Over the past few years, there has been a focus on loans made by a connected person to a trust or by a company held by a trust. This has been the case since the South African Revenue Service (Sars) introduced punitive tax measures (section 7C of the Income Tax Act) on interest-free or soft loans (where interest is charged at a rate below the official interest rate, currently 7.75%) in an attempt to combat estate duty or donations tax leakage on assets moved into trusts or companies held by trusts.
There is often confusion about the application of these tax measures. Do they apply to loans made to trusts, or do they apply to loans made by trusts?
It is clear from the wording of section 7C that the law applies only to loans made by connected persons to trusts, and companies held by trusts, and not to loans made by the trust to someone else. Section 7C applies only where a trust is the recipient or borrower of a loan. This raises the question of whether there is any tax or other consequence for trustees making an interest-free or soft loan to a connected person or to a company that is a “connected person” in relation to that natural person.
Until the delivery of the judgment by the Supreme Court of Appeal in the case of the Commissioner for the South African Revenue Service v Brummeria Renaissance on September 13, 2007, it was always the view that neither the lender nor borrower would incur any income tax consequences as a result of such a loan. This case created uncertainty and alarm regarding the tax implications of interest-free loans.
In this case, three companies - Brummeria Renaissance, Palms Renaissance and Randpoort Renaissance - developed retirement villages. The companies obtained interest-free loans in order to build units in exchange for granting life occupation rights of the units to the lenders. The commissioner assessed the companies and taxed them on these interest-free loans, contending that the right to use the loans interest-free had a monetary value and therefore formed part of the companies’ taxable income.
The commissioner’s contention was dismissed by the Johannesburg Tax Court, but upheld on appeal. The Supreme Court of Appeal held that, although a loan was not income, the value of the right to use a loan interest-free was income.
This judgment does not lay down a blanket rule that an interest-free loan is always a taxable benefit in the hands of a borrower. The facts of each case need to be considered. It must be remembered that the issue is not the loan of money as such, but the value of the right to have the use of the money without paying interest. If this right is obtained in the context of a trade or profit-making scheme, such as this case, it will be of a revenue nature and must be included in gross income and taxed accordingly.
A distinction should therefore be drawn between interest-free loans where the benefit is, in effect, a form of remuneration for goods or services or other benefits supplied by the borrower to the lender, and interest-free loans where there is no such supply. It therefore follows that this judgment does not have as far-reaching an impact as some commentators may have interpreted it. In the case of an interest-free loan by a trust to a connected person (and even an interest-free loan by a connected person to a trust), the causal connection is not present and there is not a quid pro quo (a favour or advantage granted in return for something) for the granting of the loan. It is in this context that one is not able to apply the 2007 judgment to all cases of interest-free or low-interest loans.
As a result of the confusion caused by this case, Sars issued an interpretation note (IN58) in October 2012 in order to clarify when the right to use loan capital free of an interest obligation would result in income tax consequences.
The principles from the judgment may be applied in all cases in which benefits in a form other than money (such as the right to use an interest-free loan) are granted in exchange for goods supplied, services rendered, or any other benefit given. The receipt or accrual in a form other than money could constitute an amount that should be valued and included in the gross income of the taxpayer in the year of assessment in which it is received or accrued.
Typically, interest-free loans advanced by a trust to a connected person or company are loans for consumption and are not granted as consideration for goods or services. It is advisable that these loan terms are captured in a written loan agreement, which will serve as proof that the transaction is not a donation, which will attract donations tax.
Under our common law, the borrower and the lender incur obligations under the contract, and the borrower is expected only to return a similar object of same value to the lender. Once the lender transfers the loan capital, he or she has fulfilled his or her obligations. A continual obligation rests on the borrower to repay the loan capital as agreed, in future.
It is clear that the charging of interest is not an essential element of a loan agreement, and a loan agreement may be concluded without any stipulation with regards to interest payable.
However, keep in mind the impact of the National Credit Act if the trustees aim to charge interest on a loan made by the trust. The term of repayment is not an essential element of a loan agreement. It is, however, important to note that a loan that contains no agreed repayment terms, and a loan that is repayable on demand, becomes continuously recoverable at all times. It is therefore wise to agree and record when the debt will become due for payment.
Phia van der Spuy is a registered fiduciary practitioner of South Africa, a master tax practitioner (SA), a trust and estate practitioner (TEP) and the founder of Trusteeze, a professional trust practitioner.