TAX CONSEQUENCES: INDEPENDENT CONTRACTORS AND EMPLOYEES, WHO’S WHO?

TAX CONSEQUENCES: INDEPENDENT CONTRACTORS AND EMPLOYEES, WHO’S WHO?

We have had several requests to draft independent contractor agreements for people who are factually employees, however, simply having a person sign an agreement stating that they are an independent contractor does not make them one. In this article, we are going to explore the tax risk of having an independent contractor who, in the eyes of the law, is an employee. This article focuses solely on a situation where you have a natural person contracted to do work for you. There are distinct rules that apply to entities (companies, close corporations, trusts and the like) which you will also need to consider, but are not considered here.

As a start up company, you may think that you do not need to ask this question as “you don’t have time” or “it’s really low risk”, but when you start looking for investors, this is one of the areas that may be highlighted as a tax risk. You are normally called to indemnify your own company against these tax risks when an investor invests into your company. This can have far reaching financial consequences for you as you may be called to pay arrear tax for all your “independent contractors” who are, in the eyes of the law, employees.

SARS determines whether an employee is an independent contractor through two separate tests:

  1. the Statutory Test; and
  2. the Common Law Test.

If either of these tests apply to the person that you have hired, then your company will be required to withhold Pay As You Earn (“PAYE“) tax and pay this over to SARS.

The Statutory Test

The Statutory test is set out in Schedule 4 of the Income Tax Act No. 58 of 1962 (“ITA“). Below is a basic outline of the test (this is not formal tax advice, so you should seek additional advice from your tax advisor). It is important to see if the Statutory Test actually applies in the first place. We will begin looking at exemptions to the Statutory Test:

Exemptions:

  1. If the person doing work for you employs three or more employees who are not connected persons as defined in the ITA, the Statutory Test will not apply to this person. The Common Law Test will still need to be considered, however.
  2. If the services rendered by the person are rendered less than 50% of the time on your premises, the Statutory Test will not apply. The Common Law Test will still need to be considered, however.

Other Considerations:

If the exemptions in 1 and 2 above do not apply, then the next questions must be considered, which are:

  1. Is the person subject to your control regarding the way his duties are performed or regarding his hours of work?
  2. Is the person subject to your supervision regarding the way his duties are performed or regarding his hours of work?

If your answer is yes to either of the questions 3 and 4 and the exemptions in 1 and 2 do not apply, then it is likely that you will be required to withhold PAYE tax in respect of that person.

The Common Law Test

The Common Law Test for whether a person is an independent contractor is complex. The common law is made up of case law and historical Roman-Dutch law. Generally speaking, the Common Law Test refers to a “dominant impression” test which consists of various elements.

Because the Common Law Test is complex and difficult to apply with certainty, SARS has produced a helpful rubric as guidance to people who want clarity on this point, this rubric can be found in the SARS interpretation note here at page 18.

If the Common Law Test does apply, then it is likely that you will be required to deduct PAYE.

Conclusion

This issue is one that is often overlooked, but it can have far reaching consequences for you and your company. It is important to consider these questions and look at the relationships that you have with those people who you have hired to perform work for you who are not formally “employees”. Speak to your accountant or tax expert and explore these issues in detail, it may save you a lot of trouble in the future.

The difficulties involved in setting up and managing Section 12J Venture Capital Companies

The difficulties involved in setting up and managing Section 12J Venture Capital Companies

“Section 12J Venture Capital Companies” (Section 12J VCC) seem to be a bit of a buzz phrase doing the rounds in the South African entrepreneurial world at the moment. We have had several requests from new and existing clients to set one up, mainly because of the attractiveness of these structures to investors.

A Section 12J VCC is a company formed in terms of section 12J of the Income Tax Act, 1962 (ITA) – it is essentially a pooling mechanism created by the South African Revenue Service (SARS) to encourage largely high net worth individuals to invest in start ups. The incentive to invest in a Section 12J VCC comes from the fact that investors get a full tax rebate on the funds invested into the Section 12J VCC. So, if a person in the highest tax bracket (presently 45%) invests R 1 million, they will get a tax rebate of R 450,000, meaning that the net investment is R 550,000.

The Section 12J VCC itself is relatively simple to set up, but the real complexity and difficulty comes with the management of it. The legislators have included several anti-avoidance provisions in section 12J of the ITA, which have made it particularly difficult, and in our experience prohibitive, for anyone to manage and run a Section 12J VCC. In fact, at the moment, there are only fifty six Section 12J VCCs approved by SARS and according to the information that we have gathered, and less than half of those are actually trading. It is interesting to note that the legislation allowing these funds was put in place in 2009 – that equates to, on average, seven of these companies formed (not necessarily even operating) every year since inception.

So why is it so difficult to get a Section 12J VCC off the ground? Below we have highlighted some of the major difficulties that some of our clients have had:

  1. No investor into the Section 12J VCC may be a “connected person” in respect of the Section 12J VCC, which essentially means that a natural person cannot own 20% or more of the shares in the Section 12J VCC (directly or indirectly) and a company can own up to 50%, in limited circumstances, of the Section 12J VCC (directly or indirectly), but no more.
  2. No more than 20% of the capital raised through the issue of shares may be invested into any one investee company.
  3. An investee company cannot be a “controlled group company”, meaning that a Section 12J VCC cannot own 70% or more of the equity shares in an investee company.
  4. To be recognised by SARS, the Section 12J VCC must be registered in accordance with section 7 of the Financial Advisory and Intermediary Services Act, 2002 (FAIS), meaning that the company must have a “key individual” in its employment and the Financial Services Board must issue it with a certificate.

There are many more nuances to a Section 12J VCC that we have not highlighted here as they are too lengthy to get into, but they also make for significant barriers to entry.

Regarding point one above – the issue of being a “connected person” – this provision was clearly put in place to avoid situations where a single investor uses this platform to invest in a company where he ordinarily would have done so in any event, but he simply sets up a Section 12J VCC to reap the tax benefit on an investment that he was always going to make.

What we have seen is that there are legitimate arm’s length transactions where investee companies are told that the investor will only invest in them if they are able to use the section 12J of the ITA structure and because of the anti-avoidance restrictions, investee companies are losing out on a potential investment as it is often not possible for this to be done.

Regarding points two and three above, Section 12J VCCs are often restricted in the manner that they can invest when they see a good potential investee company, as they cannot invest more than 20% of their raised capital into the investee company. This means that investee companies can, and do, miss out on obtaining more funding or any funding altogether.

It can also prevent arm’s length investors from investing into one investee company, as they cannot use the Section 12J VCC vehicle to invest into a qualifying investee company because they cannot own more than 70% of the investee company and they cannot use more than 20% of the funds raised in the Section 12J VCC to invest in the investee company. The investor also cannot hold 20% or more of the equity shares in the Section 12J VCC.

The final point is possibly the most difficult, FAIS approval is difficult to obtain as you must have a person who fits the criteria to be a “key individual” in terms of FAIS, which requires experience in the industry and further study. With the fast pace of the business environment, it is often too much of a hurdle to cross to find a party with the correct industry experience to write the exam and become qualified as a key individual.

If you have a legal team that thinks laterally about it, there are ways to manoeuvre within the compliance framework, but even then, there are limitations to the extent that it can be done.

Section 12J VCCs look very attractive from the outside, but when you scratch below the surface, there is a structure that is complex and difficult to manage and balance, which is probably the reason that they have not taken off in South Africa yet. That is not to say that forming a Section 12J VCC cannot be done, as we have assisted in setting up several of them, but it is worth considering it a little bit deeper to see whether this is going to be the best structure for you.