Included in the Draft Taxation Laws Amendment Bill of 2016 are far-reaching proposals relating to the income tax treatment of low interest or interest free loans to trusts. The proposals if enacted are serious enough as to lead to the unwinding of various trust structures.
The wording is contained in a proposed new section (section 7C) of the Income Tax Act. In essence, if the pre-conditions contained in the section are met, then:
- The difference between the interest actually charged on the loan and interest at the ‘official rate’ as defined, is to be included in the income of a natural person (usually but not necessarily the actual lender in that the actual lender may be a company that is a ‘connected person’ in relation to the natural person (see below));
- The amount so included in the income of the lender is not deemed to be interest and therefore the income tax exemption relating to interest income may not be used to offset the amount;
- The income tax payable by the natural person as a result of the inclusion of the above amount in his or her taxable income must be recovered by the natural person from the trust within three years after the end of the relevant year of assessment, failing which such amount will be treated as a donation by that person to the trust, potentially subject to donations tax;
- No corresponding deduction will be available in calculating the taxable income of the trust;
- Arrangements whereby lenders forgive R100 000 per annum of their loans to trusts in order to utilise the annual exemption from donations tax will no longer give rise to an exemption from donations tax; and
- 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 provided under the circumstances envisaged in the section.
The proposed section would come into operation on 1 March 2017 and would apply in respect of tax years commencing on or after that date. When read together with the pre-conditions for the application of the proposal which are worded in the present tense, this may lead to the interpretation that the proposal may only apply to loans, advances or credit advanced during years of assessment commencing on or after 1 March 2017. However it is doubtful that this limited application of the provision is what is intended.
The pre-conditions for the application of the section are:
- If a natural person directly or indirectly makes or provides any loan, advance or credit to a trust in relation to which that person or any ‘connected person’ as defined 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 as a vehicle to provide the loan, advance or credit to the trust. In more technical terms the proposal expresses 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. It is submitted that the proposal probably over-reaches itself in its current form as it leads to various anomalies.
A natural person would be a ‘connected person’ in relation to a trust if the natural person is a beneficiary of the trust or if a ‘relative’ of the natural person is a beneficiary of the trust. So if a loan is made to the trust by a natural person who is not a beneficiary of the trust but if his children are beneficiaries, the section could apply. It could also apply if a natural person owns 20% or more of the shares of a company that advances a loan to the trust of which the natural person’s sister is a beneficiary.
Included in the 2016 Budget review was the proposal that:
‘To limit taxpayers’ ability to transfer wealth without being taxed, government proposes to ensure that the assets transferred through a loan to a trust are included in the estate of the founder at death, and to categorise interest-free loans to trusts as donations. Further measures to limit the use of discretionary trusts for income-splitting and other tax benefits will also be considered.’
It is clear from various pronouncements over several years that trusts have been on National Treasury’s radar for some time. In addition, the first Interim Report of the Davis Tax Committee, released during July 2015 contained a number of proposals relating to trusts, some of which were extremely controversial. The main proposals of the Davis Tax Committee relating to the taxation of trusts were the following:
- The flat rate of tax for trusts should be maintained at its existing levels.
- The deeming provisions of section 7 and 25B should be repealed, insofar as they apply to RSA resident trust arrangements.
- The deeming provisions of section 7 and 25B should be retained, insofar as they apply to non-resident trust arrangements.
- Trusts should be taxed as separate taxpayers.
- The only relief to the rule should be the “special trust definition” contained in section 1 to the Income Tax Act which allows a trust to be taxed at personal income tax rates in limited special circumstances. The definition should be revisited by National Treasury.
- No attempt should be made to implement transfer pricing adjustments in the event of financial assistance or interest-free loans being advanced to trusts.
The Davis Tax Committee has not yet finalised its report. It is therefore possible that at least some of the above proposals of the Davis Tax Committee may also be enacted in future legislative cycles. What is interesting however is that the current proposal appears to fly in the face of the recommendation that no attempt should be made to implement transfer pricing adjustments in the event of financial assistance or interest-free loans being advanced to trusts. The rationale given in the Davis Committee Report for this recommendation was that ‘there would be numerous complexities associated with implementing a form of transfer pricing adjustment to deem a return on interest-free loans between SA registered trusts and SA taxpayers. The [Davis Tax Committee] concurs with the recommendations of the Katz Commission that this be avoided.’
Fortunately, the seemingly unworkable proposal that assets transferred through a loan to a trust be included in the estate of the founder at death did not find its way into the current proposals. Neither has the issue of income splitting been addressed.
Issues arising from the current proposals
One of the problems associated with the proposed section 7C is that it may lead to economic double taxation. Consider the example of a founder who lends cash to a trust on an interest free basis. Assume the founder is a ‘connected person’ in relation to the trust. If the trust invests the cash and earns interest, the interest will be taxed either in the hands of the trust, the founder or the beneficiaries. In addition, the founder will, in terms of the proposals, be taxed on an amount based on the official rate of interest for the year of assessment applied to the capital outstanding on the loan. The trust will enjoy no tax deduction for the notional amount so included in the taxable income of the founder.
It would also seem that, due to the extremely wide wording of the second bulleted pre-condition above, the proposal may in certain cases lead to the taxation of the notional amount in the hands of more than one natural person.
As mentioned above, it is proposed that section 7C come into operation on 1 March 2017 and that it would apply in respect of tax years commencing on or after that date. When read together with the pre-conditions for the application of the proposal which are worded in the present tense, this may lead to the interpretation that the proposal may only apply to loans, advances or credit advanced during years of assessment commencing on or after 1 March 2017. It is doubtful that this is what is intended.
It would also appear that if a natural person makes the loan to the trust prior to his or her death and that the loan is bequeathed, that the provision would not apply in the hands of the heirs.
In my view it is likely that the proposals after amendment will survive the legislative process. Assuming that they do, the question arises as to what action could be taken to mitigate their impact.
The drastic step of terminating the trust may trigger capital gains on the disposal of trust assets and increases in the personal estates of the beneficiaries from the perspective of estate duty. On the other hand, if the trust has available liquidity, it could fully or partly repay the low interest loan. This would lead to the non-application of the provision. It must be borne in mind that depending on the use to which the lender applies the funds, this course of action may lead to growth over time in his or her personal estate for purposes of estate duty. As mentioned above, the tax effects of disposals of assets by the trust in order to acquire liquidity must also be considered.
The lender and the trust could, depending on the terms of the loan agreement, renegotiate the terms whereby the lender would charge interest on the loan at the official rate. The trust would then have an interest expense which could, depending on the circumstances and in particular the type of income earned by the trust, be deductible in calculating its taxable income. The lender would have an actual amount of interest against which he or she could utilise the annual interest exemption.
In short, there is little doubt that the proposals, if enacted, would detract from the attractiveness of trusts from a tax perspective. It is sometimes forgotten in this context that tax savings should not be the main reason for setting up a trust. Issues of estate protection and planning should take centre stage.
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