The use of interest-free loans to a trust
Currently, the sale of assets to a trust which is financed by way of an interest-free loan does not trigger any adverse tax consequences for the seller or the trust. According to the Explanatory Memorandum, the benefit of this is that a seller who is a natural person can extinguish the loan by making use of the annual R100,000 exemption from donations tax, in terms of s56(2)(b) of the Act (persons other than natural persons enjoy an annual exemption of R10,000 in terms of s56(2)(a)). The financing of the asset in this manner is also beneficial from an estate duty perspective as the seller’s asset base is reduced tax-free through the use of the annual exemption from donations tax. As no interest is payable in terms of the loan, the tax base is further reduced.
The impact of the proposed s7C on the tax treatment of interest-free loans to a trust
In response to the reduction of the tax base created by such arrangements, the Draft TLAB proposes to insert s7C into the Act.
Firstly, s7C(1) states that the section will only apply to natural persons where that person and a trust are connected persons and apply to companies who are connected persons in relation to such natural persons or to the trust. Secondly, for s7C to apply such a natural person or company or connected persons in relation to them must directly or indirectly provide a loan, credit or advance to the trust.
To address the avoidance of interest accruing to the seller or lender, s7C(3) states that if no interest accrues to the seller or lender or it accrues at a rate lower than the official rate of interest, as contemplated in the Seventh Schedule to the Act, the difference between the amounts will be included in the taxpayer’s income. In addition, s7C(4) states that the seller may recover this amount from the trust and if it is not recovered by the seller or lender within three years from the end of the year of assessment in which the loan is extended, it will attract donations tax.
Furthermore, s7C aims to prohibit a natural person from applying the interest exemption in s10(1)(i) of the Act to such interest, in terms of the Explanatory Memorandum. According to the Explanatory Memorandum, the trust will only be allowed to deduct the interest paid if the payment of such interest complies with the general deduction formula in s11. This appears to be the intention of s7C(2), which states that no deduction, loss or allowance may be claimed in respect of a disposal, including by way of reduction or waiver, or in respect of the failure of a claim for the payment of any amount owing in respect of a loan, advance or credit.
To address the avoidance that occurs whereby the annual exemption of R100,000 for donations tax available to natural persons is used by the seller to settle the outstanding loan, s7C(5) states that s56(2) of the Act, which contains the exemption provision, does not apply to any amount owed on loan account that is disposed of under a donation.
Analysis and comment
Paragraph 1 of the Seventh Schedule to the Act defines the official rate of interest as a rate of interest equal to the South African repurchase rate (repo rate) plus 100 basis points, where a debt is denominated in rand. Based on the current repo rate of 7%, it means that the official rate of interest is currently 8% where a debt is denominated in rand. For purposes of s7C(3), the effect of this provision is that if a natural person and a trust are connected persons and the trust owes R200,000 to the person on loan and no interest is payable in terms of the loan, an amount of R16,000 (R200,000 x 8%) will be included in the income of that person.
Furthermore, s7C has the potential of taxing the seller or lender twice, by not only including the amount in the income of the lender or seller if the loan is made at a rate below the official rate of interest, but by also causing that person to incur a donations tax liability should this amount not be recovered by the seller within three years after the year of assessment in which it accrued to him or her. In terms of the example used in the previous paragraph, an additional R3,200 (R16,000 x 20%) would be payable by the natural person.
Interestingly, s7C will not outright prohibit a natural person from applying the annual donations tax exemption to a donation to the trust. Section 7C(5) states that s56(2) of the Act does not apply “in respect of any amount owing in respect of a loan, advance or credit contemplated in subsection (1) that is disposed of under a donation”. This means that if a natural person donates an asset worth less than R100,000 to a trust in relation to which he or she is a connected person, s7C will not apply and no interest will be deemed to have accrued to that person in terms of s7C(3).
If it is enacted in its current form, s7C could very well deter persons from using the trust as a vehicle for tax avoidance in future. Taxpayers should keep in mind, however, that s7C will not affect the established principles applying to trust law such as the conduit-pipe principle. In a nutshell, the conduit-pipe principle states that any income that accrues to or is received by a trust on behalf of its beneficiaries will not be taxed in the hands of the trust, but only in the hands of the beneficiaries, provided that it vests in the beneficiaries in the year of assessment in which it accrued to the trust. For example, if a trust beneficiary sells property to that trust, s7C will apply to that sale if the property is sold on loan account. However, any income received from the rental of that property to a third party, will not be taxed in the hands of the trust, but in the hands of the beneficiary, provided that the income vests in a trust beneficiary in the year of assessment in which the amount accrues to the trust.
The Draft TLAB states that s7C will come into effect on 1 March 2017, but it is not clear whether it will also apply to interest-free loans that were made before this date, if enacted in its current form.