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.