Section 7C of the Income Tax Act explained

What is section 7C?

This section of the Income Tax Act is an anti-avoidance measure aimed at transactions between connected persons and trusts, where a trust is funded by low interest or interest-free loans. This is usually done to ensure that assets form part of the trust’s capital, and the funder (who is usually a trustee or founder of the trust) allows for the transfer of ownership of the assets, and the creation of a loan account in said person’s favour.

The sections allow for any loan, advance or credit by a connected person, directly or indirectly to a trust, and this loan, advance or credit incurs no interest, on the loan, advance or credit, or incurs interest at a rate lower than the official rate, an amount equal to the difference between the amount of interest incurred, and the amount it would have incurred had an acceptable interest rate (official rate)  been used, will be deemed as a donation in the hands of the lender. For purposes of this section, the same principle applies where a company who is owned by trust loans on terms that are not regarded as commercial or market-related and no interest is charged.

What is the reasoning behind section 7C?

Trusts have traditionally been a very popular estate planning tool. In the past, the practice was to sell growth assets to a trust and to then extend an interest-free loan to the trust for that sale price. That would mean that the estate of the seller would be pegged at that value because the loan would not increase in value as time goes by while the assets would grow in the trust. Section 7C seeks to address this practice, as it is argued such a transaction should be seen as having no commercial sense, as only the trust benefits. The seller earns no interest on the loan and hence derives no value or benefit.

How does section 7C work?

Section 7C deems the interest that is not levied or charged on an interest-free loan, as a deemed donation on the last day of each tax year for a loan that was outstanding for any period during that preceding tax year.

The interest forgone is calculated by using the official interest rate in the 7th Schedule to the Income Tax Act, currently being 7.25%. This would be regarded as a deemed donation on the last day of the tax year and as a consequence donations tax would be levied on that donation.

Where there is a low interest-bearing agreement, the difference of the official interest rate and the lower interest rate will determine the deemed donation.

Trusts and loan accounts

Should I be charging interest on a loan, advance or credit to a Trust?

Making section 7C practical will require the use of a few examples to illustrate its effect.

Example 1

A loan in the amount of R10 million is advanced by an individual to a trust with no interest charged by the lender. The individual will choose to apply his annual donations tax exemption of R100,000.00 to the deemed donation.

The deemed donation will be R725,000 (R10 million x 7.25%). The individual then applies his annual exemption of R100,000.

The donations tax liability will be calculated as follows: R625,000 x 20% = R125,000 which the individual will be required to pay.

Example 2

A loan in the amount of R10 million is advanced by an individual to a trust with an annual interest charge of 5% by the lender. For this example, we will ignore the lenders annual donations tax exemption.

The deemed donation will be calculated as follows: R10 million less x 2.25% (the difference between interest levied and the official rate or 7.25% – 5%). The deemed donation will be R225,000.

The actual donations tax liability is then R225,000 x 20% = R55,000. The lender may now apply his annual R100,000 donations tax exemption.

It is clear that the non-charging of interest, or charging at a lower rate, may result in an increase in personal tax liability for the lender.

This article is a general information sheet and should not be used or relied upon as professional advice. No liability can be accepted for any errors or omissions nor for any loss or damage arising from reliance upon any information herein. Always contact your financial adviser for specific and detailed advice.  Errors and omissions excepted (E&OE)