"In a far-reaching recent Supreme Court of Appeal (SCA) case it was decided that the right to use a loan without paying interest is now taxable in the hands of the borrower," says Johan Troskie, Director of Deneys Reitz Tax. "In so doing an established principle of the commercial world has been given the death sentence. Effectively, interest-free loans will now become taxable in the hands of the person enjoying the interest-free use of the loan, undoing a long standing principle in commerce that such loans have no adverse tax consequence."
"This case essentially will bring an end to interest-free loans, which have been widely used in many business transactions since I can remember," says Troskie. The right to use such loans will now become taxable and expensive. The case has far reaching implications. Troskie explains that interest-free loans are used in may different transactions, such as transactions between shareholders and companies, loan transactions with trusts, loan transactions between companies and employee share trusts and BEE transactions.
The case is Commissioner for SARS v Brummeria Renaissance (Pty) Ltd, Palms Renaissance (Pty) Ltd and Randpoort Renaissance (Pty) Ltd. The facts of the case were that a property development company had entered into a written agreement with potential occupants of retirement village units still to be constructed. In so doing, the companies obtained an interest-free loan from a potential occupant in order to finance the construction of a unit in a retirement village. The loan was properly secured and there was little risk of the loan not being protected. The retired person would then receive a right of lifelong occupation of the unit, whilst the actual ownership of the unit remained with the company. However, the company was obliged to repay the loan to the occupant either upon cancellation of the agreement, or upon the occupants death. The standard agreement entered into with each occupier stated that the interest-free loans constituted the consideration for the life right to occupy the particular unit.
Troskie explains that SARS contended that the value of the company's right to make use the funds free of interest should be included in the company's "gross income", the starting point of tax in South Africa. The value of the right was determined by applying the weighted prime overdraft rate for banks to the average amount of the interest-free loans. "This valuation methodology was accepted by the SCA," Troskie says. "But the decision raises many questions. Can a taxpayer avoid the effect of the decision by introducing a low interest rate on a loan? The case seems to suggest that it should be the prime bank interest rate that should be used. But what about cases where bank customers enjoy a lower rate of interest on loans? Is that right also taxable?
The company appealed against the assessment raised by SARS and the Johannesburg Tax Court upheld the appeal by the company. The case went on appeal to the Supreme Court of Appeal in Bloemfontein.
The definition of "gross income" in the Income Tax Act states that what must be taxed in the hands of a taxpayer is ". . . the total amount, in cash or otherwise, received by or accrued to [the taxpayer] during such year of assessment"
The crucial issue that the court had to decide was whether the right to retain and use the loan capital, interest-free, should be valued and taxed in the hands of the company who had received the loans, says Troskie. "In other words, did the rights to use the loans interest-free constitute "amounts" which had "accrued to" the companies according to the definition of "gross income"?"
In a previous court case it has been held that not only income actually received, but also rights of a non-capital nature which have accrued to the taxpayer are capable of being valued in money. In this case, SARS contended that the right to retain and use the loans without paying interest had a money value, and accordingly that the value of such right must be included in the taxpayers "gross income". The right to use interest-free loans should be subject to tax.
In another previously decided SCA case it was held that the making of an interest-free loan constitutes an ongoing donation to the borrower which confers a benefit upon such borrower. In this latest case, the court was adamant that in the modern commercial world, a right to retain and use loan capital for a period of time, interest-free, is a valuable right. As long as the right can be valued, it will become taxable. Troskie explains that the judgement has far reaching implications for the valuation of this right to use loans free of interest as the court said that is an objective test, not subjective.
The court held that the right to retain and use interest-free loan capital is indeed a right which has a value and which should be subject to tax in the hands of the borrower. "But would this not lead to double tax in cases where the loan money was invested and income was received on the income?", asks Troskie. "The SCA said no, there are two different accrual of income, the first is the investment income and the second is the right to use the loan interest-free."
"The decision will have the effect of raking in millions of additional tax for SARS as interest-free loans are widely used in a variety of transactions in the business world," says Troskie. "The success will depend on the ability of SARS to investigate and follow up on interest-free loans."
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