Article by: Fourways Accountant: Annja Louca
There are differences in the tax treatment of earnings and expenses between executive directors and non-executive directors (NEDs) who earn income from the companies where they hold office. To provide more clarity on the treatment of NEDs, SARS released two Binding General Rulings (numbers 40 and 41) in 2017.
In this blog entry we’ll look at the tax treatment of both executive and non-executive directors under these headings:
VAT
Let’s begin by discussing the definition of a non-executive director (NED) in the context of South African tax laws. While there is no definition of a NED in the Act, SARS refers to the characteristics listed in the King III report which indicates that it is a person who is independent of, and not involved in, management of the company.
Binding General Ruling 40 goes on to state that SARS considers a NED to be be a “director who is not involved in the daily management or operations of a company, but simply attends, provides objective judgement, and votes at board meetings.” An executive director is therefore a director which is involved in the day-to-day management of a company.
EMPLOYEES’ TAX
The legislation for calculating Pay As You Earn (PAYE) is contained in the Fourth Schedule to the Income Tax Act, which covers employees' tax. Key to this is the definition of "remuneration", "employee" and "employer".
It's important to note that PAYE is only applied to remuneration paid by an employer to an employee. According to common law, a NED is not considered an employee. Therefore, payments made by a company to a NED are not classified as "remuneration", and as a result, are not subject to employees' tax.
On the other hand, executive directors are treated differently. Payments made to them by a company fall under the definition of "remuneration" and are subject to employees' tax, which is calculated in a similar way as any other employee.
INCOME TAX
Let's begin with the definition of "gross income". According to paragraph (c) of the definition in section 1 of the Income Tax Act, any amount received by a person for services rendered must be included in their gross income. This means that any amount received by either executive directors or NEDs for services rendered to the company will be included in their gross income.
Regarding tax deductions, section 23(m) is important to consider. This section contains a list of prohibited deductions, and subparagraph (m) specifically addresses taxpayers who earn mainly remuneration. This subparagraph allows only a few employment-related expenses as deductions against gross income. These expenses include legal costs, bad debts and provisions for doubtful debts, wear and tear, retirement fund contributions, and expenses and repairs relating to a home office.
Therefore, an executive director can only deduct the expenses listed above when calculating their taxable income. On the other hand, a NED does not earn "remuneration" and is not subject to section 23(m). As a result, a NED can claim expenses incurred in the production of income that may not be allowed under section 23(m).
Let’s use a simple illustration:
X is a director of ABC Ltd. X earns R500 000 from the company. Below is a list of expenditures incurred by X. For purposes of this illustration, assume that it is all directly incurred in the production of income.
| EXPENDITURE | FURTHER INFORMATION |
|---|---|
| Laptop | The laptop costs R18 000. The useful life of this laptop is 3 years. If applicable, wear and tear would thus be R6 000 per year |
| Fuel | R8 000 |
| Legal costs | R5 000 legal costs incurred to compel ABC Ltd to pay outstanding fees. |
| Home office expenses | R10 000 |
| Insurance and maintenance on vehicle | R7 000 |
| Mobile phone and data costs | R2 000 |
What would be the impact on the calculation of taxable income if
| DESCRIPTION | EXECUTIVE DIRECTOR | NON-EXECUTIVE DIRECTOR TAX |
|---|---|---|
| Income | 500,000 | 500,000 |
Expenses |
||
| Laptop wear and tear | (6,000) | (6,000) |
| Fuel | 0 | (8,000) |
| Legal costs | (5,000) | (5,000) |
| Home office expenses | (10,000) | (10,000) |
| Insurance and maintenance | 0 | (7,000) |
| Mobile Phone and data costs | 0 | (2,000) |
| Taxable Income | 479,000 | 482.000 |
In the above illustration, as an executive director the taxpayer would be earning “remuneration” and tax deductions would be limited in terms of section 23(m). As a NED the taxpayer does not earn “remuneration” and section 23(m) is not applicable, resulting in more expenses allowed as a deduction.
VAT
In SARS Binding General Ruling 41, VAT and NEDs are discussed. The VAT Act requires taxpayers who generate supplies of R1 million or more while carrying on an "enterprise" to register as a VAT vendor.
The definition of an "enterprise" excludes amounts considered "remuneration" under the Fourth Schedule. Executive directors earn "remuneration" and are therefore not considered to be carrying on an "enterprise" for VAT purposes. Consequently, they cannot and should not register as VAT vendors.
On the other hand, NEDs are considered to be carrying on an "enterprise" as they do not earn "remuneration." Therefore, NEDs who earn R1 million must register as a VAT vendor and charge output tax on their fees to a company.
Such taxpayers must also submit VAT returns to SARS and comply with the administrative duties of VAT vendors. Once registered as a VAT vendor, a NED can also claim input tax on expenses incurred. It is worth noting that a person who carries on an enterprise with supplies exceeding R50,000 per year can voluntarily register as a VAT vendor.
While an executive director is treated similarly to other employees, being a NED has significant income tax and VAT consequences.
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