Unraveling the VAT puzzle: can VAT be levied on penalties in a construction contract?

13 July 2023

In the construction industry, the imposition of penalties plays a crucial role in enforcing timely project completion. When it comes to levying value-added tax (VAT) on these penalties, however, matters become more complex. Contractors and stakeholders often grapple with determining whether VAT should be applied to penalty amounts in construction contracts.

Penalties are generally levied at the agreed rate from the contractual stipulated date to the actual date of completion. The agreed rate is to represent a genuine pre-estimate of damages that may be suffered as a result of the failure by one of the parties to fulfill its obligations timeously, or at all, and if it is excessive or out of proportion to the prejudice suffered it may be susceptible to relief provided for under the provisions of the Conventional Penalties Act, Act 15 of 1962.

The common inquiry is whether value-added tax (VAT) can be certified and invoiced in consideration of the penalty levied for payment.

The requirement to pay VAT is regulated by statute and the applicable statute in South Africa provides in Section 7(1)(a) of the VAT Act 89 of 1991 that:

“[s]ubject to the exemptions, exceptions, deductions and adjustments provided for in this Act, there shall be levied and paid for the benefit of the National Revenue Fund a tax, to be known as the value added tax on the supply by any vendor of goods or services supplied by him on or after the commencement date in the course or furtherance of any enterprise carried on by him.

However, penalties may result in a deduction to the contract price and accordingly reduce it which then in effect results in the opposite of the “supply of goods or services in the course or furtherance of a vendor’s enterprise”. In addition to the aforesaid, penalties are agreed to instead of general damages claims and the payment thereof remains for damages suffered and not for any services rendered.

SARS’s VAT 409 – Guide for Fixed Property and Construction for Vendors sheds some light on the issue, stating that a “penalty could represent a reduction of the agreed contract fee, in which case the value of the supply is reduced and VAT must be accounted for on the reduced amount” (emphasis added). Furthermore, “the penalty could be a payment which is not in relation to a  taxable supply of  goods  or  services  and as such not subject to VAT”, which indicates that penalties are therefore not subject to VAT.

However, while the above appears to be uncomplicated, it in fact presents challenges that require careful consideration. Balancing the requirements of VAT regulations with the unique circumstances of construction projects is essential. It is crucial for employers, contractors and other project stakeholders to have an understanding of the relevant laws to ensure compliance therewith. 

Consulting sound legal advice can provide clarity and guidance on how to mitigate risks, make informed decisions and to ultimately navigate complex legal scenarios such as the one explored herein.

Our legal professionals offer valuable insights on general and contract-specific provisions and regulations by guiding our clients throughout the lifecycle of the project to ensure compliance with the law and avoid potential dire legal complications.

By Gerard van Beek | Associate

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