Deductibility of input tax on share issue costs in the context of the broad taxation principles

Abstract

Purpose: The purpose of this article is to determine whether input tax on share issue costs incurred should be deductible, in consideration of the broad taxation principles of neutrality, efficiency, flexibility, certainty and simplicity and effectiveness and fairness.

Motivation: Share issue costs incurred by companies to raise capital may be large amounts. The denial of input tax deductions on share issue costs incurred adds an additional 15% to taxpayers’ cost to raise capital.

Design/Methodology/Approach: A doctrinal research methodology was employed to evaluate the deductibility of input tax on share issue costs incurred in the context of the broad taxation principles.

Main findings: This article found that the current denial of input tax on share issue costs incurred does not enhance the broad taxation principles of neutrality, efficiency, certainty and simplicity and effectiveness and fairness.

Practical implications: It is suggested that SARS and National Treasury consider a specific deduction for input tax on share issue costs incurred.

Novelty/Contribution: This article considers the denial of input tax on share issue costs incurred and whether it enhances or detracts from the broad taxation principles. It is the first study to consider the broad taxation principles in the context of share issue costs.

Keywords:

• share issue costs
• input tax
• broad taxation principles
• neutrality
• effectiveness
• fairness

1. Introduction and background

The issue of a company’s shares is one of the main sources of finance used to start up or grow a business (Correia, 2015). Costs incurred, which include accounting fees, listing fees, and costs associated with the preparation of product disclosure statements (Correia, 2015) aid in the share issue of listed and private companies. Value-added tax (VAT) is levied on the supply of these services when provided by vendors in terms of section 7(1)(a) of the Value-Added Tax Act No. 89 of 1991 (the VAT Act). The input tax on these costs incurred is not allowed as a deduction by the South African Revenue Service (SARS) against the VAT payable by a vendor (Badenhorst et al., 2010).

Input tax may be deducted when VAT is incurred on goods or services acquired by a vendor, to the extent that the goods or services are used for the purpose of consumption, use or supply in the course of making taxable supplies (definition of input tax in section 1(1) of the VAT Act). The definition of financial services in section 2(1) of the VAT Act includes the issue, allotment and transfer of shares, and financial services are listed as an exempt supply in terms of section 12(a) of the VAT Act. Input tax on costs incurred in the course of making exempt supplies is not allowed to be claimed as a deduction in terms of the definition of input tax in section 1(1) of the VAT Act. Silver (2009) opines that where a vendor makes principally taxable supplies in the course and furtherance of its enterprise, and issues shares, the vendor should be allowed the input tax deduction on the share issue costs incurred, as the capital raised will be employed to further the vendor’s enterprise.

However, this is not SARS’s current policy – vendors are denied an input tax deduction on share issue costs incurred (Badenhorst et al., 2010), even where the capital raised is employed to further the vendor’s enterprise in the course of which taxable supplies are made. The argument on which SARS denies the deduction of input tax on share issue costs incurred is mainly based on the interpretation of the judgment in Income Tax Case No. 1744 (65 SATC 154) (2002) (ITC 1744). The judgment in ITC 1744 (supra) relied on the principles established in the Court of Justice of the European Union (CJEU) in BLP Group PLC v Customs and Excise Commissioners CJEC C-4-94 1995 (BLP Group case) where it was held, at 19, that a direct and immediate link should exist between costs incurred and the making of taxable supplies for input tax to be deductible. As a result, it was held in ITC 1744 (supra), at 155, that the absence of a direct and immediate link between the share issue costs incurred and the making of taxable supplies excluded the vendor from claiming an input tax deduction in respect of the share issue costs incurred.

ITC 1744 (supra) was only heard in the Tax Court. The Tax Court is not a court of law, and as South Africa follows the English rule of stare decisis, a decision made in the Tax Court is not binding on any higher courts but is binding on the parties of the relevant case (Stiglingh et al., 2022, p. 19). Van der Zwan and Stiglingh (2011, p. 320) submitted that although ITC 1744 (supra) is not binding on SARS, the outcome is favourable to SARS and is currently the only case law providing guidance on the treatment of input tax on share issue costs incurred. Various South African authors disagree with the interpretation of the phrase “in the course of making taxable supplies” provided in ITC 1744 (supra) and state that the phrase “in the course of making taxable supplies” means that only some link should exist (Badenhorst et al., 2010; Holdstock, 2013; Botes, 2018; De Koker & Badenhorst, 2019), and not necessarily a direct and immediate link.

In Consol Glass (Pty) Ltd v CSARS (1010/2019) [2020] ZASCA 175 (18 December 2020) (Consol Glass case), the company decided to refinance the Eurobonds issued during 2007 to hedge the company against unfavourable exchange rates in 2012. Consol Glass procured various services from local vendors as well as foreign suppliers. SARS denied the input tax deduction on the services acquired from local vendors and levied VAT on the imported services acquired from foreign suppliers as it was argued that the services were not in the making of taxable supplies. The Supreme Court of Appeal held, at 36, that the services acquired were for the purpose of reorganising the debt structure of the company and that there was no functional link between the Eurobonds issued and the making of taxable supplies and therefore SARS’s treatment was correct. Moonsamy and De Wet (n.d.) opine that the judgment in the Consol Glass Case (supra) (with reference to the functional link) seems to suggest that a person has to consider both the purpose and effect of the services acquired to determine whether it is in the making of taxable supplies. Even though the Consol Glass case (supra) did not deal with share issue costs, but rather with refinancing expenditure, the findings are still relevant for the purpose of input tax on share issue costs. The direct and immediate link test as decided in ITC 1744 (supra) was enhanced with the functional link test in the Consol Glass case (supra).

While the Consol Glass case provides additional guidance on the functional link test, it does not provide vendors that issue shares to raise funds with a clear and certain answer as to the deductibility of input tax incurred in the process. In situations of ambiguity and uncertainty, a proper approach to the interpretation of tax legislation would be to attribute meaning to the words of the legislation, while having regard to its context, as affirmed in Natal Joint Municipal Pension Fund v Endumeni Municipality 2012 4 SA 593 (SCA) (Natal case) at 18. Context includes looking objectively at the entire statute as a whole, the circumstances and the history in which the specific policy was enacted, as well as its purpose (Natal case, at 18).

The VAT Act was modelled on the New Zealand Goods and Services Tax Act 1985 (the New Zealand GST Act) and adjusted for differences in South African socio-economic conditions (Value-Added Tax Committee (VATCOM), 1991). According to the New Zealand Inland Revenue (New Zealand IR) (2016, p. 4), in New Zealand, input tax on share issue costs was also denied in 2001, when ITC 1744 (supra) was heard. The New Zealand GST Act also classifies financial services as exempt supplies for Goods and Services Tax (GST) purposes and included in financial services is the issue of shares. It follows that prior to 1 April 2017, the New Zealand IR took a similar view to SARS (following the judgment in ITC 1744) that the issue of shares is an exempt supply of financial services. Therefore, a business principally making taxable supplies at that time was unable to deduct GST on the costs incurred in the process (Trombitas, 2015). In 2015, a legislative amendment to the New Zealand GST Act was announced by the New Zealand IR to allow for a specific deduction for input tax on share issue costs incurred to raise capital by businesses principally making taxable supplies (New Zealand IR, 2015, p. 4), effective 1 April 2017. The key objective of the final amendment, which consisted of the insertion of section 20H in the New Zealand GST Act, was to align the treatment of input tax on share issue costs incurred by businesses principally making taxable supplies to the broad taxation principles of neutrality, effectiveness and fairness (New Zealand IR, 2016, p. 4). As the VAT Act was modelled on the New Zealand GST Act, the authors consider these recent developments in the New Zealand GST Act as valuable insight into the context and history of the denial of input tax on share issue costs in South Africa.

Adam Smith advocated the so-called canons of taxation in 1776 (Stack et al., 2015, p. 151) on which the broad taxation principles are based. The canons of taxation are considered the basic criteria to determine whether a tax system is “good” (Smith, 1776) and were restated by the Organisation for Economic Co-Operation and Development (OECD) in 1998 for application in the new electronic era (Stack et al., 2015, p. 152). The broad taxation principles were subsequently included in the OECD International VAT/GST Guidelines (OECD, 2017, p. 18). In terms of the OECD International VAT/GST Guidelines (OECD, 2017, p. 18), the broad taxation principles are as follows: neutrality, efficiency, flexibility, certainty and simplicity and effectiveness and fairness.

Although South Africa is not a member of the OECD (2018), its relationship with the OECD is considered “mutually beneficial” (OECD, 2018). Moreover, the OECD, National Treasury and SARS agreed to continue to work together in the area of taxation by means of a Memorandum of Co-operation (MOC) signed on 11 January 2019 (SARS, 2019). The MOC’s common objectives are to promote fairness and efficiency in South African tax systems (SARS, 2019). Collaboration with the OECD in the areas of tax policies is considered beneficial for South Africa and will allow the three parties to the MOC to share experiences to strengthen and modernise international tax practices (SARS, 2019).

Additionally, the broad taxation principles were specifically considered to evaluate the policy design of the VAT Act (VATCOM, 1991). The Davis Tax Committee (2018, p. 6) also highlighted that proposed legislative amendments on the treatment of financial services should be done with the purpose of enhancing the broad taxation principles. Therefore, it is suggested that the OECD’s broad taxation principles may be relevant to interpret and evaluate the provisions of the VAT Act, and to consider possible amendments to enhance the VAT system.

2. Research aim

The aim of this research article was to determine whether input tax on share issue costs incurred should be deductible, in consideration of the broad taxation principles that are fundamental to a “good” VAT system. The New Zealand IR (2016, p. 5) considered the broad taxation principles at the heart of its amendment to allow for input tax deductions on share issue costs incurred by businesses principally making taxable supplies. To that end, this research article considers how the changes adopted by the New Zealand IR may provide valuable policy insights for National Treasury and SARS to consider in a South African context.

3. Research rationale

Share issue costs incurred by companies to raise capital may be large amounts (Van der Zwan & Stiglingh, 2011, p. 320). One such example is Dis-Chem Pharmacies Limited that spent an estimated R149 million in share issue costs to list on the Johannesburg Stock Exchange in November 2006, which comprised more than 3% of the capital raised (Tarrant, 2016). Similarly, the vendor in ITC 1744 (supra) incurred share issue costs that amounted to 20% of the capital raised in a private share placing (ITC 1744, at 156). VAT is levied in terms of section 7(1)(a) of the VAT Act as a standard-rated supply of 15% on these services when provided by vendors. Therefore, the denial of input tax deductions on share issue costs incurred adds an additional 15% to taxpayers’ cost to raise capital, which may already comprise 20% of the value of the capital raised, which was the case in ITC 1744 (supra). Van der Zwan and Stiglingh (2011, p. 320) argue that the magnitude of the amount spent on share issue costs might have an influence on how much capital a business decides to raise, especially considering that the input tax on these costs is not allowed as a deduction.

In achieving the research aim as stated above, this article demonstrates that input tax on share issue costs incurred should be deductible, which may benefit businesses that incur significant costs to raise capital through the issue of shares.

4. Limitations of scope

This article focuses on the policy decision to deny input tax deductions on share issue costs incurred, with reference to the broad taxation principles. Consequently, this article does not provide an in-depth analysis of the appropriateness of using the direct and immediate link test as established in ITC 1744 (supra), which may also indicate that input tax on share issue costs incurred should be deductible. Furthermore, this article does not provide an in-depth analysis of whether the issue of shares constitutes a “supply” as defined in section 1(1) of the VAT Act, although such an analysis may also suggest that input tax on share issue costs incurred should be deductible as highlighted by Van der Zwan and Stiglingh (2011, p. 338). Therefore, this article assumes that the issue of shares constitutes a supply as defined in section 1(1) of the VAT Act.

While other jurisdictions such as the European Union and Australia also have updated positions on the deductibility of input tax on share issue costs, focus in this article is placed on recent developments in the New Zealand GST Act as context to the current position on input tax on share issue costs in South Africa as the VAT Act was modelled on the New Zealand GST Act. Further analysis of the comparative position of jurisdictions other than New Zealand may add further value and this provides an opportunity for future research.

5. Research methodology

A doctrinal research methodology, as described by Hutchinson and Duncan (2012, p. 101), was followed. A doctrinal research methodology has previously been applied in legal studies. The doctrinal research methodology applied in this study followed a systematic process. Firstly, an analysis was performed of the comparative treatment of the requirements to deduct input tax in terms of the New Zealand GST Act and the VAT Act respectively. This was followed by an investigation of the broad taxation principles in the context of input tax on share issue costs incurred, to determine whether the current approach in South Africa can be improved by employing the approach followed by the New Zealand IR. A qualitative research approach was followed in the form of a literature review to achieve the research aim. Primary and secondary data were collected, predominantly from legal databases, academic articles, books, publications by regulatory bodies and theses. Keywords used to identify relevant case law and articles are share issue costs, input tax, broad taxation principles. Law and policy developments up to 30 June 2022 are reflected in the research.

6. Analysis of the comparative treatment of the requirements to deduct input tax in terms of the New Zealand GST Act and the VAT Act respectively

The comparative treatment of the requirements to deduct input tax in terms of the New Zealand GST Act and the VAT Act respectively, before and after the introduction of section 20H to the New Zealand GST Act, is considered next. This is done to show that it may be appropriate to consider similar arguments as the New Zealand IR to amend VAT policy on the deductibility of input tax on share issue costs incurred. The comparative treatment of the issue of shares in both jurisdictions are discussed first.

6.1. Comparative treatment of the issue of shares

In terms section 3 of the New Zealand GST Act, the issue of shares constitutes a financial service. The supply of any financial service is exempt from tax (section 14 of the New Zealand GST Act). Two exceptions to the exemption of financial services supplied are included in the New Zealand GST Act:

1. Financial services supplied by financial service providers to businesses principally making taxable supplies are zero-rated and input tax deductions on the costs incurred in the process are deductible (New Zealand IR, 2016, p. 3).

2. Financial services supplied to non-residents outside New Zealand are also considered zero-rated supplies, and input tax deductions on costs incurred in the process are deductible (New Zealand IR, 2016, p. 3).

Despite the two exceptions provided for, as noted above, the issue of shares to raise capital is considered an exempt supply of financial services (New Zealand IR, 2016, p. 3). However, Trombitas (2015) suggested that there are grounds to argue that the issue of shares does not constitute a supply in terms of the New Zealand GST Act, in line with the judgment in Kretztechnik AG v Finanzamt Linz 2005 ECJ C-465/03 (Kretztechnik case) in the CJEU. The Kretztechnik case (supra) determined that since the issue of shares provides the new shareholder with a right of ownership of part of the business’s capital, the consideration paid is an investment on their part and does not constitute consideration for services received (Kretztechnik case, at 26). Therefore, the CJEU held that since nothing is given up or provided by the business issuing the shares, no supply takes place (Kretztechnik case, at 26). In the absence of a specific supply to which the share issue costs can be linked, the CJEU further held in Securenta Göttinger Immobilienanlagen und Vermögensmanagement AG v Finanzamt Göttingen 2008 ECJ C-437/06 (Securenta case) that input tax on share issue costs incurred may be deductible to the extent that the business as a whole makes taxable supplies. Although taxpayers in New Zealand have provided arguments in support of the judgment in the Kretztechnik case (supra) (Trombitas, 2015), the New Zealand IR still considers the issue of shares to constitute a supply (New Zealand IR, 2016, p. 3; Trombitas, 2019). To the best of the knowledge of the authors, the New Zealand IR has not commented on arguments in support of the judgment in the Kretztechnik case (supra).

In a South African context, the VAT Act similarly states that the issue of shares is a financial service (definition of financial services in section 2(1)(d) of the VAT Act) and that the supply of financial services is exempt from VAT (section 12(a) of the VAT Act). The South African courts held in ITC 1744 (supra) that it is common cause that the issue of shares is an exempt supply. In contrast, Van der Zwan and Stiglingh (2011, p. 335) submitted that there are grounds to argue that the issue of shares is not a supply in the South African context, following the arguments put forth by the CJEU in the Kretztechnik case (supra) and the Securenta case (supra). Similar to the New Zealand IR, SARS has not commented on South African authors’ submissions that the arguments in the Kretztechnik case (supra) may indicate that the issue of shares does not constitute a supply.

Therefore, although authors in both jurisdictions (Van der Zwan & Stiglingh, 2011, p. 338; Trombitas, 2019) have suggested that there are grounds to argue that the issue of shares does not constitute a supply, it is currently treated as a supply in terms of both the New Zealand GST Act and the VAT Act. The comparative requirements to deduct input tax on share issue costs incurred in both jurisdictions are discussed next.

6.2. Comparative treatment of the requirements to deduct input tax in the context of share issue costs incurred

Section 3A(1)(a) of the New Zealand GST Act defines input tax as a “tax charged under section 8(1) on the supply of goods and services acquired by the person”. Section 20(3C) of the New Zealand GST Act states that “input tax as defined in section 3A(1)(a) and (c) may be deducted to the extent to which the goods or services are used for, or are available for use in, making taxable supplies”. In a South African context, input tax is defined in section 1(1) of the VAT Act to mean inter alia a tax charged by a supplier on the supply of goods or services made by that supplier to the vendor in terms of section 7 of the VAT Act, where such goods or services are acquired by the vendor wholly for the purposes of consumption, use or supply in the course of making taxable supplies. Where such goods and services are acquired by the vendor partly for such a purpose, input tax is deductible only to the extent (as determined in accordance with the provisions of section 17(1)) that the goods or services are acquired by the vendor for such purpose (definition of input tax in section 1(1) of the VAT Act). It is therefore concluded that input tax deductions in both the New Zealand GST Act and the VAT Act are allowed to the extent that the goods or services concerned are used to make taxable supplies (section 20(3C) of the New Zealand GST Act; definition of input tax in section 1(1) and section 17(1) of the VAT Act). However, to further understand the requirements to deduct input tax in both jurisdictions, the closeness of the connection between costs incurred and the making of taxable supplies in both jurisdictions is examined further.

In its 2015 Tax Policy publication, the New Zealand IR (2015, p. 1) considered how close a connection should exist between share issue costs incurred and the making of taxable supplies for it to be deductible in terms of section 20(3C) of the New Zealand GST Act. It was stated that, in general, the deductibility of input tax on costs incurred is dependent on the underlying specific supply to which the costs incurred relate (New Zealand IR, 2015, p. 1). The New Zealand IR (2015, p. 1) further concluded that the specific supply to which input tax on share issue costs incurred relate is the issue of shares, which is considered an intervening exempt supply.

In a South African context, the court held in ITC 1744 (supra) that for input tax on share issue costs incurred to be deductible, a direct and immediate link should exist between the share issue costs incurred and the making of taxable supplies. The court considered that the specific supply to which share issue costs relate is the issue of shares, which is considered an intervening exempt supply (ITC 1744, at 158). Although various South African authors disagreed with the judgment in ITC 1744 (supra) and argued that only “some link” should exist (Badenhorst et al., 2010; Holdstock, 2013; Botes, 2018; De Koker & Badenhorst, 2019), ITC 1744 (supra) is still the leading guidance on the matter. Therefore, it is concluded that, before the inclusion of section 20H in the New Zealand GST Act, input tax on share issue costs incurred in both the New Zealand GST Act and the VAT Act was deemed not deductible where an intervening exempt supply in the form of a share issue exists.

To align the treatment of input tax on share issue costs incurred with that of the broad taxation principles, the New Zealand IR (2016, p. 4) amended the New Zealand GST Act through the introduction of section 20H effective 1 April 2017, which is evaluated next.

6.3. Section 20H of the New Zealand GST Act

The New Zealand IR (2015, p. 3) concluded that the unintended consequences of the exempt treatment of the issue of shares for all types of taxpayers may be resolved by specifically disregarding the exemption for businesses principally making taxable supplies when raising capital. It was further suggested that, since money is fungible between different activities, it is impossible for taxpayers to attribute share issue costs incurred to a specific business activity (New Zealand IR, 2015, p. 3). Therefore, the New Zealand IR concluded that, to the extent that the business as a whole makes taxable supplies, input tax on share issue costs incurred should be deductible and that, when required, input tax deductions may be apportioned in the same reasonable and fair manner as general overhead costs (New Zealand IR, 2015, p. 3). It was suggested that such an approach would provide taxpayers with certainty on the extent to which share issue costs are deductible and would result in the right amount of tax levied at the right time (New Zealand IR, 2015, p. 3). In turn, this may enhance the broad taxation principles of neutrality, effectiveness and fairness.

To give legislative effect to the New Zealand IR’s position outlined above, section 20H was introduced to the New Zealand GST Act, effective 1 April 2017. Section 20H was amended in 2019 to extend the deduction in certain instances to a holding company that incurs costs to issues shares which are used to fund the activities of its operating company that principally makes taxable supplies. This amendment sought to further align section 20H to the policy intent on capital raising deduction rules by extending the deduction to groups where the holding company is not also the operating company that makes taxable supplies (New Zealand IR, 2020, p 76). Further amendments in 2022 saw the inclusion of cryptocurrency as a funding method which falls within the ambit of section 20H. With the inclusion of changes up to 30 June 2022, section 20H of the New Zealand GST Act determines in subsection (1) that:

A registered person who principally makes taxable supplies and who makes supplies of financial services referred to in paragraph (a), and is, or intends to be, principally making supplies that would be taxable supplies in the absence of the supplying of financial services, has a deduction under section 20(3)(hd) of input tax for the supplies that are used in making the supplies of the financial services, if—

(a) the supplies of the financial services (the funding support services) are made in the course of raising funds that are intended to be used in a taxable activity, or to be a replacement for funds used in a taxable activity, of the registered person or of a person (the group company) in the same group of companies under the Income Tax Act 2007; and … 

(d) the funding support services are—

1. the issue or allotment of an interest or right (a funding security) that is a debt security, participatory security, equity security, or a cryptocurrency with similar features and function;

2. the renewal of a funding security;

3. the payment of an amount of interest, principal, or dividend for a funding security;

4. the provision or variation of a guarantee of the performance of obligations in the issue, allotment, or renewal of a funding security; and … 

Provisos (b) and (c) to section 20H(1), which are not listed above, maintain that where the financial services in question are zero-rated in terms of section 11A(1)(q) and (r) of the New Zealand GST Act or do not give rise to a deduction in the absence of section 20H(1), the specific deduction included in section 20H does not apply. Input tax on such share issue costs incurred for shares issued to non-residents is then deductible in terms of the normal zero-rating provisions. In terms of proviso (e) to section 20H(1), an input tax deduction is allowed irrespective of whether the required funds were successfully raised to further taxable activities. Proviso (f) to section 20H(1) further maintains that the deduction under section 20H(1) is only available if the funds spent would have qualified for a normal input tax deduction if used directly in the taxable activity in which the funds are intended to be used. Furthermore, section 20H(2) maintains that the specific deduction provided in section 20H(1) is not available for non-resident persons who are registered for GST.

It follows that section 20H of the New Zealand GST Act is therefore not available for businesses within a group of companies that principally make exempt supplies, such as banks and other financial institutions, but conversely specifically caters for businesses within a group of companies that principally makes taxable supplies. The New Zealand tax community welcomed the amendment as a “principled solution to a long running issue and area of dispute” (KPMG, 2015) and a “welcome GST policy law change” (Trombitas, 2015). Although Trombitas (2019) suggested that the inclusion of section 20H of the New Zealand GST Act still does not address the uncertainty of whether the issue of shares constitutes a supply in the first place, it seems to provide a pragmatic solution for taxpayers in New Zealand who incur significant share issue costs.

The introduction of section 20H of the New Zealand GST Act enhanced the broad taxation principles of neutrality, effectiveness and fairness, which are fundamental to a good VAT system. To determine how the New Zealand IR’s approach to input tax on share issue costs can improve the current position in South Africa, where input tax on share issue costs incurred is considered not deductible, the broad taxation principles in the context of input tax on share issue costs incurred are considered next.

7. The broad taxation principles in the context of input tax on share issue costs incurred

The OECD International VAT/GST Guidelines (2017, p. 11) support that jurisdictions should draft and implement VAT legislation in an autonomous manner. However, by establishing the broad taxation principles, the OECD (2017, p. 11) aims to provide a reference point from which jurisdictions can assess and develop VAT policies.

To determine whether input tax on share issue costs should be deductible in South Africa, each broad taxation principle is considered next in the context of input tax on share issue costs incurred. The steps followed in respect of each principle are as follows: firstly, the meaning of the principle is contemplated, secondly, the principle is evaluated in the context of input tax on share issue costs incurred in South Africa, and lastly a conclusion is drawn on whether the denial of input tax deductions on share issue costs incurred detracts from each principle evaluated. The arguments provided by the New Zealand IR to advocate the deductibility of input tax on share issue costs incurred are considered with respect to each principle where applicable. While each of the broad taxation principles are addressed in this article, the New Zealand IR did not specifically consider the principle of flexibility, and regarded the principles of neutrality, effectiveness and fairness as key objectives.

7.1. Neutrality

The OECD (2017, p. 20) laid down three guidelines to the neutrality principle:

1. VAT rules should be established in such a way that they are not the primary influence on business decisions.

2. The burden of VAT should not be placed on taxable businesses except where explicitly provided for in legislation.

3. Businesses in similar situations carrying out similar transactions should be subject to similar levels of taxation.

7.1.1. VAT rules should be established in such a way that they are not the primary influence on business decisions

In terms of the neutrality principle, VAT should be neutral and equitable between different forms of commercial transactions (OECD, 2017, p. 18). Business decisions should not be influenced by the VAT implications thereof, but should be motivated by economic factors (OECD, 2017, p. 18). In all likelihood, the VAT implications of a business decision will be considered, but it should not be the driving force behind why a transaction is structured in a certain way (OECD, 2017, p. 21).

Input tax on share issue costs incurred to raise capital in South Africa is not deductible (Badenhorst et al., 2010). However, input tax on costs incurred to obtain a bank loan, is deductible. In terms of section 2(1)(f) of the VAT Act, the provision of credit, which includes a bank loan, is a financial service, which is an exempt supply in terms of section 12(a) of the VAT Act. The interest incurred on a bank loan is also a financial service as defined in terms of section 2(1)(f) of the VAT Act, and therefore also an exempt supply. However, where “any fee, commission, merchant’s discount of similar charge” that relates to the provision of credit, among other, is payable, it shall not be deemed to be financial services (proviso to section 2(1) of the VAT Act). Therefore, where a fee or commission is payable in relation to the provision of credit, it is not considered a financial service and is therefore not an exempt supply. Input tax on costs incurred to obtain a bank loan is therefore deductible in South Africa where the services rendered consist of a fee or similar charge, and the loan is used in the course of making of taxable supplies. This is contrary to the treatment of input tax on share issue costs, which is not deductible (Badenhorst et al., 2010). This may influence the business decision made by a vendor to rather obtain a bank loan to finance its business than to issue shares, to take advantage of the input tax deduction on costs incurred in the process.

The issue of shares to non-resident shareholders may also be considered a zero-rated supply in terms of the VAT Act. This results in differential treatment of the input tax deduction of share issue costs based on whether the shares were issued to non-residents or residents, which nullifies the neutrality principle of a good VAT system. Section 11(2)(l) of the VAT Act prescribes the VAT treatment of services supplied to non-residents. In some cases, where the services are rendered to non-residents, but the services relate to immovable property situated in South Africa, then the services are not zero-rated. Where the non-resident is physically present in South Africa at the time that the services are rendered, the supply is also not zero-rated (section 11(2)(l)(iii) of the VAT Act). Therefore, provided that shareholders are not physically present in South Africa at the time of the issue of shares to non-resident shareholders, it may fall within the ambit of section 11(2)(l) if the issue of shares is considered a supply.

Silver (2019) opines that where financial services fall within the ambit of section 11(2)(l), or any other subsection in terms of which VAT is charged at a rate of zero per cent, the zero-rating provision takes precedence over the exemption provided in section 12(a). Zero-rated supplies in terms of section 11 of the VAT Act are also taxable supplies (definition of taxable supply in section 1(1) of the VAT Act). The implication of this is that input tax on costs incurred in the course of making zero-rated supplies are deductible in terms of the definition of input tax in section 1(1) of the VAT Act. Therefore, input tax on costs incurred to issue shares to non-resident shareholders may be deductible, provided that the non-resident shareholder is not present in the Republic at the time the shares are issued. It follows that where a company issues shares to a non-resident shareholder (physically present outside of South Africa) and similarly issues shares to a resident shareholder inside the Republic, dissimilar treatment of input tax on the share issue costs incurred arises. As share issue costs incurred are often significant amounts, the deductibility (or not) of the input tax incurred could lead to a vendor making a different commercial decision. This is not in line with the OECD’s (2017, p. 21) guideline that VAT rules should not be the primary influence on an organisation’s business decisions.

Similar considerations were made in New Zealand, before the inclusion of section 20H of the New Zealand GST Act. Trombitas (2006, p. 6) distinguished between the costs incurred to issue shares and to obtain similar types of financing and found that the New Zealand GST Act treated input tax on these costs differently, which negates the principle of neutrality. For example, the input tax on costs incurred to obtain a bank loan is deductible, whereas input tax on costs incurred to obtain financing through the issue of shares was not (Trombitas, 2006, p. 6), prior to the changes made by the New Zealand IR in 2017. The issue of shares as well as the provision of credit are considered exempt supplies in terms of the New Zealand GST Act (section 3 of the New Zealand GST Act). Trombitas (2006, p. 6) argued that the different VAT treatment of two similar transactions, which are both considered exempt supplies in terms of the New Zealand GST Act, detracts from the principle of neutrality.

In addition, the New Zealand IR (2016, p. 4) also highlighted the different treatment of input tax on costs incurred to issue shares to shareholders who are residents and those who are non-residents. Prior to the inclusion of section 20H of the New Zealand GST Act, input tax on share issue costs incurred in New Zealand was not deductible since the share issue costs were incurred for the making of an exempt supply (New Zealand IR, 2016, p. 4). In contrast, input tax on costs incurred to issue shares to non-resident shareholders was deductible since the issue of shares to non-resident shareholders was considered a zero-rated supply. VAT is levied at zero per cent in the case of a zero-rated supply, but it remains a taxable supply, whereas an exempt supply is not a taxable supply. The New Zealand IR (2016, p. 4) noted the inconsistent treatment of the deductibility of input tax on share issue costs incurred based on whether shares were issued to non-residents or issued to residents. This inconsistent treatment created a disincentive for the issue of shares to residents, which negated the neutrality principle (New Zealand IR, 2016, p. 5).

The neutrality principle further requires that VAT merely “flows through” the business, which is discussed in the ensuing section.

7.1.2. The burden of VAT should not lie on taxable businesses except where explicitly provided for in legislation

VAT is an indirect tax as it “flows through” the business (OECD, 2017, p. 20) and vendors act as agents to collect the tax on behalf of the revenue authorities. The VAT burden is ultimately borne by the end consumer (OECD, 2017, p. 20).

The International VAT/GST Guidelines of the OECD have highlighted certain scenarios where jurisdictions are allowed to shift the VAT burden from the end consumers to businesses, as long as it is specifically provided for in legislation (OECD, 2017, p. 21). The perception is that financial services are complicated and therefore challenging to tax, and for this reason the OECD (2017, p. 20) has indicated that financial services may be exempt from the levying of VAT and that jurisdictions may shift the VAT burden from the end consumer to businesses.

The reason financial services are perceived to be challenging to tax is that fees charged by financial service providers can easily be replaced by margins made on the financial services supplied (New Zealand IR, 2015, p. 1). Therefore, the supply of financial services in most jurisdictions are exempt from the levying of VAT (Mirrlees et al., 2011, p. 196). The manner in which jurisdictions then collect VAT on exempt financial services is by the denial of input tax deductions on costs incurred in the process of making the exempt supplies of financial services (Mirrlees et al., 2011, p. 196). The denial of input tax deductions on costs incurred in the making of exempt supplies provides a simpler way for jurisdictions to collect VAT and in the process, it places the VAT burden on the business instead of placing it on the end consumer.

The cost of the non-deductible input tax can either be passed on to customers of the business or the business can absorb it, which creates a cascading effect (New Zealand IR, 2015, p. 2). In a South African context, the Davis Tax Committee (2018, p. 6) has identified VAT cascades that arise from the exemption of financial services and the subsequent denial of input tax deductions on costs incurred in the process as a breach of the neutrality principle. VAT cascades occur in scenarios where financial services are supplied as a transitional supply in relation to a subsequent taxable supply and the input tax paid on the goods or services acquired in the making of the exempt financial services is not allowed as a deduction (Davis Tax Committee, 2018, p. 30). VAT cascades detract from the neutrality principle since it does not result in the VAT burden being carried by the end consumer, but rather by a business making taxable supplies (Moodley, 2016, p. 28).

It is suggested by the New Zealand IR (2016, p. 4) that the intended purpose of GST is to be a tax applied only once on final consumption, and since the denial of input tax deductions on share issue costs incurred results in tax cascades, this intended purpose is not met. In South Africa, the Davis Tax Committee (2018, p. 29) has contemplated whether the exemption of financial services and subsequent denial of input tax deductions incurred in the process, negates the principle of neutrality due to the existence of VAT cascades. According to the Davis Tax Committee (2018, p. 6), the existence of VAT cascades as a result of the exemption of financial services was considered the most crucial area for contemplation in the context of VAT exemptions. Despite the Davis Tax Committee highlighting this as an important area, the report failed to consider the VAT treatment of financial services in the context of businesses principally making taxable supplies, where shares are issued to raise capital. The focus was placed instead on financial services supplied by financial service providers, such as banks and other financial institutions.

Since the denial of input tax on share issue costs incurred results in VAT cascades, it detracts from the neutrality principle of a good VAT system, as businesses principally making taxable supplies are also denied an input tax deduction and as such the VAT burden shifts from the end consumer to the business. A further guideline of the neutrality principle states that, in addition to the concept that VAT rules should not direct business decisions, businesses in similar situations carrying out similar transactions should be taxed similarly (OECD, 2017, p. 18). This is considered in the following section.

7.1.3. Businesses in similar situations carrying out similar transactions should be subject to similar levels of taxation

The same levels of taxation should apply for taxpayers in similar positions, carrying out similar transactions (OECD, 2017, p. 18). What this guideline achieves in a VAT system, is that the correct amount of VAT is collected along the supply chain, which is proportional to the VAT paid by the end consumer irrespective of the type of the supply (OECD, 2017, p. 21). In addition to this, neutrality is also achieved in a VAT system that is “unbiased and impartial” with no undue tax burden or unreasonable compliance cost for taxpayers (OECD, 2017, p. 20).

Compliance costs to vendors include the cost to calculate, remit and account for VAT, as well as the cost incurred to acquire the necessary knowledge and to understand the legal obligations thereof where the vendor is uncertain of the implications (Sandford et al., 1989). Compliance costs therefore include administrative costs, which refer to the cost of tax authorities to administer and collect taxes, from initial policy formulation through to the cost of a judicial and tax dispute system (Evans, 2008, p. 450).

It is submitted that the denial of input tax on share issue costs incurred in a South African context is not in line with the neutrality principle since it results in increased compliance costs for taxpayers if apportionment between taxable and exempt supplies needs to be made. Input tax on share issue costs incurred is currently not deductible based on the judgment in ITC 1744 (supra) (Badenhorst et al., 2010), as the issue of shares is considered an exempt supply in terms of section 2(1)(d), read together with section 12(a), of the VAT Act. Where costs are incurred in the making of both non-taxable and taxable supplies, an apportionment of the input tax of the costs should be done and only the portion that relates to the making of taxable supplies is deductible (Legal and Policy Division, 2017, p. 59).

In addition to compliance costs incurred to apportion goods or services acquired, businesses might have to incur costs to obtain legal advice in respect of whether the input tax would be deductible or not, or whether the matter should be referred to the tax court (Sandford et al., 1989). It is suggested that the need to resort to a tax court to determine the correct VAT treatment of a transaction, may result in unreasonable compliance costs for taxpayers and administrative costs for tax authorities to fund the legal proceedings, which negates the neutrality principle. It is submitted that this is a possibility in South Africa, where the judgment in ITC 1744 (supra) directs SARS’s policy on the deductibility of input tax on share issue costs incurred. Since no guidance on the matter has been provided since ITC 1744 (supra) was heard in 2001, taxpayers may have to follow the dispute resolution process in terms of the Tax Administration Act No. 28 of 2011 which could resort to the tax court to determine whether input tax on share issue costs incurred is deductible.

The principle of efficiency, which is discussed next, compliments the neutrality principle (OECD, 2017, p. 80), since it also speaks to low taxpayer compliance costs.

7.2. Efficiency

The broad taxation principle of efficiency holds that the administrative cost for tax authorities and the cost of compliance for taxpayers should be kept as low as possible (OECD, 2017, p. 18). The OECD (2017, p. 24) lists examples of VAT compliance costs that relate to employment, infrastructure, and an entity’s financial affairs. Employment-related compliance costs include the costs of collection and recovery of VAT, obtaining the necessary knowledge and skills to determine the VAT treatment as well as completing a VAT return (Evans et al., 2014, p. 460). Infrastructure costs include the setting up of appropriate systems and processes to correctly account for VAT, including the continuous software changes to the system (OECD, 2017, p. 24). Compliance costs that relate to the financial affairs of the entity include cash-flow costs and bank guarantees (OECD, 2017, p. 24).

In a study conducted by Evans et al. (2014, p. 463), the internal compliance costs of tax for four countries (Australia, Canada, South Africa and the United Kingdom) were compared. VAT compliance cost was reported as the largest for three of the four countries. Canada was the only country which reported that income tax was the largest contributor of compliance cost (Evans et al., 2014, p. 463). For the period under review (2010–2011), VAT compliance cost was considered to make up 38% of all compliance costs over all the different taxes (Evans et al., 2014, p. 463).

It is submitted that the denial of input tax on share issue costs will further increase the cost of VAT compliance by businesses in South Africa. An employee may need to obtain further training (or in some cases, tax opinions by specialists) in the case where an apportionment of costs of goods or services supplied needs to be assessed. It is therefore concluded that the principle of efficiency is not enhanced through the current treatment of input tax on share issue costs incurred. The broad taxation principle of flexibility is considered next.

7.3. Flexibility

The principle of flexibility considers that the “systems for taxation should be flexible and dynamic to ensure that they keep pace with technological and commercial developments” (OECD, 2017, p. 24). The principle of flexibility therefore ensures that a government has sufficient tax revenue and that the systems are adaptable to any changes (technological and commercial) in the environment (OECD, 2014, p. 31). The Davis Tax Committee (2014, p. 82) viewed VAT as “a stable and broad-based source of tax revenue” in its First Interim Report on Macro Analysis – Full report during 2014. The principle of flexibility is also referred to as tax buoyancy, which refers to the measurement of the responsiveness of tax revenue to changes in economic growth (Stiglingh et al., 2022, p. 8). As VAT is regarded as a flexible or buoyant tax, the principle of flexibility is not considered to be negated by the denial of input tax on share issue costs.

7.4. Certainty and simplicity

The rules of a VAT system that incorporates the principle of certainty and simplicity are clear and simple, and it is easy for taxpayers to anticipate the VAT consequences of their transactions (OECD, 2017, p. 18). Conversely, it follows that where the VAT consequences of certain transactions are unclear, ambiguous and open to different interpretations by different taxpayers, the principle of certainty and simplicity is not enhanced by the rules which underpin the VAT system.

Interpretation Note No. 70 (Legal and Policy, 2013, p. 5) states that VAT legislation should be clear on which types of transactions constitute taxable or non-taxable supplies. This suggests that SARS aims to maintain VAT legislation that enhances the principle of certainty and simplicity.

Based on the contrasting views between the judgment of ITC 1744 (supra) and various South African authors (Badenhorst et al., 2010; Van der Zwan & Stiglingh, 2011, p. 337; Holdstock, 2013; Marais, 2014, p. 37; Botes, 2018), it may be submitted that the current treatment by SARS of input tax on share issue costs incurred is unclear and difficult to anticipate. Van der Zwan and Stiglingh (2011, p. 338) submit that there are grounds to argue that the issue of shares is not a supply in terms of section 1(1) of the VAT Act. This view is in contrast with the tax court’s considerations in ITC 1744 (supra), at 156, where it was considered common cause that the issue of shares constitutes an exempt supply, and that the share issue costs incurred have a direct and immediate link to that exempt supply. South African authors further disagree on whether it is appropriate to use the direct and immediate link test established in ITC 1744 (supra) to apply the provisions of section 1(1) of the VAT Act (Badenhorst et al., 2010; Van der Zwan & Stiglingh, 2011, p. 337; Holdstock, 2013; Marais, 2014, p. 37; Botes, 2018). It is therefore submitted that, since the current treatment of input tax on share issue costs incurred in terms of the VAT Act produces uncertainty and is difficult to anticipate, it detracts from the broad taxation principle of certainty and simplicity. Since certainty and simplicity are required for a VAT system to be effective and fair, the absence thereof also detracts from the principle of effectiveness and fairness (OECD, 2017, p. 80), which is considered in the ensuing section.

7.5. Effectiveness and fairness

The OECD (2017, p. 18) maintains that a taxation system that produces the right amount of tax at the right time, and where the potential for tax avoidance and tax evasion is minimal, enhances the principle of effectiveness and fairness. “Right” means “being in accordance with what is just, good, or proper”, which is synonymous with “fair” and “justified” (Merriam-Webster, 2021). Fairness or equity in a VAT system is achieved when all parties are treated equally (Moodley, 2016, p. 26), which means that every taxpayer contributes their “fair share” in line with the purpose of the VAT system. According to the OECD (2017, p. 14), the purpose of a VAT system is to tax final consumption in a broad-based manner.

It is submitted that the VAT Act does not distinguish between the supply of financial services by financial services providers and businesses principally making taxable supplies. This seems to provide insight into the reason input tax on share issue costs incurred is denied in the first place and is therefore considered fundamental to the overall objective of this article. Section 2(1) of the VAT Act states that “the following activities shall be deemed to be financial services” (own emphasis added). It is further stated in section 12 of the VAT Act that “the supply of any of the following goods or services shall be exempt from the tax imposed under section 7(1)(a)” (own emphasis added), which includes in subsection (a) the “supply of any financial services”. It is therefore not financial institutions that are exempt from VAT, but rather certain activities that comprise financial services that are considered exempt from VAT (VATCOM, 1991). Consequently, it seems that there is no distinction in the VAT Act between the supply of financial services by financial service providers and those supplied by businesses principally making taxable supplies. It follows that the provisions of the VAT Act result in the uniform treatment of both the supply of financial services by financial service providers and the issue of shares (which is considered the supply of financial services) by businesses that principally make taxable supplies. For businesses that principally make taxable supplies, the incidental provision of financial services (through the issue of shares) in the pursuit of raising capital results in an additional tax cost, due to the denial of input tax on share issue costs incurred.

On the one hand, it may be argued that this uniform treatment of financial services, irrespective of whether supplied by financial service providers or businesses principally making taxable supplies, was intended by the legislature, given the wording of section 2(1) and section 12 of the VAT Act. Criticism against the former argument includes that, in most instances, speculation is used to ascertain the intention of the legislature, which the courts considered “dangerous” in Shenker v The Master and Another 1936 AD 136, at 143. Wallis JA further warned in the Natal case (supra), at 21, that “there is no such thing as the intention of the legislature in relation to the meaning of specific provisions in a statute” and dubbed the search for the legislature’s intention as “ephemeral” and “possibly chimerical”. On the other hand, it may be argued that the uniform treatment of input tax on share issue costs incurred by financial service providers and businesses principally making taxable supplies was incidental, and not the explicit intention of the legislature. The VAT Act was modelled on the New Zealand GST Act (VATCOM, 1991) and therefore the latter argument is supported by the inclusion of section 20H in the New Zealand GST Act, which specifically allows for a deduction of input tax on share issue costs incurred by businesses principally making taxable supplies.

In its motivation for the inclusion of section 20H in the New Zealand GST Act, the New Zealand IR (2016, p. 4) argued that a distinction should be made between financial services supplied by different types of businesses. On the one hand, banks and other financial service providers supply financial services as part of their core business activity. On the other hand, businesses that principally make taxable supplies may supply financial services incidentally when issuing shares to raise capital. This distinction highlighted that the exemption of financial services was intended to address the difficulty experienced in taxing the supply of financial services supplied by financial service providers, due to the volume and nature of the transactions (New Zealand IR, 2016, p. 3). However, since the New Zealand GST Act treated the issue of shares by any type of business the same, the inadvertent result was the denial of input tax deductions for businesses that issue shares in the pursuit of raising capital to expand their business of making taxable supplies (New Zealand IR, 2015, p. 1). This was considered inappropriate, since regular businesses that issue shares on an ad hoc basis to expand their taxable business did not seek to add value to the supply of financial services (New Zealand IR, 2015, p. 1). Financial services supplied in such instances are also not consumed by the providers of the capital, being the shareholders (New Zealand IR, 2016, p. 4), and are merely an intermediate supply of financial services in relation to a taxable supply made to an end consumer (New Zealand IR, 2015, p. 2). In contrast, financial services supplied by financial service providers such as banks and other financial institutions are mostly consumed by the recipient of the financial service, for example the consumer who receives a loan from a bank (New Zealand IR, 2016, p. 4).

Based on this distinction, the New Zealand IR (2015, p. 2) concluded that the treatment of financial services supplied by businesses principally making taxable supplies, that are regarded as an intermediate supply, should differ from those supplied by financial service providers, that are considered a final supply. Consequently, the New Zealand IR (2015, p. 2) concluded that the denial of input tax deductions on share issue costs incurred to raise capital is contrary to the New Zealand GST Act’s ultimate purpose of taxing final consumption, since the denial of input tax deductions on share issue costs incurred results in the taxation of non-final consumption. This was considered contrary to the principle of effectiveness and fairness since it did not result in the right amount of tax at the right time (New Zealand IR, 2016, p. 5).

In a South African context, since a business principally making taxable supplies may use the capital raised through the issue of shares to expand its business of making taxable supplies, it seems that the denial of input tax deductions on share issue costs incurred also results in the taxation of non-final consumption. Since this does not produce the right amount of tax at the right time, it may be concluded that the principle of effectiveness and fairness is not enhanced through the current treatment of input tax on share issue costs incurred in South Africa.

8. Summary and conclusion

The research aim of this article was to determine whether input tax on share issue costs incurred should be deductible, in consideration of the broad taxation principles that are fundamental to a “good” VAT system. The New Zealand IR (2016, p. 5) considered the broad taxation principles at the heart of its amendment to allow for input tax deductions on share issue costs incurred by businesses principally making taxable supplies. This research article considered how the changes adopted by the New Zealand IR may provide valuable policy insights for National Treasury and SARS to consider in a South African context.

This article outlined that the current denial of input tax deductions on share issue costs incurred does not enhance the broad taxation principles of neutrality, efficiency, certainty and simplicity, and effectiveness and fairness. Consequently, this article suggests that, to align the treatment of input tax on share issue costs incurred with the broad taxation principles, SARS and National Treasury should consider a policy amendment to allow for an input tax deduction on share issue costs incurred.

This article suggests that the changes to the New Zealand GST Act, on which the VAT Act was modelled (VATCOM, 1991), may provide the required pioneering work for SARS and National Treasury to address the anomaly created by the denial of input tax deductions on share issue costs incurred. Due to the comparability between the requirements to deduct input tax on share issue costs incurred in both the New Zealand GST Act and the VAT Act, it is submitted that it may be appropriate for National Treasury and SARS to consider the introduction of a similar provision in the VAT Act to that of section 20H of the New Zealand GST Act, to specifically allow for an input tax deduction on share issue costs incurred in a South African context.

It is suggested that such a specific deduction may be a pragmatic remedy for SARS and National Treasury to consider, since it does not mandate a new interpretation of the definition of input tax in section 1(1) of the VAT Act, but rather makes specific provision for an identified anomaly within the input tax regime. Furthermore, a specific deduction for input tax on share issue costs incurred may not necessitate clarification or legislative amendments to conclude on whether the issue of shares constitutes a supply in the first place. This may eliminate other unintended consequences that result from deeming the issue of shares to not be a supply, which may be beneficial to SARS and National Treasury. It is further suggested that such an amendment may provide a welcome distinction between financial services regularly supplied by financial service providers and financial services in the form of share issues incidentally supplied by businesses that principally make taxable supplies. Since the VAT Act does not contain group registration rules similar to the New Zealand GST Act, the authors recognise that the extension of the deduction to holding companies that issue shares to fund other group entities’ businesses of making taxable supplies may be a step too far for SARS and National Treasury, albeit a step in the right direction.

Therefore, this article suggests that a specific deduction for input tax on share issue costs incurred by South African vendors who principally make taxable supplies may be a pragmatic and non-invasive amendment that SARS and National Treasury could consider, to align the treatment of input tax on share issue costs incurred with the broad taxation principles.

Disclosure statement

No potential conflict of interest was reported by the authors.

Acknowledgements

This article is derived from the following master’s thesis: Beukes, W. (2020). Value-added tax: a critical analysis of input tax in respect of share issue costs. Stellenbosch University, South Africa. Retrieved from: http://hdl.handle.net/10019.1/108332