BY DAVID WARNEKE, HEAD OF INCOME TAX TECHNICAL, BDO SOUTH AFRICA
The first release of the Draft Taxation Laws Amendment Bill of 2016 included far-reaching proposals relating to the income tax treatment of low-interest or interest-free loans to trusts. The Bill proposed to introduce these measures by means of a new section 7C of the Income Tax Act.
The reason for the measures, from the perspectives of National Treasury and SARS, is that there is a perceived avoidance of donations tax and estate duty which is achieved by the transfer of growth assets to trusts on interest free loan account.
In essence the main consequences of the proposal were that:
- A notional charge, based on the difference between the “official rate” of interest and the interest rate actually charged on the loan to the trust, would be included in the taxable income of the lender and subject to income tax at marginal rates. In cases where the lender is a company that is a “connected person” in relation to a natural person, the inclusion would be in the hands of the natural person;
- The amount included in the income of the lender would not be deemed to be interest and the tax exemption relating to interest would not allow offset;
- The income tax payable by the natural person following inclusion of this amount in taxable income would have to be recovered by that person from the trust within three years after the end of the year of assessment. If not so recovered, the amount would be treated as a donation by that person to the trust, potentially subject to donations tax;
- The trust would not receive a corresponding deduction against its taxable income;
- If a lender were to forgive R100 000 per annum of a loan to a trust in order to utilise the annual donations tax exemption, such forgiveness would no longer be exempt from donations tax; and
- No deduction, loss or allowance would be available to a lender as a result of the failure of the trust to repay a loan, advance or credit.
The proposal elicited much criticism and commentary. It was extremely widely drafted and its application was unclear in many respects. The following were to be the pre-conditions for the application of the provision:
- If a natural person directly or indirectly provides a loan, advance or credit to a trust in relation to which that person or any “connected person” in relation to that person is a “connected person”; or
- If instead of a natural person providing the loan, advance or credit, a company that is a “connected person” in relation to the natural person is used to provide the loan, advance or credit to the trust. In technical terms, the proposal expressed this intent in the form that the provision would apply if the loan, advance or credit is provided directly or indirectly by a company in relation to which a natural person is a “connected person” and if the company or any person that is a “connected person” in relation to the natural person or the company is a “connected person” in relation to the trust.
With regard to the second pre-condition above, there was little doubt that the proposal over-reached itself in the breadth of its application. For example it would have applied if a natural person owns 20 per cent or more of the equity shares in a company that provides an interest free loan to a share incentive trust, if the company was a residual beneficiary of the share incentive trust. In these circumstances the provision would have applied whether or not the natural person influenced the granting of the loan. It could also have led to an inclusion of the same amount in the hands of more than one natural person. Loans to trusts that are public benefit organisations, “special trusts” and non-resident trusts would all potentially have been subject to the treatment.
A second proposed version of section 7C was released on 23 September 2016 for public comment. In a Draft Response Document from National Treasury and SARS presented to the Parliamentary Standing Committee on Finance on 21 September 2016, the rationale for the provision is stated as follows:
“Specifically, section 7C addresses the avoidance of donations tax and estate duty through the use of loan structures in the transfer of assets to trusts. In monetary terms the issue of estate pegging is mitigated by taxing the low or no interest free (sic) element of loans as donations throughout the life of the loan. In doing so, tax leakage from such loan structures is significantly reduced.”
The revised proposal retains the same core idea as its predecessor, namely to subject the lender of a low interest loan to a trust to tax so as to compensate for perceived avoidance of tax. However, instead of subjecting the notional charge to income tax in the hands of the lender, the notional charge will be deemed to be an annual donation subject to donations tax.
The main points contained in the revised proposal may be summarised as follows:
- A notional charge, based on the difference between the “official rate” of interest and the interest rate actually charged on the loan, advance or credit provided to the trust, would be treated as a donation for donations tax purposes made by a natural person to the trust on the last day of the natural person’s year of assessment;
- In the case of a loan by a company to a trust, the provision requires that the loan was made at the instance of a natural person and if the natural person is a “connected person” in relation to the company by virtue of the holding of 20 per cent or more of the equity shares or votes;
- If a loan is made by a company to a trust at the instance of more than one natural person that is a “connected person” by virtue of the holding of 20 per cent or more of the equity shares or votes, then the amount of the deemed donation is split pro-rata according to the relative shareholdings or voting rights of those natural persons;
- The natural person in whose hands the deemed donation arises may offset the deemed donation against the annual donations tax exemption of R100 000;
- No deduction, loss or allowance will be available to a lender as a result of the failure of the trust to repay a loan, advance or credit;
- Loans to the following types of trusts are excluded from the application of the provision:
- Trusts that are approved public benefit organisations;
- Loans to vesting trusts (if a number of pre-conditions are met);
- Loans to special trusts created solely for the benefit of disabled persons;
- Loans to trusts that funded the acquisition of the primary residence of the lender or of the lender’s spouse;
- Loans to foreign trusts (subject to section 31 of the Income Tax Act);
- Loans to trusts in terms of a sharia compliant financing arrangement; and
- A loan provided by a company to a trust if the non-charging of interest on the loan gives rise to a deemed dividend in terms of section 64E(4) of the Income Tax Act.
If enacted in its revised form, the provision would come into effect on 1 March 2017. It has been clarified that it would apply in respect of loans made prior to and after this date.
The latest version, like its predecessor, does not only apply to loans to trusts but also advances and credit provided to a trust. Both versions apply to the provision of direct and “indirect” loans, advances and credit. The meaning of “indirect” in this context is not clarified.
In many situations it will be far from clear whether a loan should be regarded as having been made by a company to a trust “at the instance of” a natural person. For example, if an individual holding 20 per cent of the shares in a company is also the company’s managing director, would the approval of the loan by the company’s board be “at the instance of” the individual? It is interesting to note that a now-repealed provision of the Income Tax Act, section 57(2), used to prescribe circumstances in which a donation made by a body corporate was deemed to be made “at the instance of” a person. These circumstances were, if having regard to the circumstances under which the donation was made, the Commissioner was of the opinion:
- That the donation was not made in the ordinary course of the normal income-earning operations of the body corporate; and
- that the selection of the done who received the benefit of the donation was made at the instance of the person.
The repeal of the above provision means that there is no longer legislative guidance as to the meaning of the above term.
It would appear likely that the revised proposal, perhaps with some refinements, will survive the legislative process. A question faced by taxpayers is therefore which course of action they should follow. They could, for example unwind existing trust structures or retain existing trust structures with or without refinements.
If consideration is given to charging interest on a loan to a trust, an important principle to bear in mind is that would be better to suffer donations tax at the rate of 20 per cent than income tax on interest at a rate of 41 per cent, if the trust would obtain no income tax deduction for interest paid in respect of the loan.
Although the revised version of the proposal is subject to criticism on various fronts, it is more taxpayer-friendly than its predecessor. In the majority of cases the previous version would have led to taxation on a notional amount at the rate of 41 per cent whereas the current version leads to tax at the rate of 20 per cent.
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