When a person transfers ownership of an asset to a trust in circumstances where the trust does not have the funds to pay a market related purchase price for the asset, a seller (who is a connected person to the trust) will often loan the purchase price to the trust.
In such loans, which are not at arm’s length, the seller will often charge a low interest rate or no interest at all to the trust. Treasury has published the Draft Taxation Laws Amendment Bill for comment by 8 August 2016, which introduces a new section 7C to the Income Tax Act to prevent estate duty and donations tax avoidance through the transfer of assets to trusts using interest free or low interest loans.
When ownership in an asset is transferred to a trust, donations tax is not paid as the asset is usually sold at market value. Sometimes the seller will reduce the loan capital by donating amounts to the trust to set off against the loan by using section 56(2)(b) which allows for a R100,000 annual exemption from donations tax. This arrangement avoids estate duty through the tax free reduction of the asset base of the seller by the annual donation to the trust. As no or very little interest is paid to the seller by the trust, the seller will not be liable for income tax resulting in a further reduction of the tax base.
According to the new proposed law, if no interest is incurred by the trust on the loan, or if interest is incurred at a rate lower than the official rate of interest (currently 8%), an amount equal to the difference between the amount of interest incurred by the trust and the amount that would have been incurred had the official rate been applied, must be included in the seller’s income tax assessment for that year. This amount can be recovered by the seller from the trust which has benefited from the low interest loan. If the seller does not recover this amount of tax from the trust within a period of three years, the tax attributable to that income will be treated as a donation by the seller to the trust on the date on which the three year period ends, therefore triggering donations tax.
The interest which is attributed as income in the hands of the seller does not qualify for the annual exemption in terms of section 10(1)(i). Furthermore, the loan will not qualify for the R100,000 annual donations tax exemption in section 56(2)(b).
The amendment comes into effect on 1 March 2017 and applies in respect of years of assessment ending after that date.
This article has been written by Graeme Palmer, a Director in the Commercial Department of Garlicke & Bousfield Inc
NOTE: This information should not be regarded as legal advice and is merely provided for information purposes on various aspects of tax law.