Personal service companies were used as tax planning vehicles until a clampdown in 2000 left them without many of the benefits available to other small businesses. Now amendments to the law have helped balance the scales.
The concept of a personal service company was introduced in 2000 to combat a tax avoidance scheme whereby employees contracted to render services through a company in order to escape employees tax being deducted from their earnings.
For example, the scheme was used by information technology personnel. While employees are liable for PAYE, a person could do the same work and avoid PAYE by setting up a company or close corporation (CC) that would employ him or her to render services to the former employer. No employees tax was withheld from the fees paid to the company or CC in these circumstances.
In terms of rules that have been in operation from 2000 until now, employees tax (currently at 34 percent) had to be withheld from payments made to personal service companies. These companies were also not able to claim a deduction for any expenses other than salaries paid to their employees. This resulted in a much higher tax burden on such companies. Personal service companies also did not qualify for the income tax concessions (such as lower tax rates and accelerated depreciation allowances) available to other small business corporations.
A personal service company is essentially any company (excluding a labour broker) whose services are rendered on behalf of that company to a client by a connected person in relation to that company. A connected person in relation to a company includes an individual who, individually or together with a relative or trust of which that person is a beneficiary, holds at least 20 percent of the equity share capital or voting rights of the company. A connected person in relation to a CC includes a member of that CC and any relative of the member.
In addition, any one of the following four conditions had to apply:
- The person rendering the service would be regarded as an employee of the client if the service was rendered by that person directly to the client; or
- The person or company is subject to the control or supervision of the client as to the manner in which, or hours during which, the services are to be performed; or
- The amounts payable in respect of such service include earnings of any description that are payable at regular daily, weekly, monthly or other intervals; or
- Where more than 80 percent of the company's income during the tax year from services rendered consisted of amounts received from any one client.
However, a company was not a personal service company if throughout the tax year it employed more than three full-time employees who rendered such services on a full-time basis, other than shareholders, members or connected persons in relation to a shareholder or member.
Significant changes to the tax regime applicable to personal service companies are contained in the Revenue Laws Amendment Act of 2006. These changes are effective from the start of tax years ending on or after January 1, 2007.
The most important changes are:
- The payment of earnings at regular intervals to a company no longer triggers the application of the personal service company rules.
- The control/supervision criterion applies only if services are rendered mainly at the client's premises.
- If a company has three full-time employees (as opposed to more than three) providing services, that company is not a personal service company.
- A client using the services of a small business can rely on an affidavit or solemn declaration issued by the entity that it is not a personal service company. Previously, the client bore the onus of identifying whether an entity was a personal service company. If the client relies on an affidavit or declaration in good faith, it cannot be held liable for a failure to withhold employees tax. This is a very welcome change for clients using the services of small businesses.
- Personal service companies are no longer restricted from claiming their business-related expenses as an income tax deduction. They can claim deductions for certain legal expenses, bad debts and contributions to pension, provident and benefit funds, as well as certain expenses relating to business premises and assets.
- Jenny Klein is a senior tax manager at Cliffe Dekker Tax.
This article was first published in Personal Finance magazine, 2nd Quarter 2007. See what's in our latest issue