Navigating the proposed amendments to section 7C: what taxpayers need to know
On 1 August 2024, National Treasury published the 2024 Draft Taxation Laws Amendment Bill (“2024 Draft TLAB”) containing a noteworthy amendment to section 7C of the Income Tax 58 of 1962 (“the Act”), which we will unpack in further detail below.
Understanding the rationale and principles of section 7C
Section 7C, which became effective on 1 March 2017, was implemented as an anti-avoidance measure in response to perceived abuse by individual taxpayers to minimise donations tax and estate duty liabilities in South Africa (“SA”).
Example of pre-section 7C transactions
Consider a scenario where Person A (a SA tax resident) holds listed shares worth R1,000,000 and embarks on an estate planning strategy to transfer the ownership of the shares into a trust for the benefit of his family members. If Person A donates the listed shares directly to the trust, a donations tax liability of 20% would arise on the amount exceeding the annual R100,000 donation exemption, resulting in a donations tax liability of R180,000 (calculated as (R1,000,000 – R100,000) x 20%).
To avoid the donations tax liability, Person A would rather proceed to sell the listed shares to the trust on loan account. The trust would then be indebted to Person A, but no interest would be charged on the loan. Over the next ten years, for example, the tactic mostly employed would be for Person A to forgive R100,000 of the loan annually, avoiding donations tax due to the annual donation exemption.
As a result, the trust would acquire listed shares originally valued at R1,000,000, which will likely appreciate over time, while Person A’s estate would reflect no corresponding assets or debt claims, reducing estate duty upon Person A’s death.
Introduction of section 7C
To counter the perceived abuse, National Treasury introduced section 7C into the Act. In summary, section 7C provides that the foregone interest (i.e. the difference between the ‘official rate of interest’ and the actual interest charged) on loans made to a trust by a connected person is treated as a donation, taxed on the last day of each year of assessment.
For example, should Person A attempt the above strategy on or after 1 March 2017, the R1,000,000 interest-free loan to the trust would be subject to the deemed donation provisions of section 7C to the extent that the loan does not attract interest at the ‘official rate of interest’.
Detailed examination of section 7C(1)
Section 7C(1) specifically targets loans made by natural persons to trusts. Although section 7C(1) also applies to loans made by companies connected to natural persons, this newsletter will focus solely on loans made by natural persons to trusts.
When a loan, advance or credit is extended by a natural person directly or indirectly to a connected trust, section 7C(2) stipulates that no deductions, losses, allowances, or capital losses may be claimed by the lender concerning the loan’s disposal or failure to repay it. Essentially, there is no income tax benefit for the lender, regardless of whether the loan carries no interest or a low-interest rate.
Furthermore, section 7C(3) provides that a deemed donation arises for the lender on the last day of the trust’s year of assessment (being the last day of February each year). The deemed donation is calculated as the difference between the ‘official interest rate’ and the actual interest charged. The ‘official interest rate’, in respect of a Rand denominated loan, is the ruling repurchase rate as published from time to time by the South African Reserve Bank plus 1%.
Focus on section 7C(5)(e) and the proposed amendment
The key provision in focus for the 2024 Draft TLAB is section 7C(5)(e), which currently excludes certain transactions from the application of the deemed donation rules where those transactions qualify as ‘affected transactions’ under the transfer pricing (“TP”) provisions of section 31(1) of the Act.
For a transaction to be classified as an ‘affected transaction’ under section 31(1), the following conditions must be met:
- The transaction must occur between a SA resident and a non-resident connected person, not on an arm’s length basis, and
- The transaction must result in a ‘tax benefit’.
The arm’s length interest rate refers to the rate of interest that would be charged in a transaction between unrelated parties, where each party is acting in their own best interest. This rate reflects what is typically available in the open market for similar loans and no ‘safe harbour’ rates apply.
The application of section 31(1) is best explained through a practical example where Person A, a SA tax resident individual, makes an interest-free loan of R10,000,000 to an offshore trust where Person A is also one of the discretionary beneficiaries. Further complications could arise on application of the attribution rules under section 7(8) together with section 31(1), but for the sake of simplicity have been excluded from this newsletter. If the arm’s length interest rate (i.e. the rate at which the trust would borrow from a bank) is 5%, and the ‘official rate of interest’ is 9.25%, then section 31(2) requires that the tax payable by Person A be calculated as if the transaction occurred on an arm’s length basis as follows:
- Primary Adjustment: The difference between the arm’s length interest rate and the actual interest charged is subject to income tax in the lender’s hands (Person A) at their marginal tax rate.
- Secondary Adjustment: The difference between the arm’s length rate and the actual interest charged is also treated as a deemed donation in the case of an individual.
Proposed amendment to Section 7C(5)(e)
The 2024 Draft TLAB proposes amending section 7C(5)(e) to address an inconsistency between the trust anti-avoidance provisions in section 7C and the TP rules in section 31. The current interaction between these provisions can create an anomaly where cross-border low-interest or interest-free loans to trusts are taxed at a lower rate under TP than under the section 7C provisions, potentially leading to improper tax structuring and erosion of the tax base. The amendment aims to ensure that the exemption from section 7C applies only to the portion of the loan that has been subject to a TP adjustment, thereby aligning the provisions with the intended policy and preventing unintended tax benefits. Essentially, in cases where the ‘official rate of interest’ exceeds the arm’s length rate, a top-up tax in the form of a deemed donation would apply, ensuring that taxpayers cannot exploit the TP exclusion under section 7(5)(e) to minimise donations tax.
Illustrative example of the proposed amendment
Consider the earlier example where Person A, a connected person to the trust as a discretionary beneficiary, made an interest-free loan of R10,000,000 to an offshore trust. If section 7C applied, the deemed donation would be R920,500 (R10,000,000 x (9.25% – 0%)), with a donations tax liability of R164,100 (calculated as (R920,500 – R100,000) x 20%, assuming no other donations were made during the year).
Under section 31(2), the tax consequences would be:
- Primary Adjustment: R10,000,000 x (5% – 0%) = R500,000, included in Person A’s taxable income, taxed at a maximum marginal rate of up to 45%.
- Secondary Adjustment: R10,000,000 x (5% – 0%) = R500,000, with a donations tax liability of R80,000 (calculated as (R500,000 – R100,000) x 20%, assuming no other donations were made during the year).
Hence, with the proposed amendment, Person A would need to pay a top-up tax on the difference between the ‘official rate of interest’ and the arm’s length interest rate, resulting in a total donations tax liability of R164,100 instead of R80,000.
Conclusion and takeaway
The proposed amendment to section 7C highlights the tightening of anti-avoidance provisions, particularly concerning offshore structures funded from SA. This change could result in a higher tax liability for taxpayers by eliminating the current advantage of the section 7C(5)(e) exclusion when the ‘official rate of interest’ exceeds the arm’s length rate. Therefore, it is crucial for taxpayers to reassess their international tax planning strategies to avoid unexpected and potentially significant tax consequences.
if you require guidance on exchange control or any international tax related aspect. Please follow us on social media
to keep track of tax-related developments.