Should you be charging interest on loans made to a trust?
06 Jun 2017
When will s7C apply?
Clients who have made, as well as those who are considering making, interest-free or low-interest loans to trusts must take note of a recent inclusion to the Income Tax Act (“the Act”). This inclusion comes in the form of Section 7C, which was inserted in the latest Taxation Laws Amendment Act No. 16 of 2016 and is operative from 1 March 2017. Most notably, it not only applies to loans, advances or credit applicable from this date, but also targets existing agreements.
Section 7C will apply from 1 March 2017 to any loan, advance, or credit provided to a trust directly or indirectly by a natural person or a company in relation to which that person is a connected person holding an aggregate interest of at least a 20%.
Effect of s7C
Two types of transactions are specifically targeted by s7C:
- Interest-free or low-interest loans, credit or advances; and
- deductions, losses or capital losses claimed in respect of disposals (including reductions or waivers) or the failure to claim payment (in whole or in part).
In respect of interest-free or low-interest loans, the interest concession being the difference between the actual rate of interest levied on the loan and the official rate of interest (currently 8% p.a.) will be deemed to be a donation in hands of the lender and subject to donations tax of 20%. The interest foregone in respect of low- or no-interest loans, will be treated as an ongoing annual donation made to the trust on the last day of the year of assessment of the trust.
With regard to disposals or the failure to claim payment in respect of loans, credit or advances where interest is levied at a rate of less than the official rate of interest, no revenue or capital loss associated with that loan, advance or interest may be claimed by the lender.
Instances of indirect loans, advances or credit subject to s7C
Section 7C will apply to amounts vested by a trust in a trust beneficiary which is not distributed to the beneficiary provided that the non-distribution resulted from:
- an election exercised by the beneficiary; or
- a request by that beneficiary that the amount not be distributed.
In instances where distributions are however withheld solely at the discretion of the trustees, such amounts will not fall within the application of s7C. This would, for example, be the position where an amount is vested irrevocably by a trustee in a trust beneficiary and is used or administered for the benefit of the beneficiary without a distribution or payment to the beneficiary, provided that the trust deed specifies that:
- the amount not be distributed to the beneficiary, e.g. before the beneficiary reaches a specific age; or
- the trustee has the sole discretion as regards the timing and extent of any distribution to that beneficiary of such vested amount.
What is the official Rate of Interest?
The legislator uses the “official rate of interest” defined in paragraph 1 of the Seventh Schedule to the Act, which links it to the repurchase rate (repo rate) whilst adding 100 basis points thereto. The repo rate has been 7% since 18 March 2016, making the current official rate of interest 8% per annum.
When will Section 7 not apply?
The most notable exclusion to the application of s7C in respect of traditional trusts is that it will not apply to loans, credits or advances which are wholly or partly applied for purposes of funding the acquisition of a residence that is used throughout that year of assessment by the lender or their spouse as a primary residence, as defined by the Eight Schedule to the Act.
Contrary to the provisions contained in the draft Bill released earlier in 2016, the annual donation allowance of R100,000 may be applied towards the deemed donation imposed as a sanction by the insertion of s7C.
Other exclusions are also available in respect of:
- special trusts created solely for the benefit of minors with disability;
- loans made by a trust beneficiary of a vesting trust provided that certain qualifying provisions are met (rationale being that the vested interest of the beneficiary in the assets and receipts or accruals of such trust will form part of that beneficiary’s estate – which is the aim of the provisions of s7C).
- trusts that are approved public benefit organisations or qualifying small business funding entity;
- affected transactions dealt with by section 31 of the Act (transfer pricing);
- qualifying sharia compliant financing arrangements;
- loans subject to the provisions of section 64E of the Act (to value extracting provisions).
Should I be charging interest on a loan, advance or credit to a Trust?
By way of a simple example, the tax liability following from a loan, advance or credit subject to s7C could be illustrated as follows:
a Loan in the amount of R10 million is advanced by an individual to a trust at no interest, with the individual choosing to apply his annual donation exemption to this deemed donation.
The deemed donation will be R800,000 (R10 million x 8%).
The donations tax liability will be R140,000 (R700,000 x 20% (R800k– R100k (donation exclusion)).
a Loan in the amount of R10 million is advanced by an individual to a trust with interest levied at a rate of 5% p.a. where the individual has either chosen not to utilise, or has already depleted their donation exclusion.
The deemed donation will be R300,000 (R10 million less x 3% (difference between interest levied and the official rate)).
The donations tax liability will be R60,000 (R300,000 x 20%).
The important consideration illustrated by the above examples, is that, from a commercial perspective, one must consider the implications of the sanctions imposed by s7C versus the consequences of charging interest at the official rate.
In the first example, the trust will have additional funds in the amount of R800,000 available (which would otherwise have been paid out as interest) whilst the lender will suffer tax liability of R140,000. A consideration not taken into account in the above example is the income tax liability which would be levied on the R800,000 interest income received by the lender, which if taxed at the 41% bracket, would result in a tax liability of R318,242 (R800,000 – R23,800 (annual interest exemption) x 41%).
We suggest that clients obtain specific advice when considering amending existing trust deeds or affecting amendments to existing loan agreements between qualifying persons and trusts.