The phrases "service charge", "gratuity" and "tip" are often used interchangeably but they actually have different meanings. The persons most affected by these variations are (i) persons who operate a restaurant, club, bar or hotel and (ii) persons who patronize restaurants, clubs, bars or hotels. If you fall into either category, ask yourself if you know the different meanings.
A proper service charge has three main characteristics:
One — a service charge is generally not discretionary. A fly could be doing the backstroke in your soup that your waiter spilt on you and you may still be required to pay the service charge. After all, it's not called a 'good-service' charge.
Two — a service charge is automatically added to the bill before presentation. If so, it ought to be clearly and legibly printed in the menu or some other conspicuous place so that it may form a part of the contract with the customer, even if the customer never actually sees it. If the service charge is not mentioned in the menu or other conspicuous place, then the customer is entitled to ask that it be removed from the bill as there was no agreement between the parties for a service charge to be applied. The customer must have the opportunity to see that a service charge will be applied before he or she places an order because that is the point at which the contract is formed.
Three — a service charge is subject to General Consumption Tax (GCT). The general rule is that all goods and services that are supplied for a fee are subject to GCT unless specifically exempted. The sale of food and beverages in a club, bar, restaurant, hotel or similar venue is considered for GCT purposes to be the supply of a service, not the supply of a good. To illustrate, if a rotisserie chicken is sold in a supermarket, that is considered a supply of a good. If the same rotisserie chicken is sold in a restaurant, that is considered a supply of a service. Thus, a service charge applied at a restaurant is somewhat redundant as the restaurant business is a service industry, just like a law business. Imagine your lawyer sending you a bill for legal fees and then adding a 10 per cent service charge.
Here is where the difference between a service charge and a gratuity becomes critical. Gratuities paid to employees are exempt from GCT but service charges are not. If service charges were exempt from GCT, the owner of the restaurant, club or bar could reduce the prices of the meals and drinks and increase the service charge as a way of reducing the taxable portion of the bill. Many businesses seem to be unaware that GCT is payable on service charges. If you happen to retain the receipts when you eat out, take a look and see for yourself. Chances are, you will not find a single receipt in which GCT has been applied to the service charge.
Before you restaurateurs go and reprint your menus to replace the phrase 'service charge' with 'gratuity' you should know that the label doesn't determine what the thing really is. For example, a statement that "a 10 per cent gratuity will be added to parties of six or more" isn't really a gratuity at all if it's mandatory. It's a service charge that those 6 or more socialites are required to pay whether they are grateful for the service or not. Of greater significance, therefore, is whether the charge (a) is automatically applied to the bill, and (b) is capable of being decreased or removed by the customer. In general, a service charge is automatically applied to the bill and cannot be removed by the customer, a gratuity may be either automatically applied (for "convenience" as they say) or added by the customer and can be removed by the customer. A tip is added to the bill by the customer as he or she sees fit or simply left as cash on the table.
From a tax perspective, if the customer has the right to remove a gratuity that has been automatically added to the bill (for "convenience", of course) then the gratuity, even though not removed, should be exempt from GCT. If the customer is denied that right then it's not a gratuity but is really a service charge, and a service charge by any other name is just as taxable.
From a practical perspective this may mean that the operators of restaurants, clubs and bars may need to align their menus with their point-of-sale software or vice versa. It would appear that much of the software has been incorrectly programmed to treat service charges as if they were tips and discretionary gratuities which are exempt from GCT. Most menus, however, do not indicate that the customer has any discretion in the matter at all. It ought not to be assumed, merely because the word 'gratuity' is used, that the customer should be aware that he or she has the right to remove that gratuity from the bill. The customer should be specifically advised of this right. Failure to do so will leave a bad taste in customers' mouths and possibly incur a liability to pay the Revenue the amount of GCT that should have been collected on these service charges over the years. That's sure to be one hefty bill.
Gavin Goffe is a Partner at Myers, Fletcher & Gordon and is a member of the firm's Litigation Department and Tax Practice Group. Gavin may be contacted via email@example.com or on twitter @ggoffe. This article is for general information purposes only and does not constitute legal advice.