Republic of Serbia (“RS”) has recently amended its tax law provisions on individual income tax by adopting Act on Amendments of the Individual Tax Act, published in the Official Gazette of the RS, No. 86/2019 (“Act”). Among many changes, the one that attracts the most attention is the inclusion of a test on “dependence” and its influence on the tax status of entrepreneurs. The Act sets out the criteria which are to be applied by the tax authorities (“TA”) to determine cases in which the entrepreneur is not actually independent from his client. Entrepreneurs that do not pass this test will be similarly treated as if they were employees, and will, therefore, be subject to a different tax regime.
The criteria employed by the independence test aim to determine the nature of the relation between the client and the entrepreneur. The criteria relate to the entrepreneur’s financial, contractual, professional, recruitment and instructional dependence to the client. Five of nine of the following criteria have to be fulfilled in order for the different tax regime to be applied:
- The working hours, vacation or leave are determined by the client, and the entrepreneur’s financial compensation is not reduced during the time spent on leave;
- The entrepreneur usually works at the client’s premises, or the client provides the tools or other means necessary to conduct work, or finances the acquisition of those tools;
- The client organizes training and education for the entrepreneur, or he manages and leads the entrepreneur’s work process;
- The entrepreneur has been engaged after a public call or by a recruitment agent;
- The entrepreneur usually conducts work together with other contracted entrepreneurs engaged by the same client;
- At least 70% of the entrepreneur’s revenue obtained in the previous 12-month period which begins or ends in the respective tax year is obtained from the client;
- The entrepreneur does not bare the usual business risk by contract for work delivered to business partners of the client;
- The agreement concluded between the client and the entrepreneur contains clauses that prohibit the entrepreneur to provide services to other clients;
- The entrepreneur works for the same client for 130 or more days in a 12-month period which begins or ends in the respective tax year.
The amendments also introduce the notion of the expected dependency status. Namely, if at the beginning of a business cooperation can be expected that five out of nine criteria of dependency will be fulfilled, the income arising from that cooperation will be subject to a different tax regime in case the status of an entrepreneur is afterward determined as a dependent. The income obtained in the period when the dependence test is not attained will be equated with the income obtained in the status of dependence in terms of tax treatment. Legal provisions do not provide the TA with any additional guidance and no further evidence than a simple “expectation” is required from the TA. As a result, the TA has unrestricted discretion to determine the tax status of the entire income obtained from a client in the course of entire business cooperation. It is expected that in most, if not all, of the cases where the TA is to confirm the dependence status, all income obtained from the client is to be treated in the same manner and be subject to the special tax regime.
What do these changes practically mean?
The main intention of the proposed changes is the reduction of the grey economy and the increase of the government budget inflow. However, it is yet to be seen how effective these changes are to be in practice. The status of the dependant entrepreneurs is to be practically equated with the status of the employees for tax and budgetary purposes.
The potential consequences of the “dependent” status are particularly problematic for flat-rate taxed entrepreneurs. The tax base and as a consequence the amount of tax payable for the flat-rate taxed entrepreneurs depends on different factors, including the subject of the work, location of the entrepreneur’s seat, etc. The tax regime was appealing for many professionals, diminishing the tax burden and making income obtained more competitive. “Dependent” entrepreneurs cannot opt for flat-rate taxation.
One of the most important changes is that now income obtained in the status of “dependence” is not considered “income from the independent profession” but it’s classified as “other income”. Whereas the tax rate on the income from employment and the income from the independent profession is 10%, the taxable rate of “other income” amounts to 20%.
The goal of this change is to make the position of the “dependent entrepreneur” unsustainable and transform what legislator considers pseudo-entrepreneurs into employees. The professional that did not pass the dependency test, by being taxed higher, is being incentivized to enter into a labor agreement with their client and become an employee. Although by doing this they lower the tax burden, they also lose the tax incentives they had in the position of an independent contractor.
In practice, this may disincentivize professionals, as well as companies from certain industries (such as IT) to work in Serbia. To alleviate the negative aspects of the proposed changes in the short term, incentives for hiring unemployed people as well as sole entrepreneurs are provided, as well as changes in the area of payroll taxation for newly founded innovative companies.
How the Act is to be applied?
The practical results of the current changes directly depend on the aptitude and expertise of the TA officials. It is reasonable to expect that acting TA officials will have significant expertise in applying the dependence test, as the opposite could potentially have problematic results and lead to legal uncertainty. That expectation may turn out to be overly optimistic as the TA officials have proven to be inefficient in matters where they have to apply legal provisions containing different criteria. Some examples where they historically demonstrated this inefficiency is transfer pricing or the principle of facticity. Furthermore, these inherent inefficiencies of the tax authority apparatus are less of a concern compared to the actual danger of misapplication of the material legal provisions on the status of the entrepreneurs.
It is expected that the TA will follow the decisions and the interpretation of the independency test of the Ministry of Finance. Yet, the final say stays with the courts, and the fact that the decision periods of the Administrative Court in practice amount to almost two years remains as a glaring practical issue. In addition, the Administrative Court never opts for actually solving the case and most of the time return the cases to lower courts. Judicial proceedings are lengthy while tax enforcement procedures are strict and efficient, making implications of this situation for independent professionals quite significant. And while the actual effects of the proposed changes are yet to be seen in practice, a shadow of doubt cast by the earlier practices of the tax authority remains present in our evaluation of their ability to apply these new tax provisions successfully.
This text is for informational purposes only and should not be considered legal advice. Should you require any additional information, feel free to contact us.
By Milos Velimirovic, Partner, and Stefan Jugovic, Associate, Samardzic, Oreski & Grbovic