Developments in the VAT and residential property realm: A move towards a clearer picture?

Part 1: The VAT rules that apply to fixed property transactions in South Africa and complexities that arise, the relief granted when temporarily letting a property, the introduction of permanent relief and an explanation of adjusted costs.

The South African Value Added Tax (VAT) rules that apply to fixed property transactions have never been straightforward and, as noted in the Budget Review 2023, there are some inconsistencies in the provisions of the Value Added Tax Act (VAT Act), which seem to exacerbate the challenges faced by property developers in meeting their VAT obligations.

The sale of fixed property in South Africa is either subject to VAT or transfer duty. VAT applies where the seller of the fixed property is a VAT vendor, that is a person who is, or is required to be, registered for VAT, and the sale is made in the course or furtherance of that vendor’s taxable enterprise (business). Where the seller is a non-registered person (who is not required to be VAT registered), the sale would generally attract transfer duty.

While this may sound straightforward, the complexities arise when property developers construct or develop residential properties for sale, which is a taxable activity and forms part of their taxable business, but then let those properties for residential purposes, which is not a taxable activity for VAT purposes. To clarify, the sale of residential property by a developer is subject to VAT, while the letting of residential property is exempt from VAT and therefore does not form part of a developer’s taxable business.

Supply of residential property by developers
The VAT Act defines a "developer" as a vendor who continuously or regularly constructs, extends or substantially improves residential property or parts of that property for the purpose of disposal.

During adverse market and economic conditions, buying residential property is a luxury that many cannot afford, and developers often battle to sell all their newly-built residential property stock as intended. This was a stark reality for property developers in South Africa during the COVID pandemic, which forced them to take necessary steps to ensure the continuation of their businesses and being able to service their financial obligations, including towards creditors and staff. Many developers therefore sought to generate rental income by letting the properties until the economy stabilised and the properties could be sold. This change in intention (i.e., from taxable sale to exempt residential rental) did not necessarily grant relief because of the financial impact on developers that resulted from certain VAT obligations.

Temporary letting of residential property-deemed disposal
When a developer constructs or develops a residential property for sale, its intention is ultimately to make a taxable supply, which is subject to VAT at the standard rate of 15%. If the developer subsequently decides to rent out the property, there is a change in intention for the use of that property, i.e., from sale (which is a taxable supply) to letting (which is exempt from VAT). This change in intention triggers a deemed disposal for VAT purposes whereby the developer is deemed to have disposed of the property in the course or furtherance of their taxable business and, as a result, has an obligation to account for output tax at the open market value (OMV), i.e., the amount which the supply of property would generally fetch if supplied in similar circumstances on a specific date in South Africa, being a supply freely offered and made between unconnected persons, of the property when it is first let. The cash flow burden placed on the developer is considerable, as the exempt income generated is usually charged over the period of the lease and is substantially less than the OMV of the property.

Due to the effect of the disproportionality between the OMV and the rental income in the developer’s pocket, the government proposed a temporary measure that essentially granted relief to developers letting out property on a temporary basis during the period from 10 January 2012 to 1 January 2018 (Relief Period). In this regard, the duty placed on the developer to declare output tax on the OMV of the property was suspended for the duration of the Relief Period. The developer would only be required to declare output tax on the earlier of the date on which the temporary letting period of 36 months had been exceeded or the property was permanently used for a non-taxable purpose.

Section 18D - permanent relief introduced
Since the Relief Period ended on 1 January 2018, there were no immediate alternative relief measures available to developers during and subsequent to COVID. Therefore, the previous dispensation (i.e., immediate disposal on the OMV basis) continued to apply until a more permanent solution to the issues faced by developers was introduced. Section 18D of the VAT Act came into effect from 1 April 2022 and stipulates that a developer is deemed to be making a taxable supply where he, for any reason, temporarily lets out residential property that has been developed for the purposes of sale.

"Temporary" for purposes of section 18D means a period of 12 months or less; anything more than that is regarded as permanent. Therefore, section 18D does not apply to any lease period exceeding 12 months (Fixed Lease Agreement). Currently, under section 18D(2), the developer is still deemed to be making a disposal of the fixed property in the course of his taxable business, but is required to account for VAT at the standard rate on the "adjusted cost" of the construction, extension or improvement of the residential property, as opposed to the OMV of the property. Furthermore, no output tax is payable on the rental income received by the developer as the amounts constitute consideration that is paid or payable in respect of exempt supplies.

Adjusted cost
"Adjusted cost" is currently defined in the VAT Act as any cost where VAT has been charged or would have been charged, in respect of which an input tax deduction may be claimed by the developer. This means that the developer will be deemed to supply the property for an amount equal to the costs incurred by him in constructing, extending, or improving that property, to the extent that the developer’s supplier would have charged VAT on the supply to the developer or if the developer would have been entitled to claim an input tax deduction in respect of such costs. Therefore, any costs incurred by the developer that are not VAT-inclusive and are unrelated to the development of the property would not be included in determining the value of the supply.

As indicated in the South African Budget Speech, it is uncertain under the current provisions whether the phrase "adjusted cost of the construction, extension or improvement of the residential property" includes the cost of the land, as incurred by the developer. If so, the value of the supply would be higher and undoubtedly give rise to a higher output tax. The general view is that the cost of the land should be included, as it essentially includes the costs associated with constructing the property. This is arguably correct, as there can be no construction of the residential property if there is no land. Considering the uncertainty of whether costs of land could be regarded as costs for construction, it was proposed in the 2023 Budget Review that the meaning of "adjusted cost" as contemplated in section 10(29) of the VAT Act should be clarified for purposes of its application in section 18D. This is crucial considering the long history of the development of tax policy as far as property issues are concerned.

Certainty in the interpretation of these provisions is overdue and recognised by SARS in Binding General Ruling (VAT) 64, published on 21 June 2023.

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Part 2: The subsequent sale of a residential property and the proposals outlined in the Draft Taxation Laws Amendment Bill (TLAB)

Subsequent sale of residential property
When economic conditions improve, the VAT Act recognises that the developer may revert to his initial intention in use of the property. If the developer sells the residential property within the temporary lease period of 12 months, the normal VAT rules will apply and the transaction will be subject to VAT at the rate of 15%. As the sale of residential property is not an exempt supply, the developer is entitled to an input tax deduction of the VAT incurred on the amounts expended on constructing, extending or improving the property, which would have been reversed under the operation of section 18D(2) and the developer will be entitled to claim a deduction of the output tax previously accounted for under section 18D(2), as explained above. Following the proposals in the Draft TLAB (discussed below), it is now clear that this would extend to the output tax previously declared on the cost of the land.

Strangely, section 18D(5) of the VAT Act as it currently reads also permits a developer that previously made an output tax adjustment under section 18D(2) to reclaim that tax in accordance with the provisions applicable to the temporary lease of residential property in the tax period "after" that developer ceases to supply the property temporarily (i.e., outside the 12-month period and therefore under a Fixed Lease Agreement). This contravenes the purpose of section 18D, especially as Fixed Lease Agreements are specifically excluded from the ambit of section 18D. To address this anomaly, it was proposed in the 2023 Budget Review that the enabling provision be deleted as far as it refers to Fixed Lease Agreements.

2023 Proposals
On 31 August 2023, SARS published, for public comment, the Draft TLAB. Firstly, it was proposed that where a developer makes a deemed disposal in terms of section 18D(2) (i.e., a change in intention from sale to letting), that developer would be required to account for VAT at the standard rate on the "adjusted cost of the residential property", as opposed to the adjusted cost of the "construction, extension or improvement" of the property, which is the current wording of the VAT Act. According to the 2023 Explanatory Memorandum, the reason for this amendment is to clarify that the term "adjusted cost" includes the cost of the purchase of the land. Therefore, a developer who decides to lease their residential property on a temporary basis will, if this amendment comes into effect, inevitably be deemed to supply the property at a higher amount inclusive of the cost of the land and consequently, have a higher VAT liability. Notwithstanding, this is arguably a better tax consequence than the previous dispensation, whereby the deemed disposal was on the higher OMV of the property, resulting in a greater immediate VAT liability. In addition, under the current proposal, the developer could, upon the eventual sale of the property, claim an input tax deduction of the VAT paid on the amounts expended on purchasing that property and would be entitled to claim a deduction of the output tax previously accounted for under section 18D(2) on the deemed disposal of the property (i.e., output tax adjustment).

Secondly, a proposal was made to limit a developer's output tax adjustment following the deemed disposal under section 18D(2) to situations in which residential property leased on a temporary basis is sold during the temporary lease period of 12 months or if the property is no longer used for purposes of supplying accommodation immediately after the expiry of the temporary lease period of 12 months. In line with this amendment, and finally, a proposal has been made to delete section 18D(5) in its entirety to remove the anomaly created in the application of provisions relating to temporary leases to Fixed Lease Agreements. Therefore, in a fixed-lease situation (not covered in this article), the developer would not be able to rely on section 18D for any output tax adjustments.

Conclusion
The proposals cited in the Draft TLAB are welcomed and will bring certainty to the application of the VAT provisions relating to temporary leases once they take effect on 1 April 2024. Considering that section 18D and other related provisions are new, it is crucial that the inconsistencies are addressed (as we now see in the Draft TLAB) to limit the adverse effects of the incorrect application of these provisions. Finally, developers who avail their new residential properties for rental are encouraged to seek professional tax advice to understand their resultant VAT obligations and benefits, to the extent that they have not already done so.