26 Oct 2020

The Big Debate: Are trusts required by SA law to pay interest on any outstanding loans to SA lenders?

We have seen much confusion on this important topic and here we hope to provide some simple answers to help you navigate this question.

TAKEAWAY: A popular way of financing a trust from South Africa is to sell assets to the trust and leave the consideration outstanding as a loan, or to loan funds to the trust. There have been many changes to the treatment of no interest or low interest loans for South African tax. Many now insist on charging interest, but this is not the only answer.

Is a trust required to pay interest on a loan owed to a South African person?

No. There is no requirement that a loan owed to a South African lender should be interest bearing. However, where interest is not charged,  or charged at a low rate, certain anti-avoidance measures will apply. Depending on the circumstances, the interest not charged will be subject to donations tax in the hands of the lender (the ‘deemed donation provision’), or the lender will be taxed as if interest was actually charged (the ‘transfer pricing provision’). Therefore, the law does not require interest to be charged, but provides for certain tax mechanisms where interest is not charged at a market-related rate.

Where the deemed donation provision applies, the deemed donation is the difference between the interest charged and the official rate of interest (a defined rate in South Africa).


For example, assuming a  loan of £10 million, with zero interest, and an  official rate of interest of  4.5%, the total donation for the year will be:

 £10 000 000 x (4.5% – 0%) = £450 000

Donations tax is levied at 20% of the first R30m (about £1,5m) of donations per year, and 25% thereafter. Assuming that the lender made no other donations that year, the lender will pay donations tax of £90,000 for the year on the interest not charged.


Where the transfer pricing provision applies, the tax legislation deems interest to have been charged. However, where the transfer pricing provision applies, the deemed donation provision cannot also apply.


For example, assuming a  loan of £10 million, with zero interest, and a market-related rate of interest of  4.5%, the deemed interest  for the year will be:

  £10 000 000 x (4.5% – 0%) = £450 000

The lender is deemed to have received £450 000 of interest income for the year. Income tax in South Africa is charged on a sliding scale of 18% – 45%. Assuming that the lender is subject to the marginal tax rate of 45%, the lender will pay income tax of £202 500 on the deemed  loan interest for the year.


It is important to note that, in addition to the deemed interest or transfer pricing provisions, attribution provisions may apply to tax the income of the trust in the hands of the lender where interest is not charged at a market-related rate.

What happens if interest is charged?

Where the South African lender charges interest on the loan, the interest payable by the trust, whether actually paid or not, is income accruing to the lender. This interest income is subject to income tax in South Africa.


Assuming a loan of £10m and a market-related rate of interest of  4.5%, the interest income for the year would be as follows:

         £10 000 000 x 4.5% = 450 000

Assuming that the lender is subject to the marginal tax rate of 45%, the lender will pay income tax of £202 500 on the loan interest for the year.


The great equaliser: estate duty

Depending on the circumstances, the tax for the lender in any year could be the same regardless of whether interest is charged,. Not charging interest brings the anti-avoidance provisions into play, which can be complicated. Why would a person then choose to not charge interest on a loan?

While the year to year cost for the lender may be the same, the big difference comes in on estate duty. When interest is not charged, the value of the loan remains stagnant and the estate duty on the loan does not increase. However, where interest is charged, the value of the lender’s estate increases year by year (either with the value of the loan increasing as interest accumulates, or in the lender’s personal estate if the trust actually pays the interest). This results in an additional cost of 20% or 25% at death, depending on the lender’s estate value, on the interest accruing each year.

As the estate duty is only payable at death, this hidden cost is often overlooked, even though it can place a substantial burden on the lender’s estate.  In our example above, over a period of 20 years the estate duty effect  where interest is charged can be £1,8 million to £3,5 million. In comparison, the estate duty effect of not charging interest is £0.*

The bottom line?

There is no requirement to charge interest.

  • If interest is charged, it is necessary to consider both the annual income tax cost as well as the estate duty effect at death on the growing value of the loan.
  • If interest is not charged, the tax legislation will deem interest to have been charged, or a donation to have been made. When considering the total cost of this option, it is necessary to also take into account the attribution rules which taxes (some) of the income in the trust in the lender’s hands.

It has been our experience that, depending on the circumstances of the planner and his family, it may be the more cost-effective option, for a tax perspective, not to charge interest.

However, tax is not the only consideration when making this decision. It is merely one of the consideration when deciding on how the funding to the trust should be structured. Our view is that the holistic cost and implications of all options should be considered before making such a weighty decision, and we would advise any person to take advice in such a case.

Contact us should you wish to review the loan arrangements of the trusts you manage.

* The estate duty on the initial loan value being the same between the two scenarios.

26 Oct 2020

Offshore trustees: How to add value to your South African client at little cost to your company

We are often asked by offshore trustees how they can expand their business in South Africa. The answer is quality service, especially around the following few important considerations which we touch on here.

Anticipating reporting needs

The South African tax year runs from 1 March to the last day of February of the following year. South African beneficiaries need to declare whether they have received a distribution from any trust, and a South African financier may need to declare certain income of the trust in their tax return, even if it did not accrue to them. Offshore trustees therefore, need to be sensitive to the reporting requirements of their South African beneficiaries and funders.

Offshore trustees may, for example, want to consider whether a reporting period of 1 March to the last day of February is not perhaps more appropriate than a January to December period, where the primary reporting obligations arise in South Africa.

Distributions

A South African beneficiary needs to declare any distribution received and disclose what portion of the funds received is paid from interest income, dividend income, capital gains (calculated based on South African rules), or original capital (the amount settled on the trust).

Making a distribution, and then leaving the beneficiary in a lurch as to the nature of the funds, may result in the total amount being taxed as interest income, even if the whole amount consists of original capital. This is important, as the marginal tax rate for interest income is about double that of dividends or capital gains tax, and no tax is payable at all on distributions paid from original capital.

We would recommend that any trustee be proactive and plan distributions together with the beneficiaries. Ideally, distributions should be planned at the start of each year and be made from income, leaving the original capital available for making unplanned or emergency distributions tax-free.

Original capital

As original capital can be distributed free of tax in South Africa, accurate records of the capital in the trust should be kept. When a distribution is made, the trustee should record the amount that is being paid from original capital. The trustee should have a clear record of the original capital of the trust (all settlements received), the distributions made from original capital, and the remaining balance of original capital.

In such a way, the trustee is helping to protect the trust funds distributed from unnecessary tax, as the South African tax authority will tax original capital as income – potentially at 45% – if it cannot be proved that the distribution was made from original capital.

TAKEAWAY: A trustee insensitive to the South African beneficiary’s reporting needs, can wipe away 45% of the value of the trust funds distributed by not keeping the necessary records. No amount of careful investing can make up for that. On the other hand, at minimal cost to the trustee, the value of the trust fund on distribution can be protected and maximised for the South African beneficiary by good record keeping.

Using income to settle the trust’s costs

Another way a trustee can easily increase the value of the trust fund for a South African beneficiary, is to pay the trust’s costs – including trustee fee – from income. In preparing the accounts for the trust, the trustee can show that the trust’s costs are settled first with interest income (current or accumulated), then from dividend income, then capital gains, and lastly from original capital. This ensures that the highest-taxed funds are used for costs, leaving the lowest taxed funds available for distribution to beneficiaries.

It is small considerations such as these which add immense value to the South African client and sets the offshore trustee apart from its competitors.

We are happy to provide complimentary training to teams working with South African clients or beneficiaries; please contact us if you are interested.

26 Oct 2020

Understanding international wealth diversification for SA clients in the right context

Guest article by Lindsay Bateman of Brooks Macdonald
28 September 2020

South African resident clients today can internationalise their wealth through specific exchange control concessions, meaning such individuals can apply for an annual allowance of ZAR10m per calendar year, a far greater and more flexible scenario than was the case some years back.  With the right advice and support from their trustee, or independent advisor, they can apply for a “tax clearance certificate”, production of which at their local bank will facilitate the external transfer of these funds to their trustee to position with their selected offshore asset manager, in their agreed and risk aligned international investment strategy. Such certificates are valid for a twelve-month period from date of issuance.

Today’s world is ever more challenging as the impact of Covid-19 continues to disrupt economies, lifestyles and earning power, and South Africa is by no means an exception. Because of this, the benefits of true international wealth diversification for South Africans is being increasingly recognised by clients and trustees alike.

South Africans investors seek out good quality, regulated and experienced advisors and trustees that understand both the South African and international implications of their intended investment path, and the use of tailored structures to hold fixed property, investment portfolios, intellectual rights and other assets remains a well-trodden path.

Trustees pay attention to several key factors when selecting a suitable investment strategy and provider, which include the following:

  • Investment provider: Are they reputable, established, independent, regulated in both their own jurisdiction and in South Africa? Are they of sufficient size in terms of assets managed and investment managers employed to provide substance and continuity, offer a range of suitable investment services, travel to SA regularly to meet clients and have deep knowledge & experience of both the SA and international investment and regulatory frameworks?
  • Counter-party risk: Is the trustee placing full reliance on the investment provider’s balance sheet, or does the investment firm “ring-fence” client assets and place them with a large highly rated global banking group as nominee?
  • Investment services: Are these accessible in terms of minimums, offer transparent and competitive all-in fee levels, provide a range of currency options (USD, GBP and Euro)? Do they offer a range of risk profiled investments from very cautious to growth orientated mandates, provide daily liquidity, and cater for any short-term unexpected redemptions without penalty or delays?
  • Relationship support: Is online access in place for both the trustees and if required, the underlying client? Will the investment manager meet the clients in SA alongside the trustees, or on request, to conduct regular portfolio reviews? How easy is it to contact the investment manager to get information provided, SA tax reporting as may be required, or other statements, valuations and performance reporting? Can this reporting be tailored to meet the specific needs of the trustees or clients? Is a dedicated team in place at the investment firm with clear experience and knowledge of the region, and a commitment to ongoing and regular travel?

South Africans are besieged with offers to “invest” internationally, with some exploiting the demand for such opportunities by offering highly attractive sounding returns and often exotic and complex investment strategies. Trustees can help protect clients from themselves in such cases, and through their role to protect and grow assets for the beneficiaries of the trust, ensure that the best possible investment manager, strategy, risk profile and ongoing investment returns are all in play. It is often only in the long term that clients realise and appreciate the powerful benefits that can be delivered through a quality trustee working hand in hand with an independent, regulated and experienced investment manager.

 

26 Oct 2020

Hatstone named as one of the world’s top private client firms

Hatstone Lawyers has been named by eprivateclient as one of the world’s top private client firms in its 2020 Top Offshore Law Firm rankings.

The rankings are based on a survey of over fifty leading private client firms.  They recognise the success of Hatstone’s fast-growing team of partners, lawyers and other professionals in the BVIJerseyLondon, Panama and South Africa, in providing outstanding legal, fund administration, trust and corporate services to private and corporate clients across the globe.

Group Partner, Simon Vivian said: “We are delighted to be recognised by eprivateclient.  Our clients consistently tell us how much they value our global team’s pragmatic and timely advice to guide them through the complex legal and corporate challenges of managing transactions and assets across multiple jurisdictions.  We are a young and dynamic firm, but we have a wealth of experience across all areas of offshore practice and deep relationships with other leading firms around the world.  It is very pleasing to see this recognised as we continue to develop the compelling offering for our clients which eprivateclient has recognised.”