Financial planners and their clients have, as part of the estate planning process, been using interest free loans (or loans at very low interest rates) for a long time to accumulate assets in their family trusts thereby reducing estate duty and capital gains tax liabilities that would have been payable if the assets were kept in the name of the individual client.
This has resulted in South African Revenue Service implementing Section 7C of the Income Tax Act as an anti-avoidance provision. Section 7C of the Income Tax Act was designed to ensure that natural persons who make loans to trusts and companies controlled by individuals are not able to use these loans to artificially reduce their tax liability.
What is a trust and why would someone use it?
A trust is a legal arrangement where one person (known as the settlor) establishes an entity designed to hold assets by another person (known as the trustee) on behalf of and to the benefit of a third person (known as the beneficiary). Trusts can be used for a variety of purposes, such as estate and estate duty planning, asset protection as well as caring for persons that can not take care of themselves.
- An onshore trust is a trust that is established in the same country as the settlor.
- An offshore trust is established/controlled in a different country from the settlor.
Section 7C of the Income Tax Act is applicable to loans to both onshore and offshore trusts.
Using loans as funding for trusts and what are the implications.
Loans to trusts are a common way to fund these trusts. However, in South Africa, there are two main tax implications that need to be considered when making loans to trusts:
- Donor attribution rules: The donor attribution rules state that where a natural person makes a loan to a trust at an interest rate lower than the official rate of interest, that person is deemed to have made an ongoing donation to that trust to the amount of the difference between the official rate of interest and the rate charged by the natural person.
- Transfer pricing principles: The transfer pricing principles contained in section 31 of the Income Tax Act apply in the case of an individual who is a connected person in relation to the trust (such as a beneficiary of such trust or a relative of such beneficiary) making a loan to the trust at an interest rate less than the official rate of interest.
The official rate of interest is determined in terms of the 7th Schedule of the Income Tax Act. This can be defined as the South African repurchase rate (rate at which the central bank advances loans to commercial banks) plus 100 basis points.
Why would you use interest free loans to trusts? A section 7C example:
The Jones family loves spending their holidays in Hermanus and has decided to purchase a vacation property there with a purchase price of R3 million. As part of their estate planning and since they want to ensure that the property remains available for their descendants, they decide that the property should be registered in the name of the family trust that Mr. Jones established a number of years ago.
Before the introduction of the Section 7C measures a normal practise to enable the trust to acquire the property would be that Mr. and Mrs. Jones makes an interest free loan of R3 million to the trust. They will annually donate R100 000 each to the trust (more than R100 000 will result in donations tax payable), which the trust will immediately use to repay the loan. It would therefore have taken 15 years for the loan to be fully repaid and their plan to have this growth asset fully under the control of their family trust completed. This type of an arrangement was used by many people to move or acquire growth assets in the name of their family trusts, thereby addressing possible estate duty and capital gains tax problems as well as to ensure that certain assets are retained for the benefit of their descendants.
Section 7C will have the following effect on the above example (assuming an official rate of interest of 8%). In the first year the interest component that should have been charged at the official rate will be calculated as follows:
R3 million at 8% = R240 000.
SARS will calculate that Mr. Jones made a deemed donation to the trust of R240 000 (interest that would have been charged if it was an arm’s length transaction).
Total donations made by Mr. Jones: R100 000 (donation to trust) + R240 000 (deemed donation) = R340 000.
Donations tax of R48 000 will be payable by Mr. Jones, calculated as follows:
Total donations – R100 000 (exempt amount) = R240 000.
Donations tax at 20% on R240 000 = R48 000.
It is important to note that Section 7C is also applicable to loans that were in existence before the introduction of the Section 7C anti-avoidance measurements.
Is Section 7C of the Income Tax Act only applicable to individuals?
Section 7C is not only applicable to individuals but is also applicable to companies that have made loans available at the instance of a natural person and that natural person holds more than 20% equity (or more than 20% voting rights) in that company.
Are there any exceptions to Section 7C of the Income Tax Act?
There are a number of exceptions to section 7C that do not deem loans made by natural persons to trusts as donations. These exceptions include:
- Loans advanced by banks or financial institutions.
- Loans made to trusts that are used for charitable purposes.
- Loans made to trusts that are used to acquire a primary residence for the lender or their spouse.
- Loans that are made on an arm’s length basis, as defined in section 31 of the Income Tax Act.
- Loans that are made to trusts that are not connected persons to the lender.
If a loan falls under one of these exceptions, it will not be deemed as a donation and will not be subject to donations tax.
Should you have any questions regarding your tax affairs, you are welcome to contact FinGlobal. Our dedicated tax team is available to assist with any tax emigration queries you may have.