New proposals for taxation of loans to trusts
A person may fund a trust in different ways. Each way brings about different tax consequences for that person.
- First, a person may donate assets to a trust, and in doing so becomes liable for donations tax that is taxable at 20% of the market value of the asset donated (section 54 read with section 64 of the Income Tax Act, no 58 of 1962 (the ITA)).
- Second, a person may sell the assets to a trust at market value. In this instance the seller will be liable for capital gains tax, in terms of paragraph 3(a) of the Eighth Schedule to the ITA.
- Third, a person may sell the assets to a trust on loan account at a market-related interest rate. In this instance the seller will be taxed on the interest income received from the trust, in terms of section 24J(2) of the ITA.
- Fourth, a person may sell the assets to a trust on loan account at an interest rate that is not market-related. As there is no gratuitous disposal, there will not be a donations tax liability for the seller. The seller may also reduce the loan capital by annually donating an amount of ZAR100 000 to the trust. The ZAR100 000 is exempt from donations tax in terms of section 56(2)(b) of the ITA. All this has the effect of avoiding estate duty, which is the key concern of National Treasury (Treasury) and the South African Revenue Service (SARS).
The tax review is being conducted by Judge Dennis Davis and a committee, including Treasury and SARS officials. The committee is known as The Davis Tax Committee (the Committee).
It was identified in the Committee's interim report on estate duty that restrictive measures should be applied to interest free loans to trusts, thus making it a less viable option for those intending avoiding estate duty.
Similarly, it was stated in the 2016 Budget that it "proposes to ensure that the assets transferred through a loan to a trust are included in the estate of the founder at death" and that it intends to "categorise interest-free loans to trusts as donations".
However the Committee had also acknowledged 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 proposed section 7C of the ITA applies to any person (lender) who provides a loan to a trust, to which they are a "connected person", at an interest rate that is not at arm's length or not market-related. It also applies to a company (lender) that is a connected person, directly or indirectly, in relation to the trust. By way of example, the section will apply if the company providing the loan to the trust is a "connected person" to a natural person and that natural person is a "connected person" to the trust.
The lender must include in its income, the difference between the amount of interest that should have been charged, if the official rate of interest as determined in terms of the Seventh Schedule to the ITA were utilised, and the amount of interest that was actually charged on the loan.
In light of the abovementioned scenarios, there may be far-reaching unintended implications for Black Economic Empowerment trusts, Employee Share Incentive Scheme trusts, charitable trusts, and trusts established for the benefit of minors and the maintenance of children.
It would seem that this section applies equally to both local trusts and foreign trusts. The attribution rules in terms of section 7(8) of the ITA as well as paragraphs 72 and 73 of the Eighth Schedule to the ITA adequately tackle the treatment of foreign trust dispositions.
Section 7(8) of the ITA provides that in the instance of a South African tax resident's "donation, settlement or other disposition" to a non-resident trust, any taxable income accruing to that trust, as a result of the "disposition" made by the resident, "as is attributable to that donation" will be included in the income of the resident that made that "disposition".
Similarly, in terms of the transfer pricing rules in section 31 of the ITA, if the actual terms and conditions of an "affected transaction" involving loans and other debt are not those that would have been agreed if the lender and borrower had been transacting at arm’s length, and if this difference results in a tax benefit to any of the parties, then that taxpayer is required to calculate its taxable income based on the arm’s length terms and conditions that should have applied to the "affected transaction". Therefore the interest rate must be arm’s length and the interest relating to the excessive portion of the debt will be disallowed as a deduction.
The term "affected transaction" is defined in section 31(1) and includes any transaction "entered into or effected between…a person that is a resident and any other person that is not a resident…and those persons are connected persons in relation to one another".
It is as yet unclear how this section will be applied in connection with the existing attribution rules and transfer pricing rules. It may lead to double taxation as adjustments are applied under more than one of the three rules affecting these types of transactions. In this regard it would seem that section 7C is at odds with the recommendation made by the Committee.