2008-06-07
Close corporations, trusts attacked again

Close corporations, trusts attacked again

In order to discourage the use of corporate entities as intermediaries to provide personal services to a principal which are, in essence, services provided in terms of a contract of employment, amendments were introduced to the Income Tax Act during 2000 [Section 23(k) and the Fourth Schedule] to ensure that:

• the remuneration payable to a personal service company by the principal be subject to employees' tax (prevent deferment of tax liability);
• the tax deductions of a personal service company be limited; and
• the tax liability is not diluted or avoided.

The reasoning behind this change is to eliminate the use of a trust, company or close corporation (CC) as a vehicle or conduit through which you could provide services to someone, which in the absence of the trust, company or CC, would otherwise constitute a normal employee - employer relationship.

These changes do not include individuals (sole proprietors, partnerships).

There have been some amendments to the governing sections and have been identified herein.  However, the amendments are not retrospectively applicable, and taxpayers will still be audited and assessed by Sars based on the legislation applicable from that year of assessment.

The definition of an "employee" in paragraph 1 of the Fourth Schedule to the Income Tax Act was amended to include a personal service company with effect from August 1 2000, but the definition of a "personal service company" was inserted into paragraph 1 of the Fourth Schedule to the Act only with effect from years of assessment commencing on or after April 1 2000.

A company could, therefore, not be a personal service company in its years of assessment commencing prior to April 1 2000 and, accordingly, could not be an employee and have employee's tax deducted from amounts payable to it in such years.  In fact, all provisions of the Act applicable to personal service companies can apply only in the years of assessment of companies qualifying as personal service companies, that is, years of assessment commencing on or after April 1 2000.

This means that a company with a February year-end may qualify as a personal services company for the first time only in its year ending in February 2002, since its previous year would have ended on 28 February 2001 and would have commenced on March 1 2001, being after April 1 2000, but the effective date for employees' tax to be recoverable is effective from August 1 2000.

A "personal service company" is defined, according to Paragraph 1 of the Fourth Schedule to the Income Tax Act, as one where the services are rendered on behalf of the company (other than a company which is a labour broker) personally by a member / shareholder (a connected person) of the company or any relative of the member / shareholder of the company.

Bear in mind that the provision of services to a client must personally be rendered by a connected person as defined in Section 1.  The provision of services on their own would not define a personal services company - at least one of the following sets of circumstances must be present:

• The person who renders the service would be regarded as an employee of the principal if it was not for the existence of the personal service company.  The term ‘employee' is most probably used in its defined sense for employees' tax purposes in paragraph 1 of the Fourth Schedule.  What is intended here is that the company is not merely a sham, but has lawfully been introduced between the natural person providing the service and the client.  The company must add resources and trade structure;
• The person who renders the service is subject to the control and supervision of the principal as to the manner in which, or hours during which, the contractors' duties are performed.  Effective from 1 March 2007, this test has been amended as follows: "[W]here those duties must be performed mainly at the premises of the client, such person or such company is subject to the control or supervision of such client as to the manner in which the duties are performed or are to be performed in rendering such service";
• The amounts payable in respect of the services rendered consist of earnings of any description which are payable at regular daily, weekly, monthly or other intervals.  Only ‘a contractual right ... to demand payment at those regular intervals' satisfies the requirements of the ‘regularity' test.  What is intended is that there is a legitimate expectation harboured by the targeted company of being paid regularly.  This requirement was removed as an element of the definition effective as from March 1 2007;
• More than 80% of the income of the personal service company results from the services rendered to any one client or associated institutions, i.e. the company is economically dependent upon a single client or group of companies.  Very broadly speaking, ‘associated institutions' as defined in paragraph 1 of the Seventh Schedule are ‘companies managed or controlled directly or indirectly by substantially the same persons'.  The amendment introduced the opportunity for the company to issue a declaration to verify to the service user that no more than 80% of the company's income will be from that one source.

Excluded from the scope of a personal service company is a company or close corporation which employs, throughout the year of assessment, more than three full-time employees (other than the shareholder, members, or connected persons) who are on a full-time basis engaged in the business of the company or close corporation of rendering any service.

The "more than three" (meaning four or more) employee requirement was reduced to ‘three or more' effective from March 1 2007.

With regards to the exemption where the corporation has full-time employees, the following should be noted: As there are no reported court cases regarding the interpretation, or limitation, for this section, we must consider the possible interpretation that could be given to this section.  The exemption requires that the company employs "full-time employees who are on a full-time basis engaged in the business of such company of rendering any such service, other than any employee who is a shareholder or member of the company [including close corporations] or is a connected person in relation to such person".  I submit that the requirement for defining an employee as a bone fide employee that could be used for purposes of exception is as follows:

• The employee must be employed on a full-time basis throughout the year of assessment.  Being employed on a full-time basis would imply that the employee may not hold any other employment;
• The employee must, on a full-time basis, be engaged in the business of such company and for the rendering of such services.  The employee must spend all their working time personally rendering the targeted services on behalf of the company to its client/s.  This specific condition would imply that the employee would have to be engaged in providing the same services as the connected person, and in general to contribute to the business.  In practice this would equate to excluding administrative and supporting staff, such as the receptionist;
• The employee may not be a member of a close corporation or shareholder of a company; and may also not a connected person to the member or shareholder.

So the statement that I have heard so many times, "I have four employees", is not sufficient.  The employees have to meet all the above mentioned requirements.

The applicable tax rate in regards to personal service companies is a 5% inflated rate from that of the normal company tax rate (meaning the current tax rate is 33%; previously 34%).  This inflated corporate rate, except where a Sars directive instructs differently, will be the rate of employees' tax that service users will have to withhold from all payments to personal service companies.

A personal service trust is subject to employees' tax according to the rates applicable for a trust (currently 40%).

A disadvantage to being defined as a ‘personal service company' or ‘personal service trust' is that the requirement to withhold employees' tax from all payments could cause trouble for these entities, as this would seriously impact on their cash flow.

A personal service company or trust would be entitled to apply for a tax directive, whereby Sars should consider the deductible expenses that the company, close corporation or trust would have on assessment.  This would mean that the limitations imposed by section 23(k) to the Income Tax Act must be considered, which prohibit the deduction of any expense incurred except for those expenses actually incurred that would constitute amounts paid or payable to any employee of such company, close corporation or trust.

Besides the elevated tax rate and cash-flow conundrum that the withholding of employees' tax presents, the deductions of expenses are limited.  The general deduction formula (section 11(a) read together with section 23(g)) must first be applied; being that expenses must be actually incurred, in that year of assessment, for purposes of making income, not of a capital nature, and for purposes of pursuing a trade.

The negative test (generally the provisions of section 23) contains a specific section 23(k) disallowing all expenses incurred for personal services companies or personal services trusts, other than expenses constituting salary, which will be taken into account in determining the taxable income of a salaried employee of such entity.  This section was amended effective from March 1 2007 to limit deductions not merely to expenses constituting salaries, but to now allow deduction of expenses for:

• Remuneration paid or payable to an employee for services rendered, which will be taken into account in the employee's taxable income;
• Qualifying legal expenses (section 11(c));
• Bad debts (section 11(i));
• Contributions to approved pension, provident, and benefit funds (section 11(l)); and
• Expenditure in respect of premises, finance charges, insurance, repairs, fuel and maintenance in respect of assets if such premises or assets are wholly and exclusively used for trade purposes.
• It is important to note that the expenses must be "wholly and exclusively" incurred for purposes of the personal service company's trade and efforts to generate income.  This means that apportionment of expenses party incurred for business would not apply.  Also, section 23(k) makes no provision for deductions in regards to scrapping allowance (assets), wear and tear allowance (assets), research and development, patents and trade-marks, or office expenses that is not in respect of premises or assets used for trade (such as telephone, internet access, stationery).

However, it could perhaps be argued that section 23(k) does not provide exceptions for capital allowances.  A capital ‘allowance' is not an ‘expense'.  To illustrate this I will compare section 23(k) with section 23(m).  Section 23(k) reads ‘any expense incurred', where section 23(m) reads ‘any expenditure, loss or allowance'.  Interestingly enough, the Sars Interpretation Note 35 (issue 2 - 2007) makes no reference to limiting capital allowances!

A personal service company or trust would not qualify for the ‘small business corporation' tax incentives for the stimulation of start-up and growth of small businesses.

A ‘personal service trust' is defined as any trust (other than a trust which is a labour broker), where any service rendered on behalf of such trust to a client of such trust is rendered personally by any person who is a connected person in relation to such trust.  The rest of the definition accords with the definition of a ‘personal service company' and will not be repeated.

Currently there is no exemption certificate or opportunity for relief from hardship available in the legislation.  It is also Sars' policy not to issue any letter or declaration, outside of enforcement action, to confirm the independence or application of the definition of ‘personal service company'.

The newly introduced binding advanced tax rulings have mandatory exclusions (Section 76G) which expresses that the Commissioner may not issue a binding private ruling in connection with certain matters.  The current list of major mandatory exclusions includes "an employer's duty to determine whether a person is an independent contractor, labour broker, personal service broker or a personal service trust".

Ettiene Retief is the chairperson of the South African Institute of Professional Accountants Tax Committee.