Tax treatment of tips for recipients, employers and patrons

In 2011, the South African Revenue Service's (SARS) Advance Tax Ruling Unit released a binding class ruling dealing with the potential pay-as-you-earn (PAYE) implications of tips received by an employee from a satisfied customer. In particular, the binding class ruling (BCR 27) dealt with the question as to whether tips received by employers on behalf of employees (from satisfied customers) constituted "remuneration" as contemplated in paragraph 2(1) of the Fourth Schedule to the Income Tax Act, No 58 of 1962 (Act). In other words, whether an employer incurred an obligation to withhold PAYE from the tips received by their employees from satisfied customers. It was accepted in BCR 27 that because a tip is paid by the satisfied customer and not the employer, the tip does not constitute remuneration and, as such, does not give rise to a withholding obligation for the employer.

In a recent draft interpretation note released by SARS, SARS aims to clarify the tax position relating to the receipt of tips. From the outset it must be noted that the draft interpretation note does not deal with the tax implications of the compulsory service charges, which are added by the owner to the patron's bill (for example, adding a 10% service fee to a restaurant bill for tables of greater than eight guests), as these service charges are generally received by the owner for his own benefit and, thus, included in that owner's gross income. The draft interpretation note therefore only focuses on the tax implications of the tripartite tipping relationship between the employee, the employer and the patron. However, for the purpose of this article, I will only consider the potential tax implications of the bipartite tipping relationship between the employer and the employee.

For purposes of clarity, the potential tax implications for each party are dealt with separately below.

The employee

From the employee's perspective, it is critical to establish whether the tip constitutes "gross income" as defined in s1 of the Act. "Gross income" is defined as "the total amount in cash or otherwise received by, accrued to, or in favour of a resident during a year of assessment, which is not of a capital nature."

In addition, paragraph (c) of the definition of "gross income" specifically includes "any amount, including any voluntary award, received by or accrued in respect of services rendered or to be rendered."

Accordingly, once it is established that an amount has been received by or accrued to the employee, the next step is to determine whether the amount was received in respect of services rendered or to be rendered.

On this point, the draft interpretation note specifically states that it is a well-established practice and fact that a tip is worked for and is, therefore, an expected source of income for the employee. The mere fact that the tip is paid by the patron and not the owner, does not alter the fact that there is a direct causal connection between the services rendered and the tip received.

Accordingly, tips are received in respect of services rendered and, therefore, fall within paragraph (c) of the definition of "gross income".

Therefore, an employee is required to declare all income in the form of tips in his annual income tax return and income tax will be payable by the employee if the taxable income exceeds the annual threshold.

The facts and circumstances of a particular case will determine whether the tips constitute "remuneration" as contemplated in paragraph 2(1) of the Fourth Schedule to the Act. In most situations, the tip will constitute remuneration as defined and the recipient will not be required to register for provisional tax. However, in those limited circumstances where the tip does not constitute remuneration, the recipient will be required to register for provisional tax.

The employer

The potential tax implications for the employer will depend on whether the employer is acting as a conduit for the patron or in his own capacity when paying the employee a tip.

In situations in which the employer is acting as a conduit, in other words where the employer merely facilitates the transfer of the tips into the employee's bank account, the employer will not be required to withhold employees' tax from the tips received by the satisfied customer and paid over to the employee. Under these circumstances, the employer will also not be required to include the tips in the leviable amount for Skill Development Levy (SDL) purposes or to make or withhold any contribution in respect of the Unemployment Insurance Fund (UIF).

However, when the employer receives the tip for his own benefit and on his own behalf and subsequently decides to pay the employee a tip in his own capacity, the obligation to withhold employees' tax will depend on whether or not the amount so paid constitutes remuneration.

Where the amount constitutes remuneration, the owner will be obliged to withhold employees' tax and will also be required to include the tip in the leviable amount for SDL purposes and to make his own UIF contribution as well as withhold the employees' UIF contribution. On the other hand, where the tip does not constitute remuneration, no employees' tax must be withheld and the owner will also not be required to include the tip in the leviable amount for SDL purposes or to make or withhold any contribution in respect of UIF.

Although the draft interpretation note is useful in that it seeks to establish that a tip is, in fact, subject to tax, the question is whether SARS has given enough thought to the administrative burden created by the taxing of such tips. In particular, whether SARS has the necessary resources to ensure that all employees declare their tips received in their annual income tax returns.

SARS has indicated that comments on the draft interpretation note are due by no later than 31 May 2013.