Much has been written about Treasury’s latest attempt to curb the use of trusts as tax avoidance (not evasion!) vehicles, but it seems the jury is not quite out. The main issue that remains undecided is whether interest accumulating on unpaid distributions falls within the ambit of the provision.
When faced with an interpretation conundrum, it is always good to heed the advice of Julie Andrews in The Sound of Music: “Let’s start at the beginning; a very good place to start.”
What section 7C aims to target is the avoidance of wealth taxes (estate duty and donations tax) where interest free loans are made to a trust. The donor’s asset (the capital amount made available to the trust) remains stagnant, while the capital asset acquired by the trust grows in value. Had the donor simply transferred the asset to the trust, he would have been liable for donations tax. In addition, the donor would often waive or reduce the loan capital using his annual R100 000 donations tax exemption. Doing so, he reduces the value of his assets for estate duty purposes. The absence of interest results in an erosion of the income tax base.
The anti-avoidance provision first saw the light in the 2016 Draft Taxation Laws Amendment Bill. In its original form, it was downright scary:
- The deemed interest in the loan, i.e. the difference between interest calculated at the official rate (Seventh Schedule fringe benefit rate) and the interest actually charged, would be subject to income tax in the hands of the lender.
- The deemed interest would not qualify for the annual interest exemption, thus the full amount of “interest” would be treated as taxable income.
- Any waiver or reduction of the loan amount would be subject to donations tax, with the lender being denied the annual donations tax exemption.
- The lender would not be allowed to claim any deduction, allowance or loss on the waiver or cancellation of the loan.
- Finally, the amount of income tax payable on the loan would have to be recovered from the trust within three years. If not, it would be treated as a further donation to the trust.
Needless to say, these proposals were not very well received, the main criticism being that Revenue was trying to cover a shortfall in donations tax and estate duty by imposing income tax. Fortunately, in this case, the cries did not fall on deaf ears and the legislators went back to the drawing board.
The following extract from the Final Response Document issued by SARS and National Treasury shows that they made a complete U-turn:
The interest forgone in respect of interest-free or low interest loans will no longer be treated as income but will be treated as an on-going and annual donation made by the lender on the last day of the year of assessment of the lender.
The revised section 7C came into effect on 1 March 2017 and applies to any amount owed by a trust in respect of a loan, advance or credit provided to the trust before, on or after that date. It applies regardless of whether the loan was made by a natural person who is a connected person by that trust, a natural person who is a connected person to that person, or a company in relation to which that person is a connected person. In other words, there is no getting away.
The difference between the “official rate of interest” and the interest charged on the loan constitutes a donation. Initially the official interest rate was linked to the fringe benefit interest rate determined in the Seventh Schedule to the Income Tax Act, currently 7,5% per annum. However, Treasury perhaps felt that they had surrendered too much with the watered-down edition of section 7C, and for years of assessment commencing on or after 1 January 2018 the “official rate of interest” is now linked to repo rate, with 100 basis points added for good measure.
On the upside, the annual donations tax exemption is back in play to give some relief.
Time to tackle the elephant in the room. From the onset one of the main causes of concern was the matter of beneficiaries’ loan accounts, or “unpaid benefits”. These consist of amounts distributed to beneficiaries but not paid to them and are a common feature of many trusts. Once again, the deliberations leading to the final version of the provision are of value:
Comment: The exclusion of vesting trusts from the application of the anti-avoidance measure is welcomed. However, it does not go far enough and should also exclude discretionary trusts where the income of the trust vest in the beneficiary but are not actually paid to the beneficiary.Response: Noted. This issue stems from the interpretation that vested but accrued distribution are regarded as a loan, advance or credit made by the beneficiary to the trust. This is an interpretation issue that has not been tested and consideration will be made on the provision’s practical application in such scenarios.
The Explanatory Memorandum on the Taxation Laws Amendment Bill 17B of 2016 goes a step further:
An amount vested by a trust in a trust beneficiary that is not distributed to that beneficiary will, however, qualify as a loan or credit provided by that beneficiary to that trust if that non-distribution results from an election exercised by that beneficiary or a request by that beneficiary that the amount not be distributed or paid over, e.g. if the beneficiary has reached the age at which a vested amount must be paid over or distributed to him or her and the trustee accedes to a request by that beneficiary that this not be done; or the beneficiary enters into an agreement with the trustee in terms of which the amount may be retained in the trust.
So, it seems that as long as the beneficiary does not explicitly agree to the funds being retained in the trust, the unpaid benefit should not be treated as a loan or credit advanced to the trust. Somehow, this is not comforting enough to put beneficiaries with unpaid benefits at ease. Especially if the rather nasty prototype of the original section 7C is any indication of how seriously SARS wishes to curb the use of trusts to avoid (any) tax. And remember, agreements come in various shapes and forms. It is not inconceivable that, in the scenario sketched in the Memorandum, SARS may view a failure by the beneficiary to request payment of distributed amounts as a tacit or implied agreement that causes the whole arrangement to fall foul of section 7C.
In trying to get to the bottom of this, there have been two guiding lights. The first is the stated purpose of section 7C. The Explanatory Memorandum is quite straightforward; the aim is to “limit taxpayers’ ability to transfer wealth to a trust without being subject to tax”. A beneficiary who does not receive payment in respect of distributions is surely not transferring his wealth to the trust. Or is he?
The second guiding light comes from SAIT’s Piet Nel in the course of a recent tax update webinar, and specifically his focus on a verb. Section 7C applies to a loan, credit or advance provided by a person to the trust. He used the Oxford Living Dictionary to define “provide” as “make available for use”. To provide requires more than mere acquiescence. If the vested funds merely stay in the trust, held in trust for the benefit of the beneficiary, there should be no problem. However, what if the trustees decide to use those funds to acquire a new asset or enhance the value of an existing asset? Then we are back to exactly the kind of mischief the legislation aims to prevent.
And not wanting to be a prophet of doom, there is another tiny word that causes ominous ripples in the back of the mind. Time to call a spade a spade. Many trusts are used as vehicles to deflect income tax and capital gains tax to beneficiaries who are taxed at a lower rate. This is perfectly legal. Section 25B provides that to the extent to which an amount has been derived for the immediate or future benefit of any ascertained beneficiary who has a vested right to that amount during that year, that amount will be deemed to have accrued to that beneficiary. Now, in the context of income tax, “accrued” has been held to mean “unconditionally entitled”, even if payment is to be effected somewhere in the future.
What niggles is this: In order to have a favourable tax treatment of trust receipts and accruals, we need to have a beneficiary with a vested right to the income or capital gain. On the other hand, the beneficiary’s right to his share of that income or capital gain needs to be watered down and be made dependent on an additional decision to actually make the payment, lest it be regarded as the tacit provision of a loan, advance or credit.
Once again, back to the Explanatory Memorandum:
An amount that is vested irrevocably by a trustee in a trust beneficiary and that is used or administered for the benefit of that beneficiary without distributing or paying it to that beneficiary will not qualify as a loan or credit provided by that beneficiary to that trust if
- the vested amount may in terms of the trust deed governing that trust not be distributed to that beneficiary, e.g. before that beneficiary reaches a specific age; or
- that trustee has the sole discretion in terms of that trust deed regarding the timing of and the extent of any distribution to that beneficiary of such vested amount.
It is significant that the Memorandum makes reference to that beneficiary and such vested amount. Can it be inferred that that amount may then not be applied for the benefit of any other beneficiary? Prof. Walter Geach’s comments in a seminar hosted by CM2 in August 2017 certainly seem to point in that direction:
“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.”
What is required to steer clear of section 7C’s tentacles is essentially a two-tier exercise of discretion by the trustees. First, to vest an amount in a beneficiary and then, later, to pay that amount to the beneficiary. Prof. Geach explains as follows:
“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’”.
With conditional vesting we can play it safe for purposes of section 7C. The question is: Are we then still toeing the line for purposes of section 25B?
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Specialist Tax Consultant