Often, assets are moved into trusts on loan account due to the fact that trusts do not have access to cash to buy the assets. Traditionally, this was also a very effective way to move growth assets away from your personal estate into a trust in order to prevent the attraction of estate duty on such growth.
However, since March 2017 the South African Revenue Service (Sars) introduced an anti-avoidance provision to prevent such estate-duty savings (section 7C of the Income Tax Act). Now, many people sit with a dilemma, as donations tax is payable annually if such loans carry interest at less than the official interest rate (currently 7.75%). Traditionally, no interest was charged on such loans in order to avoid the payment of tax thereon by the lender. Many people believe that they can simply reduce the loan, without realising that it may attract tax. There may be serious tax consequences resulting from writing down loans.
Sars addresses debt reduction in the Income Tax Act, and you need to be aware thereof before taking any action. The debt-reduction rules are meant to apply only to debts that are not in the estate duty, donations tax or employees’ tax nets. This means that debt reduction as a result of a bequest, donation or employment relationship is excluded from these rules.
First, you need to determine what the debt was funding, because different treatment is applied depending on whether the debt was funding any expenditure in respect of which a deduction or allowance was granted in terms of the Income Tax Act (section 19) or capital assets and capital expenditure (paragraph 12A of the Eighth Schedule of the Income Tax Act). Both these provisions came into effect for years of assessment starting on or after January 1, 2013, but were substantially amended for years of assessment starting on or after January 1, 2018.
Initially, section 19 dealt with the reduction or cancellation of debt, but from 2018 it deals with a concession or compromise in respect of a debt.
An important fact is that section 19 now includes interest in the “debt benefit” calculation, but excludes a “tax debt” funded. If debt is partly cancelled, waived, remitted or extinguished, the debt benefit rule will still apply to the part that has been reduced.
Types of loans
* Loans funding expenditure in respect of which a deduction or allowance is granted in terms of the Income Tax Act. The effect of section 19 is that if a debt owed by a debtor is cancelled, waived, extinguished or converted to shares as a result of an arrangement, such that a “debt benefit” arises for the borrower and that debt funded the purchase of trading stock, revenue expenditure (working capital), or an asset on which tax allowances were claimed, then:
* For trading stock, the amount of the “debt benefit” to the borrower first reduces the cost of such trading stock, (if it is still on hand), with any excess being treated as a recoupment. Writing down the cost of the stock does not have an immediate tax implication, but the recoupment of a cost will be taxed as ordinary revenue - in other words, such amount will be included in that year’s income tax calculation.
* For allowance assets (those are assets on which tax allowances are claimed), the “debt benefit” first reduces the base cost of the asset, and any excess is treated as a recoupment of the tax allowance on that asset, similar to trading stock.
* Loans funding capital assets and capital expenditure. Paragraph 12A deals with the concession or compromise of debt which funds or funded capital assets. It is important to note that it only applies where there is a “realisation event” - in other words, where a debt is actually repaid or extinguished. So it does not apply where the mere terms of the debt are amended, such as where the debt is subordinated or one loan is substituted for another (such as replacing a bridging loan with long term funding). It does also not deal with any adjustment in respect of interest or a recoupment of interest. That would fall under section 19.
Applying the rules
You need to apply the following rules:
* If the trust still holds the asset. First, you would reduce the base cost of the capital asset on hand - in other words, the cost to acquire, create or improve the asset, excluding interest on funding such asset. The amount by which the “debt benefit” exceeds the base cost (for allowance assets) will be treated as a recoupment of the capital allowance on that asset, and the recoupment will be included in income, and taxed, in terms of the rules of section 19.
* If the trust disposed of the asset in a prior year of assessment. Compare the actual capital gain or loss when it was disposed of with what the capital gain or loss would have been if the “debt benefit” arose in the year in which the asset was disposed of, and treat the “absolute difference” as a capital gain in the current year in which the debt benefit arose. It appears if only extra gains will be included and not extra capital losses.
You need to be mindful of the tax effects of reducing a loan. Always consult a specialist before you act. In the next article, the exclusions to these rules will be discussed.
Phia van der Spuy is a registered Fiduciary Practitioner of South Africa, a Master Tax Practitioner (SA), a Trust and Estate Practitioner and the founder of Trusteeze, a professional trust practitioner.