JOHANNESBURG – A proposal by National Treasury, that aims to address the avoidance of estate duty by moving assets to a trust, could have significant tax implications for individuals involved.
The draft Taxation Laws Amendment Bill that was published for public comment in July, includes a provision that aims to make it detrimental for an individual to sell assets to a trust to which he or she is a so-called ‘connected person’ (typically family of the founder or beneficiaries of the trust) and extending a low- or interest-free loan to the vehicle.
Louis van Vuren, CEO of the Fiduciary Institute of Southern Africa (Fisa), says National Treasury has for some time held the view that South Africans move assets into trusts to avoid estate duty.
A common practice has been for individuals to sell their assets to a trust they have set up, but instead of the trust paying for the assets, the individual extends an interest-free or low-interest loan to the trust to enable the trust to finance the transaction.
Up until now, there have not been any problems with this type of structure. The common law position has always been that no loan bears interest unless interest is explicitly specified, he says.
But Treasury has argued that this makes it too easy for people to divest themselves from their assets by transferring it to a trust. This practice allows the assets to increase in value outside the estate of the original owner. When the individual eventually dies the only asset in the estate is the outstanding loan.
Van Vuren says this effectively pegs the value of the assets at the date of the sale, as there is no further growth of those assets in the estate of the founder.
“So what Treasury and the minister are saying is that this robs the State of estate duty, because those assets would have stayed in the estate and at death would potentially be susceptible or liable for estate duty,” he says.
The draft legislation proposes to curb this practice by charging income tax on deemed interest.
Should the new provisions take effect in their current form on March 1 2017 as proposed, any individual who sells assets to a trust in relation to which he or she is a connected person and finances those assets by way of a loan at an interest rate that is less than the official interest rate (currently 8% in terms of the Seventh Schedule of the Income Tax Act), will be subject to income tax on the deemed interest.
The deemed interest will be the difference between interest on the loan at 8% (the official rate) and the actual interest rate charged (in the case of an interest-free loan this will be 0%).
Thus, if an individual sells assets to the value of R10 million to a trust that he sets up and extends an interest-free loan to the trust to finance the assets, the individual will be taxed on R800 000 of deemed interest (8% of R10 million) even though this is a fictitious amount. This is the result of a proposed new section 7C of the Income Tax Act.
The ‘sting in the tail’ is that the annual interest exemption of R23 800 for individuals younger than 65 won’t apply. Moreover, no costs or other deductions could be offset against the interest, Van Vuren says.
The Income Tax Act allows individuals to donate R100 000 per annum to anybody without paying donations tax on it. A common practice among estate planners is to donate R100 000 to the trust every year to reduce the outstanding interest-free loan. In terms of Treasury’s proposal, any reduction of the loan to a trust under these circumstances will not qualify for the R100 000 annual exemption from donations tax and normal donations tax of 20% will be levied on any such donation.
Van Vuren says at this stage it is unclear whether the new provision will only affect new loans or whether existing ones will also be included.
Fisa is also of the view that the official interest rate of 8% is inappropriate in these situations. This rate is usually applicable in situations where employers extend a loan to employees at a preferential rate. The difference between the official rate of interest and the interest rate the employee has to pay is deemed to be income in the hands of the employee and the employee is taxed on the amount as a fringe benefit.
Van Vuren says the official interest rate is not really appropriate for the trust situation. He argues that one should rather use the interest rate a private individual could earn on a money market or related investment – somewhere between 5% and 7%.
His biggest concern is that the proposal essentially wipes the common law position – that there is no interest on a loan unless specified – off the table for tax purposes.
Practically this means that if someone sets up a trust on behalf of his/her vulnerable child and a friend extends an interest-free loan to the trust, the friend will not be taxed on the notional interest as he/she is not regarded as a connected person to that trust. However, if the friend extends the same loan to a trust he/she sets up for his/her own child, the new provision will trigger income tax on the deemed interest.
Van Vuren says in practice, there are also situations where distributions to beneficiaries of a trust are held back until a later date (for example where the beneficiary is still completing tertiary studies). In practice, accountants often record these amounts as beneficiary loans to the trust.
This is not a true reflection of what actually happens under these circumstances. The withholding of the payment of such a vested distribution happens under powers extended to the trustees in the trust deed and this can never be a loan, as there is no requirement in the typical trust deed that the beneficiary must agree to this arrangement.
There is a concern that beneficiaries may now become liable for income tax on the deemed interest on these ‘loans’ because they are regarded as connected persons in relation to the trust, even though they had no say in the matter.
The new provision is one of the few, if not the only case, where one tax is used in order to enable the collection of another, he says.
* This content was sponsored by the Fiduciary Institute of Southern Africa.