SummaryThis article deals with the structuring and tax consequences of low interest and interest free loans to South African trusts.
Trusts have consistently proved to be a reliable and attractive vehicle for many family office structures, offering flexibility and benefits with regard to investments, estate planning, protection of assets and tax planning.
Trusts originate from England, where they were used by crusading English knights when they left their homes in the care of trusted friends for safekeeping. This financial innovation remains a vital component of multi-generational family wealth planning, and it is also very useful in corporate structures, such as broad-based community trusts, bankruptcy remote securitisation structures, etc.
The Davis Tax Committee was established in 2013, and one of the committee’s objectives was to look at ways to tax wealth more effectively in order to promote inclusive growth. The result was the introduction of section 7C in the Income Tax Act from the 2018 income tax year. This section comes into effect when a person makes an interest-free or low interest loan to a connected trust and was introduced to prevent taxpayers from reducing the growth of their dutiable estate and eventual estate duty charge by selling growth assets to trusts on interest-free loan accounts.
The tax consequence for the person making the loan to a connected trust is a deemed donation on the last day of the tax year equal to the difference between the interest charged on the loan at the official interest rate and interest actually charged. The official rate is equal to the Reserve Bank repo rate and a margin of one percent. Fortunately, the first R100,000 donated by a natural person each year is exempt from donation tax. The person making the loan must manually submit an IT144 donations tax declaration form together with proof of payment at a SARS branch. There are no tax or accounting consequences for the connected trust receiving the loan.
By way of an example, if a person makes a three-million-rand interest-free loan to a trust, that person is deemed to have made an annual donation equal to R35,000 (assuming a repo rate of 3.5%) on which donation tax of R7,000 is payable every single year.
An alternative strategy for a person making an interest-free or low interest loan to a connected trust is to charge interest at the official interest rate. The person making the loan will be taxed on the interest income (less any annual interest exclusion) at his or her marginal rate, which could be higher or lower than the 20% donation tax rate. The trust will recognise an interest expense, but the income tax deductibility thereof will be dependent on the trust generating income from carrying on its trade. The accrued interest will result in an annual increase in the loan balance that will increase the value of the lender’s estate and his or her eventual estate duty charge.
Another alternative is to donate the loan to the trust. This donation will trigger an immediate donation tax for the person making the donation, and the trust will eventually be subject to the income tax consequences that come from receiving a debt benefit. Deeming provisions in the Income Tax Act will deem any income generated by the trust as a consequence of that donation to accrue to the person who made the donation.
Although the introduction of section 7C of the Income Tax Act complicates the use of trusts in family office structures, their unique characteristics will ensure that they remain relevant for most families dealing with the challenge of managing multi-generational wealth. Careful structuring and administration can ensure that the tax consequences of loans to trust structures are minimised.