For tax and legal purposes, it is important that employers distinguish between employees and independent contractors. Let us demystify the distinction.
Does being an independent contractor (as opposed to a salaried employee) make it possible to have a huge legal saving on income tax? This question taxed the minds of employers, employees, and independent contractors alike for several years until the court case ITC 1718, 64 SATC 43 and the Circular Minute No. 22 of 1999, issued by SARS.
Before 1999, employers employed employees, some at the maximum tax rate of 45% while the corporate rate was 30% at that time. Many structures were put into place in which employers and employees would agree that the employees would resign and on the same date be appointed as “independent contractors”. An ex-employee then formed a company of which he or she was the only director and employee and rendered the same service under the same conditions to the ex-employer. The employee paid R45 000 in tax on gross remuneration of R100 000 and the “independent contractor” company paid R30 000 in tax on the same amount of R100 000. By implementing this structure there was a R15 000 tax saving for the ex-employee and the new company could also reduce its taxable income by claiming certain tax-deductible expenses. (These expenses could not be deducted by salaried employees.)
This practice came to an end after SARS issued Circular 22 and several changes were made to the Fourth Schedule to the Income Tax Act. These were aimed at preventing employees from operating in the guise of independent operators. Whilst the aim of flushing out employees from the thickets of so-called independence is both understandable and laudable, in doing so the legislation has made life difficult for thousands of genuine independent contractors and those who use their services.
The latest changes were issued by SARS in Interpretation Note 17 (issue 4) dated 14 March 2018.
This article will specifically focus on individuals who are South African residents but will not deal with companies, non-residents or labour brokers.
To fully understand the extent of this topic, it is recommended that some of the definitions in the Income Tax Act be thoroughly read and understood.
“Employee”, “employer” and “remuneration”
It is the responsibility of the employer to determine whether the provisions of exclusionary subparagraph (ii) of the definition of “remuneration” are applicable and whether payments are subject to employees’ tax. Not only is this responsibility set by the provisions of the Fourth Schedule, but it is also the employer that is in the best position to evaluate the facts and the actual situation.
An employer that has incorrectly determined that a worker is an independent contractor is liable for the employees’ tax that should have been deducted, as well as concomitant penalties and interest. The employer has the right to recover the tax paid from the employee.
There are two statutory tests to determine whether a person rendering services is an employee or an independent contractor, and they are both conclusive in nature. Note that the second test overrides the first test.
The first test
The first test is a provision deeming that a person will not carry on a trade independently if both parts of the test are satisfied.
The first part
The first element is that the services or duties are required to be performed mainly (which is a quantitative measure of more than 50%) at the premises of the client. The “client” referred to must be carefully considered. The statutory tests refer to the premises of either the person:
- by whom the amount is paid or payable; or
- to whom such services are rendered or will be rendered.
This means that if the services are rendered mainly at the premises of either of these parties, who are not necessarily the same person, this part of the statutory test is satisfied. This type of arrangement may, for example, occur with third party arrangements such as waitrons receiving tips, or with labour brokers.
The second part
The second element of the test is whether the worker is subject to the:
- control of any other person as to the manner that the worker’s duties are or will be performed, or as to the hours of work; or
- supervision of any other person as to the manner that the worker’s duties are or will be performed, or as to the hours of work.
The control-or-supervision part of this test refers to “any” person. This is wide, and could include the payer of the amount, the recipient of the service or any other person who has a contractual right to control or supervise the person in respect of those specific services.
If either (i) or (ii) above applies (that is, control or supervision), the second element of the first test is satisfied. It is not necessary for both control and supervision to be applicable in a particular situation.
If the first test is met, the person is deemed not to be carrying on a trade independently, with the result that the amount paid is deemed to be “remuneration” and will be subject to employees’ tax, unless the second test is met.
The second test
A person who employs three or more full-time employees, who are not connected persons in relation to him or her and are engaged in his or her business throughout the particular year of assessment, is deemed to be carrying on a trade independently.
This test is the overriding test in subparagraph (ii) of the exclusions from the definition of “remuneration”. It will take precedence over the first test, even if the requirements of the first test have been satisfied, and over the common law position. A “connected person” in relation to a natural person means any relative and any trust of which the natural person or the relative is a beneficiary. “Relative” in relation to any natural person means the spouse of the person or anybody related to him or her or to the spouse within the third degree of consanguinity, or any spouse of anybody so related. For the purpose of determining the relationship between any child referred to in the definition of a “child” in section 1(1) of the Act and any other person, the child is deemed to be related to its adoptive parent within the first degree of consanguinity.
In the event that the second test is satisfied, the person will be deemed to be carrying on a trade independently, and the amount earned will not be “remuneration” as defined and will consequently not be subject to employees’ tax.
It is possible that a person could meet the first test, and be deemed not to be carrying on an independent trade, but also meet the second test and then be deemed to be carrying on an independent trade. As stated above, the second test overrides the first test.
From above it follows that:
- A person rendering services to an employer is a person who qualifies to be an independent contractor if he or she also renders a service to another company (employer) and he or she:
- does not have to perform the service mainly at the premises of the client;
- is not subject to the control of any person as to the way in which the duties are or will be performed, or as to the hours of work; and
- employs three or more full-time employees, who are not connected persons in relation to him or her and are engaged in his or her business throughout the particular year of assessment.
If all three these conditions are met, the independent contractor will qualify as such and no employees’ tax should be deducted from the amount paid to him or her.
If neither a. and b. are satisfied but c. applies, the conditions are still met. If a. is satisfied but not b., the conditions are still met because both a. and b. must be met.
- Working part time for two or more employers
- Should someone render services for more than one employer or client, the above test must be applied to each separate client.
It might happen that for one client someone might qualify but for some of the other clients
not. One client might insist that the work must be done on the client’s premises and that the contractor is subject to control. If the contractor does not have three or more full-time employees, the contractor is deemed not to be independent and for this client he or she will be an employee and employees’ tax must be deducted from payment for the services rendered. Other clients might not insist on work being done at their premises and they also do not have control over the work. For such clients the independent contractor provisions will apply, and no employees’ tax must be deducted.
- Retired and semi-retired persons rendering services
- In this current day and age people live longer and so it happens that many people are still capable of doing very good work after “retirement age”. If such a person is rendering services to one or more clients or employers, the same test per employer must be done as mentioned in paragraph 1 above.
There is a big difference between the tax treatment of “independent contractors” that prevailed before 1999 and what is allowed in 2018 and for that reason, expert advice should always be sought before employers do their planning.
This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice. Errors and omissions excepted (E&OE)