The judgment of the Supreme Court of Appeal (“SCA”), which established certain guidelines and principles regarding the claiming of input tax for value added tax (“VAT”) purposes in the Commissioner for South African Revenue Services v De Beers Consolidated Mines Ltd (503/11) (1 June 2012) case may have far-reaching consequences for the private equity and venture capital industry.
In a report released by the Southern African Venture Capital and Private Equity Association in February 2016, it was noted that private equity in southern Africa experienced steady deal flow and exit activity in 2015 and that the industry was well positioned to back new deals in the coming years on the backdrop of a number of private equity houses having successfully raised funds. The expectation is that the private equity industry in southern Africa is to remain buoyant in 2016, with announcements of acquisitions and asset realisations1. The purpose of this article is to comment on the VAT implications of such acquisitions that may need to be considered.
An example of a typical private equity transaction
A truncated methodology of a private equity acquisition may involve a consortium (usually involving more than one private equity firm) that provides equity financing to incorporate a holding company, which in turn provides equity financing to incorporate a new operating company (“OpCo”), to acquire the business of the target company. This is usually done by way of a sale of the business as a going concern for VAT purposes. Generally, a consortium member incurs expenditure in relation to the proposed acquisition of the target. The consortium member will seek to recover certain expenses from the OpCo, who will reimburse the consortium member for these expenses by either crediting a loan account in favour of the consortium member in its financial records, or in cash. In some instances, the service providers will invoice the OpCo directly for their services.
The issue at hand is whether either the consortium member or the OpCo will be entitled to claim input tax deductions in respect of the expenses incurred in relation to the acquisition of the business from the target, which were incurred by the consortium member and recovered from the OpCo.
The claiming of input tax
For an amount to comprise “input tax”, the amount must meet certain requirements embodied in the definition of input tax in section 1(1) of the Value-Added Tax Act No. 89 of 1991 (the “VAT Act”). Such requirements include:
- the goods or services to which the amount relates must be acquired by a vendor;
- the supplier of the goods or services must have charged VAT in terms of section 7 of the VAT Act;
- the goods or services must have been supplied to the vendor claiming the amount as input tax; and
- the goods or services concerned must have been acquired by the vendor wholly or partly for the purpose of consumption, use or supply in the course of making taxable supplies.
For the amount of VAT paid to the supplier to qualify as input tax, the goods or services must be supplied to the vendor seeking to claim the deduction. The input tax deduction must therefore be made by the recipient of the supply. The word “recipient” is defined in section 1(1) of the VAT Act to mean “in relation to the supply of goods or services, the person to whom the supply is made”.
Further, the goods or services in respect of which the VAT is claimed must have been acquired wholly or partly for the purpose of consumption, use or supply in the course of making taxable supplies.
The De Beers case
De Beers carried on the business of mining and selling diamonds and was approached by a consortium that proposed a transaction in terms of which a new company would be established by the consortium to become the holding company of De Beers. Being a listed company, De Beers, was required, in terms of the South African Companies Act, to evaluate whether the offer was fair and reasonable in order to advise its board accordingly. De Beers engaged the services of an offshore independent financial advisor, NM Rothschild & Sons Limited (“NMR”) and various local legal and tax advisors for advice on the reasonability of the offer in order to implement its obligations. NMR did not charge VAT on its fees but the local advisors charged VAT on their services.
De Beers claimed the VAT incurred on the local advisors’ fees as input tax, and did not account for any VAT on “imported services”2 charged in terms of section 7(1)(c) of the VAT Act. The South African Revenue Service (“SARS”) contended that the NMR fees were not utilised or consumed by De Beers in the course of making taxable supplies, and disallowed the input tax deductions claimed by De Beers on the local advisor’s fees on the basis that these fees were not incurred for the purpose of making taxable supplies. De Beers argued that the provision of the foreign and local advisory services were a necessary concomitant of its taxable mining and commercial enterprise as a public company; it could rightly be said to have been wholly utilised or consumed in the making of supplies in the course of its commercial enterprise.
The SCA concluded that when the transaction was conceived and the consortium came into being, what was being sought was the acquisition of the whole of De Beers at the most advantageous price to the consortium. The SCA stated that the De Beers enterprise for the purposes of the VAT Act consisted of the mining, marketing and selling of diamonds.
The SCA refused to countenance the notion that the NMR services were acquired for the purpose of making taxable supplies because the De Beers enterprise was not in the least affected by whether or not De Beers acquired the NMR services. With regard to the local services, the SCA held that they were acquired to comply with the statutory requirements of De Beers, to obtain tax advice on the implementation of the transaction and obtaining the required court and unit holder approval for the transaction, and that they were not acquired for the purpose of making taxable supplies comprising the mining, marketing and selling of diamonds.
Deduction of VAT incurred by consortium member
The typical expenses incurred by the consortium member would include the following:
- Consulting company one – to the undertaking of a commercial assessment of the target’s business and the industry in which it operates; to assist the consortium member in understanding the commercial environment in which the target operates and whether it should proceed with a binding offer for the target’s business.
- Consulting company two – a financial due diligence, an IT due diligence and HR due diligence;
- Law firm – drafting transaction agreements, legal and tax due diligence review and implementation of the transaction. The majority of the expenses are of an advisory nature i.e. expenses incurred to implement the transaction once the decision to invest in the target was made.
In view of the approach followed by the SCA in the De Beers case, it is arguable that the services supplied relating to consulting companies one and two were acquired by the consortium member for the purpose of determining whether the consortium should proceed with its acquisition of the target (and if so, at what price). These expenses are therefore not incurred for the purpose of use, consumption or supply in the course of making taxable supplies by either the consortium member or the OpCo. The said services are generally acquired by the consortium member prior to the commencement of the enterprise activities of the OpCo, and prior to the OpCo’s VAT registration. It is arguable that the consortium member applied this information in assessing the risks and opportunities in relation to the target for purposes of its investment, even though the information obtained may be applied to enhance the taxable enterprise activities of the OpCo (in future). With regard to the expenses incurred prior to the incorporation of the OpCo, the consortium member will have difficulty in substantiating that it acquired these services for the purpose of either its own taxable enterprise or for the enterprise to be carried on by OpCo. Consequently, the consortium member will not be entitled to deduct the VAT incurred on the expenses as input tax. Where expenses are incurred in relation to the implementation of the transaction, it could be argued that certain of these services are rendered to the OpCo for the purpose of its taxable enterprise activities, and the VAT incurred thereon may then qualify as input tax in the hands of the OpCo.
Where expenses were incurred for the business operations of the OpCo prior to its incorporation, then the OpCo may, in certain instances, claim the VAT paid thereon as input tax in terms of section 19 of the VAT Act. In terms of the general input tax rules, the OpCo must be the recipient of the supply of the services in order for it to be entitled to claim the VAT incurred on the services. Any expenses incurred prior to the incorporation of the OpCo cannot be considered to be supplied to the OpCo, because the OpCo was not a legal person prior to that date. However, section 19 of the VAT Act deems a company to be the recipient of goods or services supplied before its incorporation in certain instances.
Section 19 provides that if a person acquires goods or services for and on behalf of, or in connection with the incorporation of a company, being a vendor, and the goods or services were acquired prior to the incorporation of the company, then the company is deemed to be the recipient of the goods or services, provided:
- the person who incurred the expenses was reimbursed by the company for the whole amount of the consideration paid for the goods or services; and
- the person acquired those goods or services for the purpose of an enterprise to be carried on by the company and has not used those goods or services for any other purpose other than carrying on such enterprise.
The provisions of section 19 do not apply, where –
- the supply by the consortium member to the OpCo in recovering the expenses is a taxable supply, i.e. where the consortium member on-charges the expenses by way of a taxable service plus VAT to the OpCo; or
- the consortium member acquired the services more than six months prior to the date of incorporation of the OpCo; or
- the OpCo does not hold sufficient records to establish the particulars relating to the deduction to be made.
It follows that where the consortium member acquired services for and on behalf of the OpCo prior to the incorporation of the OpCo, then the OpCo is deemed to be the recipient of the services if the OpCo reimburses the consortium member for the whole amount of the consideration paid for the services. The reimbursement must be in cash. In addition, the consortium member must have acquired the services for the purpose of the OpCo’s enterprise, and must not have used the services for any purpose other than for the OpCo’s enterprise. Further, for the OpCo to be entitled to deduct the VAT as input tax, it must be a vendor. Therefore, if the OpCo reimburses the consortium member for services acquired on its behalf prior to its registration as a vendor, the OpCo will not be entitled to claim any input tax, even if the expenses are incurred for the purpose of its enterprise.
Where the expenses fall within the ambit of section 19 of the VAT Act, then the requirements relating to the claiming of input tax must still be complied with before the amount can be claimed as input tax. The services must, therefore, have been acquired for the purpose of consumption, use or supply in the course of the OpCo’s taxable enterprise activities for it to qualify as input tax.
Where service providers issued their tax invoices to the consortium member, there may be a temptation to request service providers to cancel their tax invoices and to re-issue them in the name of the OpCo to enable the OpCo to claim the VAT as input tax, especially if the services concerned do not fall within the ambit of section 19 of the VAT Act.
However, if the services were supplied prior to the incorporation of the OpCo, then the OpCo cannot be considered to be the recipient of the services, unless the provisions of section 19 apply. In addition, where service providers supplied their services to the consortium member for the purpose of enabling the consortium to determine whether to proceed with its acquisition of the target’s business, the service providers cannot cancel their invoices and reissue them in the name of the OpCo, because the services were not supplied to the OpCo. Only invoices that relate to the implementation of the transaction after the incorporation of the OpCo may be issued in the name of the OpCo, and it may only claim the VAT incurred on such expenses if they are attributable to its taxable enterprise.
The claiming of input tax in relation to expenses incurred in private equity transactions must be carefully considered in order to avoid the unlawful deduction of VAT that may lead to the imposition of penalties.