Is your business paying too much tax? It could qualify as a SBC…

Companies are taxed at a flat rate of 28% however S12E of the Income Tax Act allows for certain qualifying companies (Small Business Corporations (“SBC’s”)) to be taxed at marginal tax rates being 0%, 7%, 21% and 28% for taxable income in excess of R550,000 per annum. In addition, it provides accelerated depreciation allowances on certain capital assets brought into use by the SBC.

Sounds great! However, many business owners and their accountants may overlook this tax break. In some instances, they will disqualify themselves as a SBC as they would they would not meet the criteria at face value or as a result of poor income tax planning. You should be asking yourself why your business has not qualified and whether there is a more efficient income tax structure to suit your business.
Let us unpack the qualifying requirements, they cover:

  • Legal entity
  • Holder of shares
  • Gross income limitation
  • Business activity
  • Prohibition of “personal service providers” (as defined in the 4th Schedule)
  1. Legal entity requirement
    The taxpayer must be a juristic person in the form of a:
    • “close corporation”;
    • “co-operative”;
    • “private company” as defined in section 1 of the Companies Act; or
    • “personal liability company” as contemplated in section 8(2)(c) of the Companies Act.
    The above entities, which are included in the definition of “company” in section 1(1), are referred to as “qualifying entities”. Your business must satisfy one of these juristic personas to qualify as a SBC.
  2. Legal entity requirement
    • The holding of shares in the potential SBC
    [section 12E(4)(a)]

    ALL the shareholders or members of a qualifying entity must, at all times during the relevant year of assessment, be natural persons. No part of the share capital or members interest of an SBC can therefore be held by a juristic person such as another company, a trust or otherwise.

    A contravention of this requirement, even if for one day during the year of assessment, will disqualify a qualifying entity from being an SBC for the year of assessment in which the requirement was not met, irrespective of whether all of the other requirements are met. Many business’ in South Africa have shares that are held by the business owner’s family trust, rather than in their personal capacity. In this case, the entity is disqualified as a SBC.

    A qualifying entity whose shares or members interest are held in a trust may qualify as an SBC provided that the beneficiaries hold a vested right in those shares or members interest throughout the year of assessment and are all natural persons.

    The holders of shares requirement looks at the beneficial ownership of the shares or members interest. Therefore, if the shares or members interest held by a trust are beneficially owned by natural persons, the share or interest in the qualifying entity would be viewed as being held by a natural person. However, to the extent that the shares are beneficially held by the trust, the company will not qualify as a SBC even if its trustees are natural persons. The trustees are merely the representative taxpayer of the trust and do not have any beneficial interest in the trust assets.

    • The holding of shares in any other company by the holders of shares or members of the close corporation or co-operative [section 12E(4)(a)(ii)]
    The holders of shares in, or members of, the qualifying entity may not at any time during the particular year of assessment hold any shares or have any interest in the equity of any other “company” as defined in section 1(1), except in those companies specifically permitted (that are inactive and have assets in value of less than R5 000). The reason for the limitation is to prohibit multiple shareholdings or arrangements which may be used to split income between various qualifying entities, thus providing taxpayers with an undue tax benefit.

    A share or interest held in the equity of another “company”, as defined in section 1(1), which is held as a trustee or nominee will generally not be regarded as contravening this requirement provided the holder or member is not the beneficial owner of the share or interest and is not entitled to any profits, income or capital of that other company for the relevant year of assessment.
  3. Gross income limitation requirement
    The gross income of a qualifying entity may not exceed R20 million for the particular year of assessment. Key factors for consideration are what constitutes gross income, what is a year of assessment and the circumstances in which the limitation of R20 million must be reduced.

    Gross income includes income that is exempt from normal tax, for example, a government grant of a non-capital nature which qualifies for an exemption under section 12P. Taxable capital gains are not included in gross income, since section 26A specifically provides for the inclusion of a taxable capital gain in the determination of taxable income.
  4. Business activity requirement
    Not more than 20% of gross income consists of investment income (dividends, royalties, rental, interest) and income from rendering personal services.

    Section 12E(4)(d) defines “personal service” as: “(d) ‘personal service’, in relation to a company, co-operative or close corporation, means any service in the field of accounting, actuarial science, architecture, auctioneering, auditing, broadcasting, consulting, draftsmanship, education, engineering, financial service broking, health, information technology, journalism, law, management, real estate broking, research, sport, surveying, translation, valuation or veterinary science, if—

    (i) (i) that service is performed personally by any person who holds an interest in that company, co-operative or close corporation or by any person that is a connected person in relation to any person holding such an interest; and

    (ii) that company, co-operative or close corporation does not throughout the year of assessment employ three or more full-time employees (other than any employee who is a holder of a share in the company or a member of the co-operative or close corporation, as the case may be, or who is a connected person in relation to a holder of a share in the company or a member), who are on a full-time basis engaged in the business of that company, co-operative or close corporation of rendering that service.”

    It may happen that a qualifying entity provides a service falling within the ambit of the services listed in section 12E(4)(d) which is performed by a person holding an interest in the qualifying entity or by any person who is a connected person in relation to any person holding such an interest, and the qualifying entity employs less than three full-time employees who are not connected to that person in the business of rendering that service. In this situation only the service rendered by the person holding the interest, or by a connected person in relation to such person, is regarded as a personal service.

    This is important because, when calculating whether the 20% limitation on investment income and income from rendering a personal service has been exceeded, it is necessary to determine the amount of income from the rendering of a personal service and that will require a Rand-value apportionment of the income which is attributable to such persons’ involvement.

    The Act does not prescribe a specific method of record-keeping or apportionment in calculating the income from personal services; it may be done either by means of an hourly charge out system or per job or any other appropriate method.
  5. Prohibition of “personal service providers” as defined in the Fourth Schedule
    Section 12E(4)(a)(iv) excludes a company which is a “personal service provider” as defined in paragraph 1 of the Fourth Schedule from qualifying as a SBC.

    A “personal service provider” is defined in the Fourth Schedule as a company if the services rendered on behalf of such company to a client are rendered personally by a connected person in relation to the company and –

    • the connected person would be regarded as an employee of the client if that person had rendered the service directly to the client; or
    • the services must be performed mainly at the premises of the client and the connected person or the company is subject to the control or supervision of the client as to the manner in which the services are rendered; or
    • more than 80% of the income of the company during the year of assessment is or is likely to be received directly or indirectly from any one client or associated institution in relation to that client,

    except if the company, throughout the year of assessment, employs three or more full-time employees who are engaged on a full-time basis in the business of the company of rendering any such service excluding any employee who is a holder of a share in the company or is a connected person in relation to a holder of a share in the company.

    A full-time employee who holds one or more shares in the company is not included in the “three or more full-time employee” count even if that employee is not a connected person in relation to the company.

    A “personal service” is different to a “personal service provider”. Although the definitions of a “personal service” and a “personal service provider” share some common features, they also contain some distinct differences. Both definitions must therefore be considered in light of the facts of each case.

    A company that is not a “personal service provider” under the Fourth Schedule may render a “personal service” under section 12E and vice versa.

    A company will need to ensure that it is not a “personal service provider” as defined in the Fourth Schedule and that its investment income and income from personal services is equal to or less than 20% of its total receipts and accruals (excluding those of a capital nature) and capital gains in order to potentially qualify as a SBC.
Now that we have unpacked the criteria of who qualifies as a SBC, a more detailed application can be found by SARS Interpretation Note 9 SBCs.

Let’s have a look at an example:

Company A sells computer equipment and provides IT services to a number of clients, has six full-time employees (two holders of shares, X and Y, and four other employees).

The employees are all involved in rendering IT services to clients throughout the year of assessment.

Company A’s gross income from Computer Equipment for the year of assessment was R13 million, IT Services R2 million of which was directly from services of the 2 shareholders and R1 million rental income.

Company A purchased a delivery vehicle for R200,000 during the year. Directors remuneration and other operating expenses amount to R15 million for the year.

In addition to the shares in Company A, X is the holder of a number of shares in a share block company and Y is the holder of shares in Company Z, which is inactive and has assets of less than R5 000.
  1. Determine if the Company Qualifies as an SBC and
  2. Calculate the tax liability for an SBC and for a Non-SBC

    - Legal Requirement: Company A is a Private Company
    - Holder of Shares:
    o The shares held by X in a share block company are permissible under section 12E(4)(a)(ii)(cc).
    o The shares held by Y are in an inactive entity with assets of less than R5 000 are permissible.
    - Gross income limitation requirement & business activity
    o R13 million – Computer Equipment
    o R2 million – IT Services Connected Shareholders
    o R1 million – Rental Income
    o Total = R16 million
    o Thus R2m + R1m = R3m personal service and investment income / R16m total income = 18.75% thus within the 20% limitation.
    - Company is not a personal service provider as defined per the 4th schedule
      - Thus Company A Qualifies as a SBC

The tax liability is calculated as follows:

 
Income SBC   Normal Company Tax  
- Computer equipment 13,000,000   13,000,000  
- IT Services 2,000,000   2,000,000  
- Rental Income 1,000,000   1,000,000  
  16,000,000   16,000,000  
Expenses        
Wear & Tear S12E (50/30/20) 100,000 Wear & Tear S11E 20% 40,000.00  
Director salaries and other operating expenses 15,000,000   15,000,000  
  15,100,000   15,040,000  
Taxable Income for the year 900,000   960,000  
Tax for the year 156,870.00 Tax @28% 268,800.00 111,930.00-Tax saving from SBC

One should remember that the application to be a SBC is not a 1-size-fits-all approach, each business owner has their unique goals and this is when proper tax planning becomes essential.

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