You need a good reason to operate as a CC or company now that the Receiver has introduced the concept of personal service companies.
Are you member of a close corporation (CC) or a company that employs you to provide services to its clients? If you are, beware: you may find the Receiver of Revenue taking up to 61 percent of your fees on a monthly basis in the form of income tax.
The percentage could be even greater if the turnover of your CC or company is more than R300 000 a year. At that level you have to register for VAT, which means charging your clients an extra 14 percent. If your clients baulk at the extra cost, and you have to quote inclusive of VAT, that's another 14 percent to the Receiver from the fees paid by your clients.
How can this happen? Very easily these days, because tax law now includes the concept of a personal service company.
If your CC or company (let's use CC to cover both these entities) falls within the definition of a personal service company, your clients will be required to withhold 35 percent from any payments they make to your CC. So, if the fee charged is R10 000, your CC will only receive R6 500. The balance of R3 500 will be paid to the South African Revenue Service (SARS) as employees' tax, or PAYE as it is commonly known.
When your CC pays provisional tax, it can offset PAYE against any provisional tax payable. If the tax paid by the CC for the year is less than the PAYE, you have to wait for SARS to assess the tax return and refund the money before you get any of the PAYE back.
It is likely that the CC's taxable income will be less than the total fees it has charged - and from which 35 percent PAYE has been deducted - because your CC will be paying you a salary. As a member of a CC, SARS treats you as a director of a private company, and from March 1 this year your CC is required to withhold PAYE on a monthly basis from the salary it pays you. The PAYE calculation is based on the higher of either your total salary last year or your actual salary this year. If that salary was more than R240 000, your CC must deduct PAYE at a rate of 40 percent. Forty percent of R6 500 amounts to R2 600.
Thus, the total tax paid in the month amounts to R6 100 (R2 600 + R3 500), or 61 percent. If, in the previous year, your salary from your CC was much higher, the amount of PAYE your CC may have to pay to SARS may be even more!
In addition, if your CC is classified as a personal service company, the deductions it may claim when it submits its tax return will be limited to your salary. It will not be able to claim any other expenses.
What is a personal service company?
A personal service company is a company or CC where any service rendered to a client is rendered by you and you are connected to the CC (for example, if you are a member of a CC or related to a member of a CC), and any one of the following apply:
- If you rendered the same service but were not employed by the CC, you would be regarded as your client's employee;
- Your client has supervision and control over you - in other words, the client tells you what hours to work, what your duties are, and how you should carry out those duties;
- Your CC is entitled to be paid at regular intervals - for example, weekly or monthly; and
- More than 80 percent of your CC's income is earned from one client.
If, however, your CC employs more than three people who work in the business on a full-time basis and who are not members or connected to members, the CC is not deemed to be a personal service company.
The definition is very broad and many businesses that are carried on in companies, CCs and trusts and which the law did not necessarily intend to include, will be caught in this definition.
Say, for example, a firm of architects is incorporated and the company has two architects and an administrative person. It wins a large project, which keeps the two architects busy for a year and a half. As a consequence, the company's income comes primarily from one client during the current tax year. Despite the company being independent in every other respect, it will be classified as a personal service company during that year because more than 80 percent of its income was earned from one client during the year. The client will be required to withhold 35 percent of the fees and pay them as PAYE, and the architects will not be entitled to deduct any expenses, other than the salaries paid to themselves and the administrative person.
The contractor's perspective
A person entering into an agreement with a company or CC has to be aware of this law, because if they enter into a contract with a personal service company and do not withhold PAYE from the fees paid to that CC, and pay it to SARS, they face the prospect of being called upon to pay the PAYE to SARS in any event, plus penalties and interest.
It may be difficult for you, as a contractor, to know how much of the CC's income comes from you, but it should be easier to know whether you are paying the CC regularly, or the person providing the service is under your supervision and control.
SARS has issued guidelines to help you to decide. However, it will not issue a letter saying that a certain CC or company is a personal service company or not. So, what do you look at?
One of the most important considerations is whether the contract is for the completion of a specific task or job, as opposed to a member of the CC being required to be present for a specified period.
For example, if someone contracts with your CC to design a building, you would design that building and be paid the agreed sum. Thereafter, the arrangement is terminated until a new contract is entered into. The contractor does not tell you what hours to work or how to design the building. He or she cannot tell you whether you can take leave or not, and you cannot resign. But if you do not complete the design, the contractor can sue you for non-performance under the contract. He or she may pay your CC in two instalments based on how far the design is complete, but you don't have any right to that money unless you complete the job. In this instance, assuming your CC earns more than 20 percent of its income from other sources during the year, it will not be classified as a personal services company.
But if someone contracts with your CC on the basis that he or she will pay it R10 000 a month provided that you attend to various pieces of work as determined by that person, your CC will be classified as a personal service company.
Even if your CC does not charge an equal amount per month, but charges based on hours spent, if the relationship is ongoing until your CC resigns, and the work you are given is not specified in separate contracts with a price for each task, your CC may be said to be a personal service company.
So beware of the 61 percent cash flow partner in your business. The ever-vigilante Receiver is out to stop the gap that has allowed long-term employees from using CCs and companies to gain a tax advantage.
Deborah Tickle is a tax partner at KPMG.
What you can do
If you are a member of a close corporation (CC) or are a director of a company that falls into the personal services company net, you may want to consider disbanding your CC or company and operating as a sole proprietor (or sole trader) instead. That way you will avoid having 35 percent of your fees deducted upfront by any company you work for.
But, Deborah Tickle warns, even as a sole proprietor, you are still liable to have PAYE at the appropriate rate deducted from your fees upfront, if:
- Your client has supervision or control over you;
- You are paid on a regular basis, rather than in separate fees for each job you do; and
- You earn more than 80 percent of your income from one company.
(You can, however, apply to the Receiver of Revenue to have PAYE deducted at a lower rate.)
Furthermore, as a sole proprietor, you can deduct genuine business expenses from your income to reduce your tax liability. As a personal services company, no expenses, other than salaries, can be deducted from your income for tax purposes.
However, before you change your CC or company into a sole proprietorship, consider the advantages and disadvantages of being a sole trader.
The advantages include:
- Income earned through the business goes directly to you;
- As the owner, you operate the business as you see fit;
With the exception of the legal requirements and tax returns, there are no complicated statutory returns; and
- Termination of the business is simple.
The disadvantages are:
- There is no limit to your liability, which means that you can be sued for the debts of the business;
- An employer/employee relationship does not exist between sole proprietors and their businesses;
- The business terminates on the owner's death;
- You are taxed as an individual, so the more your business earns, the more tax you will pay; and
- You have no partners with whom to share ideas or problems. - Charlene Clayton