On 1 March 2017, s7C of the Income Tax Act, No 58 of 1962 (Act) came into effect. One of the reasons for introducing this provision was to prevent taxpayers from avoiding estate duty, by selling assets to a trust on loan account, which loan account they would then extinguish by making use of their annual donations tax exemption of R100,000. Section 7C addresses this avoidance, by providing, amongst other things, that the trust must pay interest on such loan, advance or credit, but only where the trust and the natural person are connected persons, such as where the natural person is a beneficiary of the trust. Where the trust does not pay interest on the loan to the natural person or pays interest at a rate below the official rate of interest, as defined, a deemed donation would arise in the hands of the natural person. We discussed the provisions of s7C in our Tax and Exchange Control Alert of 10 February 2017 (Trusts – the new position).
In the 2017 Budget, National Treasury (Treasury) noted that in response to s7C, some taxpayers attempted to circumvent this anti-avoidance measure by making low-interest or interest-free loans to companies owned by a trust and that s7C might be extended to also apply to such avoidance schemes.
In the Draft Taxation Laws Amendment Bill, 2017 and the Explanatory Memorandum on the Draft Taxation Laws Amendment Bill, 2017, Treasury has indicated exactly how it intends to address these avoidance schemes.
The 2017 Memorandum - reasons for change
The 2017 Memorandum again highlights the anti-avoidance that arises where the loan, advance or credit is made by a person to a company owned by the trust, instead of to the trust. As s7C only applies to trusts, it would not be necessary for the company to pay interest on such loans or credit advanced to it by the lender. The 2017 Memorandum further notes that the companies receiving these loans, benefit from this low or no interest funding and tax can only be collected at a much later stage when the company makes distributions to the trust (First Scheme).
Another avoidance scheme that is highlighted in the 2017 Memorandum, is one where taxpayers enter into an arrangement where the loan claim of the natural person who made the loan, advance or credit to the trust (or the natural person at whose insistence a company made a loan to a trust) is transferred to another natural person. The natural person to whom the loan claim is transferred is usually a current beneficiary of the trust or a future beneficiary of the trust to which the loan, advance or credit is made, such as a child or a spouse. By subsequently transferring the loan claim, taxpayers argue that this breaks the link between the natural person who advanced the loan and the loan. The natural person to whom the loan claim is transferred does not account for the deemed ongoing and annual donation as that natural person did not advance the loan to the trust (Second Scheme).
Proposal – the bad news
In order to curb the avoidance that arises from the First Scheme, it is proposed that the application of s7C be extended so that it also applies to interest free or low interest loans, advances or credit that are made by a natural person or a company (at the instance of a natural person) to a company that is a connected person in relation to a trust.
Furthermore, the 2017 Memorandum states that to address the avoidance that arises from the Second Scheme, the person who acquires the loan claim from the person who made the original loan to the trust, will be deemed to have advanced the amount of that claim as a loan on the date that person acquired that claim. In other words, the trust would have to pay interest on the loan to the person who acquired that loan and to the extent that it pays interest on the loan at a rate lower than the official rate of interest, as defined, a donation will arise in the hands of such person.
Importantly, the 2017 Memorandum states that these proposed amendments come into effect on 19 July 2017 (yesterday), in respect of any amount owed by a trust or a company in respect of a loan, advance or credit provided to that trust before, on or after that date.
The silver lining – exclusion of employee share schemes from s7C’s application
In the 2017 Memorandum, Treasury acknowledges that trusts are used for various purposes other than to facilitate the transfer of wealth through the use of interest free or low interest loans, advances or credit, which could lead to the avoidance of estate duty. Currently, s7C(5) lists the following seven circumstances under which the anti-avoidance provisions in s7C, discussed above, will not apply:
- where the trust is an approved public benefit organisation in terms of s30(3) of the Act or a small business funding entity approved by the Commissioner in terms of s30C of the Act;
- in the case of a vesting trust (bewind trust), where the loan is made by a trust beneficiary to a vesting trust, provided that the four requirements of s7C(5)(b) are met;
- if the trust is a special trust created solely for the benefit of minors with a disability as defined in paragraph (a) of the definition of “special trust” in s1 of the Act;
- where the loan, advance or credit constitutes an affected transaction as defined in s31(1) of the Act (which deals with transfer pricing);
- where the loan, advance or credit was provided to that trust in terms of an arrangement that would have qualified as a sharia compliant financing arrangement as contemplated in s24JA of the Act, had the trust been a bank as defined in that section;
- if the loan, advance or credit is subject to the anti-value extraction provisions of s64E(4) of the Act; and
- where the trust used that loan, advance or credit wholly or partly to fund the acquisition of a residence that is used by that person or their spouse as their primary residence, to the extent to which that loan, advance or credit was used to fund the acquisition.
Treasury acknowledges in the 2017 Memorandum that s7C may have a negative impact on some employee share schemes (ESOPs) that often make use of trusts to hold shares in the employer company (or its associate) that will be allocated to qualifying employees. These types of trusts are established to facilitate incentive programmes for employees and cannot be treated in the same manner as trusts that are established to transfer wealth.
In order to ensure that ESOPs are not negatively affected, it is proposed that a specific exclusion for them should be provided. However, certain requirements must be met for the exclusion to apply to ensure that business owners do not abuse the exclusion to transfer wealth to family members employed by the business. The requirements are as follows:
- The trust should be created solely to give effect to an employee share incentive scheme in terms of which that loan, advance or credit was provided by a company to that trust for purposes of funding the trust’s acquisition in that company’s shares or in any other company forming part of the same group of companies;
- Shares or other equity instruments that relate to or derive their value from shares in a company) may only be offered by that trust to someone by virtue of that person being a full-time employee or being a director of a company; and
- If a person is a connected person in terms of paragraph (d)(iv) of the definition of “connected person” in s1 of the Act, in relation to a company or any other company forming part of the same group of companies as that company, such person may not participate in the scheme.
The proposed amendment will be deemed to have come into effect on 1 March 2017 and applies in respect of any amount owed by a trust in respect of a loan, advance or credit provided to that trust before, on or after that date.