The True Source of Employment Income

It has become a small world after all, with individuals and companies operating in various jurisdictions.  What most tax authorities like to do, is to tax their subjects (residents) on their worldwide income, while taxing non-residents only on income from a local or domestic source.  While certain general rules pertain to the determination of a person’s tax residence, identifying the source of income often means navigating murkier waters.  Earlier this year, the Western Cape division of the Tax Court issued a judgment that turned the concept of source, at least as far as employment income is concerned, on its head.[1]

The question to be decided by the court was whether certain employment income received by the appellant was “from a source within the Republic”.  Now, the Income Tax Act determines the source of certain categories of income like royalties, interest and dividends.  As far as employment income is concerned, however, the Act is silent, and one must search for the “true” source.  Fortunately, intrepid pioneers of the tax world have already embarked on this brave expedition and the discovered the source of employment income to be … where the services are rendered.[2]  So it should have been plain sailing.

Most countries have entered into agreements for the avoidance of double taxation (or DTA’s).  Most of these agreements are based on the Model Tax Convention on Income and on Capital published by the Organisation for Economic Cooperation and Development (or OECD).  This organisation has thirty-six member countries.  Although South Africa is not a fully-fledged member, cooperation with our country has been strengthened through “Enhanced Engagement programmes” and we are now identified as a “Key Partner”.

If a South African tax court is required to consider the content of a certain DTA, for example to make a ruling on the source of certain income, the OECD would not be a bad starting place.  Especially as the organisation has also issued a Commentary on the Model Tax Convention to facilitate interpretation.

Back to the case before the Tax Court.  A certain individual (Mr. X) is employed by a company.  After much to and fro between SARS and Mr. X, it was confirmed that, for tax purposes, he is in fact a resident of the United States of America.  He is “ordinarily resident” in the US and has taken a breather from President Trump to come and work for a South African “branch” of a US company.  His employer is registered in South Africa as an “external company”.  This, the court finds to signify that “the foreign company is given legal recognition in South Africa, for taxation purposes, at least.”  So that settles the question of who falls in which jurisdiction:  the employer is deemed to be a South African resident (so it seems) and Mr X remains a native of the US.

Mr X received a salary from his employer for the period 1 March 2013 to 31 October 2013.  During this period, he performed services outside the borders of South Africa for a total of 62 non-continuous days.  The question before the court was whether the income earned in respect of these services was income “from a source within the Republic” and therefore to be included in Mr X’s income for purposes of South African tax.  To be specific, the court said:

“The entire dispute hinges on the definition of where the employment is exercised and consequently where the source off the remuneration is located, as set out in the DTA.”

Paragraph 1 of Article 15 of the DTA between South Africa and the United States provides as follows:

Subject to the provisions of Articles 16 (Directors’ Fees), 18 (Pensions and Annuities) and 19 (Government Service), salaries, wages and other remuneration derived by a resident of a Contracting State in respect of an employment shall be taxable only in that State unless the employment is exercised in the other Contracting State. If the employment is so exercised such remuneration as is derived therefrom may be taxed in that other State.

In interpreting this provision, the judge refers to the Vienna Convention on the Law of Treaties (to which South Africa is not a party) and ultimately decides to appply the primary rules of interpretation used in our domestic law.  She proceeds to interpret the provision “in good faith in accordance with the ordinary meaning to be given to the terms of the treaty in their context and in the light of its object and purpose”.

The court consequently interprets Article 15(1) as follows:

  • “The place where: “…the employment is exercised…” ordinarily means the place where the employment agreement is implemented.”
  • “If the words were meant to convey the meaning that the non-resident country must be the country in which the person fulfils his/her employment obligations at any given time, then the active voice would have been used in the construction of the relevant phrase. Instead, the phrase is constructed in the passive voice with the employment as the subject and no actor is mentioned.”
  • “No mention is made of where each actor must be located when the employment is exercised.” (Referring to the wording “employment exercised”)

The court then poses five questions in order to determine where the employment is exercised:

  1. What the contract itself stipulates concerning the law governing it – South Africa
  2. Where the contract was concluded – South Africa
  3. Who is paying the employee – An external company registered in South Africa
  4. Who the services are being rendered to – The employer
  5. Where the services are being rendered – Outside South Africa

With respect to the last question, the court finds that the services were rendered “to the employer’s clients qua the employer.  In effect and in substance, appellant therefore rendered the services to his employer”.

The judge finds herself persuaded that “there is a sufficiently close connection between the raison d’etre for rendering the service outside S.A. and the employment contract to interpret the rendering of the services as no more than reciprocal performance by the appellant to his employer” and hence decides that the remuneration has its source in South Africa.

It seems that the nature of the employment contract itself, which contract had been concluded in South Africa, was the deciding factor for the Court in holding that the source of the income was local.

Now to address the befuddlement created by this decision.  For most tax practitioners, Silke on South African Income Tax is a first point of reference.  Paragraph 5.8 of this very textbook has the following to say about the source of employment income:

“While the High Court has yet to consider the point, the Special Court for the Hearing of Income Tax Appeals (now the Tax Court) has consistently held that the source (in the sense of ‘originating cause’) of income from employment and other services rendered is the services, irrespective of the place where the contract is made or the remuneration is paid.  The source of the remuneration would therefore be located at the place where the services are rendered.”

And it seems that Silke’s is not a lone voice in the wilderness.  The OECD’s commentary on Article 5 of the Model Convention regards the location of where the services are rendered as the determining factor:

“Employment is exercised in the place where the employee is physically present when performing the activities for which the employment income is paid.”

Poor Mr X.  It was beyond contention that he rendered certain services outside the borders of South Africa.  In fact, he spent a full 62 days performing services in other locations.  As a US tax resident, the remuneration for these services will be included in his worldwide income and subject to tax there.  Now, due to the “reciprocal nature” of his employment contract, this remuneration will also be taxed in South Africa.  Furthermore, if the other tax jurisdictions where he had physically been present when rendering the services have also entered into DTA’s based on the Model Convention, he would have been subject to tax there as well.  At least the tax paid in South Africa will be allowed as a credit against his liability for tax in the United States.

Annalize Duvenage

Specialist Tax Consultant

[1] TCIT 14218, judgment delivered by Judge R Allie

[2] COT (SR) v Shein 1958 (3) SA 14 (FC); CIR v Nell 1961 (3) SA 774 (A)

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