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.

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