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Does Our Current Tax System Really Support Small Business?

06 May 2011   (0 Comments)
Posted by: Author: Vuyisa Qabaka
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Does Our Current Tax System Really Support Small Business?
 
A tax system which supports small business has always been a popular cause.National Treasury has recognised this with several SME tax incentives within s 12E and has previously stated that "internationally, it is recognised that small and medium enterprises have an important role in economic development and employment creation”.In legislating the SME tax incentives, it was hoped that they would "markedly improve the cash flows of growing small businesses and further enhance the potential for this sector to create jobs”.While such incentives may have resulted in some limited relief,it is argued here that the actual structure of South Africa’s current tax system is so heavily biased against small businesses that any such relief is negligible.

The cause of this bias is that our current system neglects the fact that the corporate tax, which is levied on these small businesses, is in fact shouldered by the people who own these businesses.It makes intuitive sense that there is no real difference between the single shareholder of the company and the company itself.The more taxes the company pays, the less is available to the shareholder from which to live.The profits from the company are, after all, the SME owner’s sole income stream.The examples below show just how punitive the current system is.
 
Before turning to the examples, it is proposed here that SMEs should be taxed similarly to trusts to the extent that the income from the company should be vested in the shareholder and taxed in his/her personal capacity along with any other income that he/she may have such as interest.Essentially corporate taxes are ‘integrated’ with the personal taxes.In this way, the company does not pay any taxes but rather the income from the company is taxed in the hands of the shareholder.This mode of taxation recognises that there is no substantive difference between the company and the shareholder insofar as SMEs are concerned.From an administrative perspective, the company can withhold the taxes and pay it over to SARS on the shareholder’s behalf in exactly the same way that employees’ tax is withheld by the company on behalf of the employee.The shareholder would then be able to claim a tax credit on the taxes withheld by the company. 
 
The two systems – our current system and the integrated one – can now be compared by way of an example.To simplify things, the examples below assume the corporation to have a taxable income of R100 000, one shareholder who does not earn any other income other than from the company and that the company distributes all of its after-tax profits.Because the company makes this distribution to which STC is applied, the effective rate of 35.2% is applicable and not 28% .Example 1.1 gives the tax consequences under an integrated system.As can be seen, the R100 000 is attributable to the shareholder who pays schedule tax on it at 18%. From this is deducted the primary rebate as well as the corporation withholding tax of R35 200 which was levied at the company level but is incurred at the individual level.The overall position is that the shareholder will receive a tax refund of R26 956 with the company paying R35 200 on his/her behalf.The overall position is an effective tax rate of 8.244% which is exactly what it would have been had the income been subject to schedule tax only, for example if it were a salary earned.

Example 1.1: An integrated system 
(all amounts in Rand)
Taxable income attributable to individual = 100 000
Corporate ‘withholding’ taxes paid = 100 000*0.352 = 35 200
Schedule tax payable on company earnings attribution = 100 
000*0.18 = 18 000
Primary rebate = (9 756)
Tax credit = (35 200)
Tax refund = 18 000 – 9 756 – 35 200 = 26 956
Effective tax rate = (35 200 – 26 956)/100 000 = 8.244%
 
Example 1.2 shows the taxes payable under South Africa’s current tax code.The company is taxed on its R100 000 earnings as though it is truly a separate person from its shareholder yielding taxes payable of R35 200 with an effective rate of 35.2%.
Example 1.2: Current system
(all amounts in Rand)
Company taxable income = 100 000
Corporate tax payable = 100 000*0.352 = 35 200
Tax applicable at the shareholder level = N/A
Effective tax rate = 35 200/100 000 = 35.2%
 
When the two approaches are juxtaposed like this, the inequity of the current system is glaring.It is unfair on several levels.Firstly, it is regressive taxation of the worst kind.A person such as this hypothetical taxpayer earning R100 000 should be in the lowest income tax bracket with an effective rate of 8.2% but is actually subject to a tax rate of 35.2%.Based on the 2010 personal tax tables, this is the rate at which a salary earner of R1 400 000 pays. One way of defining the extent of the overpayment is to simply take the difference in the two rates being 27% (35.2% – 8.2%). To emphasis the regressive nature of this taxation, if the same exercise is undertaken for a higher income of R600 000 instead of R100 000 the overpayment, as measured by the difference in effective tax rates under the two systems, is only 6.3%.The excess burden is clearly greater for the lower income individual.That is, less the small business owner makes, the more he/she is overtaxed.

Secondly, the current system discriminates against those people who earn their income from business rather than employment.The integrated system achieves the same result regardless.This accords, not just with fairness, but common sense in that the same income of two individuals should be taxed equally regardless of the source. A strong case could even be argued that if equity is to be affirmed, it would actually mean taxing the business owner at a lower rate than the employee.The reason being that, despite equal incomes, the business owner has assumed far greater risk than has his salaried counterpart.Calculated risk taking, as exemplified by the small business, is something that government should seek to foster and support rather than undermine and inhibit.One of the central motivations for establishing the close corporation was to provide smaller undertakings with corporate status in an effort to support this sector.It begs the question why government would then undermine its own efforts by choosing to tax them as companies and not trusts where it allows for the benefits of corporate status with integration.In this way, government has forgone the opportunity to provide real support to smaller enterprises in the form of financial assistance and fairer treatment via the tax system. 

A rebuttal by National Treasury to the above would submit that avenues of relief are available to the shareholder.For instance, the person should rather operate as a sole-proprietor or partnership and avoid the situation altogether.However, this misses the point; there are significant benefits to operating as a company, especially limited liability and perpetual succession.It is also a means of allowing the business owner to formally structure the operations and lay the groundwork for future stakeholders.
 
Furthermore, it was even emphasised in South Africa’s Margo Report of 1986, that the tax asymmetry between companies and individuals "has in practice had a significant impact on the choice of the form in which entrepreneurs carry on their business activities”.A further rebuttal by National Treasury to the deleterious consequences above would be to claim that they are mitigated via the tax breaks granted  to small businesses in terms of s 12E and the turnover tax.While relief is granted in theory, the criteria to qualify for a small business corporation, as defined in s 12E, are so stringent that it would not be easy for a company to qualify.For instance, the company would be disqualified from s 12E, if the shareholder happened to hold shares in other non-listed companies (this is particularly realistic for the entrepreneur who may float several small companies owing to the diverse nature of the businesses he/she is involved with) or a company is above the qualifying revenue threshold but is in operational difficulty such that the taxable income is low despite a relatively high gross income.The turnover tax is similarly restrictive and in any event targeted more toward micro-enterprises than SMEs.As can be seen, the limited nature of s 12E and turnover tax is not sufficient in redressing the problems cited above, this is especially so given that s 12E only became relevant, to all intents and purposes, in 2006 with the increase in the qualifying threshold despite the fact that the above scenario has been in existence for decades.
 
As an aside, the examples above make a broader point: corporate taxes must eventually be borne by individuals. Of course, where larger corporations are concerned, the link is not as clear-cut and who the individuals are, is uncertain but the principle still remains.It should be emphasised that the Taxpayers’ Foundation is in no way against corporate taxation. We support it, but it should just be recognised that it is eventually a tax paid by actual people and not by the ‘legal fiction’ of the corporation.
 
Overall, it is quite clear that our current system is biased against one of the most important sectors in the economy being small businesses.At a time where it is difficult for people to gain employment, they should be encouraged to start their own ventures and not be punished when they do.These ventures are critical in growing the economy and for them to become future employers. Addressing this tax problem should be a priority for National Treasury.The solution is simple: just tax SMEs as though the shareholder is a sole proprietor with all the income being vested in his/her hands.

Vuyisa is a man with a mission; an entrepreneur who was thrust into the limelight when Finance Minister Pravin Gordhan singled him out  in the 2010 Budget speech for one of his ‘tips for Pravin’. Vuyisa’s belief that the country needs a larger budget for youth development and his initiative to launch an online social platform called Student Enterprises, to support youth job creation and entrepreneurship, won him the recognition.With a BCom (financial accounting) and specialist qualifications in property, Vuyisa is studying entrepreneurship, too.His experience covers the property industry, business development and communications.He is a director of the South African Black Entrepreneurs Forum (SABEF).Not content to watch things happening around him, he sets out to make them happen and to change the world for the better.He is determined to give South African taxpayers a voice and work to improve the efficiency of government expenditure.
 
Source : By Vuyisa Qabaka (TaxTALK)
 



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