Although very important from an economic point of view, from a tax point of view this debate is of a lesser relevance than the question whether the new Companies Act, which took effect on 1 May 2011, and the King III Report, which took effect in March 2010, impacts the tax treatment of directors’ fees.The new Companies Act and the King III Report have introduced some additional requirements on companies regarding the manner in which directors are remunerated and the disclosure of directors’ remuneration.
Although the new Companies Act does not make a distinction between different types of directors, the King III Report distinguishes between executive, non-executive and independent non-executive directors.With regard to the tax, the issue has for some time been whether the amounts paid to executive directors should be treated similarly to amounts paid to non-executive directors and, specifically, whether non-executives should be treated as so-called independent contractors.
Given the inclusion of the terms in the King III Report, the debate seems to still be relevant.Both executive and non-executive directors provide services to the company for which they derive payment. However, an executive director is involved in the day-to-day management of the company and its subsidiaries and is in the full-time employment of the company for this purpose.To this end, they derive remuneration from the company.Non-executive directors (NED), on the other hand, are appointed to the board of directors of a company to perform an oversight responsibility for the shareholders.Their function is to constructively challenge management and examine the corporate affairs of the company to ensure that sound corporate governance is adhered to.They are also required to scrutinise the performance of the executive body to ensure that objectives are achieved and that the long-term corporate strategy is attained.They must act in an independent manner when considering the conduct of the company.
As an executive director is, effectively, a salaried employee, their remuneration is subject to the withholding of employees’ tax on a monthly basis in the same manner as any other employee.It should be remembered that, in the case of directors of private companies, the provisions of paragraph 11C of the Fourth Schedule to the Income Tax Act should be taken into account.Paragraph 11C essentially smoothes the employees’ tax withholding, taking into consideration the total remuneration the director received in the previous year, including the incentive elements, so that adequate employees’ tax is withheld during the course of the tax year.
NEDs, by contrast, are not remunerated with a salary in the way that executive directors are.They receive directors’ fees which are approved in advance at an annual general meeting, and are paid for services which are inherently different to the services rendered by the executive directors.
Although, remuneration is widely defined in the Fourth Schedule to include fees, which may be construed as referring to directors’ fees, this definition excludes amounts that are paid or payable for services rendered by a person in the course of a trade carried on by them independently.In other words, amounts paid to an independent contractor, who is a South African tax resident, are not considered as remuneration and thus not subject to employees’ tax withholding.
For a person to be treated as an independent contractor, they need to pass both the statutory and the common law (dominant impression) tests. In terms of the former, a person will not be considered to be an independent contractor if:
•The services are required to be performed mainly at the premises of the person by whom the amount concerned is paid or payable or of the person to whom such services were or are to be rendered.
•They are subject to the control or supervision of any other person as to the manner in which their duties are performed or to their hours of work.
The common law test overlaps with the statutory test and essentially seeks to determine whether the control over a person’s productive capacity has been surrendered.NEDs do not have contracts which regulate their hours of work and are not under the supervision and control of the company as to the manner in which they conduct themselves.Although typically the fees they receive are based on the number of board meetings attended, these meetings are sometimes held only quarterly or less often, which means that, since the NED’s duties and obligations extend beyond the mere attendance of board meetings, such as to remain abreast of company developments and understanding the business of the company, the majority of their duties are performed away from the company’s premises.
The role of NEDs requires them to maintain an independent and autonomous stance in relation to the company in order to challenge policy and strategic decisions.It could thus be argued that the very nature of NEDs’ duties makes them independent in relation to the company and that they do not place their productive capacity at the disposal of the company.
Accordingly, a strong argument exists that NEDs are independent contractors, in terms of both the statutory and the dominant impression tests, and that directors’ fees paid to NEDs do not constitute remuneration for employees’ tax purposes.This will, in our view, also apply to NEDs of private companies–although directors of private companies are expressly considered as employees, employees’ tax is due only if remuneration (as defined in the Fourth Schedule to the Income Tax Act) is paid to an employee.
The tax effect of the classification of NEDs as independent contractors is not only relevant to the obligation or not to withhold employees’ tax.Many NEDs who act as full time NEDs for various companies, maintain a home office and have a number of associated expenses, which are incurred by them personally in generating their directors’ fees.Costs related to Internet connection, mobile phone usage, travel costs, a computer, stationery, etc. are but a few examples of the expenses which could be incurred by a NED in the production of the directors’ fees.
These are expenses, which are legitimately incurred by the NED for business purposes and are, in terms of section 23(m) of the Income Tax Act, not deductible against the NEDs’ directors’ fees if such fees are considered to be remuneration as defined in the Fourth Schedule to the Income Tax Act.It should be remembered, though, that the NED could then be seen to be carrying on an enterprise for vAT purposes and, if the annual fees derived from such enterprise exceed the threshold, would be required to register as a VAT vendor.
It is submitted that this is an area of the legislation that is ripe for some guidance by the South African Revenue Service, especially considering the financial impact on NEDs who genuinely incur substantial expenses in the production of their directors’ fees.Perhaps a separate code could be used for the directors’ fees of NEDs which,at a minimum,allows for a clearly stated dispensation with regard to claimable expenses.
Source: By Jaco la Grange and Deanna Comninos (TaxTALK)