Small Business Corporations: Exploring Section 12E of the South African Income Tax Act

Small enterprises play a vital role in South Africa’s diverse economic landscape as it drives economic growth and fosters innovation. To help small businesses navigate this diverse landscape, the South African Tax Act includes provisions aimed at supporting and incentivising small business corporations (SBCs).

Section 12E is one such provision, offering specific tax benefits designed to alleviate financial burdens and promote sustainability among qualifying small businesses. However, it’s essential for small businesses to understand the nuances of Section 12E, including provisions, eligibility criteria, benefits and practical implications for small business owners.

Definition and Eligibility Criteria

Section 12E of the Income Tax Act defines a small business corporation (SBC) in South Africa as a company, close corporation, or cooperative that meets specific criteria aimed at supporting smaller enterprises. These criteria include:

1) Types of entities

The taxpayer must be a juristic person in the form of a:

• Private Company

• close corporation;

• co-operative; or

• personal liability company.

2) Ownership by Natural Persons

All shareholders in the company or members in a close corporation, cooperative, or personal liability company must be natural persons. A natural person is simply a human being, as distinguished from a legal entity.

3) Restrictions on Shareholding

Shareholders or members should not hold shares or have equity interests in any other company, except in those companies specifically permitted (that are inactive and have assets in value of less than R5 000).

The limitation is designed to prevent undue tax benefits. Taxpayers might exploit multiple shareholdings in various small businesses to split income and obtain the tax benefits associated with each individual small business corporation (SBC).

4) Gross Income

The entity's gross income for the year of assessment must not exceed R20 million. Here it is crucial to understand the definition of gross income. Remember that capital gains are included under S26A of the Income Tax Act, not under the definition of gross income.

5) Investment and Personal Service Income

Not more than 20% of the entity's total receipts, accruals (excluding capital nature), and capital gains may collectively consist of "investment income" or income derived from rendering "personal services”.

Here it is important to note that there are 2 criteria, the first being investment income and the second being “personal services”.

Investment income constitutes income from dividends, royalties, interest and rental.

Personal services is specifically defined by S12E(4) as follows:

“(d) ‘personal service’, in relation to a company, 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)              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.”

In layman’s terms: Is the person rendering the services a shareholder or a connected person to that shareholder, and in addition to that shareholder/connected person, are there 3 or more other staff employed during the year?

6) Exclusion from Personal Service Providers

A personal service provider is a company where the business owner renders services in his personal capacity using the business as a means to do so. According to the Fourth Schedule of the Income Tax Act, a company cannot qualify as a personal service provider under certain conditions.

A personal service is defined as income derived from certain professional services listed in Section 12 (4)(d). This includes services such as accounting, architecture, medical, legal, journalism and more.

In addition, the service must be carried out personally by a shareholder, a member of the entity, or a connected person, such as a spouse or relative. This rule is intended to prevent owner-operated businesses from qualifying for SBC benefits when their income is primarily generated through personal effort or specialised skills.

TIPS WHEN CONSIDERING THE LEGISLATION:

Considering 20% personal services

Let’s take the example where John owns a company with 2 unconnected, full-time employees. Both John and his employees provide services to clients. In this example, John is a shareholder and provides personal services as defined in S12E. In such instance, only the services provided by the shareholder is regarded as a personal service. If the other employees bring in 80% or more of the gross income then the personal services will be below 20%.
This is allowed as per SARS IN 9. Therefore, detailed record-keeping is crucial if the above method of apportionment is chosen by the taxpayer.

Personal Services versus Personal Service Providers:

It’s important to make the distinction between “personal services” and “personal service providers.” These are two separate definitions and are defined by two separate sections (S12E and the fourth schedule).

A person may be a personal service provider without meeting the personal services criteria, and the reverse can also be true. That’s why it's important for taxpayers to consider both criteria 5 and 6.

Consider what is seen as a full-time employee:

It’s important to consider what is seen as a full-time employee. This how it is defined by SARS:

“Employees included in the three or more full-time employee count must –

-       be engaged on a full-time basis in the qualifying entity’s business of performing the relevant service;

-       not be a holder of shares in or a member of the qualifying entity; and

-       not be a connected person in relation to a holder of shares in or a member of the qualifying entity.”

Using the above tips and recommendations, qualifying under Section 12E provides small business entities with advantageous tax treatment, including reduced tax rates on their taxable income.

Tax Benefits and Incentives

Reduced Tax Rates: One of the primary benefits of Section 12E is the reduced tax rates applicable to small business corporations. These reduced rates provide a financial advantage, allowing qualifying entities to retain more of their earnings for reinvestment or operational expansion.

Accelerated Depreciation Allowances: Small business corporations under Section 12E may also benefit from accelerated depreciation allowances on certain assets. This incentive encourages investment in capital equipment and technology, supporting productivity and competitiveness within the sector.

Practical Implications and Compliance Requirements

Application Process: To benefit from Section 12E, eligible small business entities must apply for recognition as a small business corporation with the South African Revenue Service (SARS). This involves submitting relevant documentation, including financial statements and proof of compliance with eligibility criteria.

Annual Compliance Obligations: Once recognised, small business corporations must comply with annual filing requirements, including the submission of income tax returns (ITR14) and financial statements to SARS. Timely compliance ensures continued eligibility for Section 12E benefits and avoids potential penalties or sanctions.

Impact on Business Operations: For small business owners, Section 12E offers significant advantages by reducing the overall tax burden and enhancing cash flow management. These benefits empower entrepreneurs to reinvest savings into business expansion, innovation, and workforce development, driving sustainable growth and job creation.

Conclusion

Section 12E of the South African Income Tax Act represents a pivotal tool in supporting the growth and resilience of small business corporations. By providing reduced tax rates, accelerated depreciation allowances, and loss carry-over provisions, this provision fosters a conducive environment for entrepreneurship and economic development. Small business owners are encouraged to explore the eligibility criteria and benefits of Section 12E, leveraging these incentives to optimize their financial strategies and achieve long-term success.

Navigating the complexities of tax regulations can be daunting for small enterprises. Therefore, consulting with tax professionals or advisors specializing in small business taxation is advisable to ensure compliance with Section 12E requirements and maximize the benefits available under this beneficial provision. As South Africa continues to prioritize small business development, Section 12E remains a cornerstone of support for aspiring entrepreneurs and established small business owners alike.

For further information or assistance regarding Section 12E and its application to your business, consult with a tax professional or visit the official SARS website for updated guidelines and resources.

Empower your small business to thrive in the competitive landscape with Section 12E and its tailored incentives designed to propel growth and sustainability.