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Articles tagged with: small business

Tax and small business owner remuneration

on Saturday, 08 April 2017. Posted in General, Consulting, Tax

The tax consequences of profit extraction by directors of owner managed companies.

Tax and small business owner remuneration

 

Introduction

A question that we often receive from directors is how to compensate yourself if the company is owner managed. In other words a business where the owners are the directors and have discretion in how they are going to structure their own remuneration, or how they are going to extract the profit from the company.  Let us explore three possible scenarios.

1. Building up a loan account

We often find that the owners draw money at will and build up a loan account with the company. Some directors are under the impression that this method attracts no tax. They are wrong. 

The first factor to consider here is the interest rate that the company is charging the director. In most cases this is 0%. In normal circumstances a company would charge an interest rate to someone it lends money to. Thus in this case the 0% or lower than market related interest rate is directly attributed to the fact that the director is a connected person to the company. In other words the director is receiving a benefit due to his / her employment or connection with the company. This  equates to remuneration and as you know remuneration is taxable. 

The way the income tax act deals with this situation is by a concept called a deemed dividend. The logic behind this is that the interest free \ low interest loan to the director is (substance over form) the same as a dividend. At the tax year end the balance of the director’s debit (owing to the company) loan account is used to calculated the deemed dividend. The difference between the interest rate that the company charged the director and the official interest rate (repo rate plus 1%) is used to calculated the amount of interest that “should” have been charged were the director not  a connected person. The balance times the interest rate that “should” have been charged is now deemed a dividend and off course dividend tax (currently 20%) is payable on this amount.

Let me illustrate by way of an example:

Director A of company ABC has a loan account debit balance with the company at year end of R100 000. The company did not charge any interest to the director. The current repo rate is 7% and thus the official interest rate is 8% (7% + 1%). 

Thus the deemed dividend is R8 000.00 (R100 000 x 8%) and the dividend witholding tax on that is  R1 600.00 (R8 000.00 x 20%).

Some directors might think that this is not a bad deal R1 600.00 on R100 000 cash withdrawn from the company. They are again wrong. Remember since the loan is of a capital nature it does not get deducted on the income statement as for example a salary, thus it does not decrease your taxable income. So in effect you can argue that the company pays 28% income tax on the R100 000 (since this would have been deductible if it was a salary. Already you are at R28 000 (R100 000 x 28%) plus R1 600.00 deemed dividend which is R29 600. Again the director might think that this is better than a normal dividend of R72 000 (the after tax profit R100 000 - R28 000) which would have resulted in R14 400 witholding tax (R100 000 x 20%) plus the R28 000 income tax which would which would have resulted in a total of R42 400.

In the loan account situation your total tax was R29 600 at an effective tax rate of 29.6% (R29 600 / R100 000) and in the dividend situation your total tax was R42 400 at an effective tax rate of 42.4% (R42 400 / R100 000). Well that might seem that the loan account is the better option, but the differentiating factor is that the same deemed dividend will be charged on the same R100 000 (plus interest from previous year) in the next year. In other words your effective tax rate in the loan account situation keeps on growing each year that the loan has its balance outstanding. Effectively the director is being taxed multiple times on the same initial R100 000.

2. Paying a dividend

This was basically covered in the previous section. If the director declares a dividend to him / herself the effective tax rate is 42.4%. Simply due to the fact that the company pays 28% tax on the profit and the director pays 20% dividend tax on the dividend allocated from after tax profit.  

An example:

The company has R100 000 taxable income (which the director would like to allocate to him \ herself. Thus the company pays R28 000 income tax and the after tax profit is R72 000 (R100 000 - R28 000). The company can declare a dividend on the after tax profit to the director which results in R14 400 dividend witholding tax (R72 000 x 20%). In other words the company and director paid a total tax of R42 400 (R28 000 plus R14 400) which is an effective percentage of 42.4 (R42 400 / R100 000).

3. Paying a salary

The director can also pay him \ herself a salary. For some reason many directors are under the impression that this is the least tax efficient. In many cases this is actually the most tax efficient.

A salary will be the beneficial choice up to an annual amount of R1 500 000. An amount above R1 500 000 wil be taxed at a marginal rate of 45%. As mentioned the dividend option gets taxed at an effective rate of 42.4% and will thus be the better option for any amount above R1 500 000.

Conclusion

Many factors have been left out for simplification in the discussion above. My advice would be to always contact a tax professional to evaluate your specific situation. If I had to make a rule of thumb, draw a salary up to R1 500 000 and anything above that, declare a dividend.

Contact us for assistance: https://www.chconsulting.co.za/contact

 Author: Chris Herbst

Business Valuations

on Monday, 16 January 2017.

BUSINESS VALUATIONS: THE ART OF THE SCIENCE - PART 2

Business Valuations

We will address the following two questions we ended part 1 with: 

1. The influence of our fair rate of return/discount rate ( 15% in example ) has on the valuation, or how we determine the correct rate.

2. How long we assume the company will exist (three years in the example).

In plain language the rate of return or discount rate is the rate that a rational investor will expect to earn if he / she would invest their money in your business or in our example in Company A. Off course in many valuations there is not an actual investor wanting to invest in the business, however we still use this logic. To determine the fair rate of return we use the Capital Asset Pricing Model (CAPM) : 

E(Ri) = Rf + Beta(RPm) + RPu

where:

  • E(Ri) is required return on security i
  • Rf is the risk-free rate
  • Beta is the influence the general market risk has on the specific company
  • RPm is the general market risk premium
  • RPu is the premium due to company specific risk

This may seem complicated, but fear not, I will explain.

The risk-free rate (Rf) is the rate of return an investor can expect when investing in an investment that carries no risk (all investments actually do have risk, thus we are talking hypothetically). Usually a valuator use the 10 year government bond rate for this. Let’s say in our example the 10 year government bond rate is 8%. You can find the actual bond rates for South Africa at: https://www.resbank.co.za/Research/Rates/Pages/CurrentMarketRates.aspx

The general market risk premium is the added return for additional general risk in the market. This is where the judgement of the valuator plays a role - this can be a subjective consideration. For example if the economic forecasts (say based on political events etc.) is bleak the risk for the investor is greater. Thus the investor would expect more return to compensate for the additional risk. Let’s say we add 5% return for general market risk.

However the general market risk may not have the same influence on all industries or types of businesses. This is where the Beta variable plays a role. It may be that when economic conditions are bad it is actually good for some businesses and bad for others. For example, if the economic conditions are bad people may be under financial stress and shop more at Shoprite (low cost grocery store) and less at Woolworths (high-end grocery store). So in this case bad economic conditions my be good for Shoprite and bad for Woolworths. The Beta variable can have a value between -1 and 1. With a value of -1 it means that whatever the general market risk premium is, it is has the opposite effect on the business. If the market risk premium is 3% then it actually lowers the rate the investor will expect (E(Ri)) by 3%, since -1 x 3% = - 3%. Intuitively it means say bad economic conditions are good for the specific company (Shoprite in example above). On the other end of the scale a Beta of 1 will add the full impact of the market risk premium to the business. The Beta value can also be anything else between -1 and 1. For example 0 would mean the market risk  premium has no influence on the business. The decision on which Beta to use is again one where the valuator will use professional judgement, experience and if available comparable market data. Let’s say in our example the Beta is 0.6.

Lastly the company specific risk (RPu) is the what it says, the risk specific to this company. There may be a number of risk factors specific to a company, for example an inexperienced management team may cause the investor to take on more risk and thus expect for return. Let’s say in our case the company specific risk is 4%.

Now, to calculate our example’s required return / fair rate of return:

E(Ri) = 8% + 0.6 (5%) + 4% = 15%

If you now refer back to Part 1 of our example it will be clear that a higher rate of return will make the value of the business smaller because we discount each future profit back to present value by dividing with (1 + rate of return) to the power of the relevant number of years.

Which brings us to our second question - how long the company will exist or the window period. We can expect the business to exist a certain number of years - again this is based on professional judgement and can be a subjective decision. In many cases there is no clear reason to expect that the business will only exist a certain number of years, but it may be that you are working with a clear exit strategy of say 5 years. Normally I would select 10, 15 or 20 years as a window period. In our example we used 3 years for simplicity. 

Author: Chris Herbst

How the new Tax Compliance Status (TCS) (the replacement of Tax Clearance Certificates (TCC)) works.

on Wednesday, 22 June 2016. Posted in Tax

As from 18 April 2016 the old Tax Clearance Certificate system made way for the new Tax Compliance Status system.

How the new Tax Compliance Status (TCS) (the replacement of Tax Clearance Certificates (TCC)) works.

This article will first explain the rational for the new system, then the difference with the previous system and finally on a practical note provide you with steps to obtain your tax compliance status on e-filing.

The new Tax Compliance Status system will be managed online via e-filing.

SARS has decided on the new Tax Compliance system for the following reasons:

Less printing: over ten million tax certificates were printed per annum. According to (see * below for source) one pine tree produces 80 500 sheets of paper. Thus SARS were printing 124 trees worth of tax certificates per year!
Less branch visits: over two million SARS branch visits were done per year for tax certificates.
More tax compliance: change from point in time to continuous compliance. I will elaborate on this point below.

Point in time compliance vs continuous compliance:

As you are probably aware in the past a taxpayer would apply for a tax certificate which will then be either granted or denied based on the taxpayer’s status at the specific time of the application. This is what is referred to as point in time compliance. The taxpayer’s tax certificate approval was fully based on the fact whether all the taxpayer’s tax affairs were in other at that given point in time.

As you are also probably aware many taxpayer’s only scrambled to get their tax affairs in order when they required a renewed tax certificate. This resulted in taxes only being put into order once a year and that is if a tax certificate was required. SARS did not like this.

Thus SARS have now introduced a continuous compliance system. Same as before if the taxpayer applies for a tax certificate, the taxpayer will only be granted one if the taxpayer’s affairs are in order at the time of application. However, the major difference now is that a pin will be issued to the taxpayer that should be provided to third parties (the parties requesting the tax certificate). The third parties can now at any time go online and check the taxpayer’s tax compliance status with the provided pin. If the third party checks the status today and all the the taxpayer’s affairs are in order it will show that the taxpayer is compliant. If the third party checks the taxpayer’s status tomorrow and the taxpayer’s affairs are not in order it will show non-compliant. Thus the pin provides a continuous status of the taxpayer’s compliance status and no longer a point in time view. A tax clearance certificate use to provide the third party with assurance for 12 months that the relevant taxpayer’s affairs were in order for that period. The pin now provides day to day continuous assurance.

If the taxpayer is compliant at a specific point in time the taxpayer can still obtain a tax certificate and print it out. This certificate informs the third party that the taxpayer was compliant at the point in time the certificate was granted, however the tax certificate states:

This certificate is valid until the expiry date reflected above, subject to the taxpayer's continued tax compliance. To verify the validity of this certificate, contact SARS through any of the following channels:

- via eFiling
- by calling the SARS Contact Centre
- at your nearest SARS branch

It is thus clear that going forward to conduct business with third parties that require the taxpayer to be tax compliant, the taxpayer will have to make sure they are compliant at all times.

Next I will provide you with the steps to obtain your tax compliance status on e-filing (see ** below for source):

Step 1: Logon to eFiling

Logon to eFiling by using your login name and password. If you are not yet an eFiler, register on www.sarsefiling.co.za.

You need to be registered for eFiling and have one tax product [such as Income Tax, Value- Added Tax (VAT) or Pay-As-You-Earn (PAYE)] already activated on your taxpayer profile in order to activate the Tax Compliance Status (TCS) service.

Step 2: Activate the Tax Compliance Status service

Tax practitioners and eFiling administrators for organisations must ensure that the correct rights are allocated to users who need access to the tax compliance status screen. For more information on allocating these rights, please refer to the “Guide to the Tax Compliance Status Functionality on eFiling” available on the SARS website www.sars.gov.za.

You only need to activate your Tax Compliance Status once and it will remain active. Once you have activated it and you have merged or declared all your registered tax reference numbers, you will be given access to your My Compliance Profile (MCP).

Step 3: View your My Compliance Profile

You can view your tax compliance profile by selecting the My Compliance Profile menu option. A colour-coded profile will appear to indicate whether you are tax compliant or not.

Red – Your tax affairs are not in order and you are not tax compliant
Green – Your tax affairs are in order and you are tax compliant.

Step 4: Request your Tax Compliance Status via eFiling

Select the Tax Compliance Status Request option and the type of TCS for which you would like to apply. You will have the following options:

- Good standing

- Tender 

- FIA (individuals only) Emigration (individuals only)

Complete the Tax Compliance Status Request and submit it to SARS.

Once your request is approved by SARS, you will be issued with an overall tax compliance status and a PIN. The PIN provides you with a way to authorise any third party to view your tax compliance status online via eFiling. You can request that the PIN be sent to you via SMS and you can view it on your “Tax Compliance Status Request” dashboard on your eFiling profile.

IMPORTANT: A unique PIN will be issued for each request that you make.

In addition to the PIN, you will also be able to print a Tax Clearance Certificate (TCC), in the existing format, via your own computer by selecting “Print TCC”. The “Print TCC” function will only be available if your overall tax compliance status reflects as compliant.
Once you have provided the PIN to a third party, the PIN will enable the relevant organisation or government department to view your current tax compliance status online. It will present them with your overall compliance status as at the date and time they check it and not your status as it was at the date that the PIN was issued to you. To protect the confidentiality of taxpayer information, no other information will be accessible.

Author: Chris Herbst

Contact us: https://www.chconsulting.co.za/contact

Business growth and good coffee takes time

on Tuesday, 02 April 2013. Posted in General, Consulting, Start-ups, System Implementation

Business growth and good coffee takes time

Why do some small businesses not grow? I believe the main reason is that these small businesses wants their growth the same as their coffee. When their budget is tight they are indeed prepared to make the coffee themselves, so they make instant coffee. When funds become available they buy freshly roasted coffee from a drive through, instantly.

My point is that whether these small businesses have funds or not, they want growth to be instant. Some of these small businesses do implement measures for growth and then they quickly realise there is no instant results. So in most cases the measures fade away because no results are visible. Most real sustainable growth happens over time, similar to planting a seed today and only harvesting the crop in a future season and the crop may fail a few times along the way.

Being a coffee enthusiast myself, I can tell you that a good cup comes at a cost. I prefer to buy my beans from the roaster or a retail outlet that is directly affiliated with a local roaster, meaning they get freshly roasted coffee at least weekly. I do not buy the beans that are on the shelves on most supermarkets as they are in most cases guaranteed to be stale after a month from roasting date. Further I do not buy ground coffee as with that the freshness along with the taste is basically lost 3 minutes after grinding it. I buy beans and grind it myself, preferably with a hand manual grinder. An electric grinder is fine if it is a decent burr grinder, but the decent ones are usually the industrial ones and are rather expensive for the home user. You have the electric blade grinder as a cheap alternative but it gives you an inconsistent grind (coffee particles vary in size) and the heat of the rotating blades damages the coffee's taste. There is a reason to this madness, if done correctly you will get the most amazing and authentic coffee taste. Coffee should never be bitter. And you should never kill coffee with sugar! The reason people drink sugar in their coffee is exactly because it is prepared incorrectly and then tastes bitter.

Please reread the above paragraph with instant versus patient, cheap versus quality and healthy versus unhealthy in the back of your minds. Now compare the analogy to your own business and measures for growth, if any.

I want to communicate to small business owners that they must not give up on implementing strategies to grow, rather develop patience and a long term view. Be relentless in implementing small additions to your main vision of growth and direction, but remember it takes time, so also be relentless in developing patience.

http://www.chconsulting.co.za/contact

New financial year - time to get your house in order?

on Thursday, 28 February 2013. Posted in Accounting, Consulting, System Implementation

Follow up on the Small Business Sins series - Implementing a business system

New financial year - time to get your house in order?

We are entering a new financial year for the majority of small business owners and individuals. In follow up to my previous blog regarding the small business sins, I believe a new financial year is a great time to start fresh.

For the majority of small business owners, time and money is a scarce resource. Hence implementing a proper structure and system is not at the top of their priority list. Most only spend some resources on complying with statutory obligations for SARS and CIPC, because they have to do so by law.

There are some profound underlying changes that occur when you get your house in order, but for now let’s focus on some of the more obvious ones. The typical small business owner does not want to spend time on creating a structure for their business because they perceive this as a waste of time. The reason they believe it is a waste is that they think they should rather spend their time on making more sales or getting more clients or to just do what they have to do to survive.

Make no mistake, the majority of small business owners work very hard and it is understandable that they may make this critical error in underestimating the value of order because they focus on daily survival. However order is essential for creating spare time in the future. It may seem the other way around at first when you are implementing a new system, but be sure if it is a solid logic system, you will reap the benefit in saving time in the future.

Once you reach the stage where your system takes on maturity and start running on its own, you will be able to start breathing more and returning to your original role of business strategist rather than operational slave. Remember that time when you started your business, your thoughts were occupied with questions such as what will work? What if I change this? How will this influence that? Now you have become operationally enslaved with questions such as: What time do I have to be there? How am I going to remember to do that? When do I have to pay this? What type of part did he want? What was it Mrs Jones ordered? How can he say that is bad service?

How do you ever want to grow without order as a foundation?

Is it time to get your house in order?