Are you an employee or independent consultant for taxation purposes?

1. Introduction

With the rising cost of taxation and statutory deductions on employment income, many employers and employees alike are considering converting their employment relationship to consultancy arrangements. This is aimed at mitigating the tax and statutory deductions burden.? Whilst it is the case that an independent consultant is not liable to statutory deductions such as NHIF, NSSF, Affordable Housing levy and thus the tax burden is relatively low, careful considerations need to be taken before such conversions are implemented.

This article takes a deep dive into why the distinction between an employee and an independent consultant is important, the implications of each arrangement and the considerations that need to be taken to transition from an employment arrangement to independent consultant arrangement.

2. Why is the distinction important from a tax perspective?

The tax legislations in Kenya provide for distinct taxation framework for employees compared to that of an independent consultant as follows:

2.1. Taxation of Employees

·???Pay as you earn (PAYE)- Employers are required to deduct PAYE from the employees salaries and remit to the Kenya Revenue Authority (KRA) by the 9th day of the succeeding month; and

·?Employment Benefits- employees receive various benefits depending on their terms of employment such as cash benefits, mileage, house allowances. Where an employee enjoys benefits, advantage or facility of whatsoever nature in connection with employment or services rendered, the value of such benefits is included in the employee’s earnings and charged to tax.

Notably is that the Kenyan Income Tax Act (the ITA) places the responsibility to deduct and remit PAYE to the KRA on the employer. Specifically, Section 37 of the ITA read together with Rule 4 (1) of the Income Tax (PAYE) (Amendment) Rules, 2010 (PAYE Rules) provides that an employer paying emoluments to an employee shall deduct therefrom and account for such tax. If the employer has in place net salaries for employees, they are required to gross up and account for the respective PAYE which is based on a graduated scale.

Further, Section 39A of the Tax Procedures Act, 2015(the TPA) provides that where a person is required under a tax law to deduct or withhold tax and remit to KRA and they fail to do so, they shall be responsible for the collection of the unpaid tax including payment of penalties and interest on the tax due.?

Failure to submit a PAYE return on the due date attracts a late filing penalty of the higher of 25% of the tax due or KES 10,000, whichever is higher. Additionally, failure to pay PAYE on the due date attracts a 5% penalty and a late payment interest at the rate of 1% per month or part of the month on the amount unpaid for a period commencing on the date the tax was due and ending on the date the tax is paid. Additionally, it is noteworthy that in addition to the penalty, the ITA also makes it a criminal offence for an employer to fail to deduct and account for PAYE and such an employer may be subjected to prosecution.

2.2. Taxation of Independent contractors/ consultants

·?Withholding tax- withholding tax at the rate of 5% (resident consultant) or 20% ( for non-resident consultant) is due on the consultancy fees payable to an independent consultant. The withholding tax deducted is claimable by the payee (independent consultant) when filing their annual tax returns and is therefore not an additional tax.

·? VAT- consultancy services are taxable services subject to VAT at the rate of 16%. If the Independent Consultant/ contractor fees reach the annual VAT registration of KES 5,000,000 per annum they shall be required to register for VAT and also issue e-TIMs compliant invoices for their services.

3. Factors considered in differentiating between an employee and an independent consultant for tax purposes? Substance over form considerations

In determining whether an employment relationship exists from the contractual arrangement, or whether the nature of engagement is that of an independent consultant, the?Kenya Revenue Authority or Courts examine the substance of the relationship and not the form of the agreement between the Parties. This is done by considering a number of factors which include the following:

a)?????? Control- An employer has total control over the work of an employee including the place of work, hours of work and how/manner to execute the task. An independent contractor on the other hand works under minimal supervision and determines his place of work, the hours of work and the manner in which he should perform the task.

b)????? Degree of integration in the business- employees are integrated into the business operations for example an employee is subject to employer’s rules and regulations at the workplace and are also? ?assigned a place to sit within the organization. On the other hand, independent consultants/contractors performance is subject to the terms of the contract and there is no degree of integration within the business.

c)?????? Benefits and statutory deductions- under an employment contract, an employer is obligated to make statutory payments for an employee such as NHIF and NSSF payments. The Employer is also required to remit PAYE on behalf of an employee. Additionally, the employee may receive other benefits from the employment contract such as house allowance, medical benefits, membership subscriptions, annual leave and cash benefits. On the other hand, an independent contractor/ consultant is liable for their own taxes. Also, they are not entitled to employment benefits such as annual leave, housing benefits etc.

d)????? Liability for wrongful acts- An employer is liable for the wrongful acts of his employee if the acts are committed in the course of employment. This is known as vicarious liability. On the other hand, a person who hires an independent contractor is not liable in general for the negligence and other wrongful acts committed by the contractor.

e)????? Payment of remuneration- an employee is paid a specific amount in regular intervals as per the employment contract. The terms of payment when it comes to consultants are dependent on the contract agreed upon by the Parties.? In most cases, a consultant is paid after they raise an invoice for the service provided. An employee is paid a salary while a consultant is paid fees.

f)??????? Furnishing of Tools and Materials. The fact that the person or persons for whom the services are performed furnish significant tools, materials, and other equipment tends to show the existence of an employer-employee relationship.

4. Key considerations in transition from an employment to a consultancy agreement

If you are considering transitioning from employment terms to an independent consultant, consider the following:

4.1. Understand the Legal Implications: Ensure that your new contract clearly defines your status as an independent consultant to avoid misclassification.

4.2. Evaluate Financial Impact: Assess the financial implications, including the loss of employee benefits and the responsibility for managing your own taxes.

4.3. Register for VAT if Necessary: If your income exceeds the VAT threshold (KES 5,000,000 per annum), ensure you register and comply with VAT requirements.

4.4. Maintain Accurate Records: Keep detailed financial records to support your tax filings and take advantage of any allowable deductions.

4.5 Consult a Legal/ Tax Professional: Seek advice from a Legal or Tax consultant to ensure you meet all tax obligations and understand the benefits and risks of your new status.

5. Conclusion

Converting employment contracts to consultancy agreements can offer tax benefits and increased flexibility. However, it is crucial to understand the distinctions between being an employee and an independent consultant to ensure compliance with KRA regulations. By carefully evaluating the legal and financial implications and seeking professional advice, you can make informed decisions that align with your career goals and financial objectives.

Navigating the complexities of tax classifications can be challenging, but with the right knowledge and resources, you can confidently manage your tax responsibilities and optimize your work arrangements.

(This Article serves the purpose of general knowledge only and is not intended to constitute Legal Advice. You should not act upon the information provided under this Article without obtaining specific Legal Advice)