Generally, security in most business dealings is of paramount importance to safeguard against poor quality or substandard products.
In this regard, some business operators tend to leverage on retentions to obtain some form of security against incomplete, defective, or sub-standard work from contractors or subcontractors. In most cases, a client is permitted to withhold a certain amount or a percentage of the contract fee as a retention which will only be paid subsequent to fulfilment of contractual obligations. Accordingly, some business operators tend to face a quandary on the Value Added Tax (VAT) treatment of the retention amount i.e., whether or not VAT should apply on the amounts retained by clients. Allow us to clarify in detail why VAT is applicable on retentions. In this article, words importing the masculine shall be deemed to include the feminine.
As alluded to above, a retention amount is basically withheld to ensure that a contractor or supplier fulfils contractual obligations to the client’s satisfaction. In most cases, a retention amount is directly related to the fee charged or contract fees. In the majority of instances, the retention is withheld from payments made in respect of construction projects. If P10m is payable to a contractor and 10% retention is applicable, the contractor can only receive P9m whilst the P1m retention is paid if no defaults appear on the building.
Technically, the VAT laws do not specifically address the treatment of retention in its literal meaning. However, guidance is inherently obtained from the provisions which defines and regulates a supply and the value of supply. Essentially, a supply is construed to be the provision of goods or services. Accordingly, VAT of such supply is triggered at the earlier of issuance of an invoice or receipt of any payment in respect of the supply. Technically, this means a supplier is required to account for VAT on the full value of the supply if either an invoice is issued, or payment is received, whichever occurs first.
Now, to put everything into perspective, it is apparent that a retention amount is technically a portion or a percentage of a value of supply that is withheld by a client. Put in another way, a client withholds a portion of an amount due to the construction company or other contractor. For clarity, let us assume that ABC (Pty) Ltd is a construction company which commenced the construction of a block of flats for a customer and agreed that a 10 percent retention is only due if no cracks appear on the building within 1 year after construction.
Technically, if the company sends an invoice of P10m for erecting the foundation, the customer will be permitted to withhold P1m and pay P9m to ABC (Pty) Ltd. The biggest issue is whether VAT must be applied on the P10m or the P9m. We must make it categoric that a retention does not alter the value of the services provided by ABC (Pty) Ltd and the VAT must therefore be charged on the full P10m, ignoring the retention. Retentions only impact the 3 percent withholding tax and not VAT.
Retentions constitute part of the value of supply or goods or services subject to VAT. One way to look at it is that a retention only addresses the modus of payment of services which is inconsequential to the VAT treatment of the services provided.
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