C2M hosted a Trust Seminar for our clients on 16 August 2017 where Prof. Walter Geach discussed the future of trusts in the light of Section 7C of the Income Tax Act. Click here to download the notes of the Trust Seminar.
Section 7C of the Income Tax Act which came into effect on 1 March 2017 will impact trusts extensively. In the past it was common practice for a trust to acquire assets via an interest-free or low interest loan from a natural person. The objective of Section 7C is to tax loans by related parties (founders, beneficiaries etc.) to the trust, if these loans attract interest at a rate lower than the official rate of interest. The new provision seeks to address the avoidance of estate duty and donations tax.
Prof. Walter Geach provided the following example and explanation:
If someone has lent money to a trust, and the trust incurs no interest in respect of that loan, advance or credit, or incurs interest at a rate lower than the official rate of interest, then a continuing donation (attracting donations tax) will arise each year that the loan is outstanding. The donation is calculated as follows: (*Interest rate of 8% is used for the calculation.)
- The loan should attract interest @ official rate of 8% = R x
- Establish the actual interest on the loan to the trust = R y
The difference between x and y constitutes a donation.
Donations tax is levied @ 20%. But natural persons can make a tax-free donation of up to R 100 000 every year.So if a natural person lends R10 000 000 to a trust and does not charge interest from 1 March 2017, that will constitute a donation of R 800 000 for the 2018 tax year of which R100 000 is exempt from donations tax.
The donation (for donations tax purposes) is therefore R 700 000. Donations tax @ 20%= R 140 000 (tax liability). The donations tax will be payable by 31 March 2018, and every year donations tax can arise on this loan.
- Section 7C applies in respect of all loans made on, after, or before 1 March 2017
- and therefore applies in respect of pre-existing loans on which no interest is charged
Section 7C applies in respect of any loan, advance or credit that:
(a) a natural person; or
(b) at the instance of that person, a company in relation to which that person is a connected person
directly or indirectly provides to a trust in relation to which that person or company, is a connected person.
Therefore section 7C can apply not only when there is a loan, but also when there is an ‘advance or credit’ which is wider than a formal ‘loan’. Thus section 7C could perhaps apply when there is an ‘accounts payable’ owing by a trust, but the person to whom the amount is payable chooses not to enforce payment.
A loan, advance or credit can arise (a) from the actions of a planner/donor and/or (b) from the actions of a beneficiary.
Actions of the planner/donor
Regarding the actions of the planner/donor, a person can sell assets to a trust on loan account. In my view, unless there is clear documentation either in the form of a written loan agreement or trustee resolution, this transaction can itself result in donations tax. The only difference between a sale on loan account, and a donation, is evidence of an agreement (implied or express) of repayment terms, coupled with an agreement as to whether it is interest-free or interest bearing. Therefore in some cases, section 7C does not arise because the original transaction did not result in a loan, advance or credit to a trust, because it was (or should have been) subject to donations tax on the disposal amount (market value of the asset at the time of the disposal to the trust).
If, on the evidence, the original transaction does give rise to a loan, any loan up to an amount of R 1 250 000 will (at the moment) not attract donations tax (R 1 250 000 x 8% x 20%= R 100 000) if the R 100 000 annual exemption applies (which it currently does). It is possible that the Davis committee might recommend that the R 100 000 exemption cannot apply to any loans to a trust (either for the purposes of section 7C or for the purposes of reduction of loans to a trust). If section 7C does apply, this effectively results in donations tax of 1,6% of the amount of the loan (R 100 x 8% x 20%).
Actions of a beneficiary
The word ‘vested’ right is sometimes, in my opinion, used inappropriately. Sometimes it is used to mean that ‘ownership’ of a trust asset has passed to a beneficiary. In my opinion this is incorrect. A ‘bewind’ gives rise to a real right of ownership in a beneficiary, and gives the right of ‘control’ over that asset to trustee/s. However both a vested right and a contingent right are ‘personal’ rights. The right is ‘personal’ in the sense that it confers a right on a beneficiary to compel the trustees to act in a certain way in accordance with the nature of the right that has been conferred. So, for example, if a beneficiary has a vested unconditional right to the income and/or capital amount of a trust, that beneficiary can compel the trustees to distribute the income and/or capital amount of a trust to that beneficiary. If the beneficiary has such a right (i.e. an unconditional vested right either to a capital or income amount of a trust) and chooses not to compel the trustees to distribute the income and/or capital, that would amount to a loan, advance or credit as envisaged by section 7C. Therefore, for example, if the trustees use the conduit principle, and exercise their discretion (to allocate and pay) an amount in favour of a beneficiary, and if the beneficiary does not compel distribution of the amount, this would result in the application of section 7C. A beneficiary might not compel distribution for a number of reasons including by reason of an express or tacit agreement with the trustees not to claim payment.
However a right can be ‘vested’ and the enjoyment (i.e. payment or transfer) can be postponed. It is not a necessary consequence of vesting that a beneficiary can claim payment (or delivery) of an amount (or asset) that has vested in that beneficiary. Payment/transfer can be postponed pending ‘an event’. That event could for example be the exercise of discretion by the trustees, or the attainment of a certain age, or the marriage of a person, or death of a person etc. Because a beneficiary cannot claim payment (i.e. cannot enjoy the amount/asset) until the happening of that event, there is no loan, advance or credit made by that beneficiary to the trust. Therefore section 7C cannot apply. This type of vesting is known as ‘conditional vesting’. In such cases, even though a beneficiary cannot claim payment, the actions of the trustees should be on behalf of that beneficiary in respect of the income and/or capital amount that vested. This is where a so-called ‘sub-trust’ arises. The amount (capital or income) that has conditionally vested should be dealt with solely on behalf of, and for the benefit of, that beneficiary. In my opinion, if the amount that has conditionally vested in a particular beneficiary is pooled with all other trust funds and any income and/or capital gain can arise therefrom for the benefit of other beneficiaries, this would amount to a loan, advance or credit as envisaged by section 7C.
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Professor WD Geach:
Professor Walter Geach is a advocate of the High Court for South Africa. He specialises in taxation, corporate law, trusts, financial planning and financial accounting. He is also the Departmental Chair of Accounting at the University of the Western Cape under the faculty of Economic and Management Sciences. Prof Walter presented a Trust Seminar presented by C2M Chartered Accountants Inc. and MHI Attorneys.