Interest-free loans to foreign trusts
Interest-free loans to foreign trusts
By Associate Professor David Warneke, Tax Partner
Offshore trust structures have been formed by many high net-worth South African residents due to their manifold benefits, among which are asset protection, flexibility and tax planning. From a taxation perspective, there are numerous provisions that potentially apply to such arrangements. This article considers the interplay between specific provisions – sections 7(8), 7C, 31 and paragraph 72 of the Eighth Schedule to the Income Tax Act (‘the Act’) - in relation to a structure often encountered in practice.
Usually, a discretionary foreign trust and company structure is chosen, whereby the non-resident discretionary trust, established for the benefit of the family members of the founder, holds all the shares in a non-resident company which holds the offshore assets. Invariably, the financing of such trust arrangements commences with the granting of a loan by the founder, assumed to be SA tax resident, to the offshore trust.
A loan is usually preferred to a donation as a means of financing, mostly because the latter results in an immediate tax liability in the form of donations tax at the rate of 20 or 25 percent, depending on the quantum involved. The loan may be denominated in rands or foreign currency and may be interest-free or interest-bearing. In these circumstances, one needs to consider the potential application of the above provisions.
Section 7(8) is an anti-avoidance provision that applies where ‘by reason of or in consequence’ of a ‘donation, settlement or other disposition’ by a resident, an amount is received by or accrues to a non-resident which would have constituted income had, hypothetically, the non-resident been a resident. It has been held that the non-charging of interest on a loan falls into the category ‘other disposition’ and is caught by this wording, to the extent of the founder’s generosity – on the above facts, up to the quantum of an arm’s length interest on the loan. In the structure outlined above, the income of the trust would usually be in the form of foreign dividends declared to it by the foreign company out of its profits. As discussed further below, it is somewhat unclear whether income that accrues to the foreign company would also be hit by this provision – assuming that the company’s source of funding was indirectly the interest-free loan by the founder to the trust- it is submitted that to include in the founder’s hands both the income of the foreign company and foreign dividends declared out of the same income would be double taxation. With effect from 1 March 2019, arrangements whereby the foreign trust subscribes for the shares in a foreign company which declares foreign dividends to the foreign trust may no longer avail of the so-called participation exemption in relation to the foreign dividends, in applying section 7(8). Up to the extent of an arm’s length interest on the loan, the founder may thus be taxed on foreign dividends received by or that accrue to the foreign trust from the foreign company, after adjusting for the partial exemption for foreign dividends.
Paragraph 72 of the Eighth Schedule is the capital gains tax counterpart to section 7(8). It would therefore apply if, for example, the foreign trust were to realise what would have constituted a capital gain, had it been SA resident, on the disposal of its shares in the foreign company: the founder would, once again up to the extent of the quantum of an arm’s length interest on the loan, have to include what would have constituted the trust’s capital gain as his or her capital gain. Like with section 7(8), the participation exemption no longer applies in determining the trust’s capital gain in these circumstances.
The total amounts attributed to the founder in terms of section 7(8) and paragraph 72 may not exceed the benefit derived by the trust from the non-charging of interest on the loan i.e. what an arm’s length rate of interest would have been in the circumstances.
From a practical perspective, the reach of the terms ‘by reason or in consequence of’ and ‘attributable to’ is often unclear. Both are suggestive of the legal concept of proximate causation, which the approach followed in Widan’s case, albeit on the basis of an assumption in the taxpayer’s favour. If, in the above example, the foreign trust had provided the funding required by the foreign company by subscribing for shares in the latter, would all the income derived by the foreign company be ‘by reason or in consequence of’ the founder’s loan to the trust? It is submitted that this is not necessarily the case. Depending on the facts, the proximate cause of the income accruing to the company could partly be the founder’s loan and partly other factors – for example, decisions taken by the foreign company’s board. There would plainly be difficulties in apportioning income amongst the competing causes in these circumstances, which are not addressed in the legislation.
Section 31 deals with transfer pricing and could potentially also apply to the above loan arrangement. The loan satisfies the following three requirements of this provision:
- It is between ‘connected persons’ (the founder and the trust would be ‘connected persons’ in the above scenario);
- It is between a resident (the founder) and the non-resident (the trust); and
- Had the loan been provided to the trust by a lender on an arm’s length basis, interest would have been demanded by the lender and paid by the trust. The interest-free nature of the loan is thus a term that is different from that which would have applied in an arm’s length arrangement.
There is somewhat less clarity about the fourth requirement, which is that the non-charging of interest on the loan results or will result in a ‘tax benefit’ being derived by a person who is a party to the arrangement - in this scenario, the founder. This language implies that before section 31 applies, it must be ascertained whether, after the other provisions of the Act such as section 7(8) and paragraph 72 have been applied, the founder will still be in a more favourable income tax position compared to the situation in which he or she had charged arm’s length interest on the loan. One of the problems in performing this comparison is that each year it is not known what income or capital gains may be attributed to the founder in terms of section 7(8) and paragraph 72 in future years – hence the quantum of the overall tax benefit is impossible to quantify at a given date. A possible interpretation is that, due to the application of the deeming provisions section 7(8) and paragraph 72 which will in all likelihood result in an inclusion in the founder’s income, section 31 does not apply to the above loan at all. However, this interpretation is not favoured by SARS. It is worth noting that the definition of ‘tax benefit’ includes the avoidance, postponement or reduction of any liability for tax. Since the definition of ‘tax benefit’ includes the postponement of the founder’s liability for tax, even if these deeming provisions may apply to tax the founder in later years of assessment, he or she would still have enjoyed the benefit of a postponement of liability for tax by not charging a full arm’s length rate of interest for this year and hence, it is submitted, section 31 should apply as a form of ‘top up’. If, determined on an annual year of assessment basis, section 7(8) and paragraph 72 result in a lesser inclusion in the founder’s taxable income than would an arm’s length interest, the difference becomes a section 31 adjustment, which is known as a ‘primary adjustment’.
The effect of the application of section 31 is two-fold: there is the so-called ‘primary adjustment’, levied through section 31(2), in the form of the inclusion in the founder’s taxable income of the above top-up amount. Then there would also be a ‘secondary adjustment’, essentially to compensate the fiscus for loss of the additional accretions to the founder’s estate for purposes of wealth taxes – donations tax and its tax twin, estate duty – because an arm’s length interest did not accrue to the founder. The secondary adjustment is levied through section 31(3), in the form of a deemed donation for donations tax purposes, in the same quantum as that of the primary adjustment. Donations tax is often referred to as ‘estate duty payable in advance’ and it is levied at the same rates as applies to estate duty. Donations tax on the secondary adjustment would have to be declared and paid within seven months after the end of the relevant year of assessment. Both the primary and secondary adjustments would have to be accounted for on an annual basis.
Section 7C, in essence, deems low-interest or interest-free loans to trusts (or companies the shares of which are held by trusts) to be donations for donations tax purposes to the extent of a shortfall between the interest charged and the ‘official rate of interest’ and clearly overlaps with section 31(3) in these circumstances. It is worth pointing out that section 31(3) has an international flavour in that it requires at least one of the parties to the transaction or arrangement to be non-resident or have a permanent establishment outside SA, whereas section 7C is agnostic in this regard. The definition of ‘official rate of interest’ depends on whether the loan is denominated in rands or in a foreign currency. If the former, it is the SA repurchase rate plus 100 basis points and if the latter, the foreign currency equivalent of the SA repurchase rate plus 100 basis points.
So, if an arm’s length rate of interest was 10 percent over a year of assessment and the official rate 7 percent, the secondary adjustment in terms of section 31(3) would give rise to a deemed donation based on interest calculated the rate of 10 percent while section 7C would potentially also give rise to a deemed donation based on interest calculated at the rate of 7 percent. Section 7C(5) solves the overlap problem by excluding from the application of the provision, among other things, loans that were subject to section 31, ‘to the extent of an adjustment made in terms of section 31(2)’. This proportionate wording in section 7C(5) is new: it was added by the Taxation Laws Amendment Act of 2024, with effect for years of assessment commencing on or after 1 January 2025. For prior periods, the wording granted complete relief from section 7C if the loan had been subject to section 31 at all. To understand the reason for the amendment, it must be appreciated that it is possible for the official rate of interest to be higher than an arm’s length rate. For example, if the official rate of interest is 10 percent and an arm's length rate 7 percent, by granting complete relief from 7C where the loan had been subject to section 31 at all, the difference of 3 percent between the 10 percent official rate and the 7 percent arm’s length rate would have escaped taxation as a deemed donation. This no longer applies.
To avoid the various uncertainties and difficulties associated with these deeming provisions, taxpayers most often charge full market-related interest on their loans in these circumstances. This means that none of these deeming provisions will apply (except if the ‘official rate of interest’ is higher than an arm’s length rate and section 7C applies as discussed above). Although the interest income is subject to income tax in the founder’s hands and grows his or her estate from an Estate Duty perspective, by and large the same tax result is achieved by the deeming provisions. However, the actual charging of an arm’s length interest by the founder decreases the reserves of the trust, which means that there is less to distribute and tax when the accumulated reserves of the trust are vested in SA resident beneficiaries.