In the current economic climate the acquisition of shareholder loans at a discount has become more prevalent. Generally, these shareholder loans are interest-free, with no specific terms of repayment. The tax treatment of these loans in the hands of the acquiring entity’s hands is far from clear.
At first glance, one may assume that the loan will not be regarded as an instrument as defined in section 24J(1) of the Income Tax Act, No. 58 of 1962 ("the Act") as the loan is interest-free. However, the mere fact that the loan has been acquired at a value which is lower than its face value denotes that the loan has been acquired at a discount.
The interest definition contained in section 24J(1) specifically includes a "discount or premium payable or receivable in terms of or in respect of a financial arrangement" and, accordingly, an interest-free loan issued or acquired at a discount to its face value will be regarded as an instrument for purposes of section 24J(1) of the Act as the instrument will, by definition, constitute an interest-bearing arrangement.
Therefore, the provisions of section 24J(3) may find application to the loan in question. Section 24J(3) provides that the holder of an instrument will be deemed to have accrued an amount of interest, which must be included in his gross income. The accrual amount to be included in gross income will be equal to:
- the sum of all accrual amounts in relation to all accrual periods falling, whether in part or in whole, within such year of assessment in respect of such income instrument ("Option 1"); or
- an amount determined in accordance with an alternative method in relation to such year of assessment in respect of such income instrument ("Option 2").
Option 1 requires a determination of the yield to maturity of the instrument in order to calculate the accrual amounts. If the loan does not have fixed repayment dates, it would be impossible to determine a yield to maturity without making assumptions in this regard.
Option 2, the alternative method, may only be applied if the method in terms of which the interest accrual is determined:
- conforms with generally accepted accounting practice;
- is consistently applied in respect of all such instruments (excluding any instrument as contemplated in section 24J(9)) for all financial reporting purposes; and
- the method achieves a result, insofar as the timing of the accrual and incurral of interest is concerned, which does not differ significantly from the results determined by applying the yield to maturity, i.e. Option 1.
If a calculation cannot be performed under Option 1 and the alternative method does not meet the requirements set out above, the amount to be included in the person’s gross income cannot be determined. The uncertainty which arises in this regard is whether this position is tenable.
At present, a number of differing views are held with the most prevalent of these being:
- The discount falls within the ambit of section 24J of the Act. However, since it is impossible to determine the yield to maturity, it may be argued that the discount accrues immediately;
- The discount falls within the ambit of section 24J of the Act but the amount will only accrue and be included in gross income if the repayment amount exceeds the original amount paid for the loan;
- The fact that the loan was acquired at an amount which is less than the face value thereof does not give rise to a discount for purposes of the provisions of section 24J and, therefore, this section cannot apply.
If it is to be accepted that the discount (i.e. the interest) cannot be included in the acquirer’s income merely due to the fact that a yield to maturity calculation cannot be performed as the loan has no fixed repayment date, a position arises where the Act discriminates against shareholder loans which do specify a fixed repayment date.
Shareholders who acquire interest-free loans at a discount, but where those interest-free loans have a fixed repayment date, will be in a position to determine a yield to maturity in respect of that loan and, therefore, an accrual amount can be determined under Option 1. The shareholder who wishes to regulate the loan’s repayment terms is therefore at a disadvantage as he would be required to include portions of the discount in his gross income by virtue of the application of the provisions of section 24J(3) of the Act.
In the absence of specific guidance from the South African Revenue Service ("SARS") in this regard, it would be prudent for taxpayers to exercise extreme caution when acquiring a loan at a discount and it may be advisable to approach SARS for an advance tax ruling.