Should illegal transactions be subject to VAT?

Moneymaking businesses such as prostitution, drug dealing, and the sale of counterfeit goods have been around for years and yet, taxing and moreover the application of value added tax (VAT) on these transactions has remained a contentious issue. VAT is a consumption tax that is levied on both goods and services. The rate in force in Mauritius is 15%. Should a prostitute or a dealer in counterfeit goods register as a VAT vendor (imposing VAT) and subsequently account for output VAT (charged on value of supplies)? If so, can the prostitute or dealer in counterfeit goods claim input VAT (incurred on value of business expenses)?

Generally, any natural or juristic person who generates yearly taxable supplies in excess of Rs 2 million in the course or furtherance of any business carried on by him within the Republic should register as a VAT vendor and should ultimately levy VAT at 15% or 0%, the latter rate is applicable to zero-rated supplies. A person engaged in a business or profession like accountants, architects, lawyers, project managers, etc. should register for VAT irrespective of the Rs 2 million thresholds.

A person does not have to register as a vendor for a once off or private deal. A VAT vendor is therefore, subject to limitations, allowed to deduct input vat from his output vat on any goods or services acquired or imported by him where the goods or services are intended to be used in the course of making taxable supplies. The net amount is payable either monthly or quarterly to the tax authority. How far are these obligations applicable to a person dealing in illegal transactions?

In order to establish whether or not a person is engaged in a business or a profession, the following elements should be present: a continuous or regular activity; carried on within the Republic; the supply of goods or services to any other person; and for a consideration.

It is important to note that more than one person should be involved to make a supply for the supply to attract VAT. In other words, a supplier and recipient should exist. The goods supplied to a person need not be consumed; a mere use of the item should suffice. In the absence of legislation or a practice note to the contrary, the supply of illegal goods, or the supply of illegal goods by illegal means, satisfies the requirement of supply for the purposes of business. Where something is done or is to be done to another person either by an illegal act or with an illegal result satisfies the requirement of rendering a service for the purposes of the supply of services to attract VAT.

It is clear that VAT is not concerned with the legality or illegality of a transaction. It is merely required that the transaction in question must comply with the requirement to charge VAT. It is to be noted that VAT vendors are involuntary tax collectors on behalf of the tax authority. It goes without saying that where an illegal contract was induced by the misinterpretation of the seller, the agreement remains invalid but the supply is subject to VAT.

No provision of the VAT Act prohibits vendor registration if the business or profession is solely or partially operated by illegal means. The question is, however, when such registration takes place? A person conducting an illegal business or profession is unlikely to disclose his illegal activities to the tax authority. The tax authority has to maintain confidentiality except in some specific cases laid down in the VAT Act. But what happens where a business or profession failed to register as a VAT vendor and the duty to register as such only became evident after the activities had ceased as a result of criminal charges having been brought against the person?

In my opinion, the tax authority may nevertheless assess and recover any unpaid output VAT. It is evident in the absence of any prohibition under the act that a vendor should be entitled to claim input VAT on its taxable supplies irrespective of whether the taxable supplies are illegal or are supplied illegally The tax authority may also claim penalties and interest in terms of the act.

In applying the law to determine the VAT liability of illegal transactions a moral dilemma is created where the layman could constitute the taxation of illegal contracts as government’s approval of illegal transactions. One would opine that government benefits from crime if amounts illegally received are taxed.

My conclusion is axed on two arguments. First, the illegality or unenforceability of an agreement only affects the parties to the agreement. The levy of VAT is not concerned with the lawful or unlawfulness of an agreement.

Secondly, it is an untenable situation where legitimate products are sold with VAT unfairly competes with illegitimate products sold without VAT. This could also construe as government’s approval of illegal transactions whereby government indirectly subsidizes illegal activities by allowing a discount for VAT not charged. Obviously, this will encourage the trade in illegal goods.

The core of the principle is tax neutrality. Taxing an illegal transaction in the same way as a legal transaction reflects an attitude of neutrality which neither hinders nor encourages.