Written by Mthokozisi Gumede, MaxProf Audit Manager
Introduction
VAT apportionment remains one of the more nuanced and judgement driven areas within the South African VAT framework. While the legislative principles are clear, their application often produces outcomes that are open to challenge, particularly in complex operating environments such as municipalities and public sector entities.
Binding General Ruling (VAT) 16 (Issue 3) (“BGR 16”) and the Binding General Ruling (VAT) 4 (issue 4) (“BGR 4”) provides a structured and standardised approach through the turnover-based method. However, an important question persists: does the method always produce a fair and reasonable reflection of a vendor’s actual use of goods and services in generating taxable supplies?
This article revisits the standard method, not to dispute its validity, but to assess whether under certain circumstances it delivers outcomes that align with the financial reality of vendors.
Legislative Framework and the Apportionment Principle
The VAT system is built on the principle that input tax may be deducted only to the extent that goods or services are acquired for the purpose of making taxable supplies. This principle originates from the definition of input tax read together with the deduction provisions in section 16 of the Value-Added Tax Act 89 of 1991 (“the VAT Act”).
Where goods or services are acquired for a mixed purpose, both taxable and non-taxable, section 17(1) requires that the input tax be apportioned on a basis that reflects the extent of taxable use.
Importantly, section 17(1) does not prescribe a specific method. Instead, it allows the Commissioner to determine an appropriate method through rulings, with the overarching test of the outcome being fair and reasonable.
The Binding General Ruling (VAT) Guidance
BGR 16 (for all VAT vendors) and BGR 4 (for Municipalities) establishes the standard turnover-based method as the default apportionment approach for vendors, unless an alternative method is approved by SARS.
The method applies the following formula:
- Y = apportionment ratio (%)
- A = value of taxable supplies
- B = value of exempt supplies
- C = other income not included in A or B
The ratio is calculated as follows:
Taxable supplies (A) ÷ Total supplies (A + B + C) x 100
This method is widely used because it is:
- administratively practical,
- consistent across taxpayers, and
- Easily verifiable using readily available financial information.
However, its simplicity also gives rise to potential distortions, particularly where the composition of income does not accurately reflect operational reality.
Practical Challenges in Municipal and Similar Environments
1. Gross Accrued Interest from Exchange Transactions
Many municipalities account for VAT on the payment (cash) basis, in contrast to the broader financial reporting environment, which is typically accrual-based. In practice, the turnover-based method may incorporate significant accrued amounts reflected in financial reporting records, including interest charged on overdue municipal accounts. This creates practical complexities for municipalities operating on the payment basis
Interest generally constitutes consideration for an exempt financial service and may therefore form part of the denominator under the turnover-based method.
In practice:
- Municipalities often face structural revenue collection challenges, resulting in large volumes of interest being accrued but not collected.
- These accrued interest amounts can accumulate over time, inflating exempt supplies without a corresponding economic benefit.
This creates a distortion:
- The denominator increases materially (due to exempt interest),
- while actual taxable activity remains unchanged or understated,
- leading to a reduced apportionment ratio.
There is also a subtle misalignment in timing:
- Input tax is claimed on a payment basis,
- while the ratio may reflect accrued (and potentially unrealised) income.
Illustrative Example:
Consider a municipality with:
- Taxable supplies: R1.93 billion
- Total supplies: R2.28 billion
- Of which gross interest = R323 million
Two scenarios emerge:
- Scenario A (including gross accrued interest): Apportionment ratio = 84.56%
- Scenario B (including only interest received): Apportionment ratio = 96.35%
The difference is significant:
- At 84.56%, input tax must be apportioned.
- At approximately 96.35%, the vendor may potentially qualify for the de minimis rule under BGR 4, subject to the applicable conditions being satisfied.
This raises a legitimate concern: whether the inclusion of gross accrued interest leads to an outcome that is no longer representative of actual taxable use.
2. Donations and Non-Exchange Revenue
Municipalities and public entities frequently receive donations, either in cash or in kind.
From a VAT perspective:
- A genuine donation received without any direct quid pro quo will generally fall outside the scope of VAT and therefore not constitute consideration for a supply.
- It does not constitute a taxable or exempt supply.
Under the BGR 4 framework, such receipts are typically included in “C” (other income), that is, amounts not included in taxable (“A”) or exempt supplies (“B”).
While technically correct, challenges arise when:
- Donations are material in value, or
- represent once-off transactions.
Including such amounts in the denominator:
- artificially inflates total supplies,
- without reflecting any associated use of inputs to generate taxable supplies.
The result, again, is a diluted apportionment ratio, which may not align with the actual economic consumption of inputs.
Alternative Apportionment Methods: Section 17(1) and Section 41B
The VAT Act recognises that a single method cannot accommodate all business models and financial conditions.
Accordingly:
- Section 17(1) provides the substantive basis for alternative methods, while section 41B establishes the binding ruling mechanism through which approval may be obtained from SARS, and
- Section 41B provides the mechanism for obtaining SARS approval through a ruling.
A vendor may apply for an alternative method where the standard turnover-based approach:
- does not produce a fair and reasonable result, or
- results in a material distortion of input tax recovery.
In practice, such an application requires a robust and well-supported submission, typically including:
- a detailed description of the business model and operations,
- analysis of income streams (taxable, exempt and non-supply),
- cost structures and resource utilisation,
- a comparison between the standard method and the proposed method, and
- supporting financial and operational data over multiple periods.
While the process can be administratively intensive, it serves an important purpose: ensuring that VAT outcomes remain aligned with economic substance.
Generally Accepted Alternative Methods
Although SARS does not prescribe specific alternatives, several alternative methodologies have been accepted by SARS in appropriate factual circumstances, provided they meet the fair and reasonable test:
Modified Turnover Method
- An adaptation of the standard method, excluding or adjusting specific income streams (e.g. unrealised interest or abnormal items).
- Municipalities and similar entities can apply for this method, modified for gross accrued (not yet received) interest from exchange transactions, and material donations. Other modifications can be a Cash based turnover method, to align entirely with the payment basis of VAT.
Time-Based Method
- Based on employee time allocation between taxable and non-taxable activities.
- Apportionment based on the time employees spend on taxable and exempt supplies.
- Example: Staff spend 84% of their time on taxable activities, 16% exempt, then Input tax may therefore be claimed to the extent of 84%.
- Suitable for consulting firms and financial services
Floor Space Method
- Apportionment based on physical usage of space.
- Apportionment based on the physical space used for taxable and exempt activities.
- Example: Office space of 1000m Square, 800m square is used for taxable activities & 200m square is used for exempt activities. Input tax may be claimed to the extent of 80%.
- Suitable for mixed use buildings, property companies and municipalities.
Input-Based (Cost Driver) Method
- Allocates input tax based on actual consumption drivers such as energy usage, system utilisation, or departmental costs.
- Apportionment based on actual cost drivers or resource consumption.
- Costs are allocated based on electricity usage or System usage or departmental spending.
- Suitable for manufacturing plants, complex corporates and shared service centres.
As a general principle, alternative methods are particularly relevant in environments where turnover is not a reliable proxy for resource consumption.
Conclusion
The turnover-based method remains a sound and practical default for VAT apportionment, and its continued use is justified in most cases. However, as this discussion illustrates, there are situations, particularly within municipalities and similarly structured entities, where the method may produce outcomes that are technically correct, yet economically misaligned.
The legislation accommodates this reality. Through section 17(1) and the ruling framework, vendors are afforded the opportunity to adopt alternative methods where appropriate, provided, they can demonstrate that such methods yield a more fair and reasonable reflection of taxable use.
Ultimately, VAT apportionment should not be approached as a mechanical exercise. It requires judgement, an understanding of the underlying business model and financial conditions, and where necessary, the willingness to challenge whether the standard method truly reflects economic substance. For local government entities that are already struggling with sustaining positive cash balances, the correct application of input tax apportionment can materially affect municipal cash flow and resource allocation, particularly in financially constrained environments, and the much-needed service delivery to our South African communities.
