The duality of loans to offshore trusts

The current state of affairs 

Section 7C aims to curb tax avoidance through interest-free and / or low-interest loans, advances and credit arrangements to local and foreign trusts. This is achieved by regarding discounted interest rates on these loans and credit arrangements as a deemed donation.  

Prior to the implementation of section 7C, trusts were often used to lessen the tax impact of estate duty upon the death of an individual, thereby allowing the transfer of wealth to the next generation with minimal tax impact. This was mainly achieved by an individual disposing of assets to a trust, with the purchase price remaining outstanding on an interest-free loan account. 

If section 7C applies, the charging section in subsection (3) takes effect. Section 7C(3) states that if a trust or company incurs interest in respect of a loan at a rate lower than the official rate of interest, an amount equal to the difference between the interest amount incurred by the trust or company and the interest amount that would have been incurred at the official rate of interest (as defined) must be deemed to be a donation. The deemed donation is subject to donations tax at a rate of 20% in the case of donations not exceeding R30 million in value, and 25% thereafter. 

Section 31, on the other hand, applies to cross-border transactions between connected persons, ensuring that such transactions (including loans) are in alignment with the arm’s length principle. The arm’s length principle mandates that the terms of these transactions should reflect those that would have been agreed upon by independent parties under similar circumstances. If not, transfer pricing adjustments can be made, resulting in additional tax liabilities. 

The misalignment conundrum 

Since the introduction of section 7C, there were concerns regarding the interaction between section 7C and transfer pricing, specifically regarding loans to foreign trusts. Transfer pricing rules, designed to prevent profit-shifting and base erosion, mandate that cross-border transactions between connected persons be conducted at arm's length. This is achieved by increasing income tax though a primary adjustment, and a secondary adjustment which deems a donation of the same amount to have been made. The deemed donation may be subject to donations tax. However, the focus of section 7C was predominantly on preserving individuals’ wealth, and not on the cross-border pricing concerns that are the subject of transfer pricing rules.  

For example, assume a resident individual provides an interest free-loan to a connected non-resident trust of R20 million. If the non-resident trust borrowed a similar amount from an independent financial institution, the non-resident trust would be charged interest at an interest rate of 8% (R20 million x 8% = R1.6 million). Because the transaction is with a non-resident connected person, the section 31 transfer pricing rules will apply. This will result in a primary adjustment for the resident individual of R1.6 million in terms of section 31(2). A deemed dividend of R1.6 million would also be raised in terms of section 31(3) as a secondary adjustment, which will be subject to a 20% donations tax. Similarly, if the resident were to be a company, a deemed dividend would be raised, which will be subject to a 20% dividends tax.  

Assuming an official rate of interest of 10%, an amount of R2 million (R20 million x 10%) would be regarded as a deemed donation in terms of section 7C(3). However, section 7C(5) lists various transactions which are exempt from section 7C(3). In this example, the exemption contained in section 7C(5)(e) applies. This provision states “…that section 7C(3) does not apply in respect of any amount owing by a trust…during a year of assessment in respect of a loan…if that loan…constitutes an affected transaction as defined in section 31(1) that is subject to the provisions of that section.”  

The difference of R400 000 (R1.6 million in terms of section 31 and R2 million in terms of section 7C), creates unintended structuring opportunities, which could lead to the erosion of the tax base. 

The impact of the proposed changes 

The TLAB 2024 proposed that the exemption of section 7C(5)(3) only applies in respect of the interest which is subject to a transfer pricing adjustment (i.e. R1.6 million in the example above). The remaining interest (i.e. R400 000 in the example above) will then be subject to section 7C.   

For South Africans with foreign trusts, these changes will impact estate planning and tax structuring strategies. Loans to foreign trusts, which previously enjoyed more lenient treatment, will now be subject to closer scrutiny from both a section 7C and a transfer pricing perspective.  

This dual approach reflects South Africa's commitment to adhering to OECD guidelines on Base Erosion and Profit-Shifting, ensuring that cross-border transactions do not erode the country's tax base. Taxpayers with foreign trusts will now need to re-evaluate their structures to ensure they are compliant with both domestic and international tax principles.

Authors:

Nadine Smit, Manager

Charl Hall, Senior Manager