15 June 2010

Be warned - file correctly: A warning to Employees' tax evaders

The recent decision in Crabbe v United States (Case No. 08-1393) where a business owner, Mr William Crabbe, was convicted of multiple counts of failure to pay over payroll taxes and filing false returns, highlights the need for employers to be on top of their game when it comes to Pay-As-You-Earn (PAYE) compliance. The Minister of Finance in his 2010 budget speech also made it abundantly clear that tough action will be taken on firms who are not PAYE compliant.

Many employers in South Africa are unaware that the South African Revenue Service (SARS) has the power to hold directors and shareholders, who control or are regularly involved in the management of a company's overall financial affairs, personally liable for PAYE, additional tax, penalties and interest. This means that shareholders and directors could also face criminal sanctions.

This article looks at the basis for Mr. Crabbe's convictions and compares it to similar powers available to SARS in the Income Tax Act 58 of 1962.

Facts of the case

Mr. Crabbe was the part owner of Columbine Healthcare Inc (CHI) whose business was to provide nurses to healthcare facilities on a short term basis. He held the position of Vice President and apart from a limited day to day role had no managerial duties. The nurses entered into contracts with CHI and were placed with healthcare facilities based on specific needs. CHI entered into agreements with the healthcare facilities and in turn compensated the nurses on a negotiated hourly rate. As an employer, CHI was responsible for all employment, federal and state withholding taxes of the nurses.

During 1999 Mr. Crabbe became aware that CHI had not paid or submitted the required payroll tax returns to the IRS. Instead, it became apparent that these funds were being siphoned by Mr. Crabbe's business partner in CHI for personal use. Mr. Crabbe then sought to retain a tax attorney who advised him that CHI must stay up to date with all payroll tax filings and pay all outstanding amounts as they could afford them. At this time, and with the possibility of diminishing CHI's payroll tax liability, Mr. Crabbe explored the possibility of treating the nurses as independent contractors. Mr. Crabbe was advised by corporate officers of CHI that treating the nurses as independent contractors was not a viable option.

At the end of 1999 CHI again fell behind in settling its ongoing payroll tax liabilities. In 2000 Mr. Crabbe, without the knowledge of his business partner, opened a separate bank account (of which he was the sole signatory) intended to be used for settling the outstanding tax liabilities. In 2001 Mr. Crabbe set about preparing all of CHI's delinquent payroll tax returns (IRS 941) which now spanned 2 years. Mr. Crabbe prepared the outstanding returns and took it upon himself to file them with the IRS. Upon submission of the delinquent returns, Mr. Crabbe omitted to complete the "number of employees" field and testified that the payments made were only in respect of CHI's corporate employees and did not include any of the nurses.

In the latter part of 2001 Mr. Crabbe continued to file returns, only now it included the number of CHI corporate employees (21 to 31), but again failed to declare the nurses which he admitted at the time of filing was over 100. In October 2002 a financial officer of CHI informed Mr. Crabbe of the omissions on the payroll tax return relating to employee numbers. During 2003 the IRS became aware of CHI's non-compliance and instituted criminal proceedings against the company and its officers. In August 2004, after being made aware of the criminal investigation, Mr. Crabbe re-submitted returns spanning 1999 to 2002 which now reflected the correct number of employees (including nurses) and tax liabilities.

Despite the compliance efforts of Mr. Crabbe he was convicted of ten counts of failure to pay over payroll taxes and six counts of filing false tax returns. The court found that there was a substantial amount of evidence to conclude that the nurses were employees and not independent contractors and that Mr. Crabbe was the "responsible person" for purposes of filing payroll taxes and willfully violated his tax duties as required by the IRS.

Comparison with position in South Africa

Paragraph 2(1) of the Fourth Schedule places an obligation on an employer who pays, or becomes liable to pay amounts by way of "remuneration", to deduct or withhold PAYE, unless the Commissioner has granted authority to the contrary. PAYE deducted must then be remitted to SARS within seven days after the end of the relevant month in which it was deducted or withheld.

The correct amount of PAYE is always due by operation of law at the time remuneration is paid. This is clear from paragraph 4 of the Fourth Schedule which makes any amount "...required to be deducted..." a debt due to the State and, read with paragraph 5 of the Fourth Schedule makes an employer personally liable for amounts which should have been deducted or withheld.

If, for example, a South African employer fails to withhold and pay over PAYE on independent contractors, as was the case in Crabbe, SARS would hold it liable for payment under paragraph 5(1) of the Fourth Schedule. However, to criminally charge an employer for not withholding PAYE, as required under paragraph 2(1) of the Fourth Schedule, it has to be regarded as an offence.

Any person liable to pay remuneration who fails to withhold or pay over PAYE as and when required is guilty of an offence under paragraph 30(1)(a) of the Fourth Schedule. It is further an offence where a person uses amounts deducted as PAYE for any purpose other than payment to SARS as required (paragraph 30(1)(b) of the Fourth Schedule. This would be the case where an employer deducts PAYE from salaries, submits an EMP201 return, but never pays the amount over to SARS.

But what about submitting an incomplete EMP201 return to SARS, such as the omissions by Mr Crabbe relating to employee numbers? Paragraph 30(1)(i) of the Fourth Schedule makes it an offence where any person fails or neglects to maintain records as required under paragraph 14 of the same Schedule. More specifically, paragraph 14(2) of the Fourth Schedule dealing with EMP201's state that every employer must submit "...to the Commissioner such declaration containing such information as the Commissioner may prescribe...". EMP201's (prior to March 2010) contained specified fields for employee numbers relating to PAYE, Skills Development Levies and Unemployment Insurance Fund contributions. By omitting to complete the field or misrepresenting the actual number of employees could result in an employer not providing all the information prescribed by the Commissioner and therefore committing an offence under paragraph 30(1)(i) of the Fourth Schedule. Post 1 March 2010 this is less of a concern as the new EMP201 declarations do not require employee numbers to be disclosed to SARS.

The tools to criminally charge a South African employer in a similar vein to that in Crabbe are available to SARS - the question is whether SARS will look to institute criminal proceeding where an employer subsequently settles all delinquent tax liabilities as was the case with Crabbe. Despite settling all of CHI's tax liabilities one gets the distinct feeling that in the Crabbe case the IRS wanted to make an example of him. The same cannot be said for SARS yet, however, given the statements made by the Minister of Finance in his 2010 budget speech it may just be a matter of time before a similar case finds its way to our courts.

Personal liability

The fact that Mr. Crabbe was criminally charged was based, inter alia, on the fact that he was regarded as the "responsible person" for purposes of US tax law. The Court in Crabbe held that a person is regarded as being responsible under US tax law if he or she "...has significant, though not necessarily exclusive, authority in the general management and fiscal decision making of the corporation...". In this context a non-exhaustive list of factors were considered such as whether the person held corporate office, controlled financial affairs, had authority to disburse corporate funds, owned stock and had the ability to hire and fire employees.

In a South African context the issue of personal liability is dealt with under paragraph 16 of the Fourth Schedule. From 1 March 2004 shareholders and directors, in the case of an employer that is a company, can be held personally liable under paragraph 16(2C) of the Fourth Schedule -

"where an employer is a company, every shareholder and director who controls or is regularly involved in the management of the company's overall financial affairs shall be personally liable for the employees' tax, additional tax, penalty or interest for which the company is liable". (own emphasis)

Paragraph 16(2C) of the Fourth Schedule should not be of concern, provided the company is in a position to settle all amounts arising from non-compliance. Should a company not be able to settle the liabilities then, as long as it remains unpaid, SARS would be entitled under paragraph 16(2C) to recover the unpaid tax from those persons whose duties bring them within the ambit of this liability. The South African approach appears to be narrower than that used in the Crabbe case as the Fourth Schedule only refers to overall financial affairs, whereas the US courts include general management in addition to fiscal decision making.

The use by the legislature of expressions such as 'controls', 'regularly', 'involved' and 'overall' is singularly unhelpful. There is neither a test of what constitutes control nor any formula for making such a determination. Because of the elusive nature of the concept 'regularly involved in the management of the company's overall financial affairs', it is not clear whether shareholders, by virtue of being shareholders are liable. The shareholders normally appoint the directors at a general meeting, who then undertake the management of the company. In this respect there is a definite demarcation of responsibility between the directorate and shareholders. But as always the question whether a person controls or is regularly involved in a company's overall financial affairs will be based on the facts of each case.

In Crabbe the court found sufficient indicia of fiscal responsibility because Mr Crabbe had some control over CHI's financial affairs as demonstrated by his unilateral establishment of a bank account and had the authority to distribute corporate funds as demonstrated by his signing of corporate cheques. The implications of paragraph 16(2C) of the Fourth Schedule are far reaching where a specific person is targeted by SARS under this provision. Once the personal liability tag is placed on a specific person, and an act or omission falls within paragraph 30 of the Fourth Schedule, SARS may pursue criminal proceeding similar to that in the Crabbe case.

Clause 172 of the draft Tax Administration Bill (TAB) also makes provision for the personal liability of any person (not only shareholders or directors) who controls or is regularly involved in the management of the overall financial affairs of a taxpayer. The difference between the TAB, in its current form, and paragraph 16(2C) of the Fourth Schedule is that the personal liability is subject to the discretionary powers of a senior SARS official who must be satisfied that there was an element of negligence or fraud. It remains to be seen how these two clauses will interact with one another once the TAB is promulgated.

Conclusion

Where an employer fails to pay the correct amount of PAYE as and when required it is an offence under the provisions of the Fourth Schedule. This applies equally where an employer fails to properly complete and submit an EMP201 return or misrepresents information required by SARS on a return. In the case of a company, shareholders and directors could find themselves personally liable for PAYE debts including possible criminal sanctions.

The Crabbe case highlights the risks faced by employers when it comes to PAYE compliance, especially where a tax authority has the power to pierce the corporate veil and target business owners in their personal capacity. It is therefore important that people responsible for financial affairs at companies are aware of their obligations as it relates to PAYE compliance. Employers, on the other hand, must ensure that PAYE compliance forms part of an overall solid tax risk management strategy.

Ruaan van Eeden, Senior Associate, Tax

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