June 2017

UKnow Editorial – June 2017

One of the services that we offer to our clients is to act as an independent trustee in their trusts. This is a very important appointment and independent trustees must fully understand and accept their fiduciary duty in this regard. The benefit of appointing a trusted business professional is that there usually already exists a relationship of trust built up over a period of time. In addition to this, the person acting as the independent trustee will have the in-depth knowledge of their client’s business and private environment in which the trust is generally structured. Unfortunately, due to the extent of risk and administrative burden taken on by the independent trustee, the costs of appointing such trustees are increasing. The Chief Master recently issued a directive on various matters when dealing with trusts. In this directive, the requirements for the independent trustee are clearly set out. Please read our article in this regard, and in fact the entire directive if you are involved in trusts in any capacity. We will also be communicating with our clients in this regard shortly.

Our second article in this newsletter is a very interesting one on the deduction of interest expenses against interest received, based on the way SARS allowed the application of Practice Note 31 in the past. The judgment delivered in a recent court case however changes things.

We hope that you find our newsletters interesting and informative. As always, if you want to respond to or comment on any of our news items or other relevant information, please contact us at news@unikone.co.za or 022 – 482 1169, or join the conversation on our social media platforms on Linkedin and Facebook.

Warm regards until next month.

Oddette Boshoff

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Requirements for Appointing an Independent Trustee

The Chief Master recently issued Directive 2 of 2017, to take effect from 6 March 2017. The directive is titled “Trusts – Dealing with Various Trust Matters”, and was issued to ensure uniformity in all Master’s offices in South Africa with regards to the administration of trusts.

The directive deals specifically with the requirements for independent trustees in paragraph 3.8.

The appointment of an independent trustee will be required for all “family business trusts”. This type of trust is defined in the directive as:

  • “A trust where the trustees have the power to contract with independent third parties, thereby creating trust creditors; and
  • The trustees are all beneficiaries, and
  • The beneficiaries are all related to one another.”

The qualifying criteria to be eligible to be appointed as an independent trustee are also set out in the directive:

  • The person must be an independent outsider who fully understands the fiduciary duties to be taken on, who will ensure that the trust functions properly and who will ensure that the provisions of the trust deed are observed.
  • The person must be aware that any failure to observe his or her duties as an independent trustee may result in action for breach of trust.
  • The person may be a professional accountant, admitted attorney, a trust company, etc., but does not necessarily have to be such a professional person.
  • The person may have no family relation or connection to any of the existing or proposed trustees, beneficiaries or founder of the trust.
  • The person must be competent to observe the actions of other trustees and to guide and advise them to ensure that their conduct is in observance of the provisions of the trust deed as well as applicable legislation.
  • The person must have knowledge and experience of the business environment in which the trust will operate.
  • The person is expected to be knowledgeable about the legislation applicable to trusts and would therefore be expected not to conclude or approve transactions that may be invalid.
  • The person will not have any interest in the trust as a beneficiary.
  • The person is not disqualified to act as a trustee in terms of the Trust Property Control Act, 1988.

The independent trustee can and should be nominated specifically when the trust is registered with the Master. If the trust deed does not make provision for the appointment of an independent trustee, the Master will consult with the founder, the existing trustees and any beneficiaries with a vested right in the trust to nominate an independent trustee. However, the Master is not bound by that nomination and may instead appoint a person that he considers suitable.

The independent trustee is entitled to a remuneration along with any other trustees in the trust. Due to the criteria set out in the directive as well as the significant risk and the extent of work and administration involved for the independent trustee, it is expected that the fees paid to such trustees will increase. However, the benefit of having a competent independent trustee applying his or her expertise and knowledge to ensure that the interests of the beneficiaries are looked after is worth its weight in gold.

As a result of this directive, two new forms updated with requirements contained in the directive were issued by the Master for the appointment of independent trustees, namely the J417 Acceptance of Trusteeship as well as the prescribed Sworn Affidavit by Independent Trustee.

The directive can be read at http://www.justice.gov.za/master/directives.html .

Oddette Boshoff

Director

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Practice Note 31 and the Deduction of Interest

“To give is better than to receive”.  Not the first phrase that comes to mind when one thinks of the revenue service.  However, once in a blue moon, the powers that be magnanimously decide to permit taxpayers to do something that is, strictly speaking, not allowed by the Income Tax Act.

Until now, the deduction of interest incurred by ordinary taxpayers has been one of those rare occurrences.  The general rule for deductions is laid down in sections 11(a) and 23(g) of the Act.  In determining the taxable income from carrying on any trade, a taxpayer is allowed to deduct expenditure and losses actually incurred in the production of the income, only to the extent that those moneys were laid out or expended for the purposes of the taxpayer’s trade.

Now, the simple act of investing money or advancing a loan to another party (unless you are a moneylender) does not, by the furthest stretch of the imagination, constitute a “trade”.  Enter Practice Note 31.  Issued in 1994, paragraph 2 of the Note was like manna from heaven for taxpayers who both earned and incurred interest:

While it is evident that a person (not being a moneylender) earning interest on capital or surplus funds invested does not carry on a trade and that any expenditure incurred in the production of such interest cannot be allowed as a deduction, it is nevertheless the practice of Inland Revenue to allow expenditure incurred in the production of the interest to the extent that it does not exceed such income. This practice will also be applied in cases where funds are borrowed at a certain rate of interest and invested at a lower rate. Although, strictly in terms of the law, there is no justification for the deduction, this practice has developed over the years and will be followed by Inland Revenue.

And follow it, they did.  To such an extent that, very often, taxpayers were allowed to set off any interest incurred against any interest earned and it was seldom that SARS even tried to establish whether the interest was incurred “in the production” of the interest income.  That is, until the Tax Court delivered its judgment against Mr X on 13 December 2016.

Mr X is a solicitor, admitted in England and Wales, but not allowed to practice as a qualified attorney in South Africa.  Nevertheless, he was employed by a South African law firm as an “Equity Director” in all but name.  In terms of his contract of employment, he was obliged to contribute a predetermined amount to a “director’s loan account”.  In theory, the firm could have required Mr X to borrow a lump sum to deposit in the account.  Instead, the conditions of his contract made provision for the amount to be deducted proportionally from Mr X’s remuneration until the predetermined amount was reached.  Interest accrued on the outstanding balance of the loan account at the prime rate.  Depending on the availability of funds, the Finance Director would recommend occasional distributions of interest.

A year later, Mr X decided to acquire a residence and, like most of us do when buying a house, secured a mortgage bond from a bank.  This home loan was later converted to an access bond, whereby Mr X had “paid in and drawn on the facility to fund any of his expenses”.  Specifically, any distributions of interest from his loan account were deposited into the bond.  The bond carried interest at prime less 1.85%.

Relying on Practice Note 31, Mr X claimed the interest incurred on the bond as a deduction against the interest earned on the loan account.  He was of the opinion that there was a sufficiently close link between the interest incurred and interest earned which would justify the conclusion that the interest was incurred in the production of the interest income.  Furthermore, he argued that had it not been for the compulsory contributions in respect of the loan account, he would have been able to utilise those funds to repay the bond and, accordingly, would have paid less interest on the home loan.

SARS disallowed the deduction as well as the taxpayer’s objection, on the basis that a deduction will only be allowed where funds are borrowed and then advanced to a third party as an interest-bearing loan.  In Mr X’s case, the funds were borrowed to buy a house and not for the purpose of granting a loan to his employer.

The Court’s decision to uphold SARS’ assessments that disallowed the deduction of interest was mainly based on the following:

  • The source of the funds that were advanced to the employer as the loan account was apparently a deciding factor. Practice Note 31 refers to the investment of capital or surplus funds.  Mr X earned interest on “funds which have accrued to him as income and retained by his employer” and, therefore, “interest income earned by the appellant on his loan account is not interest income on capital or surplus funds invested, but simply interest income earned on his loan account on funds retained by the appellant’s employer in terms of the contract of employment”.
  • SARS argued that the application of Practice Note 31 requires two steps. Firstly, the taxpayer has to borrow the funds and secondly, the taxpayer must advance those funds to a third party in the form of an interest-bearing loan.  This argument, although neither specifically accepted or rejected, seems to underpin the Court’s ultimate decision.
  • For an expense to be deductible there must be a “sufficiently close link between the expenditure and the income earning operations, having regard to both the purpose of the expenditure and to what it actually effects”. In the case of Mr X, the funds were borrowed for the purpose of buying a house.  Therefore, interest was incurred to finance the acquisition of a capital asset.  The monies were neither borrowed for the purpose of earning interest income, nor did it have the effect of earning interest.
  • Ultimately, there is not a sufficiently close connection between the interest earned and the interest incurred to justify a conclusion that the expenditure was incurred in the production of the interest income.

There are a few aspects of the Court’s decision that may be open to debate.  For instance, there seems to be great emphasis on how Mr X advanced the funds to his employer.  Although the loan was created from amounts retained from Mr X’s remuneration, it is important to remember that the funds first accrued to him.  Once invested, after-tax income can very easily be classified as capital.  Furthermore, while the Practice Note refers to the investment of “capital or surplus funds”, it does not necessarily require a once-off investment.  It may be argued that what happened every month was that Mr X, albeit under compulsion, made an investment by forwarding an amount to his employer as an interest-bearing loan.  Had it not been for the specific provisions of his employment contract, he could very well have paid these contributions from his access bond.  In fact, what probably happened was that Mr X’s cash flow suffered a bit as a result of the deduction of his contributions, and therefore he was required to dip into his access bond.  Bearing in mind SARS’ two-step approach to Practice Note 31, requiring the taxpayer to first borrow funds and then advance these funds to a third party, this would have been a case of Mr X putting the cart before the horses.

The Court’s decision was based on the facts of this particular case, with the nature or source of the “investment” apparently playing a particularly important role.  Different facts may have resulted in a different outcome.  What is clear, however, is that this decision has turned the way SARS applies Practice Note 31 on its head.  The lenient approach adopted in the past will most likely make way for a strict application.  Interest paid be will no longer allowed ‘willy-nilly’ as a deduction against interest received. In order to prove that the interest expense was incurred in the production of the interest income, taxpayers will have to show a connection between the interest incurred and the interest earned.

Annalize Duvenage

Specialist Tax Consultant

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