Loans between companies and their shareholders, or other group companies are a common method of providing finance in the South African corporate environment. Loans of this nature may, however, give rise to tax implications in the hands of the lender or the recipient, and careful consideration should therefore be given to these transactions.
Dividends declared by a company to its shareholders up until 31 March 2012 were subject to secondary tax on companies (“STC”) at a rate of 10%. The Income Tax Act, No. 58 of 1962 (“the Act”) also contains provisions designed to circumvent tax avoidance transactions that enable the shareholder of a company to benefit in some way even though no cash dividend was actually declared. Under these provisions, certain types of transactions gave rise to deemed dividends with the result that STC became payable, subject to certain exemptions.
Dividends tax is levied at the rate of 15% on dividends paid on or after 1 April 2012, subject to certain exemptions, or the application of a lower rate of dividends tax in certain circumstances. Low-interest loans may also fall within the dividends tax ambit by virtue of these loans constituting a deemed dividend in certain circumstances, giving rise to a liability for dividends tax.
Loans or advances from company to shareholder (or any person connected to the shareholders) will automatically be deemed to be a dividend in certain circumstances.
The current deemed dividend provision applies where a debt arises “by virtue of a share held in the company” and where the following conditions are present: the debtor is a person other than a company; the debtor is a South African resident and the debtor is either a connected person in relation to the company, or a connected person in relation to that person. Broadly speaking, a “connected person” in relation to a company means any company that forms part of the same group of companies (where at least 70% of the equity shares in a controlled group company are held by the controlling group company), or any person, other than a company, who individually or jointly with any connected person holds, directly or indirectly, at least 20% of the company’s equity shares or voting rights.
If all of these requirements are met, the company is deemed to have paid a dividend in specie which is deemed to be an amount equal to the greater of the “market related interest” in respect of the debt, less the amount of interest payable to that company in respect of the relevant year of assessment. In other words, the amount of the dividend is determined by applying an interest rate to the debit balance on the loan during the year. For purposes of determining the deemed dividend, the term “market related interest” is the difference between the “official rate of interest” that applies for fringe benefits tax purposes, and as defined in paragraph 1 of the Seventh Schedule (currently 6.5%), and the actual interest rate charged on the loan. Only the interest effectively foregone, and not the capital amount of the loan, is deemed to be a dividend. If therefore, the loan bears interest at an acceptable rate, there would be no deemed dividend. This can be distinguished from the STC regime where the tax in respect of a deemed dividend was calculated on the principal amount of the loan.
The dividend is deemed to be paid by the company on the last day of the year of assessment, and the company is required to pay the resulting dividends tax by the end of the month following its year-end. Since the dividend is deemed to be a dividend in specie, the company (as opposed to the shareholder) is liable for the tax.
In order for a shareholder loan to constitute a deemed dividend, the debt has to arise “by virtue of” a share held in the company. The meaning of the phrase “by virtue of” is not defined in the Act and guidance can be found in a number of cases.
The phrase “by virtue of” was considered in the context of employment, in the case of Stander v CIR, 59 SATC 212, where the court considered the meaning of the phrase “in respect of or by virtue of any employment or the holding of any office”. The words “by virtue of” do not, in view of the court, bear a meaning materially different from the words “in respect of” and referred to ST v Commissioner of Taxes, 35 SATC 99, at 100 where, in regard to the phrase “by virtue of” Whitaker P stated at 100:
“ordinarily the phrase (and this was common cause between counsel) means ‘by force of’, ‘by authority of’, ‘by reason of’, ‘because of’, ‘through’ or ‘in pursuance of’. (See Black’s Law Dictionary 4 ed 252). Each of these definitions suggests there must be a direct link between the cause and result.”
The principles established in the Stander case were confirmed in the Supreme Court of Appeal case of Stevens v CIR, 69 SATC 1, where the court held that there was no material difference between the expressions “in respect of” and “by virtue of”. They connote a causal relationship between the amount received and the taxpayer’s services or employment.
It is evident from the above that there has to be a direct causal relationship between the holding of the relevant shares and the advance of the loan in question in order for a deemed dividend to arise. The deeming rule will thus only be triggered when a loan or advance has been made to a South African resident person that is not a company (e.g. a trust or a natural person) who is a connected person in relation to that company or a connected person in relation to the aforementioned person (that is connected to the person who is connected to the company).
To the extent that the amount owing to a company by a shareholder of that company or other qualifying person as set out above, was deemed to be a dividend that was “subject to STC”, no deemed dividend implications will arise in terms of the dividend tax regime. In other words, a debt that was deemed to be a dividend that was subject to STC will not be deemed to be a dividend for dividends tax purposes.
The term “subject to tax” is not defined in the Act, nor has it been the subject of any South African court decisions. Guidance can, however, be found from United Kingdom (“UK”) judgments in respect of the phrase. In the recent case of Paul Weiser v HM Revenue and Customs (TC02178), the First Tier Tribunal considered the interpretation of the double tax treaty between the UK and Israel and in particular the meaning of the phrase "subject to tax". The case centred around the meaning of the phrase "subject to tax" and the difference in international tax treaties between this phrase and the phrase "liable to tax". In HM Revenue and Custom's view, the distinction between the two phrases is that the expression "liable to tax" requires only an abstract liability to tax (i.e. a person is within the scope of tax generally irrespective of whether the country actually exercises the right to tax) and therefore has a much broader meaning than the phrase "subject to tax" which requires that tax is actually levied on the income. The First Tier Tribunal decided the case in favour of HM Revenue and Customs such that relief was not available under the UK-Israel tax treaty to exempt the pension from UK tax because the pension in question was not subjected to tax in Israel.
Income would thus not be regarded as “subject to tax” if the income in question is exempt from tax in terms of a statutory exemption from tax.
In the context of shareholder’s loans, unless STC was actually paid in respect of the debt in question, such interest-free or low interest loan would be subject to dividends tax. This effect appears to create unintended adverse consequences for taxpayers in that, even though loans of this nature may not have constituted deemed dividends under the STC regime as a result of the application of an exemption, the full capital amount of the loan would be subject to dividends tax.
For employees’ tax purposes, the issue that requires consideration is whether a “taxable benefit” as defined in para 2(f) of the Seventh Schedule to the Act, read with paragraph 11 thereof, arises in consequence of an interest-free or low interest loan to a shareholder that is a connected person in relation to the lender.
In order to constitute a “taxable benefit”, the debt in question has to arise “in respect of” the employee’s employment with the employer. As discussed above, in terms of the applicable case law, there is no material difference between the expressions “in respect of” and “by virtue of”. With regard to both, if there is an “unbroken causal relationship between the employment on the one hand and the receipt on the other”, the payment will be “in respect of services rendered” (Stevens v CSARS supra). It is submitted that the same principle will apply for purposes of paragraph 2 of the Seventh Schedule to the Act.
In order to determine whether an interest-free or low interest loan results in a taxable benefit, one will have to determine the reason or cause for the granting of the loan.
It is important to bear in mind that an interest-free or low interest loan to a connected person in relation to the company (or a connected person in relation to a connected person in relation to the company) will only be subject to either dividends tax or employees’ tax, and not to both.