Ignoring VAT characterisation can be costly

For most people VAT is not an acronym for Value Added Tax, but for Very Annoying Tax. Its labyrinth principles of dos-and-don’ts means that once registered for VAT, taxpayers have to consider the repercussions that come with each of their transactions and not so much from a VAT compliance point of view, but more commercial perspective and more importantly what it means for their business.

To put this into context, allow me to share with you something that transpired a few weeks ago. An investor who was interested in acquiring a local entity that had been operating for over eight years had asked for due diligence to be carried out before committing to the deal. Just like any prudent investor would like, this investor wanted the due diligence to cover issues such as financial, tax, legal, among others. By the time the investor requested for the due diligence, he and the shareholders of the target entity had more or less agreed on a ball-park figure based on the audited financial statement of the entity, and the due diligence was geared towards giving the investor some degree of knowledge and comfort about what he was acquiring.

Typically, a tax due diligence exercise for most people is a box-ticking affair focused primarily on confirming whether the general compliance boxes were ticked. By general compliance here I am referring to whether the prerequisite tax returns were completed accurately and that they were filed on time. That is fine and most entities will score 100 per cent as far as this is concerned, and in this particular instance the target entity did not disappoint. So far so good.

Since we were covering the finance and tax bits, after carrying out the review we congregated to share our findings amongst the team members and to also agree on how to package our findings to the investor. I agree that tax in itself is not often a deal breaker when it comes to such investment decisions, but since it impacts cash and cash-flows, it can often make a meteoric rise up the list of priorities and affect the entire transaction. This is exactly what happened in this instance through VAT.

The target entity revenue streams comprised an array of goods and a handful of services, each of which was characterised differently for VAT purposes – either standard rate or exempt. This had not always been the case.

When the entity started operations eight or so years ago, it had one or two revenue streams from the sale of goods, which were standard rated for VAT purposes.

With time though, the business grew and its product offering expanded to what it was currently offering. The unfortunate part of the success story is that the management did not characterise these products correctly for VAT purposes – over a period of five years and through changes in the VAT legislation, what should have been characterised as exempt was erroneously characterised as zero-rated for VAT purposes.

Zero rated supplies are those that are subject to 0 per cent VAT and one is allowed to claim any VAT paid on the purchase of inputs he needs to produce these zero-rated supplies. Exempt characterisation on the other hand refers to those supplies that are not subject to VAT but a person making such supplies is required to restrict the amount of input VAT that he is allowed to claim on his inputs such as raw materials, inventory or administration expenses if the percentage of exempt supplies is between 10 per cent and 90 per cent of his turnover. If it is below 10 per cent, he is allowed to claim all VAT on purchases, but if it is above 90 per cent he is not allowed to claim any VAT. In this particular case, the target entity’s turnover from exempt supplies oscillated between 75 per cent and 85 per cent per month. So what does this mean and why does it matter?

Since there are restrictions on the amount of VAT that one can claim, exempt characterisation comes with cash implications. This means that in determining the cost of exempt products and ultimately their selling price one should consider the restricted VAT amount as part of the cost of goods. Given the target entity’s exempt supplies percentages, from the entity’s perspective it means that over a period of five years it had been understating its costs by between 75 per cent and 85 per cent of its monthly VAT spend.

It also meant that the management had been understating what is owed to Caesar as well by overstating its monthly VAT spend and thus remitting less to the Kenya Revenue Authority, and as is often the case this error amount comes with penalties and interest. Since the restricted VAT should constitute part of the expense it almost meant from a corporate income tax perspective that its profits had been overstated and as a result had paid more tax than it ought to have paid.

This inadvertent error and ultimate disclosure did not extinguish the investor’s appetite for the target entity, but I can tell you for certain that it did impact the purchase price. This could have been avoided through periodic reviews of the revenue streams for VAT characterisation, especially after any legislative changes.