Loans to trusts: problems on the horizon

Graham Crocker, associate in Bowman Gilfillan Africa Group's Tax Practice.

A common approach to estate planning is to make an interest free loan to a local trust, to enable the trust to fund assets (ideally growth assets, such as shares or immovable property), and then write-off the loan in annual R100,000 increments (the annual donations tax exemption amount).

This year’s draft Taxation Laws Amendment Bill proposes new provisions aimed at curbing this form of estate planning, from 1 March 2017. 

What is the new proposal?

If you make a loan to a related party trust, for example a normal family trust:

• If you charge less than the “official rate of interest” (currently 8%), you will be subject to income tax on deemed interest. You would not qualify for the normal tax exemption for interest (currently R23,800 for individuals under 65 years) on this deemed amount.
• You will have to recover this extra income tax from the trust within 3 years, or else you will have to pay donations tax on this amount.
• You can no longer write off the loan every year in R100,000 instalments (donations tax exemption amount). Any loan write-offs would not give you any capital gains tax loss, and would result in donations tax at 20%.

In what ways is the draft legislation too broad?

The Explanatory Memorandum to the Bill is very specific – to prevent “the avoidance of estate duty and donations tax when a person sells assets to a trust and the sale of those assets is financed by way of an interest free loan or a loan with interest below market rates.” But this is not what the actual tax provision does. The actual provision:

• Applies whether or not a person sold any assets to a trust;
• Applies even where the loan has market-related interest rates; and
• Denies the normal donations tax exemption, for no good reason.

What should individuals do to minimise the negative impact of the new proposal?

On the assumption that the new section 7C is introduced in its current form, taxpayers could minimise its punitive effects by:

• Donating your annual R100,000 (donations tax exemption amount) in cash, rather than donating by writing off loans that would not qualify for donations tax exemption.
• If you are not already using the annual interest exemption amount, charge actual interest at the “official rate of interest” (currently 8%) and claim this exemption, rather than being taxed on deemed income that would not qualify for any exemption.