In our last newsletter we cautioned that the Minister of Finance in his budget speech had raised the possibility of legislation which would, in one way or another, make interest free loans to trusts taxable.

The draft Taxation Law Amendment Bill, which was recently made available to the public for comment, contains the proposed incorporation of a new Section 7C headed “Loan or Credit Advance to a Trust by a Connected Person”.  It is proposed that the new Section 7C will come into operation from 1 March 2017.

Before discussing the probable impact of the proposed Section 7C on estate planning and trusts, it is important to understand how interest free loans to a trust are currently used.  It is common practice to sell an asset to a trust, the purchase price being “settled” by an interest free loan in favour of the seller.  The acquired asset appreciates in value over time, whereas the loan value on the other hand does not increase in value.  When the seller dies, the asset in his estate is the loan which may now have a value far lower than the value of the asset held by the trust.  Effectively, therefore, the growth in value of the asset escapes the estate duty net.

The loan value can also be reduced by making annual donations to the trust equivalent to the maximum amount allowed so as to avoid payment of donations tax (currently R 100,000 per person).

Section 7C will apply when a person who is a “connected person” to a trust makes a loan to a trust which is either interest free or interest is charged at a rate less than the “official rate”.  By way of explanation:

  • a person is connected to a trust if he or any relative is a beneficiary of the trust;
  • the official rate is 1% above the repo rate and therefore currently 8%.

The consequences flowing from the above situation are the following:

  • interest will be deemed to be charged at the official rate;
  • the interest due will be imputed to the lender.  In other words, it will be added to the lender’s taxable income;
  • the interest free exemption detailed in Section 10(1)(i) of the Act will not be deductible against such deemed interest (this is currently R 23,800 for taxpayers under the age of 65 and R 34,500 for those over 65);
  • if the lender fails to reclaim the additional tax payable from the trust within three years, the amount will be treated as a donation to the trust;
  • the lender will not be able to “donate” R 100,000 of the loan by using the annual exempt donation amount.

Should the proposed Section 7C come into operation, it will without question have a significant impact.  It is certain that few new trusts will be registered.  What about trusts already in existence with interest free loan accounts?  The possibility of actual repayment of the loan must certainly be considered, but in many cases this will require the sale of an asset or assets because the trust is unlikely to have the liquidity readily available.  This in turn is likely to attract capital gains tax.  Furthermore, if the trust only has one asset the whole purpose of the trust will be negated.

The renegotiation of the loan to provide for interest to be paid can also be considered but the issue here is whether the trust has the necessary income required to pay the interest.  It is also likely to increase the income tax liability of the lender.

The dissolution of the trust would be another possibility.  In considering this option, trustees will have to consider the rights of existing and future beneficiaries of the trust and the object of the trust when formed.  In addition, capital gains tax and transaction costs will have to be considered.  In coming to any decision, trustees and planners will have to weigh up the long term benefits of savings in estate duty against the increased tax obligations of the planner who has used an interest free loan to capitalise the trust.

As soon as we have more certainty regarding the implementation of the new legislation, we will communicate with those clients likely to be impacted.