On 17 February 2023, the High Court (Nairobi) delivered a judgment in Civil Appeal No. E127 of 2020: Commissioner of Domestic Taxes v Bank of Africa Limited upholding the finding of the Tax Appeals Tribunal that VAT is not payable on interchange fee received by issuing banks (i.e., banks issuing credit and debit cards).
On 18 September 2020, the Tax Appeals Tribunal in TAT No. 319 of 2018, allowed an appeal filed by Bank of Africa against an assessment by the Commissioner of Domestic Taxes of KShs.87,729,030.00 (later amended to KShs.15,158,378.00), being undeclared VAT on payments made to various (credit and debit) card companies. Under Part II of the First Schedule to the VAT Act, money transfer related services undertaken for the benefit of a customer are exempt from VAT.
In allowing the appeal, the Tax Appeals Tribunal held that VAT is not chargeable on interchange fees pursuant to the exemptions under Part II of the First Schedule to the VAT Act.
The Commissioner challenged the decision of the Tax Appeals Tribunal at the High Court. The Commissioner argued that the Tax Appeals Tribunal erred, inter alia, in finding that the service rendered by the issuing bank that resulted in payment of interchange fees was not a taxable service.
Basic Flow of a Card Payment Transaction
In determining whether interchange fees are subject to VAT, the High Court had to appreciate how a card payment transaction occurs. In summary, an electronic card payment transaction proceeds as follows:
- The issuing bank issues a credit or debit card to its customer.
- A cardholder swipes their card on the merchant’s Process Data Quickly (PDQ) machine.
- An authorization message is transmitted to the card network for the issuing bank to accept the card.
- The issuing bank confirms the authenticity of the cardholder, whether they are authorized and/or eligible to use the card and whether the cardholder has sufficient funds in their account to complete the purchase. For credit cards, the issuing bank verifies whether the intended purchase is within the cardholder’s credit limit.
- The issuing bank, upon verifying of the above information, transmits a payment authorization to the acquiring bank. This authorization functions as a commitment by the issuing bank to settle the amounts expended by the cardholder at the merchant’s premises.
- The acquiring bank relays the authorization from the issuing bank to the merchant who generates a charge slip or transaction receipt.
- The merchant keeps a copy of the charge slip/transaction receipt which it subsequently submits to the acquiring bank for settlement.
- The acquiring bank deducts a portion of the funds from the amount due to the merchant, i.e., Merchants Discount Rate (“MDR”), and remits the remainder to the merchant. Another portion of the MDR is paid to the issuing bank and the networks involved.
The portion of MDR paid by the acquiring bank to the issuing bank constitutes Interchange Fee. The purpose of the interchange fee is primarily to cover handling costs and credit risk inherent in a card electronic payment.
The court held that VAT on interchange fees was not payable for two reasons.
- First, the court agreed with the Appellant and the Tax Appeals Tribunal that the financial service in question was one provided by the issuing bank primarily to its card-holder customers. Specifically, the issuing bank provided the service of conducting a verification process to confirm, among other things, the identity of the customer-cardholder, that the customer’s account has enough funds to complete the transaction. This service, to the extent that it constituted a money transfer related service, is expressly exempted from the imposition of VAT under Part II of the First Schedule to the VAT Act.
The court rejected the Commissioner’s argument that the service rendered by the issuing bank leading to the payment of the interchange fee was merely ancillary to financial services, hence not expressly exempted under the VAT Act.
- Second, the Court held that VAT on interchange fee was still not payable because the acquiring bank already paid VAT on the MDR. The court noted that it is the acquiring bank which collected MDR comprising interchange fee. It is also the acquiring bank which had the obligation to account for and remit VAT based on the gross MDR collected. As such, the court held, it would amount to double taxation for the issuing bank to account for and pay VAT on interchange fee.
Implication of the Decision
It is clear, at least at the moment, that banks issuing credit and debit cards are not liable for payment of VAT on account of interchange fees. Such fees constitute a financial service exempt under the First Schedule to the VAT Act.
However, the matter remains far from settled considering that the Court of Appeal has, in a different case, held that interchange fees are subject to withholding tax because they are primarily paid for management and professional services. The issue of whether interchange fees paid to issuing banks should be classified as management or professional fees liable to taxation and subject to withholding tax is currently pending before the Supreme Court.
By Vincent Oloo: Senior Associate