Attacks on low- or no-interest loans to trusts continue to be refined

Rob Hare, Senior Associate, Tax Team at Bowmans.

Low-interest or no-interest loans to trusts are again in the sights of SARS and the Treasury.

The 2017 Draft Taxation Laws Amendment Bill (Draft TLAB) was released on 19 July 2017, clarifying the lines of SARS’ and Treasury’s continued attacks on the use of trusts for tax planning.

The Draft TLAB proposes changes that are intended to tighten up the application of section 7C of the Income Tax Act, which attacks tax-free transfers to trusts using low-interest or no-interest loans. Going forward, section 7C will be especially relevant for individual and estate tax planning, where trusts and companies held by trusts are often used.

Turning up the heat

Section 7C is an anti-avoidance measure and one of the major changes to the Income Tax Act introduced last year.

Broadly, section 7C applies to low-interest or no-interest loans made to a trust by an individual (or by a company that is “connected” to that individual, where this is a related party transaction). The difference between the interest actually charged and a prescribed “official rate of interest”, currently 7.75% for local debt, is a deemed donation. This is subject to dividends tax at a rate of 20% in the hands of the individual.

Section 7C came into effect on 1 March 2017, and captures loans granted before 1 March 2017, but only triggers deemed donations on “foregone” interest payments after that date.

In the Budget Speech earlier this year, Treasury proposed two changes to section 7C. Firstly, it proposed that section 7C should also apply to low-interest or no-interest loans made to companies owned by trusts (an obvious loophole). Secondly, it proposed that the exclusions under section 7C be expanded to exclude trusts that are not used for estate planning, for example, certain trading trusts or employee share scheme trusts.

Expanded scope

The proposed expansion of section 7C to cover low- or no-interest loans made to companies owned by trusts is included in the Draft TLAB. This expansion will apply where a company is “connected” to a trust that would otherwise be caught by section 7C (ie the trust in question owns 20% or more of the shares or voting rights in that company).

However, the Draft TLAB introduces another change that was not included in the Budget Speech. This is where the loan to the trust is transferred to someone else.

It is proposed that section 7C will apply where a low- or no-interest loan claim against the trust or company is acquired by an individual who is “connected” to the trust or individual (original lender). This change is intended to capture schemes for avoiding section 7C, where the original loan claim is simply transferred to another individual, who is usually a current or future beneficiary of the trust.

Tax relief for employee share incentive schemes

A specific exclusion for employee share incentive schemes has been added to section 7C. However, no other exclusion has been proposed, for trading trusts or otherwise.

The new exclusion will apply where a trust was created solely to give effect to an employee share incentive scheme. The loan in question must have been granted to that employee share incentive trust by a company, to fund the acquisition of shares in that company or another company in the same “group of companies”.

However, the new exclusion will not apply where a person who holds 20% or more of the shares or voting rights in the relevant company (individually or collectively with a “connected” person) participates in that employee share incentive scheme. Treasury has included this requirement to prevent the use of this exclusion to transfer wealth to family members employed by the business in question.

Public participation process not yet over

Treasury’s proposed extensions to section 7C were largely expected, but tax practitioners will still be carefully considering the wording of the proposed changes to determine whether they capture any unintended targets.

The relief provided for employee share incentive trusts is welcome, but it is unfortunate that wider relief was not offered to, for example, the trading trusts that may be adversely affected by section 7C. However, it may still be possible to lobby Treasury for the inclusion of additional relief during the public participation process for the Draft TLAB.