The draft legislation about which we have written in previous newsletters has been enacted and came into effect on 1 March 2017 as Section 7C of the Income Tax Act.
In terms of this section any loan, advance or credit provided to a trust by a beneficiary or “connected party” will be deemed to have earned 8% interest per annum. If this interest is not paid by the trust, or if interest at a rate lower than 8% is paid, then the difference between the interest paid, if any, and 8% will be deemed to be a donation by the lender to the trust. Donations tax at 20% will be due by the lender on this amount, with the proviso that the first R 100,000 of a donation in any year is exempt from donations tax. This effectively means that any loan not exceeding R 1,250,000 (as 8% of R 1,250,000 equals R 100,000) will not be affected by the new legislation unless the lender has made other donations subject to donations tax in the same year.
This is best illustrated by an example:
Assume a trust owes a beneficiary R 2 million; the deemed interest is R 160,000 (8% of R 2 million) if no interest is charged; the first R 100,000 is free of donations tax so in this example R 60,000 (R 160,000 less R 100,000) of the donation will be taxed at 20% resulting in a donations tax liability of R 12,000. This is payable within a month of the end of the tax year.
Certain loans to trusts are not affected by the new Section 7C. These include loans to special trusts created for disabled persons, loans used by a trust to acquire a property used by the lender or his spouse as his or her primary residence, and loans to Public Benefit Organisations.
How can you avoid or mitigate the effect of Section 7C? One possibility is for the trust to repay the loan, or to reduce the loan to R 1,250,000. The trust’s ability to do this will depend on its liquidity and/or its ability to liquidate assets. This in turn may create a liability for Capital Gains Tax.
Another possibility is for the lender to charge interest on the loan. Such interest will be taxable in the hands of the lender, but his tax obligation may be reduced by using the annual interest exemption which is R 23,800 for taxpayers below 65 and R 34,500 for taxpayers 65 and over.
In extreme cases, the termination of the trust may be considered. Such termination is likely to trigger taxes in the form of transfer duty, marketable securities tax and capital gains tax as well as transactional costs.
Careful consideration will have to be given to the long term benefits of savings on estate duty compared with the enlarged tax obligations flowing from the new Section 7C. In the recent budget document mention is made that other proposals made by the Davis Committee will be considered when preparing the 2018 Budget. The Davis Committee has recommended that all income and capital gains earned by a trust should be taxed in the trust – in other words, the option which currently exists to make distributions to beneficiaries and have these taxed in the hands of the beneficiaries will not be allowed. This is likely to have a major impact on trusts if implemented.
Those clients who feel that Section 7C will have an impact on their tax situation are welcome to contact us to discuss their situation.
