The concept of granting a loan to a trust was commonly used in the past as an effective estate planning strategy. The general approach was that growth assets or funds were transferred into a trust, at their market value, with a resultant loan owing to the individual.
By transferring assets at their market value, this avoided exposure to any immediate donations tax. In addition, the growth on the underlying assets accrued in the trust and not in the hands of the individual, hence the estate planning benefit. In most instances, these loans would not carry any interest, thus avoiding any further accrual of income for the individual that granted the loan.
It was just these avoidance aspects that SARS sought to shut down when it introduced Section 7C into the Income Tax Act, with effect from 1 March 2017.
History of Section 7C
When the new laws were initially proposed in the 2016 Budget Speech, they attracted significant feedback. In the initial proposal, the intention was to deem interest income in the hands of a person that granted the interest free or low interest loan to a trust. It was then also intended that the individual should recover from the trust, the tax resulting from the deemed interest, failure of which would result in a dividend.
Prior to the effective date of introduction, the proposals were subject to significant revision. The main change related to the scrapping of the deemed interest approach, and rather deeming the amount of interest foregone as a deemed donation. As a result, where the interest earned on a qualifying loan was zero or less than the official interest rate, then that benefit is deemed to be a donation, subject to the donations tax rules.
At that time, the transactions that were subject to the deemed donation anti avoidance provisions were a loan, advance or credit, provided by a natural person, directly or indirectly to a trust, where that person is a connected person in relation to the trust. The provisions also extended to a loan, advance or credit, provided by a company to the trust, at the instance of a natural person, where that person held at least 20% of the shares or voting rights in the company, and is a connected person in relation to the trust.
There are certain exemptions that apply to the rules. These include, amongst others, loans granted in return for a vested interest in the income and assets of the trust. Also exempted are loans to a trust established for the benefit of a person with a disability, or a loan to a trust where the funds were used to acquire a fixed property that was throughout the year of assessment used as the primary residence of that person or their spouse.
Closing the loopholes
A shortfall or potential loophole that existed in the 7C provisions in their first form related to the scenario whereby a trust owned the shares in a company. If the individual connected person to the trust granted the loan directly to that company owned by the trust, as opposed to granting the loan to the trust, it did not fall within the scope of the 7C provisions.
The legislators quickly noticed this trend being adopted to bypass the 7C exposure, and revised the section with effect from 19 July 2017. The result of the changes was to include into the scope of 7C any loan, advance or credit made by a natural person, if that amount was provided to a company of which at least 20% of the equity or voting rights were held by a trust and that person is a connected person in relation to the trust.
This broadening of the scope of the 7C provisions limited opportunities to plan or structure affairs to mitigate exposure to the deemed donation provisions.
One of the alternatives, and perhaps the intention of the anti-avoidance provisions, is for the qualifying loan to be interest bearing, at the official rate of interest, so as not to be exposed to an ongoing annual deemed donation. However, the imposition of interest on the loan does need to be carefully considered, for the following reasons:
- The interest expense may not be deductible for tax purposes in the hands of the borrower, dependent on the application of funds and nature of activities of the borrower;
- The interest earned by the lender will be taxable at their marginal rate, and if not paid will increase the value of the loan asset in that person’s estate.
The challenge with the introduction of anti-avoidance provisions are that certain parties will continue to seek out alternate methods of structuring affairs to circumvent the anti-avoidance rules. This scenario has led to the latest proposed revision to 7C.
Preference share structures
The latest structure identified by the authorities, which is being used to circumvent the anti-avoidance provisions of 7C, relates to preference shares. This involves a natural person subscribing for preference shares, with no return or a low rate of return, in a company that is owned by a trust that is a connected person in relation to the natural person.
In order to curb this avoidance structure, amendments have been proposed to 7C in the 2020 Draft Taxation Laws Amendment Bill. The proposed amendment firstly includes a deeming provision whereby the subscription price of the preference share issued will be deemed to be a loan advanced and dividends accruing in respect of those preference shares are deemed to be interest in respect of the deemed loan.
In the Draft Response document, a concern was raised around the proposed definition of a preference share and in response Treasury have proposed to adopt the same definition of a preference share that is used in Section 8EA of the Income Tax Act. Section 8EA defines a preference share as any share other than an equity share or in the case of an equity share, where the dividends relating to such equity shares are based on or determined with reference to a specified rate of interest or the time value of money.
The draft amendments have also been refined to deem as interest, both dividends and foreign dividends, accrued in respect of the preference share. The term accrued as opposed to declared in respect of the dividends has been used to align with the principle of interest incurred.
The proposed effective date for the implementation of these amendments is 1 January 2021, and will apply in respect of any dividend or foreign dividend accruing during any year of assessment commencing on or after that date.
What to do?
It is clear that ongoing steps are being taken to extend the anti-avoidance provisions to limit any structures aimed at reducing the exposure to donations tax or estate duty by transferring wealth into a trust structure. Taxpayers need to be continually aware of these amendments to appreciate and understand any exposure to potential ongoing deemed donations where qualifying loans exist.
Any taxpayer with a trust structure should consult a Tax Practitioner to understand the potential 7C exposure, quantify the exposure and decide how best to manage this. That may include consideration of making the loans interest bearing at the official rate, or to assess the ability and impact of a repayment.
Director | Tax and Trusts, RSM South Africa
** Article originally published in Tax Talk