The South African National Treasury (“Treasury”) is moving forwards with their promises to tighten up the income tax laws which are applicable to trusts. In July 2016, Treasury released the Draft Taxation Laws Amendment Bill (“Draft TLAB”) which introduced a new section 7C into the Income Tax Act, 1962 which applies directly to trusts which are used as investment vehicles.
Trusts are often used as an investment vehicle to hold immovable property. There are a number of benefits to this, including, removing the property from your estate beyond the reach of creditors and reducing your estate’s value so as to eventually limit the estate duty payable on your estate.
Typically a person would loan money to a family trust which would enable the trust to acquire the asset in question from the lender. The loan would be an interest-free loan or a low-interest loan repayable on demand. The loan would be extinguished over a number of years by the lender making use of his annual donations tax exemption of R 100 000 to reduce the trust’s loan. The growth of the asset would occur outside of the lender’s estate, and if the loan was interest-free then the lender would further reduce the value of his estate.
The Draft TLAB aims to put a stop to this practice, and as anticipated, it has attracted much public comment.
It should be noted that the proposed amendments only applies to loans made to a trust by an individual who is a beneficiary of that trust or whose relative is a beneficiary of the trust, and to loans made to a trust by a company in which that individual holds more than 20% of the equity shares or voting rights in the company.
The initial Draft TLAB sought to add a “deemed interest” charge on to any interest-free loan which would be determined with reference to the official rate of interest (currently 8% per annum i.e. REPO plus 1%), and in respect of a low-interest loan, a “notional deemed interest” charge calculated as the difference between this deemed interest rate and the actual interest rate of the low-interest loan. This deemed interest would then be taxed in the hands of the lender at a potential maximum marginal rate of 41%.
Treasury has since conceded on a number of points and has released a second Draft TLAB (“Second Batch”) which seeks to satisfy many of the concerns raised previously.
In the context of trusts, a significant amendment in the Second Batch relates to the “deemed interest” amount and its taxation. In the first Draft TLAB the notional interest amount was to be taxed as income in the lender’s hands (potential maximum marginal rate of 41%) however in the Second Batch the notional interest is treated as a donation and is subject to 20% donations tax.
As the Second Batch currently reads, taxpayers with an interest-free or low-interest loan to a trust of equal to, or less than, R 1 250 000 will not pay any additional tax since the annual deemed donation will be equal to, or less than, R 100 000 (R1 250 000 x 8%). Therefore, the annual donation tax exemption of section 56(2)(b) will result in the taxpayer paying no donations tax. However since the taxpayer is now utilising the annual donation tax exemption in respect of the interest, the taxpayer is no longer able to extinguish the capital amount of the loan by “writing off” R 100 000 of the capital each year.
However, in the situation where a taxpayer has an interest free loan of more than R 1 250 000 (let’s take for example a loan of R 10 000 000 to a trust) the donations tax charge payable by the taxpayer would amount to R 140 000 per annum! This is calculated as follows: first, you calculate the interest component (R 10 000 000 x 8% = R 800 000 per annum); second, you subtract the annual donation tax exemption of R 100 000 from the interest, leaving you with deemed interest of R 700 000; and finally you calculate the donations tax payable on the deemed interest (R 700 000 x 20% = R 140 000).
Treasury has advised that the proposed new measures are intended to apply to all loans, including those in existences before 1 March 2017 when the measures will be introduced, notwithstanding numerous objections that it would be “grossly unfair” if these changes apply to existing loans as this means that the proposed legislation will have a slight retrospective effect in that it will apply to existing loans.
SARS has not accepted this criticism and has made it clear that the proposals will apply to all existing loans which meet the requirements of the new provision, as well as to any subsequent loans. The levying of donations tax on loans will however only apply to years of assessment starting on or after March 2017, and accordingly SARS argues that the amended is not retrospective as it does not seek to change the tax liabilities for previous years of assessment.
The result is that taxpayers who previously made a donation to a trust (e.g. in 1984) will be liable for donations tax (from 2017 and onwards) under these new measures if the loan is still outstanding.
Public comments to the Second Batch closed on 10 October 2016. As with the Draft TLAB, it is wise not to react prematurely to the Second Batch as it too is open to change. With that said, it is likely that SARS’s concessions will be well received in the industry and that the final Bill should not deviate much from the Second Batch.