Three Wishes for Small Business Tax Incentives

24 July 2024
Corporate Tax
Prof Jackie Arendse

Introduction

The importance of the small business sector in the South African economy is well documented. Small businesses are recognised worldwide as essential drivers of economic growth. However, in recent years, there have been few, if any, developments in tax policy specifically geared towards this sector. In this article, I will evaluate the current status of small business tax incentives in South Africa and suggest realistic proposals that could encourage and stimulate this underrated and overlooked sector. While numerous possibilities could be considered if small business development were a key focus, I will keep this article focused by making some observations and concluding with three proposed amendments that could be implemented within the next year.

The Current Situation

The tax incentive package for small businesses consists of three main pillars:

The micro-business turnover tax.
The small business corporation incentive.
The capital gains tax exclusion for qualifying small business owners.

1. Micro Businesses

Businesses that meet the definition of a ‘micro business’ may elect to register with SARS to pay tax on a turnover tax basis. The benefit of this system is that the compliance and regulatory burden of these businesses is reduced, as they do not have to pay normal tax and they submit a more simplified tax return.

Introduced in 2009, the micro-business turnover tax applies to both companies and individuals. The eligibility condition is that the ‘qualifying turnover’ of that person for the year of assessment must not exceed R1 million. ‘Qualifying turnover’ is defined in paragraph 1 of the Sixth Schedule to the Act and means the total receipts of that person from carrying on business, excluding any amounts of a capital nature and any tax-exempt grants received from the government or a small business funding entity. Thus, micro businesses are essentially taxed on business receipts.

According to paragraphs 2(1) and 3 of the Sixth Schedule, a person qualifies as a micro business if all of the following requirements are met:

The person is a company or an individual (including deceased and insolvent estates of an individual who was a micro business at the time of death or insolvency) with a qualifying turnover not exceeding R1 million for the year of assessment.
The person may not receive more than R15 million in capital receipts over any three-year period.
Other requirements similar to those listed for small business corporations (discussed below) must be met.

The turnover tax liability of a micro business is calculated using the following table, which has remained unchanged since 2015:

Taxable Turnover (R)	Rate of Tax
0 – 335 000	0% of taxable turnover
335 001 – 500 000	1% of taxable turnover above 335 000
500 001 – 750 000	R1 650 + 2% of taxable turnover above R500 000
750 001 and above	R6 650 + 3% of taxable turnover above R750 000

Taxable turnover is essentially the actual receipts of the business for the year of assessment but with some adjustments such as –

excluding all capital receipts,
including only 50% of any capital receipts (proceeds) derived from the sale of fixed property and other assets mainly used for business purposes.

Where an individual qualifies to register as a micro business, only his/her taxable turnover from that micro business will be subject to the turnover tax. Other income, such as annuities, interest, dividends, foreign dividends and rentals from fixed property, will be subject to normal tax.

The Davis Tax Committee’s Second and Final report on Small and Medium Enterprises was published in March 2016. The report indicated that there were 7 827 micro-businesses registered with SARS in 2013. The report contained the following recommendations:

Taxpayers should be allowed to elect to exit the Turnover Tax system on an annual basis.
All taxation liability determined under the Turnover Tax system should be discharged by way of an annual declaration made on or before 31 May each year.’

Eight years after the Davis Tax Committee Report was published, only the first recommendation has been incorporated into the Income Tax Act. Micro-businesses are still required to submit six-monthly estimates of their taxable turnover and make payments on a basis similar to the provisional tax system that applies to normal taxpayers who carry on business. An annual turnover tax return must be submitted according to the filing season deadline for income tax returns.

Nonetheless, research indicates that the micro business turnover tax operates relatively effectively for those businesses that can access it, as the turnover tax system does impose less onerous compliance obligations. Smulders et al. (2012) found that micro businesses spent less than two-thirds of the time to comply with their tax obligations compared to similar businesses that were not registered for the turnover tax. The problem is that very few businesses have accessed the turnover system due to the onerous requirements, the complexity of the legislation and the lack of knowledge on the part of the businesses that could potentially benefit from it.

2. Small Business Corporations

Section 12E of the Income Tax Act (hereafter referred to as ‘the Act’) was introduced in 2001. It provides an accelerated write-off of assets and a special tax table for a company (including a close corporation) that is a ‘small business corporation’.

Plant and machinery used by a small business corporation directly in a process of manufacture or similar process may be written off in full in the year they are brought into use. Other assets of a small business corporation may be written off over three years based on 50% of the cost in year 1, 30% in year 2 and 20% in year 3; or alternatively, the small business corporation may elect to use the section 11(e) wear and tear allowance. The write-off periods for section 11(e) are set out in SARS Interpretation Note No. 47, and assets costing up to R7 000 may be written off in full in the first year. The R7 000 limit for small assets has remained unchanged since 2009 and is long overdue for an inflationary adjustment.

The special tax table provides a tax-free threshold, which is kept in line with the tax threshold for individuals under 65 years of age, and progressive tax rates after that. For the 2024 year of assessment, the table is as follows:

Taxable income (R)	Rate of tax
0 – 95 750	0% of taxable income
95 751 – 365 000	7% of taxable income above R95 750
365 001 – 550 000	R18 848 + 21% of taxable income above R365 000
550 001 and above	R57 698 + 27% of taxable income above R550 000

The benefit of the special tax tables is that there is no tax on the first R95 750 of taxable income, progressive tax rates apply after that, and the 27% tax rate, which applies to other companies, only applies to small business corporations taxable income that exceeds R550 000.

As an illustration, a small business corporation with a taxable income of R600 000 will have a normal tax liability of R71 198. In contrast, a company that does not qualify for this concession will have a normal tax liability of R162 000 on the same amount of taxable income. Therefore, the tax saving for the small business corporation in this example amounts to R90 802 for the year of assessment.

The key that unlocks the section 12E incentives is that a company must meet the ‘small business corporation’ definition in section 12E(4) of the Act. This definition requires that all of the following criteria must be met:

All the holders of shares in the company must be natural persons at all times during a year of assessment.
None of the holders of shares may hold any shares or have any interest in the equity of any other company other than permitted investments (such as South African listed shares) as specified in the definition in section 12E(4).
The company's gross income for the year of assessment may not exceed R20 million.
Not more than 20% of the total of all receipts and accruals (other than those of a capital nature) and all the capital gains of the entity may consist collectively of ‘investment income’ as defined in section 12E(4) (includes interest, dividends, foreign dividends, rental from fixed property, annuities and any proceeds from the sale of shares or fixed property) and income from rendering a ‘personal service’ as defined in section 12E(4).
The company may not be a ‘personal service provider’ as defined in the Fourth Schedule to the Act.

It is evident from the above that this definition is complex and challenging to interpret. Furthermore, a company’s status and whether it meets this definition must be evaluated every year as the shareholders’ situations may change. For example, suppose one of the shareholders invests in foreign-listed shares. In that case, the company is no longer a ‘small business corporation’ and will forfeit the related tax incentives for that year and going forward.

The Davis Tax Committee’s Second and Final report on Small and Medium Enterprises was not in favour of the small business corporation incentive, stating that –

‘The SBC tax system is fundamentally ineffective, with a large proportion of the tax benefit being enjoyed by service-related SBC’s (such as financial, education real estate, medical and veterinary services) that were never the intended primary target of the SBC initiative. The following options remain:

Retain the current SBC allowance and accept the potential for abuse and the enforcement problems this will entail.
Remove the SBC incentive completely and redeploy the resource within the Department of Small Business Development (DSBD) or the (Department of Trade and Industry (DTI) by way of targeted interventions. In this regard, it is noted that the DSBD has recently received an annual budget of R3 billion.
Extend the current SBC resource to all tax-compliant SBCs through the refundable compliance rebate (RCR) system.’

The report also recommended that ‘consideration should be given to substantially extending the current capitalisation threshold for allowance assets of small businesses to beyond the current level’.

Notwithstanding these recommendations, the small business corporation legislation has remained substantially unchanged. According to the SARS Statistics (2023), there were 127 529 small business corporations in the 2022 assessment year, compared to 159 307 in 2021 and 166 874 in 2020. It should be noted that not all companies had been assessed for 2022 at the time the 2023 statistics were presented; thus, the final number for 2022 would probably be higher. Nonetheless, the statistics indicate that there has not been an increase in the number of small business corporations. Similar to the situation for micro businesses, the low take-up of this incentive can be ascribed to the onerous requirements, the complexity of the legislation and the lack of knowledge on the part of the small business owners who could potentially benefit from it.

3. Capital Gains Tax Exclusion

Paragraph 57 of the Eighth Schedule to the Act provides for a once-off, lifetime exclusion of capital gains of up to R1 800 000 on the disposal of qualifying small business assets by an individual who has reached the age of 55, or who has sold their business due to retirement, ill-health, or upon death. The exclusion was intended to provide tax relief similar to what a salaried person might obtain when she or he retires from their retirement fund (the first R550 000 of a retirement lump sum is tax-free). However, the criteria for accessing this exclusion are complex, and I expect that only a minority of entrepreneurs who have built up their businesses as an investment to provide for their retirement would qualify for this exclusion, although statistics on the number of individuals that have utilised this exclusion are not publicly available.

The exclusion applies to the disposal of an ‘active business asset’ of a ‘small business’ owned by an individual. The business could be carried on as a sole trader, as a partnership or in the form of a company. In the latter case, the individual must hold at least 10% of the shares in the company, and they must dispose of their entire holding.

‘Active business asset’ means –

fixed property, to the extent that it is used for business purposes; or
other assets used or held wholly and exclusively for business purposes,

but excluding financial instruments and any assets held in the course of carrying on a business mainly to derive any income in the form of an annuity, rental income, foreign exchange gains, royalties or similar income. The intention is to exclude assets generating passive income, targeting active business assets.

To qualify as a ‘small business’, the market value of all the assets of the business on the date of disposal may not exceed R10 000 000.

The person selling the assets must have held their interest in the business for at least five years prior to the date of disposal, and they must have been ‘substantially involved in the operations of the business’ during that time. There is also a time limit as the exclusion applies only to active business assets sold within a period of 24 months, commencing from the date of the first disposal that qualifies for the exclusion. Thus, accessing this exclusion requires some planning.

Both the exclusion limit of R1 800 000 and the R10 000 000 cap on the market value of the assets have remained unchanged since 2012. The failure to adjust these amounts in the last twelve years has severely denuded the benefits intended when this exclusion was introduced as part of the capital gains tax package in 2001. The limitations are particularly onerous when one considers that a small business owner forfeits the entire exclusion if the market value of the assets in a small business exceeds the R10 000 000 cap by even R1! If the consumer price index increase is considered, R1 in 2012 is equivalent to R1,83 in 2024. Thus, the R10 000 000 should have been adjusted to at least R18 000 000 to maintain the access point that was originally intended in the legislation.

Evaluation of the Incentives

Although beneficial incentives for small businesses exist as described above, the overall evaluation is that relatively few taxpayers have accessed these benefits due to the onerous requirements to qualify, the complexity of the legislation and the lack of knowledge on the part of the entrepreneurs and small business owners who could potentially benefit. In a study of the tax compliance burden on small businesses, Buthelezi (2020) found that almost all small businesses surveyed had never received any tax training and they relied on the services of tax practitioners. Thus, a programme for educating small businesses must be introduced, including online training and information dissemination through social media platforms. The Department of Small Business Development and the South African Revenue Service are best placed to pioneer such a programme.

Interestingly, the above tax concessions favour the manufacturing sector and eschew the service sector. This begs the question of whether such a bias is fair and justified when measured against the need for job creation and economic growth. Key sectors of the economy include wholesale and retail trade, financial services, tourism, construction and agriculture, and manufacturing. It is time for fresh thinking with a broader perspective in designing incentives that would attract entrepreneurs across all of these sectors.

A report by McKinsey estimates that the fourth industrial revolution and the inevitable advance of digitisation could displace more than 3 million existing jobs in South Africa by 2030; however, there is the potential to create more than 4 million alternative and new jobs with the correct strategic policy implementation and the evolution of technology. These aspects must be considered in the future design of tax incentives to ensure that the proper focus is maintained and that the incentives produce the desired results in terms of appropriate skills development to support job creation that leads to sustainable economic growth.

Looking beyond the tax incentives on offer, it is critical to consider the regulatory burden on small businesses as this is the most challenging hurdle facing the creation of small businesses and one of the biggest threats to the survival of these businesses. The tax and regulatory compliance costs of small businesses are often disproportionately high due to the limited resources within the smaller entities, the fixed nature of certain overheads and the curtailed economies of scale in smaller firms, as well as other factors such as the lack of financial knowledge and the complexity of the tax legislation. This places small firms at a competitive disadvantage against larger and multinational businesses. Thus, a key focus must be to simplify tax compliance for small businesses. This could start with incentives that achieve this, such as the turnover tax, but it needs to go deeper. An obvious target for simplification is the annual tax return that has to be submitted, as currently, the same IT14 form is used by all companies, regardless of the size and complexity. This places a costly and onerous burden on small businesses, who also face substantial administrative and financial risks if they get any disclosure wrong on the form.

Conclusion

This brings me to my three wishes for small business tax incentives:

Make inflationary adjustments to the thresholds and limitations in the tax legislation, especially the R7 000 small asset write-off in Interpretation Note no. 47 and the limitations in paragraph 57 of the Eighth Schedule. These adjustments are long overdue and easy to implement.
Simplify the entry criteria for micro-business and small business corporations to enable more businesses to access the incentives that are available.
Introduce a wide-reaching education campaign aimed at entrepreneurs and small business owners to demystify the tax legislation and create awareness about the available incentives.

Many other areas need attention, and more research is needed, but these first steps can go a long way towards revitalising the small business sector.

In the upcoming webinar on Taxion of SMMEs, I will discuss these and other tax aspects relevant to the small business sector.

Click here to view the introduction video
Click here to book your seat

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