By Chris Lynch, C.A., Managing Director
If you are a contractor or engage the services of a contractor, you need to understand the changes to the withholding tax rules which came into effect on 1 April 2017.
From 1 April 2017, contractors can elect their own withholding tax rate. This means they no longer have to have tax deducted from their payments in line with their flat rate under the withholding tax rules (otherwise known as the Schedular Payment rules).
Schedular payments apply to contractors across a broad spectrum of industries; from cleaners, farm workers and gardeners, to entertainers, sportspeople, labour-only builders and fishing boat workers. The withholding rate can be equally as broad; from 33% for examiners' fees to 10.5% for personal service rehabilitation payments.
With the new rules, however, contractors can choose to elect a lower withholding tax rate, down to a minimum of 10% (15% for non-resident contractors). This is done by the contractor electing a rate on their Tax Rate Notification for Contractors form (IR330C) which they provide to parties they invoice. The idea is that the lower rate will more accurately reflect the contractor's end of year marginal tax rate.
The changes to the withholding tax rules do not, however, apply to non-resident entertainers who will continue to be subject to withholding tax at the flat rate of 20%, with no ability to reduce this rate.
The withholding tax rules have also been extended to apply to contractors that work for 'labour-hire firms'. In addition, the current exemption that applies if a contractor is invoicing through a company does not apply to payments by labour-hire firms. In other words, labour-hire firms will have to deduct withholding tax from payments made to a contractor's company at the standard rate of 20%, unless the contractor elects a lower rate of no less than 10% or applies for a Special Tax Rate, which could be as low as of 0%.
A labour-hire firm has a wide definition and essentially includes "a person which has as one of its main activities the business of arranging for a person to perform work or services directly for clients of the entity".
Essentially, if the labour-hire arrangement is not incidental to the main business of the labour-hire firm, the withholding tax rules will apply.
There is, however, an exclusion from the new labour-hire rule for transactions with associated persons to prevent overreach of the rules.The Inland Revenue has allowed for a lead-in time of up to 1 July 2017 for those labour-hire firms that were not able to get their payroll systems in place in time for 1 April 2017.
Special Tax Rate
Contractors subject to the withholding tax rules cannot apply for a Certificate of Exemption, instead, they now have the ability to elect a 0% withholding tax rate, which means the contractors will pay their income tax through the provisional tax system.
A good option for those contactors who are able to manage three sizeable
tax payments throughout the year, with a wash-up in the annual tax return, but
perhaps not such a good option for those contractors who will struggle to
ensure they have the cash-flow to cover the payments when they fall due.
The election of a 0% withholding tax rate is done by completing an IRD Special Tax Code Application form (IR23BS) and submitting the form to the IRD.
The outcome of having a Special Tax Rate (rather than a Certificate of Exemption) means the payments to the contractor must be recorded on the payer's Employer Monthly Schedule, even though no withholding tax is deducted. This is an added compliance hassle for payers, however, from a tax base protection perspective, this ensures the contractor's income information is still provided to Inland Revenue and therefore reduces the risk of non-compliance.
Voluntary Withholding Agreements
A further change sees those contractors who are not currently subject to the withholding tax rules, able to elect into the rules if they so choose and have payers deduct withholding tax from payments made to them. In order to do this, however, the payer has to agree. Therefore, if this was going to cause unnecessary compliance for the payer, the payer could choose not to withhold. The standard rate under a voluntary withholding agreement is 20% unless the contractor elects a rate no lower than 10%.
The withholding tax changes will be positive for contractors in the long run. However we foresee there will be a few teething issues to overcome, such as the interplay with the attribution rules; when a contractor's income must be returned in the contractor's individual tax return, yet the withholding tax has been withheld under the contractor's company IRD number.
Also, contractors who have been paying tax via the provisional tax system but will now have withholding tax deducted will, in the first year or two, need to consider estimating their provisional tax down which opens them up to IRD's use-of-money interest rules.
Over time, these and other practical issues will be ironed out; it just means in the short term closer attention will need to be paid to contractors and those who make payments to contractors.