The ability to make interest-free loans to trusts that can be repaid or written off over a number of years, and the saving on estate duty and donations tax that arises from these arrangements, will end in March next year if a proposed amendment to the Income Tax Act is passed into law.
The proposed amendment, which was released this month in the Taxation Laws Amendment Bill, aims to close the loophole that allows you to avoid estate duty by placing an asset, such as an investment, in a trust.
At least one tax firm has warned that the change is sufficiently far-reaching to result in trusts being closed down.
David Warneke, the head of tax technical at BDO South Africa, says the proposed amendment will, if passed into law, mean that from March 1 next year:
• Someone who makes an interest-free or low-interest loan to a trust will be deemed to be liable for interest at the official interest rate, or, in the case of a low-interest loan, the official rate less any actual interest charged. The official interest rate is one percentage point above the repo rate and is currently eight percent a year.
• This interest will be taxable in the hands of the lender, and the founder of the trust will not be able to use the annual exemption on interest income to reduce his or her tax liability.
• The trust will not be able to deduct the deemed interest from its taxable income.
• The lender will not be able to use the annual R100 000 donations tax exemption to write down the loan.
• The income tax paid by the lender as a result of including the deemed interest in his or her income must be recovered from the trust within three years of the relevant year of assessment, or it will be treated as a donation to the trust and the lender will be liable for donations tax.
You may also be regarded as having made a loan to a trust if you are a “connected person”. For example, if a company made the loan to the trust, and you own more than 20 percent of the shares in that company, you are a connected person, Warneke says.
He says there is little doubt that if the proposals are enacted, trusts will no longer be as attractive from a tax perspective. However, saving on tax should not be the main reason for setting up a trust. Estate protection and planning should be key reasons, he says.
Both Warneke and Matthew Lester, a professor of tax at the Rhodes Business School, warn that terminating a trust may trigger capital gains tax (CGT) on the disposal of the trust’s assets and result in an increase in the value of the personal estates of the beneficiaries, which could increase their liability for estate duty. Lester is also a member of the Davis Tax Committee, which is reviewing South Africa’s tax policy.
Lester says the proposed amendment signal the beginning of a clean-up of how trusts are taxed and mean that people with trusts can no longer take the tax savings for granted.
Warneke says it could effectively result in double taxation.
He cites the example of a founder who lends cash to a trust on an interest-free basis. If the trust invests the cash and earns interest from it, the interest will be taxed in the hands of the trust, or in the hands of the founder or beneficiaries if the interest is distributed to them.
In addition, the founder will, in terms of the proposal, be taxed on interest on the outstanding loan at the official interest rate each year, while the trust cannot claim a deduction for the deemed interest, Warneke says.
He is also of the view that more than one person may be regarded as a connected person and hence liable for the deemed interest and the tax on it.
Responding to the proposal, if it is enacted, by terminating your trust would be “a drastic step”, Warneke says.
Lester warns you should be very careful if you plan to unwind a trust, because you will incur CGT, and you could be liable for transfer duty if the trust owns residential property.
In terms of the trust deed, trustees must always consider the best interests of the beneficiaries before a trust can be terminated prematurely.
An alternative, if the trust has enough liquidity, may be for the trust to repay, fully or partly, the low- or zero-interest loan, but this could have estate duty consequences for the lender, he says.
The lender and the trust could, depending on the terms of the loan agreement, renegotiate the terms, so that the lender would charge interest on the loan at the official rate, Warneke says. The trust would then have an interest expense, which, depending on the assets held and, in particular, the income earned by the trust, could be deducted from its taxable income. The lender would have an actual amount of interest against which he or she could use the annual interest exemption.
If the amendments are enacted, Lester says the consequences will depend on the type of assets held. If the trust holds listed shares or a property, there will be little room for it to deduct the interest paid on the loan.
However, if the trust is the owner of a business, it can potentially claim a market-related interest charge, he says.
If the amendment is passed, trustees, trust founders and beneficiaries will have to obtain professional advice on how to proceed, he says.
Warneke says a number of “controversial” proposals related to trusts were included in the Davis Tax Committee’s first interim report in July last year. The final report has not yet been released.
The committee did, however, recommend that where financial assistance or interest-free loans were advanced to a trust, there should be no attempt to make transfer pricing adjustments – setting the price of goods or services sold between related entities. Warneke says the current proposal appears to fly in the face of this recommendation.
HOW TRUSTS ARE USED TO REDUCE ESTATE DUTY
Most inter vivos trusts are established when the founder of the trust places an asset in the trust by “selling” the asset to the trust and granting the trust an interest-free loan. Inter vivos trusts are established by a living founder, while testamentary trusts come into being after death by way of a will.
The reason for “selling” the asset to the trust using an interest-free or low-interest loan, rather than donating it, is to avoid donations tax. Donations tax is levied at a rate of 20 percent on the donation that exceeds R100 000.
By granting the trust an interest-free loan, the value of the asset is pegged at the loan value in the founder’s estate – only the loan, which does not grow in value, remains in the founder’s estate. This can result in lower estate duty being payable on the founder’s death, and the loan can be reduced each year by the founder making a R100 000 tax-free donation to the trust.