consider alternative funding arrangements to fund their activities, which minimises cash-flow obligations to third parties in the short term, while also ensuring compliance with relevant tax legislation. One option to consider is the creation of a loan account by a debtor in favour of a creditor. In Claremont Library Development Company v Commissioner for the South African Revenue Service(1) the Tax Court had to deal with this issue and, specifically, the consequences of Section 22(3) of the Value Added Tax (VAT) Act (89/1991).
Claremont Library Development Company (CLDC) concluded an agreement with its wholly owned subsidiary (C) to develop land owned by CLDC. C funded CLDC's cash-flow requirements on loan account via inter-company shareholder loans to avoid external finance having to be obtained. C issued a tax invoice to CLDC for part of the development. CLDC subsequently claimed an input tax deduction for VAT, which amounted to approximately R10 million. CLDC paid the input VAT it received from the South African Revenue Service (SARS) to C, which in turn paid this amount to SARS. The remaining liability due to C in terms of the invoice – approximately R72 million – was credited to C's loan account in CLDC's books in accordance with the funding arrangement between the parties. After SARS conducted an audit in 2013, four years after the invoice was raised, it alleged that the requirements of Section 22(3) of the VAT Act had not been met.
The Tax Court explained that according to Section 22(3) of the VAT Act, where a vendor has claimed an input tax deduction on the basis of a tax invoice, but has not made payment of the relevant consideration within 12 months, the transaction is effectively reversed. The result is that the benefit of the input tax previously deducted is counteracted because the consideration has not been paid. The court stated that the question in the current matter was whether – considering Section 22(3) – the crediting of a loan account constituted payment of full 'consideration' within 12 months after CLDC claimed an input tax deduction for the VAT component of the invoice raised by C as a related company.
In ascertaining whether the crediting of the loan account constituted "payment made… in respect of" and "in response to… the supply" of the "goods and services", in terms of the definition of consideration in Section 1 of the VAT Act, the court first referred to the decision in Commissioner for the South African Revenue Service v Capstone 556 (Pty) Ltd(2) where it was held that if a receipt or accrual arises from a detailed commercial transaction, the transaction in its entirety must be considered from a commercial perspective, as opposed to breaking it into component parts or subjecting it to narrow legal scrutiny.
The court explained that in terms of the funding arrangement between CLDC and C, had C's loan account not been credited in the manner it was, C would have been required to advance funds to CLDC to settle its own invoice and could not have sued CLDC in the event of non-payment nor claim the amount in question as a bad debt for VAT or other tax purposes. It follows that both C and CLDC did not expect that C would be paid in cash for the relevant supply. The parties considered that the invoice would be settled by crediting the loan account of C in CLDC's books as its wholly owned subsidiary. This argument was corroborated by the evidence of CLDC's managing director, the auditor of CLDC and C. According to the court, crediting the loan account did not extinguish CLDC's liability to C, but simply changed the liability from a current liability to a long-term liability in its books.
The court referred to the decision in Commissioner for Inland Revenue v Guiseppe Brollo Properties (Pty) Ltd(3) and stated that what had to be considered was the "overriding purpose" for which the loan account liability was incurred. CLDC provided undisputed evidence that the purpose of incurring the loan liability was to discharge the invoice debt. The court concluded that what was owing by CLDC under the loan account was different from what was owing under the invoice. The definition of 'consideration' in Section 1 of the VAT Act includes "any payment made or to be made", whether "in money or otherwise, or any act or forbearance". The court held that, as long as payment amounts to the discharge of an obligation to another, there is no reason why an obligation under an invoice may not be discharged through the creation of another liability such as one under a loan. Simply put, "the effect is to discharge one obligation through another".
The court referred to the explanatory memorandum to the Taxation Laws Amendment Bill 1996, which states that the purpose of Section 22 of the VAT Act is to prevent prejudice being suffered by the Treasury, as prior to the amendment it was possible to deliberately create bad debts in order to create a tax benefit. According to the court, the intention of Section 22(3) was to prevent such deliberate manipulation and not to prevent an invoice from being considered paid through the creation of a loan account liability where a funding arrangement exists between companies within the same group. On the facts before the court, there was no such deliberate manipulation in creating a bad debt with a view to creating a tax benefit either by CLDC or by C. In light of this, the court found that the crediting of C's loan account by CLDC in the context of the funding arrangement between the two companies amounted to payment of 'consideration' in relation to the supply of goods and services invoiced.
The court's endorsement and application of the decision in Capstone is likely to be welcomed within the tax community. The application of the principles laid down in Capstone further entrenches the interpretative approach to tax legislation in terms of which the legislation should be interpreted from a commercial perspective.(4)
However, subsequent to the use of the funding arrangement by C and CLDC, in 2012 Section 22(3A) of the VAT Act was introduced, which expressly states that Section 22(3) is not applicable to a taxable supply made by one vendor to another which is a member of the same group of companies. The court also acknowledged that the funding arrangement would not have been permissible had Section 22(3A) already been in effect. It appears that the court's decision was strongly influenced by the fact that no loss was incurred by the Treasury.
For further information on this topic please contact Louis Botha or Heinrich Louw at Cliffe Dekker Hofmeyr by telephone (+27 115 621 000) or email (email@example.com or firstname.lastname@example.org). The Cliffe Dekker Hofmeyr website can be accessed at www.cliffedekkerhofmeyr.com.
(4) For a further discussion of Capstone see www.cliffedekkerhofmeyr.com/en/news/publications/2016/tax/tax-alert-11-march-capital-v-revenue-the-taxpayer-prevails.html.