CHAPTER 13

13.1 INTRODUCTION

13.1.1 In its first Interim Report the Commission acknowledged the importance of small and medium-sized enterprises in the creation of jobs in the South African economy. It also recognised the problems faced by small businesses in accessing capital, particularly working capital, and therefore recommended that the cash basis of taxation be introduced but that this special dispensation be limited to small and micro-enterprises only.

13.1.2 Enabling legislation was introduced into the Income Tax Act (the Act) in 1995 which empowers the Minister of Finance to issue regulations with regard to the taxation of natural persons who carry on a small business undertaking (SBU). Briefly, the legislation provides that the Minister may prescribe what constitutes a SBU, provides for adaptations to the provisions of the Act relating to the determination of the taxable income of a SBU, provides for the relaxation of various administrative requirements and generally makes provisions which facilitate the carrying on of a SBU.

13.1.3 The following issues have been raised as requiring further investigation before these regulations can be implemented:

1. the definition of a small business;
2. the question of taxpayer election of the cash basis of taxation;
3. provisions to exit from the cash basis of taxation; and
4. anti-avoidance measures.

13.1.4 The Commission also proposed in the first Interim Report that an investigation be conducted into the feasibility of introducing an incentive for investment in small and medium-sized enterprises similar to the United Kingdom Business Expansion Scheme. The various aspects of the Business Expansion Scheme have been investigated and are dealt with later in this chapter.

13.2 DEFINITION OF A SMALL BUSINESS UNDERTAKING

13.2.1 The Department of Trade and Industry has suggested certain general criteria for the identification of a small enterprise. These are that the business:

1. employ less than 50 but more than 5 employees;
2. have an annual turnover of less than R6 million; or
3. utilise capital assets (excluding fixed property) valued at less than R2 million.

13.2.2 In the first Interim Report the Commission recommended that more stringent criteria should be adopted in defining a small enterprise in order to minimise the cost to the fiscus of any tax relief to be provided. For the purpose of tax relief, the Commission considers that the threshold relating to turnover as set out in paragraph 13.2.1(b) above should be reduced to R2 million at this stage and that this limit should be reconsidered once the loss of revenue has been accurately determined.

13.3 QUALIFICATION FOR THE CASH BASIS OF TAXATION

13.3.1 Taxpayers who satisfy the qualifying criteria for the cash basis of taxation should be allowed to elect to be taxed on this basis at any time after the regulations have come into operation. The procedures set out hereunder are suggested.

Election of the Cash Basis of Taxation

13.3.2 In an instance where a taxpayer who falls within the classification of a SBU during a tax year elects to be taxed on the cash basis, such a taxpayer can be dealt with in either of the following ways:

1. the calculation of the taxpayer's taxable income can be split into the period of the tax year before the taxpayer elected the cash basis of taxation and the period after such election is made; or
2. the taxpayer who elects to be taxed on the cash basis may be deemed to have been classified as a qualifying SBU as from the beginning of the tax year.

13.3.3 The Commission is of the view that the procedure set out in paragraph 13.3.2(b) is preferable to those set out in paragraph 13.3.2(a). This will dispense with the necessity of splitting the tax year and calculating taxable income for the two parts of the tax year. This process would be cumbersome for a SBU and would increase compliance costs.

13.3.4 A taxpayer who owns a business which does not qualify for taxation on the cash basis at the time when the regulations come into force may subsequently shrink in size to such an extent that it complies with the definition of a SBU. In such event the Commission is of the view that such a taxpayer should not be afforded the benefit of the cash basis of taxation as the purpose of the dispensation is to promote the growth of small business.

Exit from the Cash Basis of Taxation

13.3.5 This situation will most likely occur when the taxpayer ceases to comply with the definition of a SBU during a particular tax year.

13.3.6 In such a case, once again in order to limit unnecessary increases in compliance costs, the taxpayer should be deemed to have qualified for the cash basis of taxation up to the end of the tax year.

13.3.7 Furthermore, consideration should be given to the manner in which the recoupment of previous allowances is dealt with when the taxpayer ceases to comply with the definition of a SBU. As recommended in the first Interim Report, the granting of a phasing out period would assist in alleviating the tax burden in the year the cash basis ceases to apply to the taxpayer. The Commission is of the view that a phasing-out period of at least two years should be granted as any shorter period could act as a deterrent to the growth of the SBU.

13.4 ANTI-AVOIDANCE MEASURES

13.4.1 If a special tax dispensation (for example the cash basis of taxation) is granted to small businesses, it may lead to abuse through the splitting of activities into different entities by the same taxpayer whether through nominee owners or otherwise.

13.4.2 In addressing such possibilities, consideration should be given to the formulation of anti-avoidance provisions. For example, where any beneficial interest held by a person (directly or indirectly) exceeds a pre-determined percentage of, say, 50 per cent of equity, in a business, such a business will be deemed to be owned by that person and the asset utilisation and turnover of such businesses will be deemed to be that person's for determining whether the taxpayer qualifies as a small business. Consideration should also be given to whether the use of the connected person concept in the anti-avoidance measures should be adopted to define relationships between one person and another in order to determine whether a person has a beneficial interest in another business.

13.4.3 It should also be borne in mind that if the regulations are confined to natural persons, the scope for avoidance is considerably reduced.

13.5 UNITED KINGDOM BUSINESS EXPANSION SCHEME

13.5.1 In the United Kingdom when smaller enterprises faced funding constraints similar to those experienced in South Africa, the Government decided to introduce the "Business Expansion Scheme" as a means of closing the so-called equity gap. The purpose of the scheme was to increase the flow of funds to small firms by providing tax relief to investors in unlisted companies. In January 1994 the scheme was improved and replaced by "The Enterprise Investment Scheme".

13.5.2 The Business Expansion Scheme had the following major defects:

1. most of the funding raised under the scheme was directed to low risk asset based investments as these types of investments were attractive to investors;
2. it failed to channel funds to technology-based sectors, with the majority of funds invested in the service sector, often asset backed;
3. funds were distributed between the various regions in a skewed manner because the funds were channelled into housing and established firms.

13.5.3 The Enterprise Investment Scheme attempts to overcome the problems of the previous scheme and in particular, attempts to increase the flow of small tranches of equity finance to small firms. It encourages the development of "business angels" (outside investors who introduce finance and expertise to a company) by enabling them to play an active role in the management of the company as paid directors without losing tax relief.

13.5.4 An individual investor who subscribes for eligible shares in a company will be entitled to income tax relief on subscriptions of up to ,100 000 per tax year provided the shares are held for at least five years. The total tax relief that the investor can claim in any one tax year is the lower of:

1. 20 per cent of the amount of the subscription for eligible shares (up to a maximum of ,100 000), so that the maximum relief is ,20 000; and
2. the investor's income tax liability for that year;

and any excess relief cannot be carried forward to a future tax year.

13.5.5 The maximum amount that a company may raise is ,1 million. Investors can also obtain a deferral of tax liability on capital gains reinvested under the new scheme. If the shares are sold after 5 years the gain is exempt from capital gains tax. Special anti-avoidance provisions are in place to prevent relief by an individual who is connected with the company or receives benefit from the company.

13.5.6 The advantages of the Enterprise Investment Scheme over the Business Expansion Scheme are:

1. an investor can become a paid director (a "business angel") and still qualify for relief if he or she was not connected with the company or its trade at any time before the eligible shares were issued;
2. the amount that a company can raise in a year on which relief will be given is limited to ,1 million;
3. the scheme is not available for companies providing private rented housing under assured tenancy; and
4. relief is granted through either the income tax system or the capital gains tax system if the shares are disposed of at a loss.

13.5.7 In addition to the Enterprise Investment Scheme the United Kingdom authorities also introduced tax relief for venture capital trusts in their attempt to close the small firm equity gap. Investors were enabled to invest in unquoted companies through the medium of a quoted vehicle. The main reason behind this is that it allows investors to sell their investments more easily so they are encouraged to invest the funds in areas where the economy needs them most.

13.5.8 As these changes were only introduced in 1994 and 1995 respectively it is too early to express an opinion whether these changes adequately address the problems experienced with the former scheme.

13.5.9 In deciding whether a scheme similar to the Business Expansion Scheme or Enterprise Investment Scheme would be appropriate for South Africa the following factors should be taken into consideration:

1. The Business Expansion Scheme was introduced in the United Kingdom as a means to close the small firms equity finance gap. Although a relatively large amount of money was invested through the scheme (,750 million in a 5 year period) it failed in its main task of providing support to small firms requiring relatively small amounts of equity finance. It also failed to channel funds into areas of most need, such as technology based sectors, regions with a low concentration of businesses and new businesses.
2. Given the difficulties experienced currently with tax administration in South Africa and the lack of sufficient systems to measure and control tax incentives, such a scheme could possibly contribute to the problem of tax leakage.
3. To prevent the erosion of the tax base, consideration should be given as to whether measures outside the tax system would not be more appropriate to address the small firm finance equity gap in preference to the use of the tax system.
4. Incentives provided should comply with the criteria recommended by the Commission in Chapter 7 of the first Interim Report.

13.6 RECOMMENDATIONS

13.6.1 The following criteria are proposed for the taxation of natural persons as small business undertakings (SBUs):

1. employment of less than 50 but more than 5 employees;
2. annual turnover of less than R2 million; or
3. capital assets utilised (excluding fixed property) valued at less than R2 million. [paras. 13.2.1-2]

13.6.2 Taxpayers who satisfy the qualifying criteria for the cash basis of taxation, should be allowed to elect to be taxed on this basis at any time after the regulations have come into operation. It is proposed that taxpayers who so elect should be deemed to qualify from the beginning of the tax year. Upon ceasing to qualify, a taxpayer should be deemed to have qualified up to the end of the tax year. [paras. 13.3.1-3; 13.3.6]

13.6.3 In the event of a business shrinking in size to such an extent that it complies with the definition of a SBU, the taxpayer should not be afforded the benefit of the cash basis of taxation. [para. 13.3.4]

13.6.4 With regard to the recoupment of allowances when a taxpayer ceases to qualify as a SBU, a phasing-out period of at least two years should be granted. [para. 13.3.7]

13.6.5 Consideration will have to be given to the formulation of anti-avoidance measures if a special tax dispensation is granted to small businesses. [para. 13.4.2]

13.6.6 The Commission does not make any recommendation regarding the question of introducing a scheme similar to the United Kingdom Business Expansion Scheme or Enterprise Investment Scheme.

CHAPTER 14

14.1 INTRODUCTION

14.1.1 The Commission appointed a specialist sub-committee under the Chairmanship of Dr Theunie Lategan to investigate the inclusion of a wider range of financial services in the Value Added Tax system.

14.1.2 The primary reason for the appointment of such a specialist sub-committee was that the subjects involved in the investigation were very technical and involved matters of practicality for specialised financial institutions. It was also deemed important that the relevant interested parties be given an opportunity to participate in the evaluation and consideration of the complex issues that arose.

14.1.3 The Commission places on record its gratitude for the efforts and dedication of the Sub-Committee and, in particular, to its Chairman.

14.1.4 A copy of the Sub-Committee's Report is attached to this Report as Appendix C.

14.1.5 The Commission has accepted all but one of the recommendations of the Sub-Committee, but has added certain qualifications that are addressed in sections 14.2 and 14.3 below.

14.2 QUALIFICATIONS REGARDING THE ESTIMATES OF YIELD

14.2.1 The purpose of reducing exemptions in a VAT system is never to increase the yield. It is to reduce the cascading effect of "tax on tax". It is also to simplify the working of the system and to eliminate the complex allocations of input credits between standard and zero rated goods and services (where they are allowed) and exempt ones (where they are denied). These allocations are often arbitrary, involve substantial sums of money and can give rise to costly disputes between registered vendors and the revenue authorities. A well designed VAT system is one in which exemptions have been reduced to the absolute minimum.

14.2.2 In theory the base of our VAT consists of two elements. The one is final domestic consumption expenditure on standard-rated goods and services. The other is the value of standard-rated inputs used in the production of exempt goods and services. Eliminating an exemption will normally increase the former and reduce the latter. The net effect on the base will depend on the proportions in which the previously exempt item was supplied to vendors and non-vendors, used in the production of exports and other zero-rated goods or ultimately destined for investment rather than domestic consumption. None of this information is easy to obtain.

14.2.3 It is against this background that the estimates of yield made in Chapter 6 of the Sub-Committee's Report must be judged. They should be taken to indicate no more than that a narrowing of the areas of exemption in the financial services industry is unlikely to reduce the yield. This is in itself an important conclusion. It has strengthened the Commission's view that the recommendations of the Sub-Committee should be endorsed. But so great is the importance that the Commission attaches to a smoothly functioning VAT system containing a minimum of exemptions that it would have endorsed the recommendations even if a small sacrifice of yield had appeared likely.

14.3 FINANCIAL SERVICES LEVY

14.3.1 The Financial Services Levy was introduced simultaneously with Value Added Tax in 1991. It appears to have been designed to forestall criticism that might have arisen from the perception that the financial services industry would gain some advantage from the exemption of financial services from VAT. In fact, of course, the reverse was the case. The most onerous position for a registered vendor in a VAT system is to have its outputs exempted. Input credits can then not be claimed. Costs are increased and, to the extent that they cannot be passed on, impact directly on profits.

14.3.2 The Commission believes that after four years of exposure to the workings of VAT, there is no longer any perception that exemption confers a benefit. It is therefore time to give serious consideration to the abolition of the levy.

14.3.3 The Sub-Committee has recommended that the levy on the banking industry be withdrawn as and when a wider range of banking services is drawn into the VAT system. There is no logical connection between the two events. The recommendation is made purely on revenue grounds. The Sub-Committee believes that, timed in this way, the reform could be instituted without loss to the fiscus. The Commission supports this approach.

14.3.4 The Sub-Committee has also recommended that the levy remain on pension funds, life insurers and unit trusts. The Commission does not support this view. In Chapter 8 a new regime has been suggested for pension funds that would, purely on revenue grounds, permit the abolition of the levy on all branches of the financial services industry. The Commission believes this is the course to adopt, and recommends accordingly.

14.4 RECOMMENDATIONS

14.4.1 The Commission adopts the recommendation that section 2(1) of the VAT Act, 1991, should be narrowed as set out in paragraph 8.7.2(a)-(d) of the Sub-Committee's Report, which appears in this Report as Appendix C, thereby bringing into the VAT the following:

1. all fee based financial services;
2. all fee based services in respect of life insurance and other superannuation funds.

14.4.2 Whereas the Sub-Committee recommended in paragraph 8.7.2.(e) that the financial services levy be retained for the life insurance and pension industry and be removed for banks and other financial institutions, the Commission recommends that the financial services levy be abolished.

14.4.3 The Commission adopts the recommendation by the Sub-Committee made in paragraph 9.1.4 of its Report that a specialist team at the office of the Commissioner for Inland Revenue be established to investigate the adoption of a more refined definition of financial services. The Commission also supports the publication of a detailed practice note following consultation with the Council of Southern African Bankers, the Life Offices Association and the Fund Managers' Association of South Africa and other role players.

14.4.4 The Commission adopts the recommendation that a definition of a basis of apportionment should receive the urgent attention of the office of the Commissioner for Inland Revenue, as outlined in more detail in paragraph 9.2.10 of the Sub-Committee's Report.

14.4.5 The Commission adopts the recommendation made in paragraph 9.3.4 of the Sub-Committee's Report that self-supply rules whereby specified supplies and functions are valued at market prices and are deemed to be supplied by institutions to themselves, should not be introduced.

14.4.6 The Commission recommends that, regardless of whether a system of group income taxation be introduced or not, VAT grouping provisions should not be implemented mainly due to the complexity of such a system. In contrast, the Sub-Committee, in paragraph 9.4.7 of its Report, recommended in favour of VAT grouping, should group income taxation be introduced.

CHAPTER 15

15.1 INTRODUCTION

15.1.1 Gambling is an activity which has largely occurred illegally in South Africa, with the exception of a few forms thereof, such as betting on horse racing, lotteries and scratch cards. The latter two activities have been used for fund-raising purposes by charitable organisations. The recent Report of the Commission of Inquiry into Lotteries, Sports Pools, Fund-Raising Activities and Certain Matters Relating to Gambling ("the Howard Commission") has estimated that the total amount involved in the total gambling industry in South Africa is R8 billion per annum. This includes legalised casino gambling in the former TBVC states to which South Africa had easy access and in which amounts of between R800 - R900 million per annum were spent. In horse racing, bets placed in the year ending 31 July 1992 amounted to R3,1 billion. The Howard Commission concluded in this respect that gambling in South Africa, legal or otherwise, is an extremely popular activity, not only from the point of view of raising money, but from the entertainment perspective as well.

15.1.2 The Howard Commission held the view that gambling should be legalised in order to satisfy reasonable demand therefor:

... subject however to such restrictions and controls as may be required to discourage socially harmful excesses and prevent the criminal activities associated with certain forms of gambling.

The Howard Commission also considered that legalised gambling should be so regulated as to make substantial contributions to social upliftment and economic development.

15.1.3 This view was reached on the basis that the Government cannot provide sufficient funds for all social welfare purposes, an area in which there are acute needs, without an undue increase in taxation. It found that social welfare organisations had resorted to lotteries to survive and continue to serve needy communities, even though such lotteries were prohibited by law:

Thus there is a dire need for the funds by the operation of legalised lotteries, sports pools and other forms of gambling.

15.1.4 The Howard Commission dealt with various forms of gambling and made recommendations regarding, inter alia, taxation and, more specifically, VAT. It is unnecessary to set out in detail the recommendations of the Howard Commission in respect of taxation and VAT.

15.1.5 In March 1995, the Lotteries and Gambling Board ("the Board") issued a report ("the Main Report") in which it too made numerous recommendations in respect of lotteries, sports pools, casinos, slot machines and so forth, including recommendations relating to the taxation thereof and VAT thereon. Once again it is unnecessary to set out these recommendations in detail in this report.

15.1.6 As regards taxation and VAT, the Board's recommendations are set out in paragraph 7.0 of the Main Report and read as follows:

TAXATION

Most gambling jurisdictions in the world are compelled to pay taxes and distribute revenue to good causes. The majority of countries also impose fees for the award of the initial licence and its subsequent renewal. Certain countries also impose levies on machines and the number of gamblers that play per gambling house. To discuss all these here in detail would not be appropriate and could be misleading. The principle is that the gambling industry must be a revenue generator for the government and its projects as well as for identifiable and approved good causes in society.

The introduction of casinos and, especially, a national lottery as recommended in this Report calls for careful consideration of the tax structure. The matter was not part of the brief for the Interim Report of the Commission of Inquiry into certain aspects of the tax structure of South Africa (Katz Commission) and that report, therefore, contains no reference to the subject.

The Katz Commission has not yet had the opportunity to study the subject, and the Board was unsuccessful in arranging a meeting with the Commission. Representatives from the Board did, however, meet with a delegation of the Financial and Fiscal Commission. The recommendations that follow are, therefore, based on the best information currently available and due cognisance has been taken of the views of the Inter-Provincial Liaison Committee on gambling.

INCOME TAX

(a) OPERATORS

The Board is of the opinion that there can be no reason to deviate from the principles of normal income tax payable by companies or individuals involved in running gambling activities for profit. They would operate their business for profit as any other company or individual and can, therefore, not be treated any differently.

(b) GAMBLERS

As it would be extremely difficult, if not impossible, to establish gaming and betting profits of individuals, it would be completely impractical to try and tax them. (This comment does not apply to the registered professional gambler who is liable for income tax in the normal way).

In the case of lotteries, prizes won could be established, but experience worldwide teaches that the sheer magnitude of the bigger prizes lies at the heart of the success of lotteries. By reducing the prize by levying income tax on them would severely affect participation, and consequently, money that can be made available to good causes.

VALUE ADDED TAX (VAT)

(a) LOTTERIES

The whole object of lotteries is to derive as much money as possible for good causes (eg RDP, charities, sport, art and culture), with the result that it would be senseless to levy VAT on them. Lotteries are, in any case, a form of voluntary tax as participants feel they are doing something for good causes. Worldwide experience has shown that taxing lotteries has a very negative impact on their success.

Exempting lotteries from VAT will not have a material effect on state revenue as all existing lotteries are, in any case, illegal and probably do not presently contribute much in the way of VAT.

(b) OTHER FORMS OF GAMBLING

Casinos are soon to be legalised in South Africa and in terms of the Constitution the provinces have the exclusive right to levy tax on gambling (with the exception of VAT and income tax).

Unless gambling is exempt from VAT, the provinces will not be able to optimise the benefits which they can derive from casinos. It will totally inhibit the flexibility of provinces to set realistic tax structures if operators also have to pay 14 per cent VAT on gross casino wins.

[See paragraph 15.1.7 below]

It does not help provinces to have an exclusive right to levy taxes on gambling if gambling is subjected to VAT as this, to a large extent, negates the ability of provinces to generate income from this source. North West Province, for example, levies 15 per cent tax on the gross wins of their casinos and, assuming this to be a justifiable rate, will be able to levy very little if their casinos become subject to 14 per cent VAT.

It is interesting to note that when VAT was introduced in the previous TBVC States, gambling was excluded as it was already subject to a specific gambling tax. As the existing legal casinos (ex TBVC) do not pay VAT and from all accounts very little VAT (if any) is paid by illegal casinos, the state will not lose revenue from this source by exempting gambling from VAT. There seems to be no justification for imposing double taxation.

It should be mentioned that there is no fair and equitable nor practical method of charging the end user (which is the very principle of VAT).

Services currently exempt from VAT are those financial services which include funds for the promotion of horseracing (governed by a province). Currently, financial institutions are also exempt with a special levy on their financial services. Furthermore, by exempting gambling operations, no value added input credit can be claimed on capital equipment and other expenses, which, in effect, ensures that a large portion of the VAT is included in the cost of operation.

15.1.7 It is respectfully pointed out that the Board misdirected itself as regards the effect of taxing gambling and that the correct principles in this regard appear in section 15.4 below.

15.1.8 In essence the Board's recommendation to exempt lotteries from VAT is based on the fact that the exemption causes little loss to the fiscus and there is much international precedent which supports such exemption. In the case of other forms of gambling, including casinos, it is stated that the provinces have an exclusive right in terms of the Constitution to levy tax (other than VAT) on such gambling and that unless gambling is exempt from VAT, the provinces will not be able to optimise their benefits from casinos.

15.1.9 The Board issued a supplementary report in July 1995. In that report it recommended that gambling activities should be zero rated rather than be exempt. The basis for this latter recommendation is that it achieves the recovery of input VAT.

15.1.10 It is relevant to draw attention to the international experience with regard to VAT in respect of betting, gaming and lotteries as well as racing. Tait writes as follows:

Betting, Gaming, and Lotteries

Unless betting, gaming, lotteries, and similar activities are forced into recognizable, easily located, identified premises or locations, they will probably be semi-illegal and untaxable. However, in most countries there are betting shops, licensed bookmakers, and state-registered totalisators, as well as lotteries, casinos, and gaming arcades. Nevertheless, the borderline between legal and illegal can be affected by VAT as exemplified by the Irish taxation of gambling. A VAT of 25 per cent on the betting stake so altered the odds that those placing the bets opened accounts with bookmakers in the United Kingdom - where the VAT was half the Irish rate - and improved their odds. Of course, formally the transaction was illegal but it was almost impossible to check and eventually led to a reduction in the rate of tax on betting in Ireland.

Even where the activities are identified, it is only where the state is the organizer that it is possible to levy VAT on a reliable basis. When private individuals are running the gaming tables or machines, the monitoring of income and expenses for tax purposes (for VAT or income tax for that matter) is almost impossible. The preference has to be for more simple taxes based on clearly identified characteristics, for example, the number of gaming tables or machines, the square footage of the establishment, or a licence to trade.

Sometimes, gaming machine takings are liable to VAT or special charges are made to participate in a game of chance separate from the stakes risked by players; such charges are liable to VAT at the standard rate. Of course, where establishments such as casinos sell meals and drinks as well as organize the gambling, then their activities as restaurants and caterers are liable to VAT in the normal way.

Racing

Allied to betting in some countries is the whole complex world of racing. Basically, the VAT should distinguish between horse breeders and owners who race only as a hobby or who race continuously and regularly (it is not a good idea to include profit to judge whether racing is a business or not). Trainers, jockeys, breeders, and syndicates should all be liable to VAT and registered if their turnover exceeds the threshold. Although the arrangements of this particular business can be extraordinarily tangled, involving many intercountry transactions, the basic rule is that the value added, whatever form it takes, is taxable.

Overall, the rule in applying VAT to all these difficult to tax sectors seems to be that quoted from Talleyrand at the beginning of this chapter; by all means try to pull these activities within the VAT but beware of the administrative and compliance costs of too much zeal in doing so.

15.1.11 The Commission has reviewed the difficulties raised by Tait in consultation with the Commissioner for Inland Revenue and is satisfied that if the administrative restructuring recommended in the first Interim Report is undertaken, the authorities will be able to apply ordinary VAT principles to the taxation of gambling, betting and gaming activities.

15.1.12 The question whether possible delays in the restructuring of Inland Revenue might not argue in favour of an alternative approach may arise. The answer to this query is two-fold:

1. first, it would not be prudent to introduce a special dispensation for VAT on gambling until Inland Revenue has been adequately restructured and thereafter to revert to general principles;
2. in any event, the VAT section of Inland Revenue has functioned relatively effectively and can even at this stage be relied upon to administer VAT on gambling transactions. To the extent that certain categories of gambling transactions are at present subject to VAT the collection has functioned smoothly.

15.2 CONSTITUTIONAL POSITION

15.2.1 In terms of section 156(1B) of the Constitution, the provinces have the exclusive right to impose tax on gambling, casinos and lotteries except for income tax, value added tax and other sales tax. Although VAT is collected nationally, section 155(2)(b) of the Constitution provides that a per centage of the total VAT collected must be allocated to the provinces.

15.3 GAMBLING IN THE ERSTWHILE TBVC STATES AND VAT

15.3.1 Gambling activities in the TBVC states were subject to VAT at zero per cent. Section 41(7) of the Taxation Laws Amendment Act, 1994 provides that value added tax levied at the rate of zero per cent on betting services remains in force as if enacted in terms of the Value Added Tax Act, 1991.

15.3.2 Tax harmonization provisions enacted during 1994 and 1995 provide that individuals of the former TBVC states will be incorporated into the RSA income tax system for the 1996 year of assessment. Companies whose years of assessment commenced on or after 1 April 1994 will be subject to the RSA tax laws.

15.3.3 However, the harmonisation has not yet been applied to the tax status of gambling in these former states.

15.3.4 At present VAT is levied on gambling transactions in South Africa at 14 per cent, while provincial betting taxes are simultaneously reduced.

15.4 CURRENT PRINCIPLES APPLICABLE TO THE LIABILITY OF GAMBLING TRANSACTIONS TO VAT

15.4.1 The Value-Added Tax Act in its existing form already caters for all forms of gambling. The relevant provisions are as follows:

(a) National Lottery:

1. As with any other State Department (except those listed in media statement dated 27 September 1991) the Department under which the national lottery will operate will not be an enterprise for VAT purposes.
2. The agent who will operate the National Lottery for the relevant State Department will however be conducting an enterprise and will consequently have to be a registered vendor.

(b) Racing:

1. The horse racing industry (i.e. turf clubs, the totalisators and bookmakers) is taxed at the standard rate on all bets with input tax being deducted on the tax fraction of winning bets paid out and provincial betting taxes paid.
2. Entrance monies, the sale of refreshments and other supplies are taxed in the usual way.
3. Stake monies (i.e. winnings) paid to race horse owners are subject to VAT.

(c) Lotteries:

1. The proceeds of lottery tickets are deemed to include VAT, which must be declared for output tax purposes.
2. Input tax is claimable in the ordinary manner as provided for in the VAT Act.
3. The tax fraction of winnings paid out can also be claimed as input tax.

(d) Casinos:

1. Entrance fees as well as the supply of refreshments are taxable and input tax in respect thereof is claimable.
2. In respect of bets placed and winnings paid out a practical arrangement is possible whereby in respect of a tax period only the net proceeds will be taxed at the standard rate instead of reflecting the input and output tax in respect of each transaction.

15.4.2 It follows from the aforegoing that it will not be necessary to amend the VAT Act if the recommendations of the Commission as set out hereunder are accepted by the Government.

15.5 RELEVANT PRINCIPLES

15.5.1 As set out above, exempting gambling activities for VAT purposes would result in the non-recovery of input VAT. Secondly, vendors would have to pay tax on any assets withdrawn from taxable supplies. The effect of this is that all assets used for the purposes of gambling would be subject to VAT on the market value of such assets on the date on which the activity becomes exempt.

15.5.2 The proposal to zero rate gambling activities would also give rise to conceptual problems and administrative difficulties.

1. In the first instance, the Commission has always been, and remains, of the firm view that the integrity of the VAT base should be preserved. In its first Interim Report, the Commission recommended strongly that Government should only, in exceptional circumstances, add to the list of zero rated items. The Commission does not believe that there is sufficient justification to breach this fundamental principle to accommodate gambling activities.
2. Secondly, although the provinces are perfectly entitled to tax gambling it has been pointed out that this would greatly add to administration and compliance complexity of the VAT system. Furthermore provinces would be required to create administrative structures to collect the gambling tax. In these circumstances taxpayers would have to deal with two tax administrations, two returns and two calculations. All this would add to their costs of compliance. The net additional tax that may be raised will be reduced by the additional costs.
3. Thirdly, the effect of zero rating would be to require the central Government to relinquish its right to impose tax granted in terms of the Constitution in favour of the provinces.
4. Fourthly, zero rating gambling activities as a concession in favour of the provinces might serve as a precedent in other cases, resulting in the degrading of the VAT system.

15.5.3 It follows from the aforegoing that it would be sensible to adopt the following concepts:

1. gambling should be treated like any other industry or activity for VAT purposes, with revenue shared between the central Government and the provinces as provided for in the Constitution, thereby incurring no additional administrative burden;
2. provinces should have the right to impose a tax in the form of a licence fee, levy or other mechanism arising from the fact that the provinces are required to regulate the industry.

15.5.4 Numerous submissions to the Commission stressed the fact that if gambling transactions were subject to VAT and if in addition the provinces imposed taxes on gambling activities the cumulative effect would "drive out" the industry altogether or force it underground. The Commission's response to this concern is as follows:

1. in the first instance, sound principles of taxation must inform the Commission's recommendations;
2. it is not for the Commission to prescribe what may be considered to be the correct level or rate of tax to be imposed by the provinces;
3. the base which would be liable for VAT on the application of existing VAT principles would be a small portion of the total winnings paid out by the gambling industry, and the VAT itself would be 14 per cent of that base; and
4. none of the Commission's recommendations prevent the Government from concluding arrangements with the provinces for the sharing of VAT revenues emanating from gambling.

15.6 RECOMMENDATIONS

15.6.1 The Commission accordingly makes the following recommendations:

15.6.2 Income Tax:

1. Operators: The normal income tax principles should be applied to all gambling and casino operations.
2. Gamblers: The normal income tax principles should be applied to the winnings of gamblers.
3. Lotteries: The normal income tax principles should be applicable to operators of lotteries with the sole exception of the National Lottery which should be exempt from income tax.

The effect of the aforegoing, on the basis of the existing law, is that lotteries which are operated by charitable organisations which are exempt from tax would continue not to be subject to income tax.

15.6.3 Value Added Tax: The following principles should apply:

1. all gambling, casino and lottery activities, with the exception of the National Lottery, should be subject to VAT;
2. the National Lottery should be treated in the same manner as Government Departments, in that the inputs be subject to VAT but no output VAT be charged;
3. insofar as concerns small lotteries, the normal R150 000 annual threshold should be applicable. [para. 15.5.3(a)]

15.6.4 Other Taxes: The aforegoing recommendations do not detract from the Constitutional right enjoyed by the provinces to impose certain taxes on the industry. [paras. 15.2.1; 15.5.3(b)]

15.6.5 As regards the distribution of income from a National Lottery, it would be inappropriate for the Commission to make any recommendation.