Binding General Ruling 55: A further potential VAT cost to residential property developers

The development of residential properties by property developers for the purpose of sale is an enterprise activity and the sale of each property constitutes a taxable supply by the developer. An input tax deduction may be claimed by a VAT registered developer of the VAT on expenses incurred in developing the properties for the purpose of making such taxable supplies. The property developers are required to account for VAT at the standard rate on the sale of each developed unit.

Notwithstanding a developer’s intention to sell the developed property, it often happens that in adverse market conditions the developer is unable to find a buyer at the required selling price. The property developer may then opt to let the property unit temporarily to generate some cash flow until such time as market conditions are more favourable and a suitable buyer can be found.

The letting of residential property as a dwelling is exempt from VAT. Consequently, the temporary letting of residential units developed for sale is regarded to be a “change in use” of the unit for VAT purposes, from a taxable purpose to an exempt application. The developer is then required to make an adjustment in terms of section 18(1) of the VAT Act as a means of repaying the VAT previously claimed on the development cost. However, section 10(7) requires that an adjustment in terms of section 18(1) is to be made on the full open market value of the unit as at the date on which the property is let, as opposed to repaying only the actual input tax previously claimed.

It was recognised by the Minister of Finance in his 2010 budget review that the requirement that developers must account for VAT on the open market value of the units temporarily let, is disproportionate to the exempt income received by the owners of the properties and that options should be investigated to determine a more reasonable method in dealing with the temporary letting of residential properties developed for resale.

Residential property developers were then afforded temporary relief with the introduction of section 18B of the VAT Act on 10 January 2012. In terms of section 18B, no change in use adjustment was required to be performed until the expiry of a 36-month relief period which commenced from the time the property was first let, or at the time when the property was applied permanently for letting as a dwelling as contemplated by section 18B(3). The temporary relief provided under section 18B ceased to apply on 1 January 2018.

When the temporary relief measures under section 18B were introduced, it was recognised in the Explanatory Memorandum on the Taxation Laws Amendment Bill, 2011 that the VAT payments due upon the temporary letting of the residential units undercut the cash-flow gains otherwise associated with temporary letting and may even force certain developers into insolvency. It was further stated that section 18B was introduced as a short-term measure to the cash flow problem faced by developers, whilst seeking a more permanent solution.

It seems that no effort was made to find a permanent solution to the problem during the period that the temporary relief under section 18B applied. Consequently, with effect from 1 January 2018, residential property developers are again required to perform the change in use adjustment in terms of section 18(1) on the open market value when the unit is let as a dwelling. However, the difficulties which are created by section 18(1) for property developers still remain, i.e. the requirement to account for output tax on the open market value of the unit is disproportionate to the exempt income received and it places a severe cash flow burden on the developer.  

SARS previously stated in its VAT News 14 (March 2000), that where a section 18(1) adjustment was made on the temporary letting of a unit and the developer subsequently sells the unit, the developer was entitled to deduct the total amount of VAT previously paid under section 18(1), against the output tax payable when the unit is subsequently sold. This was, however, in contradiction to section 18(4) of the VAT Act, which provides for a deduction to be made only on the lesser of the adjusted cost or the open market value of the unit. Notwithstanding this contradiction, SARS nevertheless allowed input tax deductions in accordance with VAT News 14, that is, until recently upon the issuing of BGR 55.

In terms of BGR 55, SARS now holds the view that the subsequent sale of a dwelling in respect of which the developer has accounted for VAT in accordance with section 18(1) (or 18(3B)), is not subject to VAT at all and the purchaser will instead be liable for transfer duty on the acquisition of such dwelling.

BGR 55 stipulates the correct VAT position regarding units where the developer has permanently changed its intention regarding the units and the developer now holds them as capital assets to generate residential rental income. However, in our view, BGR 55 does not reflect the correct VAT position where the units are only temporarily let, and the intention of the developer remains to sell them when a buyer at a suitable price is found.

In terms of BGR 55, a developer who performs a section 18(1) adjustment when units developed for sale are temporarily let is not required to account for output tax when the unit is subsequently sold as it no longer constitutes an enterprise asset of the developer. This seems to be on the basis that SARS contemplates a permanent change in the application of the unit, even if it is only let for a very short period. However, if it remains the intention of the developer to sell the units as soon as buyers can be found, and the developer still reflects the units in its financial records as assets held for sale, there is no permanent change in the use or application of the unit. Such units are sold in the course or furtherance of an enterprise carried on by the developer and attracts VAT in terms of section 7(1)(a) of the VAT Act. The developer is then entitled to an input tax deduction in terms of section 18(4) on the adjusted cost of the property sold.

Whilst the eventual sale of residential units which were temporarily let will not attract VAT or transfer duty if the selling price is below the R1 million transfer duty threshold, it effectively attracts VAT on the market value when the unit is first let by the developer. However, units sold at prices in excess of the transfer duty threshold will attract VAT on their open market value when the units are first let as well as transfer duty on the selling price when the units are sold. 

A binding general ruling such as BGR 55 is issued under section 89 of the Tax Administration Act 28 of 2011. It is initiated by SARS and represents the general view of SARS on the interpretation and application of a legislative provision. As a BGR is binding on SARS, but not on taxpayers, it may be cited in proceedings before SARS or the courts by either SARS or a taxpayer (Croome & Olivier: Tax Administration, paragraph 13.5.1). Since BGR 55 is not binding on taxpayers, residential property developers are best advised to consider the correct application of the provisions of the VAT Act in view of their specific circumstances. 

It is regrettable that the real problem as identified in the 2010 budget review, namely that the requirement to account for VAT on the open market value of the units temporarily let is disproportionate to the exempt income received by the developer, and that it undercuts the cash-flow gains otherwise associated with temporary letting and may even force certain developers into insolvency, is not being addressed. Both the New Zealand and Australian tax authorities have successfully addressed this issue, and guidance could easily be drawn from them to find a suitable solution in a South African context.