The 2016 Budget Speech contained a proposal to introduce new tax laws targeted at the prevention of estate duty and donations tax avoidance by making use of interest free loans to a trust. National Treasury recently released the Draft Taxation Laws Amendment Bill that contains the measures intended to give effect to the proposal.
A common practice used in conjunction with a family trust is the sale of growth assets by an individual to the trust, with the purchase price remaining outstanding on interest free loan account. The concern is that such a practice results in the avoidance of estate duty and donations tax.
This is achieved by the sale of the assets at market value, therefore not triggering donations tax. As the loan does not bear interest, there is no growth of the loan asset for estate duty purposes. In addition the individual can make an annual donation to the trust which is used to repay part of the loan to the trust. No donations tax arises if the donation to the trust is under the R100 000 annual donations tax exemption.
Section 7C has been proposed for introduction into the Income Tax Act. The section is summarised as follows:
- It will apply in respect of any loan granted on low interest rate or interest free terms to a trust. The loan may be made either directly or indirectly by a natural person, or by a company that is a connected person in relation to that person.
- If the loan does not bear interest, an amount of deemed interest will be included in the hands of the natural person mentioned above, based on the SARS official rate of interest (currently 8% per annum).
- If the loan is interest bearing, but at a rate that is lower than the official rate as prescribed by SARS, then the difference between the interest charged and interest determined at the official rate will be included in the income of the natural person mentioned above.
- If a natural person is subject to income tax as a result of deemed interest that is included in income, they may recover that amount from the trust.
- If the person does not recover from the trust within a period of three years, the amount of tax incurred as a result of the inclusion in their income, then it will be treated as a donation made by that person.
- The annual exclusion from donations tax applicable to a natural person, namely against the first R100 000 of donations made, will not apply in respect of a loan contemplated under this section of the Act.
- These rules are set to come into operation on 1 March 2017, applying to years of assessment commencing on or after that date.
What does this mean?
The introduction of this new section into the Income Tax Act in its current proposed format will most likely have negative tax consequences. It is common practice for individuals to fund a family trust by way of an interest free loan.
This will now result in a deemed amount being included in the income of the lender, equivalent to a calculated interest charge linked to the SARS official rate. In addition, even though the amount being included in the income of the person is calculated with reference to the official rate, it is not actual “interest”, and therefore there is no relief in the form of the annual interest exemption, currently R23 800 for natural persons under the age of 65.
An individual that falls foul of this new section may think that if they are required to incur income tax on the deemed interest income they will reduce their personal estate. Not so – this is why the new section gives the individual the right to recover the tax from the trust, and to the extent that the individual does not recover the tax from the trust, it will be treated as a donation. That will mean that the individual would also be exposed to the donations tax at the rate of 20% on the donation.
In certain instances it may be favourable to charge interest on the loan at the SARS prescribed rate. In that event, the individual earns interest income and as a result can make use of the interest exemption. From the perspective of the trust, each case would need to be assessed to determine whether the interest expense incurred can be deducted against other taxable income of the trust.
The trustees also need to assess the ability to repay the loan creditor so as to avoid exposure to donations tax. The proposed section will have far reaching implications and careful consideration must be given to each specific scenario before making any bold decisions.
Please note that at present these are only draft proposals. If you have any concerns regarding the potential impact to you or a family trust please contact us for further discussion and advice.
Tax and Trust Director, Johannesburg