On 17 February 2023, the High Court at Nairobi allowed Civil Appeal No. E127 of 2020: Commissioner of Domestic Taxes versus Bank of Africa Limited upholding the finding of the Tax Appeals Tribunal that VAT is not payable on interchange fees received by issuing banks (i.e., banks issuing credit and debit cards).
Brief History
On 18 September 2020, the Tax Appeals Tribunal (“the TAT”) granted Bank of Africa’s appeal against an assessment by the Commissioner of Domestic Taxes for unreported VAT on payments made to various (credit and debit) card firms. Money transfer-related services performed for a client are exempt from VAT under Part II of the First Schedule to the VAT Act.
The TAT allowed the appeal and determined that the exemptions listed in Part II of the First Schedule to the VAT Act prevent VAT from being charged on interchange fees.
The Commissioner contested the TAT’s decision at the High Court. The Commissioner claimed that the TAT erred, among other things, in concluding that the service provided by the issuing bank that led to the payment of interchange fees was not a taxable service subject to VAT.
Basics of a Card Payment Transaction
The High Court had to understand how a card payment transaction works in order to decide whether interchange fees are liable to VAT. In summary, the steps involved in a card payment transaction are:
- A credit or debit card is given to the customer by the issuing bank.
- On the Process Data Quickly (PDQ) device used by the merchant, a cardholder swipes their card.
- To allow the issuing bank to accept the card, an authorization message is sent to the card network.
- The issuing bank verifies the cardholder’s identity, their eligibility to use the card, and whether they have enough money in their account to cover the purchase. For credit cards, the issuing bank checks to see if the proposed purchase falls under the cardholder’s credit limit.
- After checking the aforementioned details, the issuing bank sends a payment authorisation to the acquiring bank. This permission serves as the issuing bank’s promise to pay the sums the cardholder has spent on the merchant’s property.
- The merchant generates a charge slip or transaction receipt after receiving the authorization from the issuing bank through the acquiring bank.
- The merchant keeps a copy of the charge slip or transaction receipt, which it then submits to the acquiring bank for settlement.
- The acquiring bank transfers the remaining cash to the merchant after deducting a fraction (the Merchant Discount Rate, or “MDR”) from the amount owed to the merchant. The issuing bank and the participating networks receive a portion more of the MDR.
Interchange Fee is the portion of the Merchant Discount Rate that the acquiring bank pays to the issuing bank. The interchange fee is largely intended to compensate for the handling expenses and credit risk involved in a card electronic payment.
The High Court’s Decision
The High Court decided that there were two grounds for not charging VAT on interchange fees.
First, the court agreed with the TAT that the financial service in question was one that the issuing bank principally offered to its cardholder clients. Particularly, the issuing bank offered the service of undertaking a verification process to verify, among other things, the identity of the customer-cardholder and that the customer’s account has sufficient funds to complete the transaction. According to Part II of the First Schedule to the VAT Act, this service is specifically exempt from the application of VAT to the extent that it is a money transfer-related service.
The court rejected the Commissioner’s contention that the service provided by the issuing bank that resulted in the payment of the interchange fee was merely incidental to financial services and, as such, was not specifically excluded under the VAT Act.
Second, the court ruled that because the acquiring bank had previously paid VAT on the MDR, the interchange charge was still not subject to payment of VAT. The court emphasized that the acquiring bank was the one that collected the interchange charge and MDR. The acquiring bank additionally had the responsibility to account for and remit VAT depending on the gross MDR amassed. The court concluded that requiring the issuing bank to account for and pay VAT on interchange fees would amount to double taxation.
Consequences of the Decision
It is evident, at least for the time being, that banks that issue credit and debit cards are not responsible for paying VAT on interchange fees. According to the First Schedule of the VAT Act, these costs are considered financial services and are therefore excluded.
Yet, the issue is still far from resolved given that the Court of Appeal determined in a different decision (Commissioner of Domestic Taxes (Large Tax Payer Office) v. Barclays Bank of Kenya Ltd [2020] eKLR) that interchange fees are subject to withholding tax because they constitute management and professional services. An appeal from the Court of Appeal’s judgment has been preferred and is currently pending determination at the Supreme Court.
We shall continue to monitor developments in this area and issue updates as they unfold.
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Disclaimer: This article has been prepared for informational purposes only and is not legal advice. This information is not intended to create, and receipt of it does not constitute a lawyer-client relationship. Nothing in this article is intended to guarantee, warranty, or predict the outcome of a particular case and should not be construed as such a guarantee, warranty, or prediction. The authors are not responsible for any actions (or lack thereof) taken as a result of relying on or in any way using information contained in this article and in no event shall be liable for any damages resulting from reliance on or use of this information. Readers should take specific advice from a qualified professional when dealing with specific situations.
