The VAT consequences of COVID 19- indemnity payments

On 11 March 2020, the World Health Organization declared Covid-19 a global pandemic. President Cyril Ramaphosa declared a national state of disaster on 15 March 2020 and announced a national lockdown which commenced on 27 March 2020. This resulted in business disruptions and closures on a massive and unprecedented scale. In the wake of the Covid-19 pandemic and crisis, there has been a surge in business interruption insurance claims and lawsuits.

Many taxpayers instituted – and continue to institute - insurance claims under the business interruption clause of insurance agreements, in respect of losses arising due to losses sustained as a result of Covid-19.

Many of these claims are subject to potential litigation, with insurers disputing whether the loss is covered by the insurance agreement at all and to the extent it may be covered, that a limit be imposed on the amount of the claim. This places these claims in doubt, as was seen in the two recent Supreme Court of Appeal decisions of Guardrisk Insurance Company Limited v Café Chameleon CC and Santam Limited v Ma-Afrika Hotels (Pty) Ltd & Another , which dealt with these issues.

In some instances, the parties may engage in settlement negotiations on compromised terms since, depending on the facts, it may be to their advantage to settle the dispute on this basis. Factors which are usually considered when entering into settlement negotiation include the potential cost of litigation which may outweigh the possible benefits, efficient use of resources from a time perspective, the prospects of success in court and whether the dispute concerns complex factual or legal issues.

Enter section 8(8) of the Value Added Tax Act No. 89 of 1991 (the Act), which in essence provides that, where a vendor receives any indemnity payment under a contract of insurance, the payment shall, to the extent that it relates to a loss incurred in the course of carrying on an enterprise, be deemed to be consideration received for a supply of services performed on the date of receipt.

The practical implications of this are that the insured, which is deemed to be making a taxable supply, must account for output tax on the indemnity payment received. The output tax payable by the insured vendor is calculated by applying the tax fraction (15/115) to the amount received from the insurer.

Two requirements that are central to this deeming provision are that the payment must be:

  1. An indemnity payment: meaning that the payment must be payment in settlement of a claim, other than a payment made by the insurer for a supply of goods or services.
  2. The indemnity payment must be made under a contract of insurance, which is a contract that guarantees against loss, damage, injury or risk of any kind whatsoever, whether pursuant to any contract or law, including reinsurance.

As noted above, the indemnity payment must be made under a contract of insurance. The dictionary definition of the word ‘under’ is “as provided for by the rules of; in accordance with”. The amount must therefore be an indemnity payment made ‘in accordance with’ a contract of insurance.

The question arises what the consequences are of the deeming provision if the parties conclude a compromise agreement.

A compromise is an agreement by which parties settle a dispute between them at less than the full value of the claim. If the dispute (contractual, delictual or otherwise) concerns an existing obligation, that obligation is terminated by the compromise.

The compromise may give rise to a new obligation since the general principle in South African law is that a compromise terminates the parties’ original rights and obligations and gives rise to new rights and obligations under the new agreement.

This usually depends on the consensus reached between the parties in settlement, and the original obligation could be discharged and a new obligation, based on the terms of the settlement, may come into existence. The ordinary principles relating to the determination of contractual consensus will apply in establishing whether or not an offer of compromise has been made and accepted.

Readers should take note that there are a number of considerations in the determination of whether a compromise agreement has been concluded.

We see no reason why rights and obligations under a contract of insurance should be treated any differently to rights and obligations arising under other forms of agreements: they are discharged, created, and replaced in the same manner.

If the parties conclude a settlement agreement, it should be considered whether the agreement is a compromise agreement.

The nature of the agreement raises important fiscal questions, such as whether it discharges the original rights and obligations under the insurance contract. Does a new obligation, based on the terms of the compromise, come into existence?

If the answer to these questions is yes, then the payment made under the compromise agreement may not be an indemnity payment made under (i.e. in accordance with) a contract of insurance, but rather a payment made pursuant to a compromise agreement. If so, depending on the terms of the compromise agreement, it may not contain the essentialia (the minimum contents or requirements) of an insurance contract. Depending on the wording of the compromise agreement, it could be an independent contract, not capable of being described as an insurance contract.

Under these circumstances, section 8(8) of the Act would therefore not likely apply to the payment made under the compromise agreement, and there would be no deemed supply.

This conclusion may however be impacted by the Supreme Court of appeal decision Ratlou v Man Financial Services SA (Pty) Ltd (Ratlou), the facts of which were that:

  1. A company entered into several rental agreements in respect of trucks. These agreements were evidently not credit agreements. The company fell into breach of these agreements and subsequent negotiations resulted in a single written settlement agreement.
  2. The company, represented by its owner (a natural person) in his personal capacity, undertook to be joint and severally liable for these debts of the company. The settlement agreement was then concluded with this natural person. The settlement amount was repayable over a period of 60 months and included additional fees, in the form of interest.
  3. The question was whether the settlement agreement was subject to the National Credit Act No. 34 of 2005, since the rights and obligations under the rental agreements (the underlying agreements) were discharged and replaced by fresh rights obligations under the settlement agreement.

In reaching its decision in Ratlou, the Supreme Court of Appeal held that:

  1. It is artificial to argue that the underlying agreements (i.e. the rental agreements) may not be examined for purposes of determining whether the settlement agreement falls within the parameters of the National Credit Act. If the underlying agreements did not fall within the parameters of the National Credit Act, then its compromise in terms of the settlement agreement, cannot logically result in the agreement being converted into one that does.
  2. The express reference in the settlement agreement to the underlying agreements – the rental agreements - is of vital significance. Clause 3 of the acknowledgement of debt provides that the agreement is “in full and final settlement of Man Financial Services’ claims against PN Transport and Stephen [Mr Ratlou] with regard to the agreements listed therein”. It was not in dispute that the accounts listed in the acknowledgement of debt related to the rental agreements. The compromise therefore remained linked to the underlying causa, being the rental agreements. Ignoring this is self-evidently artificial.
  3. The Court cited the case of Ribeiro & another v Slip Knot Investments 777 (Pty) Ltd , which found that the underlying agreement remained extant (still in existence) despite settlement, and that the two agreements were interdependent and linked.

Taxpayers who have concluded or may conclude agreements of this nature should consult their tax advisors to determine the consequences which flow from the agreement. If a compromise agreement is concluded, it must be considered whether the circumstances and the wording of the compromise agreement is legitimately distinguishable from the findings of the Supreme Court of Appeal in Ratlou and whether the deeming provisions of section 8(8) of the Act apply.

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